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considered in determining credit risk. By ignoring these
enhancements, a taxpayer such as FNBC fails to consider that a
counterparty’s credit rating may actually be equivalent to an AA
rating.
6. Netting
The parties dispute whether netting applies in determining
the fair market value of a swap. Respondent argues that it does.
Petitioner argues that it does not. We agree with respondent.
Market participants during the relevant years placed significant
stress on the use of netting agreements, and most of FNBC’s swaps
during those years were covered by ISDA agreements with netting
provisions. Netting lowered FNBC’s credit risk in that FNBC,
were it to be a nondefaulting party, could take advantage of
offsetting transactions in the event of counterparty default.
As a consequence of single- and multiple-transaction
netting, when one swap is above market to the dealer and another
swap between the same parties is below market to the dealer,
credit exposure is reduced given that the corresponding
obligations will be netted against one another. As a consequence
of closeout netting, if one swap is above market to the dealer
and another swap between the same parties is below market to the
dealer, then in the event of default, the dealer’s potential loss
will be limited because these obligations also will be netted
against one another. Moreover, even when one of the parties to a
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