-233-
payment and closeout netting contract becomes bankrupt or
insolvent, payment and closeout netting reduces credit exposure
of the nondefaulting party to the bankrupt counterparty.
FNBC had a program that took netting into account but
apparently chose not to use it. FNBC’s failure to take netting
into account in determining its credit adjustments overestimated
the credit adjustments and did not reflect the true value of its
swaps. In fact, FNBC acknowledged as much in its annual
statements when it reported that the credit exposure amount was
overstated because FNBC ignored the effects of netting and other
credit enhancements.
7. Static or Dynamic Procedure
FNBC ascertained its credit adjustments using a static
procedure. Petitioner argues that FNBC’s static procedure was
reasonable and consistent with industry practices and did not
overstate the credit adjustments compared to a dynamic model.
Petitioner asserts that the G-30 report endorsed the use of
straight-line amortization of a credit adjustment over the life
of the related transaction as the most common approach in the
industry.
We believe that a static procedure such as that used by FNBC
is contrary to the requirement of section 475 that a swap be
marked to market at each yearend. FNBC’s static procedure failed
to reflect (1) the changing market value of credit risk,
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