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(2) movements in interest rates, (3) changes in its and its
counterparties’ credit ratings, and (4) the early terminations of
some swaps or their subsequent chargeoffs. In fact, as to the
last point, FNBC in some cases even claimed adjustments to reduce
yearend swaps income when the swap that gave rise to the alleged
credit risk was paid in full before yearend. Not only was there
no value included on the return in that case, but there was no
longer a risk of nonpayment. Under mark-to-market accounting,
FNBC must reestimate the value associated with credit risk for
its outstanding swaps at yearend, in light of the then-current
conditions affecting the value of credit risk. FNBC also must
record any decreases (increases) in this value as income (loss).
Parsons testified that only a dynamic procedure captures the
actual value of credit risk at a date later than the inception of
the swap. We agree. Whereas FNBC calculated the credit
adjustment only at inception, when the midmarket value was
probably very close to fair market value, the credit risk of a
party is most often affected after inception.78 As stated by
Duffie, what may amount to small numbers at the inception of a
swap turns into the real “meat and potatoes” of the credit
adjustments, which will manifest itself after inception. FNBC’s
78 The credit risk inherent in a swap may peak not at
inception or termination, but during the life of the swap, and
the credit risk inherent in a swap may be lower at inception and
termination than at any other point in the life of the swap.
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