FAS 133 Case Study

Fannie Mae: Using Shadow Processing
To Preview FAS 133 Hurdles

In a presentation at our FAS133.com seminar in New York in November of 1999, Kimberly Rawls, with Fannie Mae’s financial standards’ department, explained that the key to the smooth adoption process at this massive financial organization has been (1) senior management involvement from day one; and (2) a shadow processing through a FAS 133 accounting prototype. This case study, which has been updated to reflect progress made through the end of the first quarter of 2000, illustrates how a large company with massive FAS 133 exposures has approached a tall implementation challenge.

Some companies have limited exposures to FAS 133. Others are greatly exposed to the new derivatives accounting rule. Fannie Mae falls into the latter category. Among the world’s largest issuers of debt – and second to the US treasury – Fannie Mae issues over $800 billion of debt securities each year. "The use of derivatives products in our business is crucial," says Kimberly Rawls, senior project manager with the company’s financial standards department. "We use derivatives to hedge our debt issuance program."

Not surprisingly, Fannie Mae’s derivatives book is equally weighty. "On December 31, 1999 Fannie Mae had about $260 billion in notional derivatives contracts outstanding, with a market value gain of nearly $5 billion."

Getting a head start

Aware of its massive derivatives portfolio and of the FASB’s efforts to change derivatives accounting, Fannie Mae did not wait until June of 1998 (when FAS 133 was officially issued) to find out what it hold in store. Instead, senior management was very involved even before the first FAS 133 exposure draft (ED) was issued, commenting on the ED’s potential content in a white paper circulated among key managers.

Senior management remained very focused throughout the various ED stages. "In fact," says Ms. Rawls, "Our CFO and President met with the FASB on several occasions to discuss various issues, including the combination of derivatives and in particular, the combination of basis swaps with other swaps."

Hence, when the final statement was issued in June 1998, Fannie Mae was in the unusual position of being intimately familiar with many of its concepts. In contrast, in most MNCs, only the accounting department was somewhat familiar with the impending standards.

Once the standard was out, a team of individuals, from Ms. Rawls' department as well as representatives from financial accounting and reporting and treasury, met off-site several times to get a way from the day-to-day "and really digest the statement in whole. We also used the time to brainstorm about the various potential implementation issues."

Immediately, it became clear that deferring the effective date would be crucial, in particular for companies of Fannie Mae’s size and the scope of its derivatives activities. Fannie Mae hence became one of the first constituents to write a comment letter to the FASB requesting a deferral (see prior alert). Ultimately, other companies (encouraged by FAS133.com and their bankers and auditors) sent in more letters. "Hopefully, we played a role in deferring the effective date," Ms. Rawls says.

The key to success: leadership

Perhaps the key to the success of Fannie Mae’s implementation process has been the ongoing involvement of senior management. "At the beginning of 1999, our CFO mandated that a team of senior officers be assembled to provide the leadership for this project," Ms. Rawls says. And, to make sure senior managers keep focused on the project, the CFO tied the managers’ performance goals and bonus for the year to its success.

With the CFO’s blessing, a team of about 20 senior managers was created, including representatives from the following departments:

1. Treasury, perhaps more than anyone else, notes Ms. Rawls, was going to be most directly affected by FAS 133. "FAS 133 is going to totally change the way that they go about their business," she says. "They really are going to have to start thinking about the accounting impact before they execute anything.
2. The controller’s office, which will now be responsible for having to book FAS 133 transactions into the general ledger.
3. The systems department, since Fannie Mae quickly realized it was going to need a system that would be able to capture all required information so that it could report on it.
4. The planning department was also involved, to incorporate any potential income or equity volatility into the corporate planning model.
5. The strategy department was brought in, in order to come up with any ideas to possibly offset any earnings or equity volatility.
6. Internal audit was of course included.
7. The tax department was invited to join, given the continued gap between tax and accounting regulations (see also).
8. Finally, the legal department was involved in looking into the possibility of changing the language in some of the company’s derivatives contracts.

Getting the teams ready

In addition to the group of senior managers, Fannie Mae also convened a smaller group of representatives from the same eight departments. The task force took responsibility for the day-to-day running of the implementation process and is accountable to the senior management team.

The task force began meeting with senior officers on a monthly basis in March of 1999. Once the one-year delay was announced (in May of 1999), the meetings shifted to a bi-monthly schedule, but the group intends to resume its monthly meetings in June (2000). "We use the meetings to update the managers on the progress, inform them on any implementation issues or hurdles that we might be encountering, and use the opportunity to go over the balance sheet and income statement impact, assuming that we have already adopted 133."

Ms. Rawls says that the ability to show hard numbers to top managers was key to the success of the effort and to keeping their attention. "We were able to actually put numbers to the theory, so that they can really get their hands around it."

Taking inventory

With a vast portfolio of derivatives and a cross-functional impact, Fannie Mae faced a tall internal education challenge, and treasury was the first stop on the internal education "road show."

The treasurer’s staff will be most affected by this, Ms. Rawls points out. Instead of being able to do the trades and "defer" concerns about accounting to the backoffice, FAS 133 will force the front office staff to think about it first.

Together with a team of treasury professionals, Fannie Mae therefore developed an inventory of derivative transactions within the FAS 133 context. The company’s previous focus has been on risk management and collateral maintenance. The FAS 133 focus is obviously different.

Very quickly, the team found that the most effective way to inventory the company’s vast derivatives portfolio is chart out each transaction. "We actually drew them out on a Powerpoint slide, showing how each transaction looks," says Ms. Rawls. Next, each transaction slide got an attachment with the appropriate accounting treatment.

"Our ultimate goal is to have a book that has all of these transactions and the accounting treatment, so that the traders can use this as a reference guide when they are contemplating their trades." When the team first started, they expected to end up with five or six individual transaction models. "Last I counted, we were up to 55!" Ms. Rawls notes.

With the inventory completed, the transaction "manual" was handed over to the external auditors for a review and sign off. This was a critical step before Fannie Mae could move forward with any type of system development effort. "The last thing we wanted to happen is go down the path of developing a system, and then have our auditors come back and say that they disagree with our interpretation."

Meanwhile, the FAS 133 task force began to draft new hedge guidelines in mid 1999. The final version should be ready by the middle of 2000. Even then, predicts Ms. Rawls, "we will continue to update the hedge guidelines to reflect any changes in implementation guidance that surface during the second part of 2000 and beyond."

The FAS 133 Accounting "Prototype"

The transaction manual developed through the painstaking inventory process was then used to chart out the system requirements of FAS 133. "The system development team used the inventory document we created to develop the rules for the logic that the system would need to capture the right information."

The system was "affectionately" called the FAS 133 Accounting Prototype. It remains a prototype, since it reflects work in progress and is not running within any type of production environment within Fannie Mae, partly due to a year 2000 freeze. With Y2K concerns over, the system is now evolving into production and it is scheduled to be in full-blown production by the beginning of the fourth quarter.

While developing the accounting system, Fannie Mae has also begun work on developing a treasury management system that would be able to value nearly all of the company’s derivatives. "Prior to this, we relied greatly on counterparty quotes to develop the market value disclosures in the financial statements," Ms. Rawls explains. But in the FAS 133 era, "we are going to need a system that could timely and accurately values our derivatives."

Shadow processing

Beginning in March of 1999, at the first meeting of the senior management team, managers were provided with what would have been Fannie Mae’s transition adjustment were it to adopt FAS 133 as of Sept. 30 1998.

At each subsequent monthly (and then bimonthly) gathering, the month-end FAS 133-ready report was presented alongside the actual numbers for the period. "We are currently processing on a monthly basis and generally have reports ready by the 10th business day," says Ms. Rawls.

"This shadow processing has really given us the opportunity to analyze these results and determine what are the drivers and the changes on a month to month basis." Continued refinement of the process will allow Fannie Mae to make the FAS 133 journal entries by the 6th business day once the standard is implemented. "We should be at this stage by the beginning of the fourth quarter," she says.

More to do!

While Fannie Mae is deep into its implementation process, several challenges loom for this year (2000).

1. Improve market value generation and classification process so that it’s done within a normal closing process – generally the first five to six days of the month.
2. Develop standard analytic procedures for individuals in the financial accounting and reporting departments, so that they have the tools to analyze the results being generated by the FAS 133 accounting prototype and to assess the reasonableness of a change from month to month.
3. Develop alternative hedging strategies for the FAS 133 era. "One of our main goals of this project has been to implement this very complex accounting standard, but also to continue with our very robust hedging program and at the same time minimize earnings and equity volatility."

   The more Fannie Mae knows about the standard and the more times it runs its numbers through the accounting prototype, the more apparent will the need for such strategies becomes. "We will develop alternative strategies when necessary to deal with any type of earnings volatility and equity volatility that we know that we will experiencing, given that a large proportion of our derivatives will be considered cash flow hedges." (Fannie Mae is looking into the chance offered by FAS 133 to move securities from the held-to-maturity to the available for sale portfolio to offset some of that potential equity volatility.)

4. Update hedge guidelines. Fannie Mae also plans to continue to update its hedge guidelines to reflect new implementation issues while following the DIG issues.

For the next nine months, Fannie Mae will continue to develop its systems and reporting processes, finalize the hedge guidelines, and begin implementing strategies to deal with equity and earnings volatility. In addition, the FAS 133 task force will continue its "road shows" to re-educate individuals in regional offices about the effect 133 will have on the company’s mortgage banking customers. "FAS 133 took a backseat for a lot of our customers since the delay, but it is now on everyone’s priority list in 2000, so our regional contacts need to be up to speed on what the issues are for mortgage bankers."