Fannie Mae, wanting to avoid perceptions that it too has taken liberties with accounting for its risk management activities to support earnings goals, is taking disclosures to new levels in its most recent 10-K, filed March 15.

Faced with potential new regulatory oversight and criticism concerning their extensive use of derivatives, both Freddie Mac and Fannie Mae are taking disclosures seriously. Fannie, wanting to avoid perceptions that it too has taken liberties with accounting for its risk management activities to support earnings goals, is taking disclosures to new levels in its most recent 10-K, filed March 15.

In a statement released in conjunction with the 10-K, Jayne Shontell, Fannie Mae’s senior vice president for invester relations noted some of the “the new or enhanced items of disclosure that you will find in this year's filing.”

One of the most noteable changes is the extent to which derivatives and hedging related disclosures have been elevated by being moved to MD&A.

• Derivative Instruments and Hedging Activities. We have moved our discussion of derivatives and hedging activities to the Funding section of the MD&A. We believe this section provides the best context for this discussion, given that we use derivatives primarily to transform the characteristics of our debt.
  
• Accounting for Derivatives. In this section, added this year to our MD&A, we detail the specific GAAP accounting treatments required for different hedging instruments, and the resulting impact on both earnings and the AOCI component of shareholders' equity. Specifically, this section details the accounting treatment applied to each of the two primary classifications of hedges that we employ -- cash flow hedges and fair value hedges.

The explanations of the earnings vs. AOCI impacts are especially detailed, since Freddie Mac-inspired scrutiny of potential earnings management has been a focus for Fannie’s critics, particularly in light of a $1bn+ 3Q revision last October due to computational errors. Also, “losses” on derivatives positions found in AOCI, resulting from those designated as cash flow hedges, have been the subject of a recent series of articles in the Financial Times, which claim these “losses” should fuel further criticism of Fannie’s derivatives activities.

Fannie Mae is working to address critics charges with its breakouts of gains and losses on hedges. As Ms. Shontell points out:

• Table 30 [in the 10-K MD&A discussion] details the changes in notional amounts and net values for cash flow hedges and fair value hedges between year-end 2002 and 2003.
  • In total, the net value of these instruments (which includes the time value of purchased options) increased from $(2,031) billion at December 31, 2002 to $6,633 billion at December 31, 2003.
  • This total includes a net positive value for fair value hedges, and a net negative for cash flow hedges. Because cash flow hedges consist largely of pay-fixed swaps used to create effective fixed-rate debt, these instruments generally show market value losses when interest rates fall.

To shed further light on the fair value hedges:

• Table 31 has been added to the MD&A . . .
  • The table indicates that the total impact of cash-flow hedges on AOCI declined from $(16.3) billion at year-end 2002 to $(12.2) billion at year-end 2003. This total included mark-to-market losses on open hedges of $(5.3) billion and costs related to closed hedges of $(6.9) billion.
  • The portion of AOCI attributable to closed hedges increased largely as a result of mortgage rebalancing activities [such activities were significant in 2003, Fannie Mae says, due to the volatility in rates and tighter risk tolerances, resulting in the termination of swap hedges to shorten (receive fixed) and then lengthen (pay fixed) the portfolio duration].

Focusing on the losses in particular, Ms. Shontel highlights these items from the 10-K:

• The level of AOCI losses attributable to cash flow hedges, and the proportion of AOCI related to open and closed hedges, depend to a significant degree on the differing accounting treatment applied to economically identical transactions.
  • When we terminate a pay-fixed swap that has been accounted for as a cash flow hedge, we transfer the corresponding market value from the open to closed hedge category of AOCI. This amount is then amortized into earnings over the lifespan of the originally hedged item.
  • When we enter into a receive-fixed swap, it is generally recorded as a fair value hedge of fixed rate debt and has no effect at all on AOCI.
  • When a receive-fixed swap is recorded as a cash flow hedge of part of a pay-fixed swap, it is recorded in AOCI as an open hedge.
  • Both realized and unrealized, to the extent not changed by interest rates and/or market volatility AOCI is amortized into net income over the same period in which the originally hedged item affects earnings.
  • The difference in accounting treatment between these economically identical transactions has no bearing on which method we decide to employ in order to meet our hedging objectives. Our decision is based on market factors, pricing, and our estimate of the relative impact these transactions would have in achieving our desired interest rate risk management objectives.
• On page 81, we discuss the amortization of hedge results out of AOCI and into earnings as a component of interest expense. We have enhanced this disclosure to break out the components of amortization related to both unrealized and realized hedge results.
  • During the next twelve months, we expect to amortize $4.4 billion for open derivatives and $1.5 billion for closed derivatives into earnings. This compares to amortizations for open and closed derivatives of $4.5 billion and $0.9 billion, respectively, in 2003.

It will be interesting to see to what extent Fannie’s enhanced disclosure/education effort will disarm critics, who are just as likely to pick out select items to fit their arguments without digesting the larger context (which is admittedly a lot160;to digest).