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Derivatives Accounting (FAS 133/IAS 39)
Freddie Mac to Taint Hedge Accounting
June 26, 2003

By Joseph Neu

Freddie Mac’s 2001 decision to report pro-forma “Operating Earnings” to reverse FAS 133 effects—given its restatement scandal—should generate new questions about accounting and disclosures for hedging.

Accordingly, companies that have legitimately foregone hedge accounting to pursue economic hedges that are ineligible for such accounting (and Freddie Mac may still belong to this group) will have a lot more explaining to do if their hedges result in a material earnings impact.

And ironically, this was precisely what Freddie Mac was attempting to do, by creating its FAS 133-adjusted “Operating Earnings” concept. Unfortunately, as a result of the failed Freddie Mac example, treasurers will be under increasing pressure to pursue only those hedging strategies that will be eligible for hedge accounting (or go through the mental and documentation gymnastics to make them eligible).

Background:On January 1, 2001, Freddie Mac implemented SFAS 133, which requires the corporation to recognize on the balance sheet all derivatives as either assets or liabilities measured at their fair value . . . . Beginning with its first quarter 2001 reporting, Freddie Mac began providing a supplemental performance measure known as Operating Earnings. Management believes that results presented on an operating basis, while not a defined term within GAAP nor comparable in many cases to supplemental performance measures used by other companies, are beneficial in understanding and analyzing Freddie Mac’s financial performance because they better reflect the economic effect of Freddie Mac’s risk management activities.

Freddie Mac’s operating earnings, along with corresponding ratios, reflect adjustments for certain income statement effects of SFAS 133.These adjustments relate primarily to the timing of derivative income and expense recognition” (Freddie Mac’s 2001 Annual Report).

What happened? During a conference call last Wednesday, Freddie Mac offered more details about its restatement —i.e., an expected increase in retained earnings of $1.5 billion to $4.5 billion and an increase in the fair value of shareholders’ equity for year-end 2002 over 2001. Much of this restatement is due to improperly avoiding implementation of fair value accounting: 1) improper classification of a significant portion of its $260 billion of mortgage securities as “held to maturity” instead of “available for sale;” and 2) improper application of FAS 133 to some of its derivatives (totaling $866.8 billion at year end December 2002, from $1.05 trillion in 2001) used in hedging activities.

With respect to hedge accounting, Freddie Mac shot itself twice in the foot. First, it did not properly apply FAS 133 to the GAAP reporting that “Operating Earnings” were supposed to adjust. Either it improperly classified hedges it deemed eligible for hedge accounting, or it failed to document/test these hedges for effectiveness appropriately (or both). In so doing:

1) It tainted its noble “Operating Earnings” concept. As Freddie Mac’s Chief Executive Officer, Greg Parseghian, announced on the call: “We will neither restate nor provide ‘Operating Earnings’ in our periodic financial reporting due to changes in accounting policies.” But, he added: “In the place of ‘Operating Earnings’ we are evaluating and expect to provide a new supplemental disclosure.”

2) It called into question that it was engaged in hedging at all. To counter this point, Martin F. Baumann, Freddie’s CFO stressed: “the changes in accounting treatment do not impact the effectiveness of our economic hedges, as demonstrated by our consistently low levels of portfolio market value sensitivity and narrow duration gap.”

Questions emerge. Analysts asked about both points in the conference call Q&A. “If this hedging is so effective, is Freddie still ‘hedging’ with the same approaches?” one analyst asked. It is. And, asked another, “if Operating Earnings were essentially the pre-FAS 133 impact of economic hedges, aimed to help analysts with their model forecasts, why not go back to it?” Here the answer was less straightforward.

Apparently, some of the “complicated adjustments” made for Operating Earnings in the past don’t look so good in hindsight. Accordingly, the new supplemental disclosure will focus on options only.

For now, analysts seem to prefer deferral of hedges to protect their forecast models. However, there is now a greater risk that an analyst looking for a “Freddie Mac story” will dig into your OCI and make his or her own “earnings” assumptions about hedge gains and losses being deferred there.

 


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