Accounting for Derivative Financial Instruments and Hedging Activities
Bob Jensen at Trinity University

In the end, derivatives are like antibiotics.  It's dangerous to live with them, but the world is better off because of them.  The same can be said about FAS 133 and its many implementation guides and amendments.  Booking derivatives at fair value is dangerous, but the economy would be worse off without it.  What we have to do is to strive night and day to improve upon reporting of value and risk in a world that relies more and more on derivative financial instruments to manage risks.  A major problem is that they are often traded in unfair and fraudulent markets --- http://www.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds 

One of the main reasons Bob Jensen chose to specialize in accounting for derivatives
Derivatives: Potential Benefits and Risk-Management Challenges
Perhaps the clearest evidence of the perceived benefits that derivatives have provided is their continued spectacular growth. As a consequence of the increasing demand for these products, the size of the global OTC derivatives markets, according to the Bank for International Settlements (BIS), reached a notional principal value of $220 trillion in June 2004. Indeed, the growth rate of the OTC markets was more rapid in 2001-04 than over the previous three years. At the same time, the growth rate of exchange-traded derivatives exceeded the growth rate of OTC derivatives over 2001-04. Throughout the 1990s, the Chicago futures and options exchanges debated whether the growth of the OTC markets was good or bad for their markets. The data seem to have resolved that debate. In the United States, the Commodity Futures Modernization Act of 2000 has permitted healthy competition between the exchanges and the OTC markets, and both sets of markets are reaping the benefits. The benefits are not limited to those that use derivatives. The use of a growing array of derivatives and the related application of more-sophisticated approaches to measuring and managing risk are key factors underpinning the greater resilience of our largest financial institutions, which was so evident during the credit cycle of 2001-02 and which seems to have persisted. Derivatives have permitted the unbundling of financial risks. Because risks can be unbundled, individual financial instruments now can be analyzed in terms of their common underlying risk factors, and risks can be managed on a portfolio basis. Partly because of the proposed Basel II capital requirements, the sophisticated risk-management approaches that derivatives have facilitated are being employed more widely and systematically in the banking and financial services industries.
"Remarks by Chairman Alan Greenspan Risk Transfer and Financial Stability To the Federal Reserve Bank of Chicago's Forty-first Annual Conference on Bank Structure, Chicago, Illinois," May 5, 2005 --- http://www.federalreserve.gov/boarddocs/speeches/2005/20050505/

Question
FAS 133 and its international equivalent IAS 39 are arguably the most complex and difficult financial accounting standards ever written.  These are important because they deal with newer types of contracts (interest rate swaps were only invented in 1984 and soared to over $100 trillion in contracting) and contracts that have become the primary means by which firms manage cash and manage financial risk.   They are also speculation contracts in the soaring number of hedge funds across the world.  In the 1990s a disturbing number of billion dollar and even trillion dollar frauds in derivative financial instruments caused the SEC to force the FASB to write FAS 133.  Many of these frauds are summarized at http://www.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds

It is clear that neither the financial world nor the accounting world is yet prepared to deal with FAS 133.  For example, failures of meeting FAS 133 got KPMG fired from the Fannie Mae audit and is causing Fannie to spend $140 million to make over one million correcting journal entries and issue restated annual reports.  The new auditing firm, PwC, has had to send hundreds of auditors to Washington DC to take on Fannie's audit and to hire over 1,500 consultants in derivative financial instrument contracting.

The are many finance professors who understand derivative contracts.  But it is extremely rare to find one who knows FAS 133.  It is extremely rare to find an accounting professor who understands derivatives, let alone FAS 133 and IAS 39.

So my question is, where do you as an accounting professor or student begin to master FAS 133 and IAS 39?

Answer
I get many email messages asking some form of the above question.  My answer is shown below:

I first recommend that you purchase two books that I use in my ACCT 5341 accounting theory course --- http://www.trinity.edu/rjensen/acct5341/acct5341.htm

The first book is one of the best and most concise textbooks I've ever seen in my professional career.  It is a finance text and has no FAS 133 accounting.  However, before you tackle FAS 133, you must understand the types of contracts covered in FAS 133.  Robert Strong at the University of Maine wrote a wonderful textbook for this purpose.

Next you must study FAS 133 and its amendments and "DIGs".  I recommend the following:

After you learn the basics of FAS 133, you can then study some of the differences between the U.S. FAS 133 and the international IAS 39.  At conception, the IASB considered simply photocopying FAS 133 and calling it IAS 39.  However, that was deemed neither politically correct nor suitable for the politics of Europe where putting some derivatives on balance sheets at current (fair) values is vehemently opposed.  Thus the IASB generated its own IAS 39 which is very similar to FAS 133, but differs on some key points.  You can read about the differences, along with the differences in the Canadian Guideline 13 (AcG-13), at http://www.trinity.edu/rjensen/caseans/canada.htm

Along the way you can seek help from my multimedia tutorials and an enormous glossary:

Some added helpers for FAS 133

January 4, 2005 message from Shannon Burchett [sburchett@risklimited.net]

Hello Dr. Jensen,

I was just looking over your website. My compliments to you on your site. Quite a volume of information on 133 and tutorials and links to other references.

Some of the people here are going to use that for further study on the topic. One fellow who is sitting for the next round on the CFA exam said he found your site particularly helpful.

If you would like to add a link to some of the information that we have online, one link that might work is a page we have with FAS 133 highlights: http://www.risklimited.com/fas-133.htm 

Talk with you soon.

Best regards,
Shannon

The question that I am asked most frequently by investment bankers, CPA practitioners, and corporate accountants is how to value interest rate swaps.  I guide them to the following links and files:

Swap valuation helpers --- http://www.trinity.edu/rjensen/acct5341/speakers/133swapvalue.htm

Swap valuation video --- Click on 133ex05a.wmv at http://www.cs.trinity.edu/~rjensen/video/acct5341/

Swap valuation Excel illustration --- Click on 133Ex05a.xls at http://www.cs.trinity.edu/~rjensen/ 

Lastly I have a very old and still popular given at 133sp.htm and 133spans.xls at http://www.cs.trinity.edu/~rjensen/ 
 

Enron collapsed mainly due to derivative financial insturments --- http://www.trinity.edu/rjensen/FraudEnronQuiz.htm

FAS 133 Trips Up Fannie Mae and the Banking Industry in General

Hedging Paradox:  
In finance, there is no way to cover your Fannie without exposing your Fannie somewhere else.
Gypsy Rose Lee would've said her fan (hedge) can only cover one Fannie cheek at a time. 

Freddie Mac Paves the Way With Risk Stress Tests and Then Fails on Hedge Accounting  

Immense Size and Looming Dangers in the Derivatives Markets 

Yield Burning Frauds 

Introduction to FAS 138 (Amendments to FAS 133) and some key DIG issues at http://www.cs.trinity.edu/~rjensen/000overview/mp3/138intro.htm 

You can see an overview of my connection of derivatives contracts with FAS 133 in some PowerPoint files that I prepared for a presentation for commodities traders.  Simply click on the PowerPoint link at http://www.cs.trinity.edu/~rjensen/Calgary/CD/

Tutorials and Helpers --- http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#Tutorials 

”Testing and Accounting for Hedge Ineffectiveness Under FAS 133, by Angela L.J. Huang and  Robert E. Jensen, Derivatives Report, February 2003, pp. 1-10.  http://www.riahome.com/estore/detail.asp?ID=TDVN

I have a draft paper entitled "The Theory of Interest Rate Swap Overhedging" at http://www.trinity.edu/rjensen/315wp/315wp.htm 
This is a very rough start on developing this theory.  I would appreciate any feedback you can give on this paper.

This is a Good Summary of Various Forms of Business Risk  --- http://www.erisk.com/portal/Resources/resources_archive.asp 

1. Enterprise Risk Management

2. Credit Risk

3. Market Risk

4. Operational Risk

5. Business Risk

6. Other Types of Risk?

In spite of FAS 133 and IAS 39, shareholders and creditors are still left in the dark about huge risks companies may be taking in their derivative financial instruments contracts.

"The Role of Derivatives in Corporate Finances: Are Firms Betting the Ranch?" Finance and Investment at Wharton, December 2005 --- http://knowledge.wharton.upenn.edu/article/1346.cfm

Many American corporations use derivatives conservatively, to offset risks from fluctuating currency and interest rates. But over the years, companies such as Procter & Gamble and Gibson Greetings have run into serious financial trouble using derivatives in a more dangerous fashion -- to speculate.

Is high-risk behavior common? Are shareholders in for ugly surprises if executives' derivatives bets go sour?

That has long been nearly impossible to determine, says Wharton finance professor Christopher C. Geczy. "It's not well disclosed in the financial [statements]. It could be widespread, but it's hard to say."

...

To get a better picture of derivatives' role in corporate finances, Geczy, Wharton accounting professor Catherine Schrand and their co-author, Bernadette A. Minton of Ohio State University, re-examined confidential responses collected in an earlier Wharton study that focused on 341 corporate respondents, 186 of which used derivatives. The companies studied were not concentrated in any one industry, but were part of a broad sample of U.S. public, non-financial firms. The researchers report their findings in a paper entitled, "Taking a View: Corporate Speculation, Governance and Compensation."

"We found that there are corporations out there, some of them very large, which have speculated, or are speculating," Geczy says. Companies reporting that they frequently "actively take positions" in currency or interest-rate derivatives on the basis of likely market movements were defined as speculators. The researchers then looked at the nature of those companies. They concluded that companies typically speculate in hopes of adding to profits, but not to "bet the ranch" to get out of financial difficulties or to hit it big. Executives who conduct the speculation typically are not renegades but instead are encouraged to do so by their superiors and board. Furthermore, firms that engage in speculation generally have oversight and monitoring procedures to prevent abuse. Finally, executives' compensation was often tied in some way to their success in derivatives speculation.

"The main findings are that firms take positions based on a view [of market conditions] when they believe they have an information advantage to predict rates, which is consistent with a profit-making motive for speculation," the researchers write.

Derivatives are contracts whose values are tied to price changes of underlying securities. A typical currency derivative gives its owner the right or obligation to buy or sell a block of dollars, yen or other currency over a given period at a set exchange rate. Interest-rate derivatives are like insurance policies that pay off if rates move up or down a specified amount during the time covered.

In one important use, derivatives can neutralize risks. An American company that must exchange dollars for yen to buy goods from Japan could use a currency derivative to make up the difference if the dollar falls and Japanese goods become more expensive. Essentially, the contract would allow the company to lock in today's exchange rate for a given period. The American company would lose money on the derivative contract if the dollar got stronger instead of weaker, but that would be offset by the lower cost of Japanese goods as dollars were exchanged for yen.

A company could, however, use the same currency contract to speculate, by simply buying a contract in hopes it becomes more valuable as exchange rates change. Since the change in the contract's value would not be counterbalanced by a gain or loss in the purchase of Japanese goods, the company would suffer a net loss if the dollar strengthened and the contract loses value. This is speculation.

In the 1990s, Procter & Gamble lost $157 million in a currency bet involving dollars and German marks, Gibson Greetings lost $20 million and Long-Term Capital Management, a hedge fund, lost $4 billion with currency and interest-rate derivatives.

"Shooting for the Moon"

Over the years, various theories have attempted to explain why firms would speculate with derivatives. One theory suggests it is practiced at troubled firms "betting the ranch" to recover. But Geczy and his colleagues concluded this is unlikely, as the speculating firms tended to have access to low-cost outside financing, which made betting the ranch unnecessary.

In most cases, firms that speculate are using types of derivatives they have gained experience with through safer hedging strategies. Those that speculate with currency derivatives, for instance, typically operate in international markets. As the authors write: Companies that speculate with foreign currency derivatives "have a greater percentage of operating revenues and costs denominated in foreign currency relative to firms that never or sometimes actively take positions."

Executives in charge of derivatives speculation tend to feel they have some unique insight into currency and interest-rate markets, even though their firm's main business may be entirely different, Geczy says. "They really believe they can make money. They feel like they can identify opportunities and/or trade with the advantage of low costs of leverage."

Another theory is that executives use derivatives to "shoot for the moon" -- trying to push up the company's earnings to boost the stock price and thus the value of their own holdings. But according to Geczy, the goal appears to be more modest -- just to make some extra profit when they think the opportunity arises. "On average, they do not appear to be trying to make the firm really risky to make big payoffs."

At the same time, says Geczy, "just because speculating firm managers do not appear to be shooting for the moon, so to speak, doesn't mean that there aren't dangers or that speculating firms cannot suffer large losses. What makes our research interesting is that these managers can, in fact, suffer large losses even if speculation is rational and profit-oriented."

Generally, firms that speculate have structures that give executives significant authority and freedom. They may be well-insulated from shareholder pressure by poison-pill anti-takeover defenses, for example. As Geczy notes, "The companies that speculate seem to be ones where shareholders don't have as much power. It's basically stronger managers... stronger, confident management that thinks it can make money. However, this in no way means they are successful."

As to whether there is more speculation going on now than in years past, "this is quite hard to say," notes Geczy. "We actually did a follow-up survey of respondents from the first survey and found that some firms moved from speculating to not speculating at all and, in fact, remarked that they didn't feel speculation added much value net of its risk. Others went from not speculating to speculating with the expectation of making a profit. So we see transitions in both directions."

The original survey did not ask companies to report how much they earned or lost through derivatives speculation. Geczy and his colleges conducted follow-up interviews with some of the companies' executives but could not determine how successful the speculation was. "It's been fairly hard to track down whether they actually do make money," he says.

But Geczy questions whether these executives, who typically speculate as a sideline to their main duties, can effectively compete with professionals who do it full-time. "It's hard to believe, frankly, that corporate treasurers know more than the financial markets about what foreign currency or interest rates are going to do," he said, adding, "We haven't been able to identify reliably positive results of using a perceived information-advantage" enjoyed by executives who speculate.

What is clear, however, is that shareholders are generally in the dark about derivatives speculation. "An important aspect of this study is that we are able to assess whether investors, using publicly available data, could identify the firms that admit to speculation in a confidential survey," Geczy and his colleagues write. "The answer is that they could not."

Continued in article

Bob Jensen's threads on Derivatives Financial Instruments Frauds are at http://www.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds

Video Tutorials

If you have a computer with speakers at home that is connected to the Internet, you may be interested in the video tutorials at http://www.cs.trinity.edu/~rjensen/video/acct5341/fas133/WindowsMedia/

Trinity University students may check out earphones in the basement of the Library at IMS and then use one of Trinity’s lab computers to watch and listen to these tutorials.

After we finish FAS 133, you may be interested in some of the other theory tutorials at http://www.cs.trinity.edu/~rjensen/video/acct5341/

If you are not connected to the Internet at home, it should be possible to burn the same CD that I used to teach a derivatives course last spring up in Calgary .  The CD to burn is the CD folder on the path TigerNet path
J:\courses\Acct5341\Calgary\CDfiles

These files have many of the PowerPoint, Excel, and Video files that we will be using in the early part of ACCT 5341.
The ITS help desk can direct you to computers that can be used to burn CDs provided you bring your own blank CD.

The Class 6 assignments are the most difficult in the course --- http://www.trinity.edu/rjensen/acct5341/class06.htm

The good news is that I provide you the answers.
The bad news is that you have to understand those answers.

Questions were raised about accounting for firm commitments using options.  There are illustrations in the Week 6 assignments.  See Question 5 to help you with alternative variations of Example 9 in Appendix B of FAS 133.

The broad FAS 133 and IAS 39 rules are as follows assuming a derivative qualifies for hedge accounting treatment. 

If the hedged item is an unbooked forecasted transaction having cash flow risk or FX risk, then hedge accounting entails using OCI (or AOCI) to offset value increases or decreases in the derivative.  But OCI can only be used to the extent the hedge is effective (or the extent of the change in intrinsic value in the case of options).  The ineffective portion (of the change in time value in the case of options) must be charged to current earnings.  Dollar value tests of effectiveness using the 80-125 Dollar Offset Rule are common except in the case where the derivative hedge uses options.  Options seldom meet the test for effectiveness using the Dollar Offset Rule.  Instead, some other form of effectiveness testing is used such as a regression test.

If the hedged item is a booked item (e.g., inventory or an investment) carried at historical cost, then OCI cannot be used (except for FX hedging) since there is no cash flow risk.  With a fair value hedge, the hedged item accounting is changed to fair value during the hedging period.  There may be charges to current earnings to the extent of hedge ineffectiveness.  .  With a fair value hedge, hedge accounting entails using an account named “Firm Commitment” to offset value changes in the hedging derivative.    There may be charges to current earnings to the extent of hedge ineffectiveness.

The same rules apply to swap hedge accounting.

A special exception arises in the case of interest rate swaps.  For hedge accounting of interest rate swaps a special “Short Cut Method” was established that eliminates the need of periodic testing of hedge effectiveness.  See “Short Cut” by scrolling down at http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#S-Terms
Most companies strive to qualify for the Short Cut Method when they are hedging interest rate risk.  They wish the FASB and IASB would extend this to other types of hedges.

Video Tutorials on Accounting for Derivative Financial Instruments and Hedging Activities per FAS 133 in the U.S. and IAS 39 internationally --- http://www.cs.trinity.edu/~rjensen/video/acct5341/fas133/WindowsMedia/ 

• Video Tutorial:  Introduction to Accounting for Derivatives and Hedging --- 
  000FAS133introduction.wmv
  
• Video Tutorial:  Overview of Bob Jensen's Helper Documents on Derivatives and Hedging --- 
  010FAS133Helpers.wmv 
  
• Video Tutorial:  Two Cases on Accounting for Options and Intrinsic vs. Time Value Accounting --- 
  015FAS133options.wmv
  
• Video Tutorial:  Two Cases on Accounting for Futures Contracts --- 
  020FAS133futures.wmv
  
  
• Video Tutorial:  Accounting for Interest Rate Swap Hedges and Valuation of Swaps --- 
  030FAS133InterestRateSwapAccounting.wmv

My SFAS 133 and IAS 39 Glossary and Transcriptions of Experts
http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm

Helpers for Accounting Educators --- http://www.trinity.edu/rjensen/default3.htm 

Accounting Theory --- http://www.trinity.edu/rjensen/theory.htm 

XBRL and XML --- http://www.trinity.edu/rjensen/XBRLandOLAP.htm 

Electronic Commerce --- http://www.trinity.edu/rjensen/ecommerce.htm 

Earnings Restatements Due to FAS 133 on Hedge Accounting

"Hedge Accounting Gets On Regulators' Radar:  Some Firms Using the Tool Have to Restate Earnings; The New Lease Accounting?" by Michael Rapoport, The Wall Street Journal, January 27, 2006; Page C3

A year ago, companies were rushing to restate their earnings because of problems with how they accounted for lease obligations on their stores and plants. Something similar may be happening with the bookkeeping for financial instruments that some firms use to guard against risk.

In 2005, at least 40 companies, from small banks to conglomerates like General Electric Co., restated past earnings because of problems with "hedge accounting," according to a new report from research and proxy advisory firm Glass Lewis & Co.

And more such revisions could be on the way. "I don't think it's really over," says Jason Williams, a Glass Lewis analyst who noted in the report that these restatements may show "a pattern similar to the recent lease-accounting restatements."

So far, the hedging moves are only a fraction of the hundreds of lease-accounting restatements. And there has been no high-profile warning from the Securities and Exchange Commission about the need to shape up on hedge accounting, as was the case with lease accounting.

But a number of smaller indications -- a recent comment in an audit firm's inspection report, a speech by an SEC staffer -- suggest that regulators may indeed be pushing companies and their auditors to clean up hedge accounting.

Hedge accounting is complex, but the goal is easy to understand: When a company uses derivatives to hedge exposure to risks like changes in interest rates and fluctuations in foreign currencies, it wants those derivatives to qualify for hedge-accounting treatment under accounting rules because any changes in the derivatives' value can be excluded from current earnings. The value changes are "smoothed" into earnings over time. Without that special accounting status, the derivatives' ups and downs would make earnings unpredictable, which companies and shareholders dislike.

To qualify for hedge accounting, however, companies have to meet a strict set of criteria. And dozens have discovered lately that either they haven't fully complied or have cut corners they shouldn't have. Some have found their hedges don't do the job they're supposed to in offsetting the changes caused by the risk they're hedging. Others don't have sufficient documentation for their hedges.

In such cases, a company typically is disqualified from using hedge accounting, and it has to restate earnings to add back in the changes in the derivatives' values -- often boosting earnings in some periods but lowering them in others.

Last fall, for instance, brokerage TD Ameritrade Holding Corp. restated earnings lower for fiscal 2003 and higher for fiscal 2004 and 2005 over documentation issues. In December, finance company CIT Group Inc. restated first-half 2005 earnings higher and third-quarter earnings lower because it used the shortcut when it shouldn't have. Representatives for both companies couldn't be reached to comment.

Many companies have said they decided to restate on their own or in consultation with auditors. Yet regulators have been voicing concern about the matter as far back as 2004, when the SEC said it had seen instances of "aggressive interpretation" of hedge-accounting rules, and cases in which companies "have not been diligent" in satisfying the requirements.

And at least a couple of the restating companies say they've had contact with regulators over hedge accounting. TD Ameritrade said it held discussions with the SEC before making its restatement in November. And the SEC is investigating GE over its hedge accounting. But Russell Wilkerson, a GE spokesman, says the company was already in the process of finding its hedge problems through an internal audit before it heard from the SEC.

One small sign that regulators are concerned over hedge accounting: Some comments the Public Company Accounting Oversight Board, which regulates auditors, has made in its recent inspection reports of big audit firms.

In a few instances, the PCAOB has indicated that firms haven't been as diligent as they should have been on hedge accounting in individual audits that the board has reviewed. In an inspection report on KPMG LLP issued in September, for instance, the PCAOB cited an audit of an unidentified client in which KPMG "failed to appropriately address" improper derivatives accounting. A report on Grant Thornton LLP last week said the firm "failed to perform sufficient audit procedures" over one client's interest-rate derivatives and didn't evaluate another's hedge accounting over foreign-currency futures.

A KPMG spokesman says the firm works with both regulators and clients to make sure clients apply accounting principles as regulators want "in an area where accounting practices continue to evolve." Grant Thornton couldn't be reached.

And in a speech last month, Mark Northan, an SEC professional accounting fellow, said some companies have used the "shortcut" to hedge accounting when they haven't met all the conditions for doing so.

Bob Jensen's glossary on hedge accounting is at http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm
 

Two Questions
How did Bob Jensen spend his summer vacation?
What can physicists do when they can't find jobs in physics?

Answers

I've spent a great deal of my summer and my Fall 2004 Semester leave plowing through a book entitled Quantitative Finance and Risk Managment:  A Physicists Approach by Jan W. Dash, by Jan W. Dash (World Scientific Publishing, 2004, ISBN 981-238-712-9)
This is a great book by a good writer.

For a more introductory warm up I recommend Derivatives:  An Introduction by Robert A Strong, Edition 2 (Thomson South-Western, 2005, ISBN 0-324-27302-9)

And what about opportunities for physicists?
See "A Geek's Walk on Wall Street," by Peter Coy, Business Week, November 15, Page 26.  This is a review of a book entitled My Life as a Quant, by Emanuel Derman (Wiley, 2005) --- http://www.businessweek.com/@@x3mnUmYQYMjg7RMA/premium/content/04_46/b3908024_mz005.htm 

As one of Wall Street's leading quants, Derman did throw off some intense gamma radiation. He worked at Goldman from 1985 until 2003 except for one year at Salomon Brothers. At Goldman, he moved from fixed income to equity derivatives to risk management, becoming a managing director in 1997. He co-invented a tool for pricing options on Treasury bonds, working with Goldman colleagues Bill Toy and the late Fischer Black, who co-invented the Black-Scholes formula for valuing options on stocks. Derman received the industry's "Financial Engineer of the Year" award in 2000. Now he directs the financial-engineering program at Columbia University.

Derman failed at what he really wanted, which was to become an important physicist. He was merely very smart in a field dominated by geniuses, so he kicked around from one low-paying research job to another. "At age 16 or 17, I had wanted to be another Einstein," he writes. "By 1976...I had reached the point where I merely envied the postdoc in the office next door because he had been invited to give a seminar in France." His move to Wall Street -- an acknowledgment of failure -- brought him financial rewards beyond the dreams of academic physicists and a fair measure of satisfaction as well.

In the tradition of the idiosyncratic memoir, My Life As a Quant is a grab bag of the author's interests. It quotes Schopenhauer and Goethe while supplying not one but three diagrams of a muon neutrino colliding with a proton. There is a long section on the brilliant and punctilious Fischer Black; a glimpse of physicist Richard Feynman; and an embarrassing encounter with finance giant Robert Merton, who sat next to the author on a long flight (Derman treated him rudely before realizing who he was).

Derman's mood seems to vary from bemused on good days to sour on bad ones. The chapter on his postdoc travels is titled "A Sort of Life"; his brief career at Bell Labs, "In the Penal Colony"; his tenure at Salomon Brothers, "A Severed Head." Pre-IPO Goldman Sachs comes off as relatively gentle yet stimulating. He writes: "It was the only place I never secretly hoped would crash and burn."

Continued in the article

Bob Jensen's threads on the trillions of dollars of worldwide frauds using derivative financial instruments are at http://www.trinity.edu/rjensen/fraudRotten.htm#DerivativesFrauds 

The name of the game is derivatives!

Will your bonus for last year come anywhere close to $9 million?  
Global commercial banks are expected to award bumper bonuses in the next three months, following a pattern set by the US investment banks in December. Forex dealers anticipate year-on-year increases of up to 50% in their annual packages, on the back of a highly lucrative year in foreign exchange as major and emerging markets currencies went haywire. An unusually active fourth quarter in particular boosted many traders' profit and loss accounts as they wound down for year-end, sending up bonus expectations accordingly. Goldman Sachs, Merrill Lynch, Morgan Stanley and Lehman Brothers were among the banks that announced their bonus payouts in December. Peers at rival banks reported that forex dealers at Morgan Stanley saw average year-on-year rises of 20%, while the very top staff in foreign exchange and derivatives may have seen as much as $9 million each. "This type of figure is not inconceivable at the top three or four banks," said one head of foreign exchange at a US bank in New York.
RiskNews Weekly on January 9, 2004

New Standards for Accounting for Derivatives are Blocking Progress of the International Accounting Standards Board
The Economic Union Rejects IAS 32 (Financial Instruments) and IAS 39 (Derivative Financial Instruments)

From The Wall Street Journal Accounting Educators' Review on April 2, 2004

TITLE: As IASB Unveils New Rules, Dispute With EU Continues 
REPORTER: David Reilly 
DATE: Mar 31, 2004 
PAGE: A2 LINK: http://online.wsj.com/article/0,,SB108067939682469331,00.html  
TOPICS: Generally accepted accounting principles, Fair Value Accounting, Insider trading, International Accounting, International Accounting Standards Board

SUMMARY: Despite controversy with the European Union (EU), the International Accounting Standards Board (IASB) is expected to release a final set of international accounting standards. Questions focus on the role of the IASB, controversy with the EU, and harmonization of the accounting standards.

QUESTIONS: 
1.) What is the role of the IASB? What authority does the IASB have to enforce standards?

2.) List three reasons that a country would choose to follow IASB accounting standards. Why has the U.S. not adopted IASB accounting standards?

3.) Discuss the advantages and disadvantages of harmonization of accounting standards throughout the world. Why is it important the IASB reach a resolution with the EU over the disputed accounting standards?

4.) What is fair value accounting? Why would fair value accounting make financial statements more volatile? Is increased volatility a valid argument for not adopting fair value accounting? Does GAAP in the United States require fair value accounting? Support your answers.

Also note http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#IASC 

An Illustration of FAS 133 Implementation and Hedging Complexities

One million lines of journal entries:  Just how expensive is FAS 133?

"The Potential Crisis at Fannie Mae," Comstock Funds, August 11, 2005 --- http://snipurl.com/Fannie133

We have no proprietary information about Fannie Mae, but what is publicly known is scary enough. As you may recall, last December the SEC required Fannie to restate prior financial statements while the Office of Federal Oversight (OFHEO) accused the company of widespread accounting regularities that resulted in false and misleading statements. Significantly, the questionable practices included the way Fannie accounted for their huge amount of derivatives. On Tuesday, a company press release gave some alarming hints on how extensive the problem may be.

The press release stated that in order to accomplish the restatements, “we have to obtain and validate market values for a large volume of transactions including all of our derivatives, commitments and securities at multiple points in time over the restatement period. To illustrate the breadth of this undertaking, we estimate we will need to record over one million lines of journal entries, determine hundreds of thousands of commitment prices and securities values, and verify some 20,000 derivative prices…”

“…This year we expect that over 30 percent of our employees will spend over half their time on it, and many more are involved. In addition we are bringing some 1,500 consultants on board by year’s end to help with the restatement…Altogether, we project devoting six to eight million labor hours to the restatement. We are also investing over $100 million in technology projects to enhance or create new systems related to accounting and reporting…we do not believe the restatement will be completed until sometime during the second half of 2006…”

Continued in article

Questions
How do Freddie and Fannie work and how have they recently posed a threat to market stability? 
What is the root cause for incentives to cheat on accounting rules?

Answers
Bert Ely, "Cut Fannie and Freddie Down to Size," The Wall Street Journal, April 12, 2005 --- http://online.wsj.com/article/0,,SB111326484187604126,00.html?mod=opinion&ojcontent=otep

Shrinking the balance sheets of Fannie Mae and Freddie Mac, as Alan Greenspan proposed last Wednesday, won't hurt the availability of home mortgages or the economy. Instead, downsizing Fannie and Freddie, the two largest government-sponsored enterprises (GSEs), will reduce the systemic risk their huge balance sheets pose to the financial system.

Congress should, as it considers legislation to reform GSE regulation, establish guidelines for shrinking Fannie's and Freddie's mortgage investments, which constitute the bulk of their balance sheets. These guidelines should limit the GSEs' investments to their short-term liquidity needs and an inventory of mortgages awaiting securitization. Such guidelines would also put a stop to Fannie and Freddie's profit-seeking arbitrage behavior, which takes them well beyond the limits of their original mandates. The GSEs take advantage of their low borrowing costs to make derivative investments that bring no benefit to taxpayers, mortgage-holders or mortgage-investors. The Fed has found that this behavior only benefits Fannie's and Freddie's stockholders while threatening the market's stability.

The capital markets finance American housing through two channels linked to Fannie and Freddie. First, several tens of thousands of investors, including many individuals, buy mortgage-backed securities (MBS) that Fannie or Freddie create by bundling home mortgages into pools and then selling pieces of those pools as MBS. By guaranteeing the timely payment of principal and interest on those MBS, Fannie and Freddie assume credit risk -- the possibility that some of the mortgages collateralizing the MBS may default or go into foreclosure. Credit risk does not pose a solvency threat to Fannie and Freddie.

However, and this is a very important however, MBS owners assume all interest-rate risk associated with the underlying mortgages -- variations in interest rates and the speed at which homeowners prepay their mortgages. MBS disperse interest-rate risk across the economy and to foreign investors. At the end of 2004, investors owned $2.25 trillion of Fannie- and Freddie-guaranteed MBS.

The second channel is investor purchase of unsecured debt that Fannie and Freddie issue to finance the home mortgages and MBS they own. In addition to credit risk, Fannie and Freddie also assume difficult-to-manage interest-rate risk on the mortgages they buy. This risk is enormous because the two use short-term debt to finance much of their investment in long-term, fixed-rate mortgages and MBS.

Fannie and Freddie then use various types of derivatives to shift much of that interest-rate risk to derivatives counterparties. At the end of last year, the notational or face amount of Freddie's derivatives contracts was $757 billion, more than its $732 billion of outstanding debt. Due to its accounting problems, Fannie has not published financial statements since June 30, 2004, when it reported total derivatives of $1 trillion, more than its borrowings of $940 billion.

Unlike the many thousands of MBS investors, Fannie and Freddie's derivatives counterparties are the same 20 to 25 large banks and investment firms. Hence, Fannie's and Freddie's interest-rate risk is highly concentrated. Mr. Greenspan's concern about potential systemic risk stems from this dangerous concentration of interest-rate risk. He said that the Fed has "been unable to find any purpose for the huge balance sheets of the GSEs, other than profit creation through the exploitation" of the low borrowing costs Fannie and Freddie enjoy by virtue of being GSEs. That is, the two GSEs are classic arbitragers, generating great profits for their stockholders.

* * * Fortunately, Congress can easily solve this problem by directing the GSE regulator it will create to limit Fannie's and Freddie's investments to the amount needed for their ongoing securitization activities. For Fannie, that number most likely falls in the $100-$150 billion range, and somewhat less for Freddie. This implies a shrinkage of their combined outstanding debt from approximately $1.7 trillion at the end of last year to about $250 billion.

This inferred shrinkage of $1.45 trillion is a big number, but it can easily occur over four or five years without Fannie and Freddie selling any mortgages or MBS financed by that debt -- there is substantial automatic liquidation built into their mortgage investments due to principal repayments and mortgage payoffs. Despite all the scare talk at congressional hearings last week, GSE shrinkage will not require asset sales which could disrupt housing finance.

Last year alone, Fannie and Freddie experienced $422 billion of portfolio liquidations as mortgages paid down and paid off. For the 2002-2004 period, their mortgage liquidations totaled $1.56 trillion. They compensated for those liquidations by buying newly issued mortgages and MBS. Going forward, Fannie and Freddie can trim their size simply by no longer buying MBS while holding the mortgages they purchase only until they securitize them and sell the resulting MBS.

By continuing to assume credit risk at the same rate they have been, through the issuance of new MBS, Fannie and Freddie could maintain the same level of credit-risk support they now provide to the housing finance market -- about $3.8 trillion. That is, as their mortgage assets shrink, the amount of MBS they create for investors to purchase would increase dollar-for-dollar. Because the MBS guarantee business is extremely profitable, with after-tax returns on equity capital exceeding 25%, Fannie and Freddie gladly provide MBS guarantees.

This substitution of MBS for the debt Fannie and Freddie now issue would steadily reduce the systemic risk the two GSEs pose, and the amount of interest-rate risk they must hedge with derivatives contracts. Because MBS and GSE debt are increasingly fungible with investors, the impact of this substitution on mortgage rates will be nil.

Once Congress enacts GSE regulatory reform, it will try to avoid dealing with GSE issues for many years. Therefore, it is vitally important that the reform legislation empower the new GSE regulator to cut Fannie and Freddie down to size by limiting their mortgage investments to what they need for liquidity and mortgage securitization, and nothing more. Letting them continue to grow could lead to the systemic crisis Mr. Greenspan understandably fears.

Bob Jensen's threads on the Fannie and Freddie scandals are at http://www.trinity.edu/rjensen/caseans/000index.htm

CEO Raines, CFO Howard Feel Push From Regulators; KPMG Is Out as Auditor 
Fannie Mae's CEO, Franklin Raines, and Timothy Howard, the chief financial officer, stepped down amid growing pressure from regulators over accounting violations. The mortgage company's board also dismissed KPMG as outside auditor.
James R. Hagerty, John R. Wilke and Johathan Weil, "At Fannie Mae, Two Chiefs Leave Under Pressure," The Wall Street Journal, December 22, 2004, Page A1 --- http://online.wsj.com/article/0,,SB110366339466106334,00.html?mod=home_whats_news_us 

Fannie Mae, which has borrowings of more than $950 billion and is involved in financing more than a quarter of U.S. residential mortgage debt, described the exit of the 55-year-old Mr. Raines as a retirement and that of Mr. Howard, 56, as a resignation. But people familiar with the board's deliberations said directors had decided that both men had to leave to satisfy the company's regulator, the Office of Federal Housing Enterprise Oversight, or Ofheo.

KPMG knew that FAS 91 and FAS 133 were being violated, but KPMG did not insist on correcting the books.  How much of Fannie’s current trouble can be blamed on KPMG?
Fannie's auditor, KPMG, disagreed with the way the company decided how much (derivatives instruments debt and earnings fluctuations) to book in 1998. The matter was recorded as "an audit difference" -- a disagreement between a company and its auditor that doesn't require a change in the books.
John D. McKinnon and James R. Hagerty, "How Accounting Issue Crept Up On Fannie's Pugnacious Chief," The Wall Street Journal, December 17, 2004 --- http://online.wsj.com/article/0,,SB110323877001802691,00.html?mod=todays_us_page_one 
Bob Jensen's Fannie Mae threads are at http://www.trinity.edu/rjensen/caseans/000index.htm 
Bob Jensen’s threads on KPMG’s troubles are at http://www.trinity.edu/rjensen/fraud001.htm#KPMG 

KPMG was eventually fired, due to SEC pressure, from the enormous Fannie Mae audit. 

"New Fannie Mae Violations Surface:  Accounting Flaws Include Possible Overvalued Assets, Insurance to Hide Losses," by Dawn Kopecki, The Wall Street Journal, September 29, 2005; Page A3 --- http://online.wsj.com/article/0,,SB112793973737254864,00.html?mod=todays_us_page_one

Investigators combing through Fannie Mae's finances have found new accounting violations, including evidence that the company may have overvalued assets, underreported credit losses and misused tax credits, according to people close to or previously involved in the inquiries.

Some people familiar with the examination said evidence also indicates the company may have bought so-called finite insurance policies to hide losses after they were incurred. Securities regulators, including New York state Attorney General Eliot Spitzer, are cracking down on corporations that they say bolstered earnings by using abusive financial reinsurance policies that are more akin to loans, where little or no risk is transferred to the insurer.

These people didn't provide details on the new violations, and it isn't clear how much new damage -- if any -- these problems will create for the company. But the people indicated that the alleged new accounting violations were designed to embellish the company's earnings and are in addition to the violations that the company and its regulator have already disclosed.

According to the people who have been involved with or are close to the investigations, for example, there are questions about how Fannie booked certain tax credits, including those used to lower its annual tab with the Internal Revenue Service. Fannie reduced its corporate-tax rate in 2003 from a statutory minimum of 35% to an effective rate of 26% by recording tax savings of $988 million in tax credits and an additional $479 million from its tax-exempt investments, according to its year-end earnings disclosure.

Earlier this year, Fannie Mae acknowledged that it violated accounting principles in recording its derivatives and other transactions, estimating a possible cumulative after-tax loss for the restatement period from 2001 through mid-2004 of as much as $10.8 billion, based on the company's finances as of Dec. 31, 2004. The company has said that its restatement process won't be completed until the second half of 2006.

In a statement released late yesterday, Fannie Mae noted that its regulator, the Office of Federal Housing Enterprise Oversight, has found that the company was "adequately capitalized" at the end of the second quarter. The company also said it believes it is "on track" to reach an Ofheo mandate that it build up its capital to 30% above the normal requirement by the end of this month. Regarding the various investigations, the company said: "We will continue to provide updates through our regulatory filings as issues are identified and resolved."

Ofheo said Fannie's projected surplus over minimum capital requirements "is sufficient to absorb uncertainties in the estimated impact to capital of the [company's] accounting errors, based on current information."

News that investigators may have found new accounting irregularities triggered a selloff in Fannie Mae stock, which dropped 11%, the largest percentage decline since the stock-market crash of 1987. The stock was off $4.99 to $41.71 in 4 p.m. composite trading on the New York Stock Exchange. That is the lowest closing price since July 1997.

The company's board initiated its own review of Fannie's finances after Ofheo accused executives of manipulating accounting rules in a scathing report delivered to the board 12 months ago. Fannie vehemently defended its accounting until the Securities and Exchange Commission sided with Ofheo last December and directed the company to correct errors in its application of two rules under generally accepted accounting principles, or GAAP. Fannie began its multiyear earnings restatement and ousted Chief Executive Franklin Raines and Chief Financial Officer Timothy Howard shortly thereafter.

Continued in article

You can read the following at http://www.trinity.edu/rjensen/caseans/000index.htm

"The Potential Crisis at Fannie Mae," Comstock Funds, August 11, 2005 --- http://snipurl.com/Fannie133

We have no proprietary information about Fannie Mae, but what is publicly known is scary enough. As you may recall, last December the SEC required Fannie to restate prior financial statements while the Office of Federal Oversight (OFHEO) accused the company of widespread accounting regularities that resulted in false and misleading statements. Significantly, the questionable practices included the way Fannie accounted for their huge amount of derivatives. On Tuesday, a company press release gave some alarming hints on how extensive the problem may be.

 

The press release stated that in order to accomplish the restatements, “we have to obtain and validate market values for a large volume of transactions including all of our derivatives, commitments and securities at multiple points in time over the restatement period. To illustrate the breadth of this undertaking, we estimate we will need to record over one million lines of journal entries, determine hundreds of thousands of commitment prices and securities values, and verify some 20,000 derivative prices…”

 

“…This year we expect that over 30 percent of our employees will spend over half their time on it, and many more are involved. In addition we are bringing some 1,500 consultants on board by year’s end to help with the restatement…Altogether, we project devoting six to eight million labor hours to the restatement. We are also investing over $100 million in technology projects to enhance or create new systems related to accounting and reporting…we do not believe the restatement will be completed until sometime during the second half of 2006…”

Continued in article

Bob Jensen's threads about Fannie's FAS 133 violations at Fannie Mae at http://www.trinity.edu/rjensen/caseans/000index.htm

KPMG was eventually fired, due to SEC pressure, from the enormous Fannie Mae audit.  You can read more about KPMG's woes at http://www.trinity.edu/rjensen/Fraud001.htm#KPMG

Fannie Mae is a great source for students learning about breakdown of internal controls

From The Wall Street Journal Accounting Weekly Review on March 11, 2005

TITLE: Fannie Regulator Tightens Its Grip 
REPORTER: James R. Hagerty 
DATE: Mar 09, 2005 
PAGE: A3 
LINK: http://online.wsj.com/article/0,,SB111030895766973673,00.html  
TOPICS: Accounting, Information Technology, Internal Auditing, Internal Controls, Regulation

SUMMARY: "Fannie Mae's regulator told the mortgage company to fix 'deficiencies' in accounting-ledger and corporate-records controls. The new requirements include policies bhannien falsified signatures on journal entries and limiting employees' ability to alter databases." The internal control framework developed by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) is used as a basis for questions. For those instructors who wish to refer their students to the executive summary for this framework, it is available on the web at http://www.coso.org/Publications/executive_summary_integrated_framework.htm The Institute for Internal Auditors publishes a checklist developed by COSO which is available on the web at

http://www.theiia.org/?doc_id=374 

QUESTIONS: 
1.) Define internal control and provide a proper reference to your source for that definition.

2.) What is COSO? Who or what comprises the members of COSO?

3.) What professional documents identify the basis for sound internal controls? Who establishes these standards?

4.) What internal control violations are highlighted in this article? Name each and describe the component of control being violated, based on COSO's five components of internal control.

5.) How does automation, and technical staff access to databases, add to issues inherent in systems of internal control?

6.) Compare the discussion of internal controls in the main article to the related article. How are the issues in the main article regarding internal controls consistent with problems that are identified in the related article as the basis for denying hedge accounting treatment for derivatives?

7.) Refer to the comparison made in answer to question 6. What general category or categories of internal control do you think were ultimately violated at Fannie Mae? Do you think this violation stems from the internal control environment at Fannie Mae? Support your answer.

Reviewed By: Judy Beckman, University of Rhode Island

"Fannie Mae Is Cited for 'Deficiencies':  Regulator Sets Conditions To Correct Internal Controls; Office of Compliance Created," by James R. Hagerty, The Wall Street Journal, March 9, 2005; Page A3 --- http://online.wsj.com/article/0,,SB111030895766973673,00.html 

Fannie Mae's regulator announced that it has instructed the mortgage company to correct "deficiencies" in its controls over accounting ledgers and other corporate records.

The new requirements include the adoption of policies banning falsified signatures on accounting journal entries and limiting employees' ability to alter database records.

The latest move by the regulator -- the Office of Federal Housing Enterprise Oversight, or Ofheo -- illustrates its tightening grip on Fannie in light of an accounting scandal that emerged last year.

Fannie's board also agreed to create an "office of compliance and ethics" and to direct the company's general counsel to inform directors and regulators of "actual or possible misconduct" at the company.

The directions to the company's board and management are included in an agreement with the regulator, signed by Fannie Mae's interim chairman, Stephen B. Ashley, and released by Ofheo yesterday. The specificity of the agreement suggests that Ofheo has found examples of Fannie employees flouting some basic standards of conduct.

An Ofheo spokeswoman declined to say whether such wrongdoing had been found but said the regulator continues to work closely with the Justice Department and the Securities and Exchange Commission in investigating Fannie's accounting and internal controls.

Rep. Richard H. Baker (R., La.), chairman of a House subcommittee that oversees Fannie and its smaller rival, Freddie Mac, said the agreement "raises many disturbing questions, especially about tampering with records, and we need to know the nature of the records and the extent of this outrageous practice." He scheduled a hearing for April 5 to look into the matter.

Mr. Ashley said in a statement that the agreement "represents the next step in Fannie Mae's cooperative effort to address issues raised by Ofheo." A spokesman declined to elaborate.

At a minimum, Fannie seems to have allowed "extreme sloppiness" in its internal controls, said Karen Petrou, a managing partner at Federal Financial Analytics Inc., a research firm in Washington.

The new agreement supplements one imposed on Fannie last September by Ofheo in the wake of findings that Fannie violated accounting rules in an attempt to smooth out fluctuations in its earnings. Those findings, backed by the SEC's chief accountant, prompted Fannie's board in December to oust the company's chief executive officer and chief financial officer.

Until recently, Fannie had the political clout to brush off concerns raised by Ofheo, but the accounting scandal has forced the company to seek a far more cooperative relationship with its regulator.

Among other things, the agreement requires Fannie to devise a plan for rectifying "deficiencies" in procedures for making and revising accounting journal entries. Those entries must be "supported by appropriate documentation," the agreement says.

In addition, Fannie agreed to "adopt appropriate internal controls" on any "overwriting" of database records by technical-support employees at the direction of management to make changes or corrections. Those changes would have to be properly documented.

The agreement also notes that Fannie's board has separated the functions of chairman and chief executive, formerly both held by Franklin D. Raines, who was forced to step down in December. Under Mr. Raines, Fannie resisted Ofheo's proposal for a regulation that would, among other things, require that the two jobs be held by different people. That proposed regulation has been held up for months by a review at the Office of Management and Budget; one person familiar with the situation said the Bush administration was reluctant to set policy on whether companies should combine the two functions. But Ofheo now has used its growing clout to persuade both Fannie and Freddie to separate the jobs, even without a regulation.

Continued in article

--- RELATED ARTICLES --- 
TITLE: Fannie Faces Billions in New Losses 
REPORTER: Jonathan Weil and James R. Hagerty 
PAGE: A3 
ISSUE: Mar 03, 2005 
LINK: http://online.wsj.com/article/0,,SB110980084894668645,00.html 

"Fannie Faces New Accounting Issues," by James R. Hagaerty, The Wall Street Journal, February 24, 2005, Page A3 --- http://online.wsj.com/article/0,,SB110916481988961983,00.html?mod=todays_us_page_one 
KPMG was fired as Fannie's auditor.  Deloitte is the new auditor for Fannie Mae.  Deloitte & Touche assisted OFHEO in its work on assessing Fannie Mae's accounting practices.

Regulator Raises Questions On Securities Bookkeeping; Capital Plan Is Approved 

Fannie Mae disclosed that its main regulator has found evidence of possible further violations of accounting rules at the mortgage company.

The giant mortgage-finance company, still reeling from earlier findings that it broke accounting rules, declined to estimate the possible effect on earnings of these new issues. But Josh Rosner, an analyst at Medley Global Advisors, an investment-research firm in New York, said the latest disclosures illustrate that many of the company's problems "are still ahead, not behind."

Fannie also said it will "sharply curtail" its corporate advertising and use of lobbyists as part of a drive to rebuild its capital in the wake of losses on derivatives contracts used to hedge interest-rate risks.

The company's regulator, the Office of Federal Housing Enterprise Oversight, or Ofheo, has approved Fannie's plans to boost capital and has given the company more time to do so, Fannie said. Ofheo has ordered Fannie to raise its capital to a level 30% higher than the ordinary minimum by Sept. 30. That represents a three-month extension from the original timetable set by Ofheo after it reported accounting violations by the company last September.

Correcting those violations will require Fannie to recognize an estimated $9 billion of losses on derivatives that otherwise would have been spread out over many years. The company is working on a restatement of its results for the past four years. That process, being conducted by a new auditor, Deloitte & Touche LLP, "may result in additional adjustments, perhaps material adjustments," to past and current financial results, Fannie warned.

Continued in article

From The Wall Street Journal Weekly Accounting Review on January 7, 2005 

TITLE: 
Fannie Mae to Select Deloitte to Succeed KPMG as Auditor 
REPORTER: Jonathan Weil 
DATE: Jan 05, 2005 
PAGE: B3 
LINK: Print Only 
TOPICS: Auditing, Auditing Services, Auditor Changes, Auditor Independence

SUMMARY: Fannie Mae's financial statements have been found to contain material misstatements, primarily due to inappropriate accounting for derivatives, and it has selected a new auditor. The original assessment of inappropriate accounting was made by the Office of Federal Housing Enterprise Oversight (OFHEO) and was confirmed by a Securities and Exchange Commission (SEC) ruling last month. Deloitte & Touche assisted OFHEO in its work on assessing Fannie Mae's accounting practices.

QUESTIONS: 
1.) Why is Fannie Mae selecting a new auditor? Describe the events leading up to this change. In your answer, describe the purpose of Fannie Mae and briefly explain how it operates. (You may refer to the related article to develop your answer to this question.)

2.) Was Fannie Mae clear in describing its reasons for selecting this audit firm? Explain. What were the probable reasons that Fannie Mae chose Deloitte and Touche to serve as its next auditor?

3.) Why are the number of firms from which Fannie Mae could choose to serve as auditor so small? What do you think is the impact of the few number of large public accounting firms on the auditing profession?

4.) Do you think that Fannie Mae could choose from among more firms than those that are discussed in the article? From the perspective of any audit firm, describe the business risks associated with taking on the Fannie Mae audit.

5.) How would you describe the nature and extent of the audit procedures the Deloitte and Touche audit team will undertake in their work on Fannie Mae's financial statements? Explain your answer in terms of auditing standards associated with these issues, such as those associated with proper engagement planning and risk assessment.

Reviewed By: Judy Beckman, University of Rhode Island

--- RELATED ARTICLES --- 
TITLE: Fannie's Dismissal of KPMG Shows Dwindling Choices Among Big Four 
REPORTER: Jonathan Weil 
PAGE: C1 ISSUE: Dec 23, 2004 
LINK: http://online.wsj.com/article/0,,SB110374574788607414,00.html 

From The Wall Street Journal Weekly Accounting Review on January 7, 2005 

TITLE: 
Fannie Mae to Select Deloitte to Succeed KPMG as Auditor 
REPORTER: Jonathan Weil 
DATE: Jan 05, 2005 
PAGE: B3 
LINK: Print Only 
TOPICS: Auditing, Auditing Services, Auditor Changes, Auditor Independence

SUMMARY: Fannie Mae's financial statements have been found to contain material misstatements, primarily due to inappropriate accounting for derivatives, and it has selected a new auditor. The original assessment of inappropriate accounting was made by the Office of Federal Housing Enterprise Oversight (OFHEO) and was confirmed by a Securities and Exchange Commission (SEC) ruling last month. Deloitte & Touche assisted OFHEO in its work on assessing Fannie Mae's accounting practices.

QUESTIONS: 
1.) Why is Fannie Mae selecting a new auditor? Describe the events leading up to this change. In your answer, describe the purpose of Fannie Mae and briefly explain how it operates. (You may refer to the related article to develop your answer to this question.)

2.) Was Fannie Mae clear in describing its reasons for selecting this audit firm? Explain. What were the probable reasons that Fannie Mae chose Deloitte and Touche to serve as its next auditor?

3.) Why are the number of firms from which Fannie Mae could choose to serve as auditor so small? What do you think is the impact of the few number of large public accounting firms on the auditing profession?

4.) Do you think that Fannie Mae could choose from among more firms than those that are discussed in the article? From the perspective of any audit firm, describe the business risks associated with taking on the Fannie Mae audit.

5.) How would you describe the nature and extent of the audit procedures the Deloitte and Touche audit team will undertake in their work on Fannie Mae's financial statements? Explain your answer in terms of auditing standards associated with these issues, such as those associated with proper engagement planning and risk assessment.

Reviewed By: Judy Beckman, University of Rhode Island

--- RELATED ARTICLES --- 
TITLE: Fannie's Dismissal of KPMG Shows Dwindling Choices Among Big Four 
REPORTER: Jonathan Weil 
PAGE: C1 ISSUE: Dec 23, 2004 
LINK: http://online.wsj.com/article/0,,SB110374574788607414,00.html 

Bob Jensen's threads on Fannie Mae are at http://www.trinity.edu/rjensen/caseans/000index.htm 

"Fannie Faces New Accounting Issues," by James R. Hagaerty, The Wall Street Journal, February 24, 2005, Page A3 --- http://online.wsj.com/article/0,,SB110916481988961983,00.html?mod=todays_us_page_one 
(KPMG was fired as Fannie's auditor.  Deloitte is the new auditor for Fannie Mae.

Regulator Raises Questions On Securities Bookkeeping; Capital Plan Is Approved 

Fannie Mae disclosed that its main regulator has found evidence of possible further violations of accounting rules at the mortgage company.

The giant mortgage-finance company, still reeling from earlier findings that it broke accounting rules, declined to estimate the possible effect on earnings of these new issues. But Josh Rosner, an analyst at Medley Global Advisors, an investment-research firm in New York, said the latest disclosures illustrate that many of the company's problems "are still ahead, not behind."

Fannie also said it will "sharply curtail" its corporate advertising and use of lobbyists as part of a drive to rebuild its capital in the wake of losses on derivatives contracts used to hedge interest-rate risks.

The company's regulator, the Office of Federal Housing Enterprise Oversight, or Ofheo, has approved Fannie's plans to boost capital and has given the company more time to do so, Fannie said. Ofheo has ordered Fannie to raise its capital to a level 30% higher than the ordinary minimum by Sept. 30. That represents a three-month extension from the original timetable set by Ofheo after it reported accounting violations by the company last September.

Correcting those violations will require Fannie to recognize an estimated $9 billion of losses on derivatives that otherwise would have been spread out over many years. The company is working on a restatement of its results for the past four years. That process, being conducted by a new auditor, Deloitte & Touche LLP, "may result in additional adjustments, perhaps material adjustments," to past and current financial results, Fannie warned.

Continued in article

Bob Jensen's threads on Fannie Mae's woes are at http://www.trinity.edu/rjensen/caseans/000index.htm#FannieMae 

"The Fall of Fannie Mae," by Bethany Mclean, Fortune, January 24, 2005 --- http://www.fortune.com/fortune/investing/articles/0,15114,1015932,00.html 

This is not your ordinary accounting fraud. Yes, there's the matter of $9 billion in overstated earnings. But the fight over Fannie is a nasty political showdown where everyone has his own agenda. And it's not over yet. By Bethany Mclean

On a sunny Monday in June 2002, President George W. Bush stood in the St. Paul AME Church in a formerly dilapidated neighborhood on the south side of Atlanta. Sitting in prime seats were Franklin Raines, the CEO of Fannie Mae, and Leland Brendsel, the CEO of Freddie Mac. The President was there to unveil an initiative aimed at helping 5.5 million minority families buy homes before the end of the decade—"Part of being a secure America," he said, "is to encourage home-ownership."

Raines and Brendsel were there because, well, encouraging home-ownership was what their congressionally chartered companies existed to do. By purchasing hundreds of billions of dollars' worth of mortgages held by banks, Fannie and its cousin Freddie made it possible for financial institutions to turn around and make more loans to prospective homeowners. Or at least that's the theory.

Franklin Delano Raines is a prominent Democrat, but that hadn't kept him from currying favor with the new Republican President. For more than 30 years Fannie Mae has straddled two worlds—business and politics—and the company placed enormous emphasis on maintaining good relations with key government officials. In 2001, Raines had written an op-ed in the Wall Street Journal lauding Bush's faith-based initiative. He had also reached out to Bush allies in the faith-based community, including Kirbyjon Caldwell, the Houston pastor who gave the benediction at Bush's first inaugural. In October 2002, at the White House Conference on Minority Home Ownership, Raines and Caldwell were both on hand to be praised warmly by Bush for their work.

It hasn't even been three years since that sunny day in Atlanta, but oh, how the world has changed. Both Brendsel and Raines have been deposed in the wake of multibillion-dollar accounting scandals. Brendsel fell in 2003, after government regulators accused Freddie Mac of understating billions in profits in an effort to smooth earnings. More recently the Securities and Exchange Commission ruled that Fannie Mae—the larger and more important of the two companies—had violated accounting rules, overstating profits by an estimated $9 billion since 2001, which represents almost 40% of its total earnings during that period. Raines, who was paid more than $90 million during his six years as CEO—much of it linked to meeting profit targets—made a last-ditch effort to save his job, but to no avail. CFO Tim Howard was also forced out. Fannie's accounting firm of 36 years, KPMG, was 

Continued in the article

FAS 133 says Fannie can't get hedge accounting for non-homongenious portfolios.  Will the SEC let they (and auditor KPMG) get way with it anyway?
Fannie Mae estimated it will have to post a $9 billion loss if the SEC finds it has been accounting improperly for derivatives. Ofheo, the mortgage firm's regulator, said Fannie incorrectly applied accounting rules in a way that let it spread out losses over many years rather than taking an immediate hit.
James R. Hagerty, "Fannie Warns of $9 Billion Loss If Derivatives Ruling Is Adverse," The Wall Street Journal, November 16, 2004, Page A3 --- http://online.wsj.com/article/0,,SB110055804528874668,00.html?mod=home_whats_news_us 
Bob Jensen's threads on the Freddie and Fannie derivatives scandals are at http://www.trinity.edu/rjensen/caseans/000index.htm 

Our review indicates that during the period under our review, from 2001 to mid-2004, Fannie Mae's accounting practices did not comply in material respects with the accounting requirements in Statement Nos. 91 and 133. http://www.sec.gov/news/press/2004-172.htm 

Donald T. Nicolaisen, Chief Accountant for the Securities and Exchange Commission (Commission), issued the following statement regarding the compliance of the Federal National Mortgage Association's (Fannie Mae) accounting practices for deferred purchase price adjustments and for derivatives and hedging activities with Statement of Financial Accounting Standards No. 91, "Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases" (Statement No. 91), and Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities" (Statement No. 133):

Our review indicates that during the period under our review, from 2001 to mid-2004, Fannie Mae's accounting practices did not comply in material respects with the accounting requirements in Statement Nos. 91 and 133.

Regarding Statement No. 91, during the period under the SEC staff's review, Fannie Mae failed to record timely adjustments to the recorded amount of its loans based on changes in the estimated speed with which those loans would be prepaid. Among other requirements, Statement No. 91 provides that when applying the method used by Fannie Mae an entity should use its best estimate of expected prepayment rates in calculating the carrying amount of its loans. Fannie Mae previously had concluded that its methodology for performing these calculations for interim balance sheet dates in the periods 2001 through 2002 was not consistent with Statement No. 91, and has stated that it has changed its accounting policies to, among other things, calculate the amounts based on quarter-end positions rather than projected year-end positions.

It also appears that, contrary to Statement No. 91, Fannie Mae recognized adjustments to the carrying amount of its loans only if they exceeded a self-defined materiality limit, referred to as a "precision threshold." Fannie Mae has represented to the Commission staff that it has initiated further changes to eliminate the "precision threshold" and is working with OFHEO to further amend its accounting practices under Statement No. 91.

Regarding Statement No. 133, one of the principles underlying the statement is that derivative instruments are to be recorded at their fair value with changes in fair value reported in earnings. If certain hedge criteria are met, however, Statement No. 133 affords special accounting for the hedge relationship. If the specific hedging requirements are not met, then special hedge accounting is not appropriate.

Fannie Mae internally developed its own unique methodology to assess whether hedge accounting was appropriate. Fannie Mae's methodology, however, did not qualify for hedge accounting because of deficiencies in its application of Statement No. 133. Among other things, Fannie Mae's methodology of assessing, measuring, and documenting hedge ineffectiveness was inadequate and was not supported by the Statement.

We understand that Fannie Mae is working with an outside adviser to amend its hedge accounting practices and develop an appropriate approach to hedge accounting under Statement No. 133.

This evening, therefore, I have advised Fannie Mae that, to be consistent with Statement Nos. 91 and 133 and to provide investors with appropriate information, Fannie Mae should:

* Restate its financial statements filed with the Commission to eliminate the use of hedge accounting. * Evaluate the accounting under Statement No. 91 and restate its financial statements filed with the Commission if the amounts required for correction are material. * Re-evaluate the information prepared under generally accepted accounting principles (GAAP) and non-GAAP information that Fannie Mae previously provided to investors, particularly in view of the decision that hedge accounting is not appropriate.

I appreciate the cooperation extended by Fannie Mae and OFHEO during our review and their willingness to provide us with information and detailed explanations of their views. It is my understanding that investigations into these and related matters by Fannie Mae's special review committee, the Commission, and others are continuing.

This is only an excerpt from the entire statement --- http://www.sec.gov/news/press/2004-172.htm

FAS 133 says Fannie can't get hedge accounting for non-homogenious portfolios.  Will the SEC let they (and auditor KPMG) get way with it anyway?
Fannie Mae estimated it will have to post a $9 billion loss if the SEC finds it has been accounting improperly for derivatives. Ofheo, the mortgage firm's regulator, said Fannie incorrectly applied accounting rules in a way that let it spread out losses over many years rather than taking an immediate hit.
James R. Hagerty, "Fannie Warns of $9 Billion Loss If Derivatives Ruling Is Adverse," The Wall Street Journal, November 16, 2004, Page A3 --- http://online.wsj.com/article/0,,SB110055804528874668,00.html?mod=home_whats_news_us 

It just gets deeper and deeper for KPMG, the auditing firm that approved some the Fannie Mae's earnings smoothing with questionable allowance of hedge accounting for speculations under FAS 133 rules.  Fannie's outside auditor, KPMG, certified its results knowing OFHEO's concerns.

OFHEO alleges that Fannie didn't qualify for this break (hedge accounting) because it didn't test whether the derivatives were eligible for such treatment.  Now, OFHEO says Fannie may not use this method (hedge accounting) at all.  Fannie could suffer a $12 billion hit from losses in derivatives, offset by $5 billion in gains, if OFHEO prevails.  But the impact could be greatly diminished if the SEC rules that Fannie can continue to account for derivatives this way if it follows the rules more closely.
Paula Dwyer, "Fannie Mae:  What's the Damage?" Business Week, October 11, 2004, Page 36 --- http://snipurl.com/Oct11Fannie

Bob Jensen's threads on KPMG scandals are at http://www.trinity.edu/rjensen/fraud.htm#KPMG 

KPMG knew that FAS 91 and FAS 133 were being violated, but KPMG did not insist on correcting the books.  How much of Fannie’s current trouble can be blamed on KPMG?
Fannie's auditor, KPMG, disagreed with the way the company decided how much (derivatives instruments debt and earnings fluctuations) to book in 1998. The matter was recorded as "an audit difference" -- a disagreement between a company and its auditor that doesn't require a change in the books.
John D. McKinnon and James R. Hagerty, "How Accounting Issue Crept Up On Fannie's Pugnacious Chief," The Wall Street Journal, December 17, 2004 --- http://online.wsj.com/article/0,,SB110323877001802691,00.html?mod=todays_us_page_one 
Bob Jensen’s threads on KPMG’s troubles are at http://www.trinity.edu/rjensen/fraud001.htm#KPMG 

When Four Just Isn't Enough!

When audits go bad, the clients just get traded around.  It appears that Deloitte may take the Fannie Mae audit from KPMG due to SEC pressures.  But Deloitte is not facing a life-threatening lawsuit.  The SEC is pressuring TIAA-CREF to drop E&Y due to violation of auditor independence.  The SEC is acting on bad audits but appears to be limited in how to correct the situation since there are only four in the Big Four.

"Fannie Restatement Sparks Debate Over Fate of Auditor:  Investors, Experts Question Quality of KPMG's Work; Checking the Annual Fees," bu Jonathan Weil and Diya Gullapalli, The Wall Street Journal, December 17, 2004; Page C3 --- http://online.wsj.com/article/0,,SB110324068628902772,00.html?mod=todays_us_money_and_investing 

The Securities and Exchange Commission's decision directing Fannie Mae to restate its earnings is sparking a debate among investors, proxy advisers and accounting experts about whether the mortgage titan should dump outside auditor KPMG LLP.

And as demonstrated by the recent experience of Fannie's government-chartered cousin, Freddie Mac, once a company gets a fresh set of eyes to pore over its books and records, there's no telling what other accounting issues may pop up.

A proposal by the Office of Federal Housing Enterprise Oversight could require Fannie to change its auditor by Jan. 1, 2006, and rotate its auditor at least every 10 years after that. The proposal is under review by the White House Office of Management and Budget.

With both the SEC and Ofheo agreeing that Fannie violated the accounting rules for derivative financial instruments, "they should immediately change auditors given this apparent lack of quality in the audit work," says Mike Lofing, an analyst in Broomfield, Colo., at Glass Lewis & Co., one of the nation's most prominent proxy-advisory firms. If Fannie doesn't replace KPMG, he says, his firm likely would advise its institutional-investor clients to oppose the ratification of KPMG as Fannie's auditor at the company's annual meeting next spring.

A Fannie spokeswoman declined to comment on any possible change in auditors. In a statement, KPMG said: "We accept the company's decision to follow the direction of the [SEC's] Office of the Chief Accountant with respect to Fannie Mae's prior financial statements." A KPMG spokesman declined to respond to suggestions that Fannie should replace KPMG as its auditor.

To be sure, not all investors believe an immediate auditor switch is necessary. "I'd like to get more information about why [the SEC's staff] made their interpretation" before deciding on whether KPMG should be replaced, says David Dreman, chairman of investment firm Dreman Value Management LLC, which held about eight million shares as of Sept. 30.

Still, two years ago, Freddie Mac's decision to replace the imploding Arthur Andersen LLP with PricewaterhouseCoopers LLP helped the company turn over a new leaf. Shortly after the switch, the new auditor found widespread accounting manipulations, including false asset valuations. After restating financials and ousting its chief executive officer last year, Freddie's stock has risen over 20% this year and the firm is gaining market share from Fannie.

In the same vein, a new auditor at Fannie might identify potentially bigger issues than the ones identified by Ofheo and the SEC. Fannie's estimate last month that a restatement could reduce its past earnings and regulatory capital by $9 billion is based on the assumption that the derivatives and other assets and liabilities on Fannie's balance sheet already were being valued appropriately as of Sept. 30. Conceivably, a new auditor might find they weren't.

"It would be astute for Fannie to contemplate whether an auditor that was not involved with the prior circumstance might not bring more credibility to their future financial statements," adds Tom Linsmeier, an accounting professor and derivatives specialist at Michigan State University, who testified last year before Congress on Fannie's accounting practices.

The audit fees that Fannie paid KPMG in recent years were paltry, raising questions among investors and analysts about just how much audit work KPMG could have been performing. Last year Fannie paid KPMG $2.7 million to audit its financial statements. It paid even less in years before -- just $1.4 million in 2001. By himself, Fannie Mae Chief Financial Officer Tim Howard got $5.4 million in compensation last year, including stock options. By comparison, Freddie Mac, with roughly $800 billion of assets at Dec. 31, paid PricewaterhouseCoopers more than $46 million for its 2003 audit.

The Fannie debacle comes at a critical time for KPMG, which has been in crisis-management mode for the past few years over a host of audit failures and government investigations. Among other things, the firm's sales of allegedly abusive tax shelters remain the focus of a criminal grand-jury investigation that began about a year ago.

If Fannie wants a new Big Four auditor, the least likely choice would appear to be Ernst & Young LLP, which is advising Fannie's audit committee in responding to the government probes. Conceivably, Fannie could hire Deloitte & Touche LLP, which has been assisting Ofheo's examination.

Continued in the article

Bob Jensen's threads on troubles of big accounting firms are at http://www.trinity.edu/rjensen/fraud001.htm#others 

Bob Jensen's threads on how "A Bad Audit is Becoming the Rule Rather Than the Exception are at http://www.trinity.edu/rjensen/fraudconclusion.htm#IncompetentAudits 

The mounting pressure on Mr. Raines comes after a career that lifted him from childhood poverty to Harvard Law School, a Rhodes scholarship, and the pinnacle of power in government and finance. For years, the company he leads got its way in Washington, wielding an army of lobbyists and calling on its many friends in Congress and the homebuilding industry. Fighting Fannie was considered futile. "You didn't question the king," says Andrew Cuomo, housing secretary under President Clinton. Fannie, which has about $957 billion of debt, is involved in financing more than a quarter of U.S. residential mortgage debt outstanding
John D. McKinnon and James R. Hagerty, "How Accounting Issue Crept Up On Fannie's Pugnacious Chief," The Wall Street Journal, December 17, 2004 --- http://online.wsj.com/article/0,,SB110323877001802691,00.html?mod=todays_us_page_one 
Bob Jensen's Fannie threads are at http://www.trinity.edu/rjensen/caseans/000index.htm 

Fannie's Unethical Tone at the Top:  There's More Wrong Than Just Accounting Fraud
Fannie Mae, eager to unload a batch of fraudulent loans it purchased from a North Carolina lender, knowingly allowed the lender to resell the loans to a government mortgage agency, according to federal law-enforcement officials. A federal judge in Charlotte, N.C., has ordered Fannie Mae to forfeit $6.5 million for not informing the agency about the fraud.
Dawn Kopecki, "Fannie Is Ordered to Forfeit $6.5 Million," The Wall Street Journal, November 30, 2004 --- http://online.wsj.com/article/0,,SB110178387928686489,00.html?mod=home%5Fwhats%5Fnews%5Fus 

Question
What is the hidden "g-fee" in your monthly mortgage payment and why doesn't it stand for the "good-fee?"

Answer
Most likely the company who initially financed your house sold that mortgage to big Fannie or her somewhat smaller brother Freddie who then tacked on a hidden g-fee that you’ve been paying every month.  Freddie and Fannie are quasi-private companies owned by shareholders.  Both companies can borrow at relatively low rates since the U.S. government co-signs their borrowings.  If these companies default upon their hundreds of billions in debt, it may well become a costly scandal analogous to the Savings & Loan scandal which most of you probably remember cost taxpayers billions of dollars.  Recently Fannie Mae’s CEO and CFO were forced out for accounting manipulations that were not allowed by accounting standards.  Fannie’s auditor, KPMG, was also fired.  This was the second time around for FAS 133 violations by Fannie Mae.  Freddie Mac also got caught up in a FAS 133 accounting scandal.

"Hidden Fees in Most Mortgages Bring Scrutiny to Fannie, Freddie," by John R. Wilke, The Wall Street Journal, January 14, 2004, Page A1 --- http://online.wsj.com/article/0,,SB110565253953225630,00.html?mod=home%5Fpage%5Fone%5Fus 

Fannie Mae and Freddie Mac have helped millions of Americans buy and refinance homes. Along the way, they've helped themselves to huge profits from little-known fees tucked into most monthly mortgage payments.

The most significant of these fees covers a guarantee that the loan will be paid by the homeowner on time each month. The fee, called a guarantee fee or a "g-fee," brought in an estimated $4 billion for the mortgage giants last year. But lenders have long complained that with no significant competition, Fannie and Freddie have kept the fees far above cost.

Now the fees, which can total thousands of dollars for consumers over the life of a mortgage, are emerging as a new battleground in the regulatory scramble to rein in the two mortgage giants after financial-reporting scandals ousted top officials at both companies.

In a previously undisclosed analysis provided last month to members of Congress, Fannie's and Freddie's primary regulator concluded the federally chartered companies use their market clout and government privileges to keep the fees high, yielding excessive profits at the expense of millions of homeowners. The fees, which Fannie and Freddie sometimes move in lockstep, may also raise antitrust issues, according to the analysis by the Office of Federal Housing Enterprise Oversight. Congress is considering new legislative curbs on the mortgage giants that could slow their growth and lead to tougher oversight.

Critics of Fannie and Freddie say g-fees should rise and fall with the companies' actual losses due to mortgage defaults. Instead, the fees in 2003 amounted to 33 times those losses -- a big jump from 4.4 times credit losses in 1995, according to internal figures cited by Ofheo. That means that despite falling losses due to defaults, guarantee-fee rates remain high. The banks say consumers should be paying hundreds of millions of dollars less in g-fees and other charges.

Sharon McHale, Freddie's spokeswoman, says Freddie's g-fees "are appropriate and competitive in today's market" and that investors "expect a reasonable rate of return or profit." Richard Syron, Freddie's chief executive, says that "it's very hard to make the argument that we are being rapacious."

The mortgage giants insist they face plenty of competition. "The secondary [mortgage] market is highly competitive, and lenders have numerous options available in the marketplace," says Charles Greener, Fannie's spokesman. Both companies are also under new management and have vowed to work to respond to their critics and work more closely with regulators.

Consumers have a big stake in the battle. On a typical $250,000 home loan, the g-fee is about $500 a year at the beginning of the loan's term and totals $11,350 over the loan's 30-year life. Fannie and Freddie impose many other charges, including fees for the use of proprietary technology the companies push bankers and brokers to use when their customers apply for a mortgage. Other transaction charges have become an increasingly important source of revenue, including a recently created fee on "cash out" refinancings made popular by falling interest rates in recent years.

Continued in the article

This might be a good assignment for students.

Question
Why do firms issue preferred shares and what is the cost/benefit to common shareholders?

Answer

"Fannie Mae Agrees to Sell Preferred Stock," by Eric Dash, The New York Times, December 30, 2004 --- http://www.nytimes.com/2004/12/30/business/30place.html?oref=login  

Fannie Mae the nation's largest buyer of mortgages, said yesterday that it agreed to sell $5 billion of preferred stock to large institutional investors in a rush to meet its regulator's minimum capital requirements.

The company is selling two types of preferred stock, allowing it to make up an estimated $3 billion shortfall to satisfy the minimum capital standards imposed by the regulator, the Office of Housing Enterprise Oversight. The regulator, known by its acronym Ofheo, determined last week that Fannie Mae would be "significantly undercapitalized" once it restates its earnings by an estimated $9 billion to correct problems with the way it accounted for derivatives over the last three and a half years.

"The placement of preferred stock is a key component of Fannie Mae's capital restoration plan," said Donald B. Marron, a Fannie director and a former chief executive of Paine Webber, who has been working with Ofheo since November on ways to increase the company's capital reserves. Because Fannie Mae is currently undercapitalized, the company must get Ofheo's approval on virtually all decisions that might alter its capital reserves.

The stock issuance is the latest in a series of steps by Fannie Mae to regain the confidence of Ofheo, which has pressed for major changes at the company since it issued a scathing report on its accounting practices last fall. Last week, Fannie Mae's independent board members ousted Franklin D. Raines, its influential chairman and chief executive, and also forced out its chief financial officer, J. Timothy Howard, and its outside auditor, KPMG, after the Securities and Exchange Commission had found that the company violated accounting rules.

Earlier this fall, the board reached an agreement with Ofheo to raise its capital reserves by 30 percent, or about $9 billion, and it has been working with the regulator to draw up plans to meet those higher requirements by June.

The infusion of $5 billion, the largest amount Fannie has raised through the private sale of preferred equity, will create a capital cushion large enough for now. But Fannie Mae must still come up with about $7 billion more over the next six months, even as questions persist about its future direction persist.

"The challenges are immense for this company," said Paul Miller, an analyst with Friedman Billings Ramsey of Arlington, Va. "There are just too many unknowns and challenges and we don't know what the overall going-forward philosophy is going to be."

Fannie Mae continues to be investigated by Ofheo, the Justice Department and the S.E.C., and it faces a groundswell of pressure from critics on Capitol Hill who have sought tighter regulatory restrictions on the government-sponsored housing corporations. Fannie's board will be looking for a permanent chief executive and chief financial officer and will be improving internal controls. It must also hire a new auditor, which will have to fix existing problems and will probably not be able to release new results for several years.

"These would be issues that buyers would take into consideration," said John J. Kriz, an fixed-income analyst who follows Fannie Mae for Moody's Investors Service.

Shares of Fannie closed yesterday up 54 cents, at $70.38. Earlier in the day, Fannie Mae said it was seeking to sell $4 billion of preferred stock, and the stock fell sharply. But it quickly rebounded amid talk that there was strong demand for a preferred stock offering. After the stock market closed, the company said it had agreed to sell a total of $5 billion in two offerings arranged by Lehman Brothers.

Preferred stock is a type of equity that shares many of the properties of debt as the companies make regular dividend payments. Fannie Mae issued $2.5 billion in securities that can be converted into Fannie Mae common stock. The company also issued $2.5 billion worth of nonconvertible preferred shares with a floating rate that adjusts quarterly.

The quick sale agreement, analysts said, was a testament to its large size and the widely held assumption that the federal government stands behind the company.

"It's a well-known company, it has a government charter, and it kicks off a lot of cash," Mr. Miller, of Friedman Billings, said.

But the sale is also a sign that Fannie has newfound respect for its regulator. "For years, Fannie Mae attacked its regulator and disparaged the regulator while nominally accepting its claims," said Thomas H. Stanton, who has written two books which argued that Fannie Mae and other government-sponsored finance companies were undercapitalized. "I think that it is very good that Fannie Mae is finally taking those issues seriously."

Many analysts believe that the company will be able to raise the additional $7 billion or so to comply with the higher capital standards. The company currently retains between $2 billion and $3 billion in earnings each quarter and it could also sell part of its portfolio holdings to raise additional funds. But yesterday's agreement to sell preferred stock reduces the threat to the company's future dividends.

Continued in article

Macro Hedging is Probably the Main Weakness of FAS 133, and Fannie Mae is Taking it in the Fanny

The bottom line is that both the FASB and the IASB must someday soon take another look at how the real world hedges portfolios rather than individual securities.  The problem is complex, but the problem has come to roost in Fannie Mae's $1 trillion in hedging contracts.  How the SEC acts may well override the FASB.  How the SEC acts may be a vindication or a damnation for Fannie Mae and Fannie's auditor KPMG who let Fannie violate the rules of IAS 133.

You can read more about macro hedges at http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#M-Terms 

On October 4, 2004 the main editorial in The Wall Street Journal presented a scathing attack on Fannie Mae (and outside auditor KPMG by implication) for simply ignoring FAS 133 explicit rules for testing hedging effectiveness and improperly keeping over $1 billion in hedging gains and losses in AOCI (accumulated other comprehensive income) rather than current earnings.

"Fannie Mae Enron?" Editorial in The Wall Street Journal
October 4, 2004; Page A16

For years, mortgage giant Fannie Mae has produced smoothly growing earnings. And for years, observers have wondered how Fannie could manage its inherently risky portfolio without a whiff of volatility. Now, thanks to Fannie's regulator, we know the answer. The company was cooking the books. Big time.

We've looked closely at the 211-page report issued by the Office of Federal Housing Enterprise Oversight (Ofheo), and the details are more troubling than even the recent headlines. The magnitude of Fannie's machinations is stunning, and in two key areas in particular they deserve to be better understood. By improperly delaying the recognition of income, it created a cookie jar of reserves. And by improperly classifying certain derivatives, it was able to spread out losses over many years instead of recognizing them immediately.

In the cookie-jar ploy, Fannie set aside an artificially large cash reserve. And -- presto -- in any quarter its managers could reach into that jar to compensate for poor results or add to it to dampen good ones. This ploy, according to Ofheo, gave Fannie "inordinate flexibility" in reporting the amount of income or expenses over reporting periods.

This flexibility also gave Fannie the ability to manipulate earnings to hit -- within pennies -- target numbers for executive bonuses. Ofheo details an example from 1998, the year the Russian financial crisis sent interest rates tumbling. Lower rates caused a lot of mortgage holders to prepay their existing home mortgages. And Fannie was suddenly facing an estimated expense of $400 million.

Well, in its wisdom, Fannie decided to recognize only $200 million, deferring the other half. That allowed Fannie's executives -- whose bonus plan is linked to earnings-per-share -- to meet the target for maximum bonus payouts. The target EPS for maximum payout was $3.23 and Fannie reported exactly . . . $3.2309. This bull's-eye was worth $1.932 million to then-CEO James Johnson, $1.19 million to then-CEO-designate Franklin Raines, and $779,625 to then-Vice Chairman Jamie Gorelick.

That same year Fannie installed software that allowed management to produce multiple scenarios under different assumptions that, according to a Fannie executive, "strengthens the earnings management that is necessary when dealing with a volatile book of business." Over the years, Fannie designed and added software that allowed it to assess the impact of recognizing income or expense on securities and loans. This practice fits with a Fannie corporate culture that the report says considered volatility "artificial" and measures of precision "spurious."

This disturbing culture was apparent in Fannie's manipulation of its derivative accounting. Fannie runs a giant derivative book in an attempt to hedge its massive exposure to interest-rate risk. Derivatives must be marked-to-market, carried on the balance sheet at fair value. The problem is that changes in fair-value can cause some nasty volatility in earnings.

So, Fannie decided to classify a huge amount of its derivatives as hedging transactions, thereby avoiding any impact on earnings. (And we mean huge: In December 2003, Fan's derivatives had a notional value of $1.04 trillion of which only a notional $43 million was not classified in hedging relationships.) This misapplication continued when Fannie closed out positions. The company did not record the fair-value changes in earnings, but only in Accumulated Other Comprehensive Income (AOCI) where losses can be amortized over a long period.

Fannie had some $12.2 billion in deferred losses in the AOCI balance at year-end 2003. If this amount must be reclassified into retained earnings, it might punish Fannie's earnings for various periods over the past three years, leaving its capital well below what is required by regulators.

In all, the Ofheo report notes, "The misapplications of GAAP are not limited occurrences, but appear to be pervasive . . . [and] raise serious doubts as to the validity of previously reported financial results, as well as adequacy of regulatory capital, management supervision and overall safety and soundness. . . ." In an agreement reached with Ofheo last week, Fannie promised to change the methods involved in both the cookie-jar and derivative accounting and to change its compensation "to avoid any inappropriate incentives."

But we don't think this goes nearly far enough for a company whose executives have for years derided anyone who raised a doubt about either its accounting or its growing risk profile. At a minimum these executives are not the sort anyone would want running the U.S. Treasury under John Kerry. With the Justice Department already starting a criminal probe, we find it hard to comprehend that the Fannie board still believes that investors can trust its management team.

Fannie Mae isn't an ordinary company and this isn't a run-of-the-mill accounting scandal. The U.S. government had no financial stake in the failure of Enron or WorldCom. But because of Fannie's implicit subsidy from the federal government, taxpayers are on the hook if its capital cushion is insufficient to absorb big losses. Private profit, public risk. That's quite a confidence game -- and it's time to call it.

 

"Fannie Mae Warns of Possible $9B Loss, KPMG Won't Sign Off," AccountingWeb, November 18, 2004 --- http://www.accountingweb.com/cgi-bin/item.cgi?id=100095 

From The Wall Street Journal Accounting Weekly Review on October 29, 2004

TITLE: Probe Into Fannie's Accounting May Last for Months, SEC Says
REPORTER: John Connor
DATE: Oct 25, 2004
PAGE: A2
LINK: http://online.wsj.com/article/0,,SB109866141167754219,00.html 
TOPICS: Accounting, Advanced Financial Accounting, Auditing, Derivatives, Earnings Management, Financial Accounting

SUMMARY: The SEC acknowledged that Fannie Mae's accounting issues are a complex matter and are not black and white, in apparent contrast to the assertions made by Office of Federal Housing Enterprise Oversight (Ofheo). The related article discusses recent congressional testimony by Franklin Raines, Fannie Mae's chairman and chief executive, designed direct focus on the SEC's assessment of their accounting practices, rather than Ofheo's.

QUESTIONS:
1.) Summarize the description of Fannie Mae's circumstances from this article and the related one.

2.) Why are the issues associated with accounting for derivative security transactions "not black and white"?

3.) Why would the Office of Federal Housing Enterprise Oversight (Ofheo) acknowledge "that Generally Accepted Accounting Principles is (sic) within the SEC's 'purview'"? Does the SEC establish accounting principles? Does any other entity do so?

4.) Why might it be particularly difficult to show that any entity undertakes accounting for derivatives with a view to smoothing income or to meet bonus targets for earnings? What evidence do you think would be necessary to demonstrate that intent?

Reviewed By: Judy Beckman, University of Rhode Island

--- RELATED ARTICLES ---
TITLE: Fannie Mae Seeks an Ally in SEC
REPORTER: Jonathan Weil and John D. McKinnon
PAGE: C1
ISSUE: Oct 12, 2004
LINK: http://online.wsj.com/article/0,,SB109752814675942250,00.html

FAS 133 (and IAS 39) do not deal well with macro (portfolio) hedges in that hedge accounting is denied unless all of the securities in a portfolio are identical in terms of the risk being hedged.  IAS 39 was recently amended (largely for political rather than theory reasons) to allow for macro hedges of interest rate risk when the maturity dates or possible early payoff dates are not identical.  But the IAS 39 amendment  is only a very small step toward solving a very large problem.  Companies like Fannie Mae and Freddie Mac find it impractical (actually impossible) to hedge individual securities (or homogeneous portfolios) as required under FAS 133.

The large problem is that when non-homogeneous portfolios are being hedged for only one of several risks, there can be a huge mismatch in terms of value changes of the portfolio versus value change of the hedging derivatives.  When writing the hedge accounting standards, standard setters took a conservative approach that virtually denies hedge accounting for non-homogeneous portfolios.  This long been known as the "macro hedging" problem of FAS 133.  By denying hedge accounting to financial institutions with large non-homogeneous portfolios, those institutions are going to show huge fluctuations in net earnings by having to mark-to-market all macro hedging derivatives with offsetting value changes being charged to current earnings rather than some offset such as AOIC for cash flow hedges or the macro portfolio itself for fair value hedges.

One of the better media articles about this controversial problem is the following article by Michael MacKenzie.  What MacKenzie does is explain just how Fannie Mae covers her fanny with macro hedging strategy that really is not eligible for hedge accounting under FAS 133.  However, the problem is with FAS 133.

:"Sometimes the Wrong 'Notion':   Lender Fannie Mae Used A Too-Simple Standard For Its Complex Portfolio," by Michael MacKenzie, The Wall Street Journal, October 5, 2004, Page C3 

Lender Fannie Mae Used A Too-Simple Standard For Its Complex Portfolio

What exactly did Fannie Mae do wrong?

Much has been made of the accounting improprieties alleged by Fannie's regulator, the Office of Federal Housing Enterprise Oversight.

Some investors may even be aware the matter centers on the mortgage giant's $1 trillion "notional" portfolio of derivatives -- notional being the Wall Street way of saying that that is how much those options and other derivatives are worth on paper.

But understanding exactly what is supposed to be wrong with Fannie's handling of these instruments takes some doing. Herewith, an effort to touch on what's what -- a notion of the problems with that notional amount, if you will.

Ofheo alleges that, in order to keep its earnings steady, Fannie used the wrong accounting standards for these derivatives, classifying them under complex (to put it mildly) requirements laid out by the Financial Accounting Standards Board's rule 133, or FAS 133.

For most companies using derivatives, FAS 133 has clear advantages, helping to smooth out reported income. However, accounting experts say FAS 133 works best for companies that follow relatively simple hedging programs, whereas Fannie Mae's huge cash needs and giant portfolio requires constant fine-tuning as market rates change.

A Fannie spokesman last week declined to comment on the issue of hedge accounting for derivatives, but Fannie Mae has maintained that it uses derivatives to manage its balance sheet of debt and mortgage assets and doesn't take outright speculative positions. It also uses swaps -- derivatives that generally are agreements to exchange fixed- and floating-rate payments -- to protect its mortgage assets against large swings in rates.

Under FAS 133, if a swap is being used to hedge risk against another item on the balance sheet, special hedge accounting is applied to any gains and losses that result from the use of the swap. Within the application of this accounting there are two separate classifications: fair-value hedges and cash-flow hedges.

Fannie's fair-value hedges generally aim to get fixed-rate payments by agreeing to pay a counterparty floating interest rates, the idea being to offset the risk of homeowners refinancing their mortgages for lower rates. Any gain or loss, along with that of the asset or liability being hedged, is supposed to go straight into earnings as income. In other words, if the swap loses money but is being applied against a mortgage that has risen in value, the gain and loss cancel each other out, which actually smoothes the company's income.

Cash-flow hedges, on the other hand, generally involve Fannie entering an agreement to pay fixed rates in order to get floating-rates. The profit or loss on these hedges don't immediately flow to earnings. Instead, they go into the balance sheet under a line called accumulated other comprehensive income, or AOCI, and are allocated into earnings over time, a process known as amortization.

Ofheo claims that instead of terminating swaps and amortizing gains and losses over the life of the original asset or liability that the swap was used to hedge, Fannie Mae had been entering swap transactions that offset each other and keeping both the swaps under the hedge classifications. That was a no-go, the regulator says.

"The major risk facing Fannie is that by tainting a certain portion of the portfolio with redesignations and improper documentation, it may well lose hedge accounting for the whole derivatives portfolio," said Gerald Lucas, a bond strategist at Banc of America Securities in New York.

The bottom line is that both the FASB and the IASB must someday soon take another look at how the real world hedges portfolios rather than individual securities.  The problem is complex, but the problem has come to roost in Fannie Mae's $1 trillion in hedging contracts.  How the SEC acts may well override the FASB.  How the SEC acts may be a vindication or a damnation for Fannie Mae and Fannie's auditor KPMG who let Fannie violate the rules of IAS 133.

Bob Jensen's threads on macro hedging are at
http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#M-Terms 

FEDERATION BANCAIRE DE L'UNION EUROPEENNE Provides a great free document on macro hedging with references to IAS 39.  The article also discusses prospective and retrospective effectiveness testing. For a link to the document go to the term "ineffectiveness" at http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#I-Terms 

Bob Jensen's threads on KPMG scandals are at 
http://www.trinity.edu/rjensen/fraud.htm#KPMG 

From The Wall Street Journal Accounting Weekly Review on October 8, 2004

TITLE: Fannie Mae Probe Into Accounting Faces a High Bar
REPORTER: John D. McKinnon
DATE: Oct 01, 2004
PAGE: A3
LINK: http://online.wsj.com/article/0,,SB109657528543632814,00.html 
TOPICS: Accounting, Accounting Fraud, Financial Accounting, Financial Accounting Standards Board, Securities and Exchange Commission

SUMMARY: Ofheo issued a reported last week critical of Fannie Mae's accounting practices as being designed to smooth earnings and, in at least one case, increase earnings from "cookie jar reserves" to support executives' receipt of bonuses. The Justice Department has now opened an an investigation of possible accounting fraud.

QUESTIONS:
1.) What are "aggressive interpretations of accounting rules"? How can these interpretations be used with "specific intent to deceive" financial statement users? What other motives might lead an entity to produce financial statements which reflect an aggressive approach?

2.) "Prosecutors' problems are...compounded because accounting standards are often so vague..." Describe a standard which you think is written in a vague manner. How do preparers have difficulty in applying the standard because of this vagueness? How might they use such vagueness to apply an aggressive approach to recording transactions?

3.) Contrast your answer to the question above with an example of an accounting standard which contains clear rules rather than vague requirements. What are some concerns with accounting standards written in that fashion?

4.) In the article, the author writes, "...the ultimate arbiters of the accounting rules are the Securities and Exchange Commission and the newly-created Public Company Accounting Oversight Board." Do you agree with that statement? Support your answer with reference to the role of each entity having authority to establish accounting and auditing standards.

5.) The last sentence in the article refers to Sarbanes-Oxley requirements regarding executive bonuses. How do those requirements relate to the discussion in the article?

Reviewed By: Judy Beckman, University of Rhode Island

--- RELATED ARTICLES ---
TITLE: Fannie Mae Board Agrees to Changes It Long Resisted
REPORTER: James R. Hagerty and John D. McKinnon
PAGE: A1
ISSUE: Sep 28, 2004 LINK: http://online.wsj.com/article/0,,SB109628948468528709,00.html

TITLE: Fannie Voice of Calm Now Is in Storm
REPORTER: John D. McKinnon PAGE: A6 ISSUE: Sep 28, 2004
LINK: http://online.wsj.com/article/0,,SB109632291730429326,00.html

First Trip Up

Fannie Mae's regulator is set to present a report highly critical of the mortgage company's accounting practices to its board:   Probe points to decisions to smooth out earnings, possibly increase bonuses 

"Fannie Mae Overseer to Present Report Criticizing Accounting," by John D. McKinnon and James R. Hagerty, The Wall Street Journal, September 20, 2004, Page A2 --- http://online.wsj.com/article/0,,SB109563119263921750,00.html?mod=home_whats_news_us 

Federal regulators are to present a report highly critical of accounting practices at Fannie Mae to the mortgage company's board today, according to several people familiar with the situation.

The company's regulator, the Office of Federal Housing Enterprise Oversight, or Ofheo, declined to comment on the status of the eight-month probe of Fannie's accounting. But people who have been briefed on the results said Ofheo found evidence of a pattern of decisions by executives aimed at manipulating earnings to present a smoother performance. Ofheo also has been examining whether the decisions were made with an eye to beefing up bonuses to executives, they added.

Fannie's corporate cousin, Freddie Mac, agreed to pay a $125 million civil penalty for using a series of exotic financial transactions and other accounting gimmicks to smooth its earnings. A finding that Fannie Mae also manipulated its financial reports to make them look less volatile could boost efforts in Congress to tighten regulation of the two federally chartered mortgage companies.

"The smoothing problem at Freddie Mac has been determined to be present at Fannie Mae,'' said Rep. Richard Baker (R., La.), chairman of the House subcommittee that oversees government-sponsored enterprises such as Fannie and Freddie. Mr. Baker was briefed on the situation by congressional staff. He said that while the Ofheo examination continues, he believes regulators are exploring whether one

reason for the smoothing was to maximize some executives' compensation.

Stepping up the pressure on Fannie, Ofheo brought in as an adviser Washington lawyer Stanley Sporkin, a former federal judge and onetime enforcement director at the Securities and Exchange Commission. Mr. Sporkin took part last week when Ofheo presented its findings to the SEC, which also regulates Fannie, people familiar with the situation said.

By engaging such a high-powered securities lawyer, Ofheo seems determined to block Fannie from driving a wedge between it and the SEC over interpretations of accounting rules. Fannie is being advised by Wilmer Cutler Pickering Hale and Dorr LLP, known for its securities-law expertise and close contacts at the SEC.

A Fannie Mae spokesman declined to comment, as did an SEC spokesman. A spokesman for KPMG LLP, Fannie's outside auditor, said that the firm hasn't seen the Ofheo findings but that "we stand behind our audit work for Fannie Mae." Mr. Sporkin, a partner at the law firm Weil, Gotshal & Manges, couldn't be reached.

Fannie's chief executive officer, Franklin D. Raines, repeatedly has defended the company's accounting.

Ofheo announced the examination into Fannie's accounting last year following the scandal at Freddie Mac. Freddie ousted two CEOs and other senior executives in the course of that investigation. Ofheo eventually found the company had manipulated its accounting to make earnings look less volatile; steadily rising earnings are important to the companies' shareholders and debtholders, who seek reassurance that Fannie and Freddie can withstand fluctuations in interest rates and the real-estate market.

Freddie later disclosed that its accounting misdeeds led it to understate earnings by about $5 billion over several years. Investors were relieved to find that Freddie was even more profitable than it had appeared.

Continued in article

The Justice Department opened a probe of possible accounting fraud at Fannie Mae. The move comes in the wake of a report by Fannie's regulator that the mortgage company may have manipulated its books to meet earnings targets.
"Fannie Criminal Probe Is Launched," by John R. Wilke et al, The Wall Street Journal, September 29, 2004 --- http://online.wsj.com/article/0,,SB109649594924831762,00.html?mod=home_whats_news_us

"Regulator Details a Wide Range Of Accounting Problems at Fannie," by James R. Hagerty et al, The Wall Street Journal, September 23, 2004, Page A1 --- http://online.wsj.com/article/0,,SB109585616894724782,00.html?mod=home_whats_news_us 

Fannie Mae's regulator accused the mortgage-finance giant of a wide range of improper accounting practices -- including at least one instance in which executives allegedly delayed expenses in an apparent effort to hit their bonus targets.

In a 200-page report released late yesterday afternoon, the regulator, the Office of Federal Housing Enterprise Oversight, or Ofheo, said its findings "raise concerns regarding the validity of previously reported financial results, the adequacy of regulatory capital, the quality of management supervision and the overall safety and soundness" of the company.

. . . 

Ofheo's interim report on its continuing examination also accuses Fannie of:

• Applying accounting methods and practices that don't comply with generally accepted accounting principles, or GAAP, to the company's derivatives transactions and hedging.
 
• Using a "cookie jar" reserve. Such reserves are used to improperly delay recognizing income so that it can be used to enhance results in later periods.
 
• Tolerating what it called "internal control deficiencies."
 
• Maintaining "a corporate culture that emphasized stable earnings at the expense of accurate financial disclosures."
 

Fannie's chief spokesman, Chuck Greener, declined to comment on whether the management agreed with any of the allegations but said the company's board is working with Ofheo "to resolve the issues." In a statement, the company promised to report back to Ofheo and the SEC "expeditiously" and said that the board has set up a committee composed entirely of outside directors "to take the lead on both the Ofheo report and the SEC inquiry." The statement was issued under the name of Ann McLaughlin Korologos, the presiding outside director.

Year 2000 Hype of Fannie Mae

"Fannie Mae: Using Shadow Processing to Preview FAS 133 Hurdles,"  April 3, 2000 --- http://www.fas133.com/search/search_article.cfm?page=161&areaid=274 

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

Year 2001 Problems in Retrospect 

"Derivatives and Hedging:  An Analyst's Response to FAS 133," by Frank Will, Finance Magazine, June 2002 --- http://www.corporatefinancemag.com/pdf/122341.pdf 

Benefits of FAS 133 for investors and external analysts

Although FAS 133 is controversial and can give rise to timing volatility in earnings and equity, as the case of Fannie Mae shows below, it has also some unquestionable benefits for investors and external analysts, who depend on the quality and scope of financial statements:

• Companies have to disclose more information on derivatives.  They are required to record and carry derivatives on the balance sheet at their current fair market value.  This reduces off-balance-sheet transactions and gives, at least in theory, a more detailed picture of the risk situation.
• Companies have to state the objectives for using each derivative, whether for hedging or speculation.  This provides transparency.
• Companies must implement a process for tracking and reporting derivatives' market values, offsetting risk position and hedge effectiveness.
• The quality of hedges has to be examined.  The hedged item must be explicitly identified and the ineffective portion of a hedge must be disclosed.

FAS 133 broadens the scope and complexity of the financial reporting and requires a company to constantly and thoroughly monitor its risk management.  While most banks and financial institutions already have sophisticated risk management systems, some non-financial companies may benefit from being forced to implement more sophisticated procedures and to more closely monitor hedge effectiveness.

Example: Fannie Mae

US mortgage lender Fannie Mae was highly affected by FAS 133 in 2001.  Fannie Mae uses derivatives only for hedging purposes and does not speculate in derivatives nor trade them for its own accounts.

Non-qualifying hedges
Fannie Mae has investment portfolios of originated mortgage assets and mortgage-backed securities that are classified as held-to-maturity.  Derivatives hedge these portfolios but they do not qualify for hedge accounting.  FAS 133 thus requires fair value accounting for the derivatives but not for the corresponding hedged items.  For example, a loss on derivatives used as economic hedges must be recognised but corresponding gains in the hedged investment portfolio cannot be recognised until realised.  The asymmetry in accounting treatment creates earnings volatility.

Qualifying cash flow hedge: derivatives as substitute for non-callable debt
Fannie Mae uses derivatives to replicate non-callable and callable debt cash flow structures.  It uses interest rate swaps (pay-fixed, receive-floating) as a substitute for non-callable debt.  These interest rate swaps convert short-term discount notes into longer-term fixed-rate liabilities that better match the expected maturity of their fixed-rate mortgage assets.  Economically there is little difference between this interest rate swap and the issue of a fixed-rated note or bond over the same period of time.  However, FAS 133 requires that Fannie Mae fair value the interest rate swaps, but not the non-callable bond nor the offsetting mortgage assets.  The swap gains and losses, primarily arising from the fixed leg, will increase or reduce the equity position, and any hedge ineffectiveness will impact earnings.  The equity fluctuations are not good indicators of the economic risk, since they arise from risk reduction.  The earnings fluctuations, however, are more informative, as they generally reflect the extent to which the derivative's risk is more volatile than the risk of the hedged item.  See Figure 1.

Qualifying cash flow hedge: derivatives as substitute for callable debt
Instead of issuing a long-term fixed-rate bond with an embedded call right, Fannie Mae sometimes issues a shorter non-callable note, and purchases an option on a pay-fixed interest rate swap for the remaining period.  Although in economic terms the two strategies are nearly the same, they are treated differently under FAS 133.  Callable debt is not carried at fair value.  However, under the second strategy, the swaption is designated as a cash flow hedge to fix the rate of borrowing on the company's anticipated debt issuance.  The derivative is fair valued with the effective hedging gains and losses deferred in equity.  The time value gains and losses on the swaption plus any hedge ineffectiveness are recognised in current earnings.  This different treatment creates volatility in earnings and in equity which, if the purchased option is held until maturity, will net to zero over the life of the hedge.  The volatility arises from accounting timing issues only.  The information is confusing and does not, in our opinion, provide meaningful economic information to investors.  Most analysts will likely want to exclude its impact from their analysis.

Fannie Mae 2001 FAS 133 impact on earnings and equity

The income and equity volatility induced by FAS 133 make it difficult to evaluate the economic performance of the company.  Hence, in addition to the required net income and equity figures, Fannie Mae publishes operating net income and core capital figures, which are adjusted to exclude the FAS 133 impact.  The charts below show a stable growth in Fannie Mae's operating income in the last five quarters.  However, in the same period net income under FAS 133 was volatile: In the two first quarters of 2001 net income was higher than the operating net income ($55m and $88m, respectively).  In Q3 2001 it was $147m lower.  In Q4 2001 it was once more $531m higher while it was lower again in Q1 2002 ($310m).  FAS 133 has had a similar effect on shareholders' equity.  While Fannie Mae core capital, which is the crucial figure for the regulators, showed a stable trend, the shareholders' equity figures were very volatile due to the change in other comprehensive income.  See Figures 2 and 3 below.

What do the rating agencies and regulators say?

Typically, the rating agencies adjust their financial statement analysis to focus on the underlying economic performance of a company.  Regarding the accounting of derivatives and hedging, all three rating agencies (Standard & Poor's, Moody's, and Fitch Ratings) have said that they focus on operating income, which is adjusted to exclude the impact of FAS 133, instead of the net income figure using FAS 133.  The same can be said for the analysis of capitalisation of a company.  The rating agencies focus on common equity and qualifying preferred stock and exclude in their analyses comprehensive income resulting from the application of FAS 133.  Nevertheless, the rating agencies consider a company's ability to manage its derivative instrument use.  This includes evaluating the risk management systems and controls, as well as the company's ability to understand and properly value the derivative instrument.  Extensive economic hedges that do not meet FAS 133 (or IAS 39) hedge accounting criteria may undermine the market's confidence in a company's ability to manage its derivatives.

Regulators of financial institutions (SEC or OFHEO for Fannie Mae) also adjust the equity for the impact of FAS 133 and exclude the other comprehensive income from the companies' calculation of minimum capital.

Conclusion

FAS 133, although controversial and difficult to implement, provides a number of benefits for investors.  From an analyst's point of view the disclosure requirements on derivatives are positive.  Having information such as objectives for using each derivative, a description of a company's risk appetite, and disclosure of the quality and effectiveness of hedges, is helpful in analysing the credit quality of a company.

However, FAS 133 still needs further clarification and improvement as the example of Fannie Mae shows.  Analysts focus more on the economic value of a company and less on unrealised gains and losses.  Much of the FAS 133 volatility in earnings and in equity does not consistently reflect the economic situation.  This makes it difficult to interpret the figures.  Therefore, analysts welcome the decision of some companies voluntarily to disclose a separate set of figures excluding the effect of FAS 133.

2004 FAS 133 Accounting Implementation Problems at Fannie Mae

$25 Billion in Derivatives Losses at Fannie Mae --- http://worldvisionportal.org/WVPforum/viewtopic.php?t=192 

Fannie Mae paid a net $25.1bn on derivatives transactions in under four years - nearly all of which may represent losses that cannot be recouped, in turn depressing future earnings.

The potential scale of the liabilities, which have yet to be recognised in the company's earnings or in the minimum capital adequacy required by its regulator, raise fresh doubts about the financial health of the mortgage finance giant.

Regulation of Fannie Mae and its sibling Freddie Mac is rapidly moving up the agenda in Washington, amid concerns that the two goverment-sponsored entities have grown so big that they pose a systemic risk to the US financial system. The two entities own or guarantee mortgages totalling $4,000 billion.

On Tuesday John Snow, US Treasury secretary, renewed the criticism, saying: "We don't believe in a too-big-to-fail doctrine, but the reality is that the market treats the paper as if the government is backing it."

His comments follow similar warnings from Alan Greenspan, chairman of the Federal Reserve, and Gregory Mankiw, chairman of George W. Bush's council of economic advisers.

Fannie Mae acknowledges it has taken losses in its derivatives trading that have not yet been recognised it its earnings, but declines to disclose the amount. The reason, said Jonathan Boyles, vice-president of financial standards and taxes at Fannie Mae, is that "we don't believe it's all that meaningful".

Next Monday Fannie Mae is due to release its annual "fair value disclosure" - a statement of the current market value of its derivatives positions. Observers will be watching to see if the gap between the company's regulatory capital and fair value has widened further than the $6bn shortfall of a year ago.

An independent analysis of Fannie's accounts suggests it may have incurred losses on its derivatives trading of $24bn between 2000 and third-quarter 2003. That figure represents nearly all of the $25.1bn used to purchase or settle transactions in that period. Any net losses will eventually have to be recognised on Fannie Mae's balance sheet, depressing future profits.

Fannie Mae maintained that the losses from cashflow hedging will have no bearing on the capital adequacy required by its regulator.

However, critics increasingly question whether Fannie Mae's financial disclosure offers a complete picture of its fiscal health.

"They have used the derivative accounting rules for cash flow hedges to defer some losses that they have taken," said John Barnett, senior analyst at the Center for Financial Research & Analysis, an independent research firm. "They may not be as well-capitalised as they appear to be for regulatory purposes."

April 2, 2004 Update on Freddie Mac and Fannie Mae
(Fresh Indications of Potential Accounting Problems for Fannie Mae)

"Senate Panel Passes Measure On Fannie, Freddie Oversight," by John D. Mckinnon and James R. Hagerty, The Wall Street Journal, April 2, 2004 --- http://online.wsj.com/article/0,,SB108085674714072041,00.html?mod=mkts%5Fmain%5Fnews%5Fhs%5Fh 

Senate Republicans pushed through a long-delayed measure to strengthen oversight of mortgage giants Fannie Mae and Freddie Mac and the federal home-loan bank system, amid fresh indications of potential accounting problems at Fannie Mae.

The Senate Banking Committee's near-party-line vote foreshadowed further difficulties ahead for the bill, which would be the first significant tightening of oversight on the lightly regulated companies since 1992.

But with potential accounting problems for Fannie Mae looming larger this week, supporters think Congress might still be pressed to set aside partisan differences and pass the legislation this year. The companies also face further pressure from the Bush administration, such as tougher affordable-housing goals, expected to be announced as soon as today.

Fannie's current regulator, the Office of Federal Housing Enterprise Oversight, or Ofheo, raised the pressure on the company yesterday by saying Fannie may have accounted improperly for the value of certain assets. Ofheo said its current examination of Fannie's accounting policies is "intensely focused on several specific issues."

One of those issues, Ofheo said, is that the company "may not have applied the proper accounting guidance" in deciding how much to write down assets that have been "impaired." Ofheo said it is looking at the way Fannie decides how much to write down impaired assets, including Fannie's $8 billion of securities backed by manufactured-housing loans. Some outside analysts have long maintained Fannie should make much bigger write-downs in the value of that paper.

Ofheo also took issue with a remarks by Chuck Greener, Fannie Mae's chief spokesman, quoted in the Washington Post, saying Fannie Mae wasn't "aware of anything that backs the assertion that there may be a need for us to restate our financial results."

Ofheo labeled that statement "inaccurate and misleading." Corinne Russell, a spokeswoman for Ofheo, said, "They are aware of what we're looking at." A Fannie spokeswoman said Mr. Greener wouldn't comment on Ofheo's criticism.

Last year Freddie Mac was forced to restate earnings by about $5 billion. The blowup also cost two chief executives their jobs and led the company to agree to pay a $125 million civil penalty. The problems opened the door for the new legislation, which the Bush administration is pushing hard. But the companies and their housing-industry allies have pushed back, leading to a deadlock last year in the House.

Despite months of hearings and headlines, yesterday's Senate vote was the first on a regulatory bill concerning the two mortgage giants since the Freddie Mac accounting mess surfaced. If the bill passes, critics of the companies say they believe it would mark the first major piece of regulatory legislation since Ofheo was created in the 1992 legislation.

Many policy makers, including Federal Reserve Chairman Alan Greenspan, worry that the two government-chartered companies have relied on their federal ties to borrow inexpensively and grow too fast. Together they now have about $1.7 trillion in debt outstanding, equivalent to nearly half the $4 trillion or so in federal debt held by the public. The companies' huge debt goes to finance their business of buying up mortgages from lenders.

The Republican-sponsored bill creates a new regulator that would have greater say over the companies' capital, operations, new lines of business and even how they would be wound down in the event of insolvency. Democrats, the companies' traditional allies, argued that Republicans were aiming at eventual privatization of the companies, which currently retain special ties to the government as former federal agencies. The wind-down provision also would undermine investors' perception that the government still backs the companies, thus driving up mortgage interest rates and hurting homeownership, Democrats argued. Republicans disagreed, saying the concerns were overblown.

Sen. John Sununu (R., N.H.), a chief sponsor of the original bill, said supporters of the amendment were seeking to muddy the waters, and thereby strengthen the so-called implied federal guarantee. For the companies' supporters, "there is a belief that a little ambiguity goes a long way," he said. But the amendment "is effectively misleading markets."

"Regulators Rebuke Fannie Mae Method for Valuing Securities," by James R. Hagerty and John D. CcKinnon, The Wall Street Journal, May 7, 2004, Page A3 --- http://online.wsj.com/article/0,,SB108387540782804295,00.html?mod=home_whats_news_us 

A federal regulatory agency ordered Fannie Mae to change the methods it uses for valuing some securities on its books in a move that may force the company to restate past earnings.

The size of any such restatement is unclear, but one person familiar with the situation said it could be as much as $500 million. That would be a relatively modest sum for the giant mortgage-finance company, whose net income was $7.91 billion last year. The regulatory rebuke, though, is a serious embarrassment for Fannie and could add urgency to the Bush administration's efforts to impose tougher regulation on Fannie and its smaller rival, Freddie Mac.

Meanwhile, Standard & Poor's said it "no longer has the same degree of confidence" as in the past that the U.S. government would bail out Fannie or Freddie in a crisis.

Fannie replied to its regulator, the Office of Federal Housing Enterprise Oversight, or Ofheo, with a statement defending its accounting and confirming that it is seeking "guidance" on the issue from the Securities and Exchange Commission. Fannie's statement indicates the company hopes the SEC will back its approach. If so, the company wouldn't need to restate the results it already has reported to the SEC. Fannie has hired Wilmer Cutler Pickering LLC, a law firm known for its close SEC contacts, to press its case.

Fannie and Freddie, both shareholder-owned companies chartered by Congress, regularly tap the government-agency bond market to borrow large sums, currently totaling about $1.7 trillion. They use that money to buy home mortgages from banks and other lenders, giving those lenders funds to make more home loans. But the Bush administration argues that Fannie and Freddie have grown so huge that they could rattle the economy if they run into financial trouble. To restrain their debt-fueled growth, the administration is trying to persuade investors that the government wouldn't necessarily pay off their creditors in a crisis.

Suggesting one way to distance the government from the companies, William Poole, president of the St. Louis Federal Reserve Bank, said yesterday that the Treasury should repeal its modest line of credit to Fannie and Freddie, a symbol of official backing.

The S&P announcement shows that the government's message is starting to change perceptions about the two companies, long considered so vital to the nation's housing policy that Washington would have to prop them up in a crisis. S&P reaffirmed its triple-A ratings on the senior debt of Fannie and Freddie, based on their current financial condition and the still considerable political backing they enjoy in Congress. But Michael T. DeStefano, a senior S&P analyst, said in an interview that if the companies' finances ever seriously deteriorate, the triple-A rating would be in peril. In the past, S&P considered the government backing so strong that the finances played a much smaller role in setting ratings for the two companies.

A spokeswoman for Ofheo said it isn't yet clear whether a restatement of Fannie's earnings will be necessary. She said the company first will have to recalculate the value of the assets in question using instructions from the regulator.

The order affects Fannie's $8 billion portfolio of securities backed by manufactured-housing loans, as well as $300 million of securities backed by aircraft leases. The manufactured-housing securities have deteriorated in quality because of a surge of defaults by buyers of mobile homes in recent years. Fannie so far has made write-downs on the manufactured-housing securities totaling about $217 million, but some analysts argue that much bigger write-downs would be in order, based on actions taken by holders of similar securities.

Though the regulatory action was narrow in scope, it suggested that other aspects of Fannie Mae's accounting could be called into question, raising the possibility of a long period of regulatory uncertainty. That could heighten the company's interest in coming to an agreement soon on long-stalled legislation to strengthen oversight of Fannie Mae and Freddie Mac.

Sen. John Sununu (R., N.H.), one of the sponsors of the Senate bill, said he hopes the latest announcement will shake House leaders into trying again to move legislation. But Rep. Barney Frank (D., Mass.), the senior Democrat on the Financial Services Committee, said Ofheo's action went overboard in an effort to create more political problems for the company. Ofheo's director, Armando Falcon Jr., "is letting himself be turned into an attack dog," Mr. Frank said, adding that the announcement would only "strengthen our resistance" to the administration's proposals for reining in the companies.

Mr. Frank said the agency's attempt to force lower valuations for Fannie's manufactured housing and aircraft-lease-backed securities shows that the administration wants to clip Fannie's wings when it comes to encouraging affordable housing.

Ofheo gave Fannie specific instructions for calculating the degree of "impairment" to the securities in question and gave the company until next Friday to provide the new sum for each quarter since the fourth quarter of 2002. If Ofheo prevails in the argument over which accounting methods should be used, those new calculations presumably will determine how large any restatement will be.

Continued in article

Also see http://www.smartpros.com/x43544.xml 

May 10, 2004 Update on Fannie

FANNIE REACHED an accord with the SEC that will let her avoid restating results but require it to change accounting methods.  . Fannie lost $25 billion in derivatives over a four year period. So many people just do not realize that hedging for fair value creates cash flow risk.  See  http://www.trinity.edu/rjensen/caseans/000index.htm 

"Fannie to Avoid Restating Results After SEC Accord," by James R. Hagerty, The Wall Street Journal, May 10, 2004, Page A2 ---

Fannie Mae reached an accord with the Securities and Exchange Commission that will allow the mortgage-finance company to avoid restating results.

The compromise will require Fannie to adopt a new method of accounting for certain securities backed by manufactured-housing loans and aircraft leases -- a demand made last week by Fannie's regulator, the Office of Federal Housing Enterprise Oversight, or Ofheo.

While Fannie will avoid the embarrassment of a restatement, Ofheo will force the company to adopt the new method in future earnings statements. That may lead to more frequent write-downs of such securities in its portfolio. "We won't allow an accounting interpretation that fails to recognize hundreds of millions of dollars in losses," Corinne Russell, Ofheo's chief spokeswoman, said late yesterday.

A Fannie spokesman refused to comment. An SEC representative also declined to comment.

At issue are Fannie's $8 billion of securities backed by manufactured-housing loans and $300 million of securities backed by aircraft leases. The manufactured-housing securities have lost value because of a surge in defaults by buyers of mobile homes. So far, Fannie has written down those securities by about $217 million, but some analysts say far bigger write-downs would be in order.

The SEC is expected to provide Fannie with a letter saying that its old method of deciding how far to write down the securities was consistent with generally accepted accounting principles. That may help Fannie fend off shareholder suits. But Ofheo will be able to say that the method it favors is the best practice and that the old method was misleading.

The dispute involves an accounting rule known as EITF 99-20, which took effect in 2001. The rule states the conditions under which companies must write down the value of certain types of securities. In the past, Fannie appears to have concluded that 99-20 didn't apply to the securities in question and to have used an accounting rule that allows more managerial judgment in determining the amount of write-downs needed. The compromise doesn't end the uncertainty for Fannie, however, because Ofheo continues to examine other aspects of the company's accounting practices.

Fannie and its smaller mortgage-finance rival, Freddie Mac, have come in for heavy criticism in recent months as the Bush administration pushes for legislation that would impose tougher regulation on the two government-sponsored enterprises, or GSEs. Fannie and Freddie borrow in the government-agency bond market and use the proceeds to buy home mortgages from banks and other lenders.

Last week, William Poole, president of the Federal Reserve Bank of St. Louis, warned that investors may be ignoring the potential dangers connected with the companies' debts. While stressing that "on the basis of information I have, no crisis is at hand" at the two GSEs, Mr. Poole said they rely on short-term debt to fund more than a third of the mortgages they hold. The risk is that a surge in interest rates could leave their cost of funding above their interest income from mortgages -- the trap that destroyed many U.S. savings and loan institutions in the 1980s.

Fannie and Freddie hedge against such dangers by purchasing swaps, options and other derivatives, financial contracts designed to parcel out risks to other parties. For instance, they can swap a promise to pay interest at a fixed rate during a certain period to another party, which in turn pays them interest floating at a given margin over a benchmark rate. That way, if a general rise in interest rates pushes up the GSEs' borrowing costs, they can expect an offsetting rise in the floating-rate interest income they receive through the swaps.

If investors lost confidence in GSE debt, however, the companies would have to pay higher interest on new borrowings relative to market benchmarks, Mr. Poole said. In that case, the swaps might no longer provide enough income to make up for the jump in the GSEs' borrowing costs.

A loss of confidence in Fannie and Freddie debt also might make it prohibitively expensive for them to raise new funds. In a typical week, Mr. Poole said, Fannie and Freddie need to raise roughly $30 billion in new short-term debt to pay off obligations coming due. To reduce the risks, he said, the GSEs should rely less on short-term borrowings and hold more capital as a cushion.

Fannie and Freddie say they hold enough capital and are good at managing their interest-rate risks. Fannie Mae Chairman and Chief Executive Franklin D. Raines last week said that his company shouldn't be viewed as inherently risky just because of its huge size, roughly comparable to Citigroup Inc. and Bank of America Corp. Size in itself isn't a cause of risk to the financial system, Mr. Raines said, adding: "The Federal Reserve seems to share that view as it allows large bank merger plans to go forward."

April 6 Update on Fannie
She lost a mere $25 billion in a derivatives even when she was hedging.

"Fannie Mae Used Disputed Methods To Adjust Results," James R. Hagerty, The Wall Street Journal, April 6, 2004, Page A4 --- http://online.wsj.com/article/0,,SB108120227130174705,00.html?mod=home%5Fwhats%5Fnews%5Fus 

Fannie Mae has relied heavily on legal but misleading methods to smooth out its reported earnings, the Center for Financial Research & Analysis says.

The findings were presented yesterday by John Barnett, a senior analyst at the Rockville, Md., research firm, majority-owned by TA Associates, a Boston-based private equity firm. Mr. Barnett spoke at a seminar sponsored by the American Enterprise Institute, a conservative think tank and frequent critic of Fannie and its smaller rival, Freddie Mac. The two giant government-sponsored companies buy home mortgages from banks, providing the banks more money to make new loans.

Freddie acknowledged last year that it had manipulated its accounting to make earnings look less volatile. Last week, the two companies' regulator, the Office of Federal Housing Enterprise Oversight, or Ofheo, said its current examination of Fannie's accounting has turned up possible problems that could lead to a restatement of earnings at that company.

One area of concern is how Fannie deals with big fluctuations in interest rates. When interest rates fall, for instance, many mortgage borrowers prepay their loans to refinance on more attractive terms. That forces Fannie to adjust its borrowings to keep the average term of its liabilities roughly in line with that of its assets.

One way Fannie adjusts is to repay some of its debt early, which often produces a loss because investors must be compensated. Another method is to adjust the portfolio of derivative contracts Fannie uses to hedge interest-rate risk. Mr. Barnett said the company has favored the latter method in recent years because that allows it to stretch out any losses from interest-rate movements over a number of years rather than immediately taking a big hit to earnings.

A Fannie Mae spokesman declined to comment. But Fannie has long said that it uses the most efficient means to adjust its portfolio and that those methods aren't designed to mislead investors.

Mr. Barnett also argued that Fannie hasn't taken deep enough write-downs to adjust for the deterioration of its $8 billion of securities backed by manufactured-housing loans. Ofheo, the regulator, last week said the company "may not have applied the proper accounting guidance" in deciding how much to write down assets that have been "impaired."

Over the past few years, defaults on the loans backing manufactured-housing securities have soared, and downgrades by rating agencies have lowered many of the securities to junk status. Fannie has made $206 million of write-downs on its manufactured-housing securities, or about 2.5% of the total value. By contrast, when the Federal Home Loan Bank of New York sold a $1 billion portfolio of similar securities last year, it recorded a loss of 18% on that investment. The home-loan bank's loss was especially severe because it sold at a time of severe weakness in the market. Even so, Mr. Barnett argues that the hits taken by the home-loan bank and other investors suggest Fannie needs to make bigger write-downs.

Fannie has defended its methodology for valuing the securities. In a recent filing with the Securities and Exchange Commission, Fannie said it might be necessary to take further write-downs on the securities but that it believed any such write-downs wouldn't have "a material adverse effect" on operating results.

Jonathan E. Gray, an analyst at Sanford C. Bernstein & Co. in New York who owns Fannie shares, accused Ofheo of scare-mongering and said the agency should present any evidence it has that Fannie's accounting was improper.

April 2, 2004 Update on Freddie Mac and Fannie Mae
(Fresh Indications of Potential Accounting Problems for Fannie Mae)

"Senate Panel Passes Measure On Fannie, Freddie Oversight," by John D. Mckinnon and James R. Hagerty, The Wall Street Journal, April 2, 2004 --- http://online.wsj.com/article/0,,SB108085674714072041,00.html?mod=mkts%5Fmain%5Fnews%5Fhs%5Fh 

Senate Republicans pushed through a long-delayed measure to strengthen oversight of mortgage giants Fannie Mae and Freddie Mac and the federal home-loan bank system, amid fresh indications of potential accounting problems at Fannie Mae.

The Senate Banking Committee's near-party-line vote foreshadowed further difficulties ahead for the bill, which would be the first significant tightening of oversight on the lightly regulated companies since 1992.

But with potential accounting problems for Fannie Mae looming larger this week, supporters think Congress might still be pressed to set aside partisan differences and pass the legislation this year. The companies also face further pressure from the Bush administration, such as tougher affordable-housing goals, expected to be announced as soon as today.

Fannie's current regulator, the Office of Federal Housing Enterprise Oversight, or Ofheo, raised the pressure on the company yesterday by saying Fannie may have accounted improperly for the value of certain assets. Ofheo said its current examination of Fannie's accounting policies is "intensely focused on several specific issues."

One of those issues, Ofheo said, is that the company "may not have applied the proper accounting guidance" in deciding how much to write down assets that have been "impaired." Ofheo said it is looking at the way Fannie decides how much to write down impaired assets, including Fannie's $8 billion of securities backed by manufactured-housing loans. Some outside analysts have long maintained Fannie should make much bigger write-downs in the value of that paper.

Ofheo also took issue with a remarks by Chuck Greener, Fannie Mae's chief spokesman, quoted in the Washington Post, saying Fannie Mae wasn't "aware of anything that backs the assertion that there may be a need for us to restate our financial results."

Ofheo labeled that statement "inaccurate and misleading." Corinne Russell, a spokeswoman for Ofheo, said, "They are aware of what we're looking at." A Fannie spokeswoman said Mr. Greener wouldn't comment on Ofheo's criticism.

Last year Freddie Mac was forced to restate earnings by about $5 billion. The blowup also cost two chief executives their jobs and led the company to agree to pay a $125 million civil penalty. The problems opened the door for the new legislation, which the Bush administration is pushing hard. But the companies and their housing-industry allies have pushed back, leading to a deadlock last year in the House.

Despite months of hearings and headlines, yesterday's Senate vote was the first on a regulatory bill concerning the two mortgage giants since the Freddie Mac accounting mess surfaced. If the bill passes, critics of the companies say they believe it would mark the first major piece of regulatory legislation since Ofheo was created in the 1992 legislation.

Many policy makers, including Federal Reserve Chairman Alan Greenspan, worry that the two government-chartered companies have relied on their federal ties to borrow inexpensively and grow too fast. Together they now have about $1.7 trillion in debt outstanding, equivalent to nearly half the $4 trillion or so in federal debt held by the public. The companies' huge debt goes to finance their business of buying up mortgages from lenders.

The Republican-sponsored bill creates a new regulator that would have greater say over the companies' capital, operations, new lines of business and even how they would be wound down in the event of insolvency. Democrats, the companies' traditional allies, argued that Republicans were aiming at eventual privatization of the companies, which currently retain special ties to the government as former federal agencies. The wind-down provision also would undermine investors' perception that the government still backs the companies, thus driving up mortgage interest rates and hurting homeownership, Democrats argued. Republicans disagreed, saying the concerns were overblown.

Sen. John Sununu (R., N.H.), a chief sponsor of the original bill, said supporters of the amendment were seeking to muddy the waters, and thereby strengthen the so-called implied federal guarantee. For the companies' supporters, "there is a belief that a little ambiguity goes a long way," he said. But the amendment "is effectively misleading markets."

2003 FAS 133 Accounitng Implementation Problems at Fannie Mae

The bookkeeping error in which Fannie Mae failed to book $1.1 billion in derivative financial statements was reported as a computer error when implementing a new FAS 149 set of amendments to FAS 133 at Fannie Mae.  The explanation is plausible, the importance of this error were probably overblown by the media.  

However, Fannie May's otherwise impeccable attempts to implement FAS 133 and its amendments illustrate what a complicated complicated mess we are in today when implementing FAS 133 issued by the Financial Accounting Standards Board (FASB).  The same can be said about its IAS 39 counterpart issued by the International Accounting Standards Board (IASB).  These two standards and their various amendments are widely criticized and have tended to create more confusion than help among investors, analysts, accountants, banks, and other corporations.

A large part of the confusion that exists centers around the public perception of hedging.  Hedging suggests elimination of risks that are hedged.  In fact, however, hedging is merely a transfer from one type of risk to another type of risk.  Before getting into this, however, let's review the Fannie Mae example of a really solid effort to implement FAS 133 and its amendments.

"Fannie Mae Seeks SEC Support For a Policy Questioned by Ofheo," by James R. Hagerty and Dawn Kopecki, The Wall Street Journal, May 6, 2004, Page A6 --- http://online.wsj.com/article/0,,SB108380924614103681,00.html?mod=home%5Fwhats%5Fnews%5Fus 

Fannie Mae is trying to win support from the Securities and Exchange Commission for an accounting policy being questioned by the mortgage-finance company's regulator, according to people familiar with the matter.

The SEC's response to Fannie may determine whether the company will be forced to restate past results, an embarrassing move that could further rattle investors in Fannie's stock and bonds and raise new concerns in Congress about regulation of the company.

The Office of Federal Housing Enterprise Oversight, or Ofheo, which regulates Fannie and its smaller rival, Freddie Mac, has been investigating Fannie's accounting for months. The agency recently said Fannie "may not have applied the proper accounting guidance" in deciding how much to write down the value of securities backed by manufactured-housing loans and certain other assets on its books.

A person who was briefed on progress in the inquiry says he believes it hinges on whether Fannie believes the SEC would be more likely to back Fannie's interpretation of the relevant accounting rules or Ofheo's view. If Fannie believes the SEC will back Ofheo, the company is likely to settle the case and agree to a restatement, this person said. But if Fannie thinks its interpretation is likely to win SEC backing, the company is more likely to fight Ofheo, in court if necessary, he said.

A Fannie spokesman declined to comment on the company's strategy in dealing with the investigation but said Fannie is "cooperating fully." A spokeswoman for Ofheo said she couldn't comment on specifics of the investigation. An SEC spokesman declined to comment.

Ofheo has engaged a team of accountants from Deloitte & Touche LLP to help it with the investigation. Fannie is drawing on advice from two other Big Four accounting firms, KPMG LLP, the company's regular auditor, and Ernst & Young LLP. Fannie also is represented in this matter by the law firm Wilmer Cutler Pickering LLC, known for its securities-law expertise and close contacts at the SEC. One of Wilmer's partners, William R. McLucas, is a former SEC enforcement chief.

One of the main items of contention is whether Fannie should have applied to some of the securities on its books an accounting rule known as EITF 99-20, created by the Financial Accounting Standards Board's Emerging Issues Task Force, or EITF. Rule 99-20, which took effect in 2001, states the conditions under which companies must write down the value of certain types of securities in their portfolios.

Accounting methods at both Fannie and Freddie have been under scrutiny since Freddie admitted last year that it had manipulated its accounting to make its earnings appear less volatile.

What is Fannie Mae? --- Federal National Mortgage Association --- http://www.primecoastmortgage.com/Fannie_Mae.htm 

The role of Fannie Mae and the secondary mortgage market in housing finance
Fannie Mae plays a vital role in financing mortgages and increasing homeownership opportunities for more Americans. A privatization success story, Fannie Mae began in 1938 as an agency of the federal government, created to bring stability to the U.S. housing market. In 1968, Fannie Mae became a privately-owned and - managed corporation. At that time, the U.S. Congress rechartered Fannie Mae as a private company, mandating that it operate with private capital on a self-sustaining basis to enhance the flow of funds through the secondary market to American home buyers.

Fannie Mae operates exclusively in the secondary mortgage market - providing support to mortgage lending institutions in the primary market. Lenders who originate loans in the primary mortgage market may either hold the loans in their portfolios or sell them in the secondary mortgage market. By selling their loans in the secondary market, lenders are able to obtain additional funds with which to make more loans to home buyers.

The secondary mortgage market helps accomplish the following important housing objectives:

• it addresses imbalances of mortgage credit among regions of the United States by making funds available to capital-deficient areas of the country to finance new mortgage originations;
• it allows lenders to originate mortgages for sale rather than for portfolio investment;
• it standardizes mortgage loans, thereby attracting investors who traditionally have not invested in the primary market, further strengthening this market.

Fannie Mae's impact on housing needs
Fannie Mae is the nation's largest investor in home mortgages today. The corporation has provided home financing for over 32 million American families since its creation in 1938. Fannie Mae currently owns in its portfolio, or holds in trust for investors, one out of every five mortgages in the United States.

In 1994, Fannie Mae announced its Trillion Dollar Commitment to provide $1 trillion by the year 2000 to finance homes for over 10 million families most in need. This targeted housing finance initiative is serving families with incomes below the median for their area, minorities and new immigrants, families who live in central cities and distressed communities, and people with special housing needs.

Through its Trillion Dollar Commitment, Fannie Mae provides renters in America the information they need to buy homes, develops specialized products and services to break down arbitrary barriers to getting home mortgages, and focuses on eliminating lending discrimination in the housing finance industry.

Fannie Mae's homepage is at http://www.fanniemae.com/index.jhtml 

Fannie Mae FAQs --- 

http://www.fanniemae.com/faq/index.jhtml?p=FAQ 

http://www.fanniemae.com/faq/index.jhtml?p=FAQ 

It is very easy to become overly pessimistic about derivatives when reading quotations from Greenspan and Buffet.  In some ways pessimism over financial instrument derivatives in the economy is analogous to pessimism over the use of antibiotics  since super-resistant microbes will evolve that might one day bring humanity to its knees.  But to cave into such fears and immediately ban all antibiotics would cause more immediate plagues and death in humanity.  Similarly to ban the use of derivatives for managing financial risk would bring modern economies to their knees overnight.

There are expensive derivatives strategy and accounting remedies such as those purportedly adopted by Fannie Mae.  Fannie Mae claims to have modified its derivative hedging strategy as a result of FAS 133 (so much for FASB standards neutrality) and has had a much better accounting system in place in spite of a brief snafu where it failed to report $1 billion in derivatives.  The snafu was rather quickly detected by Fannie's internal control system.  See an summary of this strategy at http://www.fanniemae.com/ceoanswers/ 
Note how Fannie Mae makes every effort to avoid macro hedging that will not be allowed to get hedge accounting.  The result is that changes in derivative values do not create the wild earnings fluctuations that worries Buffet, because Fannie Mae gets hedge accounting much of the time.  

Fannie Mae's CEO differs with the warnings of Fed. Chairman Alan Greenspan that the Fanny Mae's derivatives strategy poses a threat to the entire banking system ---  http://www.fanniemae.com/ceoanswers/protection.jhtml 

But such a strategy is a tremendously expensive and cumbersome in a company that owns mortgages of over 32 million households.  Note the use of Non-GAAP financial measures  and "core earnings" adjustments described at http://www.fanniemae.com/ceoanswers/discussion.jhtml 

Fannie Mae management tracks and analyzes Fannie Mae's financial results based on a supplemental non-GAAP financial measure called "core business earnings" (previously referred to by us as "operating net income"), and other non-GAAP financial measures related to core business earnings. While core business earnings measures are not a substitute for GAAP measures, we rely on core business earnings in operating our business because we believe core business earnings provides our management and investors with a better measure of our financial results and better reflects our risk management strategies than our GAAP measures. We developed core business earnings measures in conjunction with our January 1, 2001, adoption of FAS 133 to adjust for accounting differences between alternative transactions we use to hedge interest rate risk that produce similar economic results but require different accounting treatment under FAS 133. See below the comparable GAAP measures to these core business earnings measures and a reconciliation between our GAAP measures and these core business earnings measures. You should also refer to our Annual Report on Form 10-K (PDF) for our audited financial statements and a more detailed discussion of our use of non-GAAP financial measures.

Fannie got smart when she watched her little brother Freddie fall to his knees because of bad compliance with FAS 133.   Now Freddie is trying to learn about accounting from his big sister.   Fanny's CEO explains the new disclosures under FAS 133 as follows --- http://www.fanniemae.com/ceoanswers/derivativedisclosure.jhtml 

More Disclosure of Accounting Results for Derivatives

Our second new disclosure provides more information about the accounting results in one derivative category called "cash flow hedges." These include mostly derivatives we use to convert shorter-term funding into longer-term funding. While our business is relatively simple compared with other large financial institutions -- we purchase or guaranty residential mortgages -- the accounting rule for derivatives makes things seem more complicated.

Here's why. Under this accounting rule -- Financial Accounting Standard 133 -- at the end of every quarter we have to take these cash-flow hedge derivatives and assign a "mark-to-market" value on that day (the net present value of their future cash flows). The mark-to-market value generally will be different from the initial value, and will change from quarter to quarter as interest rates change.

Under FAS 133, we are required to take the difference between the initial value and the mark-to-market value, and record that figure on our balance sheet -- specifically in the section titled "Adjusted Other Comprehensive Income," or AOCI.

Previously, we have recorded the mark-to-market gains and losses on all our cash-flow derivatives together in one sum as "Impact on AOCI (net of taxes)."

But starting with our Form 10-K for 2003, we will report these in two categories: "open hedges" and "closed hedges." And we will show the gains and losses for each category.

There is no real economic difference between open and closed derivative hedge positions. The distinction is:

Mark-to-market gains or losses on open hedge positions change as market rates change, and therefore are considered "unrealized." Mark-to-market gains or losses of closed hedge positions do not change, and therefore are considered "realized." Here is the actual new disclosure in our Form 10-K for 2003:

In the top section -- "Impact on AOCI (net of taxes)" -- you can see that we recorded an outstanding net balance of losses on derivatives at year-end of $7.4 billion in 2001, $16.3 billion in 2002, and $12.2 billion in 2003.

In the bottom section -- "AOCI balance related to (net of taxes)" -- we break down those losses into those related to open hedges and closed hedges.

Specifically, in 2003, we are reporting a net balance of $5.3 billion in unrealized losses for open hedges and $6.9 billion in realized losses for closed hedges.

The net balance of losses from both of these categories of AOCI will be amortized over time through our income statement as interest expense. The only difference is that losses amortized into interest expense from open hedges may be greater or less than $5.3 billion based on changes in interest rates. Losses amortized into interest expense from closed hedges will be exactly $6.9 billion. In 2003, $5.4 billion of prior losses were reflected in interest expense. Of this total, $4.5 billion were from open hedges, and $0.9 billion were from closed hedges.

No Impact on Regulatory Capital

It is important to understand that this difference between realized and unrealized AOCI is not meaningful when it comes to regulatory capital.

Why?

Different hedging strategies require different accounting treatments, even when they serve the same risk-management purpose and have the same economic impact. For example, when we rebalance to shorten the duration of our debt, we can close a swap that lengthened short-term debt (which would then show up in AOCI as a closed position) or we can purchase another shorter swap to layer on top of what we already have (which would show up as an open position in AOCI).

Also, each cash flow hedge is funding an asset, whose value increases when the value of the hedge decreases. However, as a held-to-maturity investor, we are not allowed by accounting rules to mark-to-market these assets and therefore changes in their value do not go through AOCI.

Finally, just as these "realized" closed hedge losses do not affect regulatory capital, neither would "realized" gains affect regulatory capital when interest rates rise.

Financial regulators recognize that hedging strategies that are economically identical can produce different accounting results. In calculating regulatory capital, financial regulators choose substance over form as a guiding principle. It is the economic substance of the transaction that counts and not the particular accounting form in which it is recognized.

Indeed, the banking agencies' guide to FAS 133 treatment instructs regulators to exclude the gains or losses on cash flow hedges that are placed in AOCI from Tier I capital.

For more on our derivatives and their accounting, see pages 68-81 of our Form 10-K for 2003.

Fannie Mae provides a comparison of our GAAP results to our non-GAAP financial measures.

These pages include certain forward-looking statements based on management's estimates of trends and economic factors in the markets in which Fannie Mae is active as well as our business plans. These estimates and plans may change without notice. Future results may vary from results we expect if there are significant changes in economic conditions (including conditions in the housing market), regulatory or legislative changes affecting us, our competitors or such markets, or changes in other factors. You should review our Annual Report on Form 10-K (PDF) for a discussion of these factors. We make no undertaking to update the forward-looking information contained in these pages.

The Form 10-K contains in-depth discussions about our business, financial results and operating environment, among other things. We urge you to read it for more detailed discussions about the topics contained in these pages.

 

Fanny Mae has a tutorial on derivatives strategy and FAS 133 implementation at http://www.fanniemae.com/ir/accountingtutorial.jhtml 
The entire tutorial can be downloaded from  http://www.fanniemae.com/ir/pdf/tutorial10012003.pdf 
There is also a multimedia presentation link at the above site.
A discussion of added disclosures under the FAS 149 amendment to FAS 133 is at http://www.fanniemae.com/ir/issues/financial/100103.jhtml 

Fanny Mae's  CEO claims the following in answer to the question "Why do you have confidence that you have done your derivative accounting properly?" 

Let me walk through how we account for our derivatives:

• First, we use derivatives primarily for two purposes: as substitutes for notes and bonds we issue in the debt markets and to hedge against fluctuations in interest rates on planned debt issuances.
  
• Second, we have a very controlled process to ensure against management mistakes.
  • Importantly, our accounting function does NOT reside within the business units. Those entering into business transactions and accountable for the business results do not determine the accounting of those transactions.
    
  • In anticipation of adopting FAS 133, we catalogued each type of derivative transaction done by Fannie Mae. As part of our implementation process, we consulted with our independent auditors -- KPMG -- about the appropriateness of our FAS 133 accounting policies, interpretations, and systems.
    
  • We continue today to maintain a current catalogue of each type of derivative transaction done and to set our accounting policy at the transaction level. We don't assume that the correct treatment for one transaction is automatically the correct or best treatment for a different transaction.
    
  • Prior to entering into a new type of derivative transaction, the business unit will describe the intended transaction. Our Controller will then recommend an accounting treatment. Our policy is to have the Controllers Office discuss this recommended accounting treatment with our outside independent auditors and to update the derivatives accounting policy that governs the transactions the business units can enter into. Only when the policy is updated can the transaction be completed.
    
  • The hedge accounting treatment for each individual transaction is determined -- and documented in writing -- before we enter into the transaction. And it cannot subsequently be changed.
    
  • On a daily basis all hedging activity is reported to our Controllers Office, which monitors hedge performance and accounts for the hedge.
    
  • On an annual basis Fannie Mae's internal audit department performs a comprehensive audit of our hedging activity to ensure compliance with our Hedge Accounting Guidelines and that strong internal controls are in place. Fannie Mae's internal audit department reports directly to the fully independent Audit Committee of our Board of Directors, which reviews its work -- including the derivatives audit -- every year.

The positive derivatives strategy of Fannie Mae now being copied by Freddie Mac begs the question regarding whether any derivatives strategy can overcome the macro worries of Alan Greenspan and Warren Buffet regarding the use of derivatives to hedge enormous (trillion dollar magnitude) of risk.  We have seen so many "fiascos" in derivatives use at the hundred million dollar level (e.g, Proctor and Gamble), billion dollar level (e.g., Orange County), and multi-billion dollar level (e.g., Long-Term Capital).  For a summary of derivatives scandals, see http://www.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds 

There were a lot of bad disclosure illustrations in 2001 and 2001, most notably Enron.  Since then disclosures have gotten a lot better.  One example I like to use is Calpine --- http://www.calpine.com/

Note the $25 billion loss of Fannie Mae in derivatives 
(the company that is supposed to have the supreme hedging system.)
"Cooking The Books Part II - US $71 Trillion Casino Banks," by Michael Edward, Rense.com, March 27. 2004 --- http://www.rense.com/general50/cooking2.htm

Derivative holdings by U.S. banks increased nearly $4 TRILLION in just 3 months to now total over $71.1 TRILLION. JPMORGAN CHASE accounts for $3.1 TRILLION of this increase.

That's $ 71,100,000,000,000.

The first 7 banks listed below account for 96% of all commercial bank derivative holdings, with 90% of these derivatives in extremely risky OTC (Over the Counter) contracts.

As I said in Cooking the Books Part I, U.S. banks are giant gambling casinos, and now they have become even larger gambling addicts at the expense of all Americans.

DERIVATIVES CONTRACTS AS OF DECEMBER 31, 2003 (based on just released 03Q4 OCC Bank Derivatives report)

1. JPMORGAN CHASE BANK - $36,805,757,000,000 (Assets $628,662,000,000) Risk Ratio 58.5:1 ($58.54 of derivatives per $1 of assets). Credit exposure to Risk-Based Capital Ratio 844.6% OTC Derivatives 92.6%

2. BANK OF AMERICA - $14,869,220,000,000 (Assets $617,962,000,000) Risk Ratio 24:1 ($24.06 of derivatives per $1 of assets). Credit exposure to Risk-Based Capital Ratio 221.7% OTC Derivatives 83.4%

3. CITIBANK - $11,167,882,000,000 (Assets $582,123,000,000) Risk Ratio 19:1 ($19.18 of derivatives per $1 of assets). Credit exposure to Risk-Based Capital Ratio 267.1% OTC Derivatives 96.4%

4. WACHOVIA BANK - $2,326,465,000,000 (Assets $353,541,000,000) Risk Ratio 6.6:1 ($6.58 of derivatives per $1 of assets). Credit exposure to Risk-Based Capital Ratio 80.6% OTC Derivatives 70.2%

5. HSBC BANK USA - $1,353,741,000,000 (Assets $92,958,000,000) Risk Ratio 14.5:1 ($14.45 of derivatives per $1 of assets). Credit exposure to Risk-Based Capital Ratio 288.5% OTC Derivatives 88.7%

6. BANK ONE - $1,232,095,000,000 (Assets $256,787,000,000) Risk Ratio 4.8:1 ($4.79 of derivatives per $1 of assets). Credit exposure to Risk-Based Capital Ratio 58.7% OTC Derivatives 96.1%

7. BANK OF NEW YORK - $561,694,000,000 (Assets $89,258,000,000) Risk Ratio 6.3:1 ($6.29 of derivatives per $1 of assets). Credit exposure to Risk-Based Capital Ratio 77.7% OTC Derivatives 78.1%

8. WELLS FARGO BANK - $557,161,000,000 (Assets $250,474,000,000)

Risk Ratio 2.2:1 ($2.22 of derivatives per $1 of assets). Credit exposure to Risk-Based Capital Ratio 26.7% OTC Derivatives 66.3%

9. FLEET NATIONAL BANK - $443,708,000,000 (Assets $192,265,000,000) Risk Ratio 2.3:1 ($2.30 of derivatives per $1 of assets). Credit exposure to Risk-Based Capital Ratio 20.2% OTC Derivatives 64.1%

10. STATE STREET BANK - $369,843,000,000 (Assets $80,435,000,000) Risk Ratio 4.6:1 ($4.59 of derivatives per $1 of assets). Credit exposure to Risk-Based Capital Ratio 161.0% OTC Derivatives 89.2%

JPMORGAN CHASE is far past the point of no return. To put it in simple terms, JPMORGAN CHASE, BANK OF AMERICA, CITIBANK, and HSBC are already insolvent many times over. They have no liquidity, yet they are still operating as if they do.

This has now gone way beyond the imminent bursting of the US financial debt bubble... it has become an explosive financial weapon of mass destruction.

To understand the gambling risk U.S. banks have created, please read the following articles:

THE 3-D BOMB: DERIVATIVE DOMINO DESTRUCTION http://worldvisionportal.org/WVPforum/viewtopic.php?t=177

U.S. BANKS HAVE BECOME A PONZI SCHEME Most Bank Derivatives Have UNLIMITED Risk DERIVATIVES ARE THE KISS OF DEATH (scroll down to view these articles) http://worldvisionportal.org/WVPforum/viewtopic.php?t=160 

U.S. Bank Fraud Created Europe's Largest Bankruptcy http://worldvisionportal.org/WVPforum/viewtopic.php?t=176

$25 BILLION of Fannie Mae Derivative Losses http://worldvisionportal.org/WVPforum/viewtopic.php?t=192

Non-commercial reproduction allowed, otherwise copyright 2004 by WorldVisionPortal.Org

http://worldvisionportal.org/WVPforum/viewtopic.php?t=198 

Although most of those scandals entailed fraudulent scandals, some like Long-term Capital entailed having the top economists of the world (i.e., Nobel Prize winning economists Merton and Scholes) failing to understand the inevitable quicksand in managing derivatives hedging on a complex scale.  

In the end, derivatives are like antibiotics.  It's dangerous to live with them, but the world is better off because of them.  The same can be said about FAS 133 and its many implementation guides and amendments.  Booking derivatives at fair value is dangerous, but the economy would be worse off without it.  What we have to do is to strive night and day to improve upon reporting of value and risk in a world that relies more and more on derivative financial instruments to manage risks.

In May of 2003, the Financial Accounting Standards Board (FASB) issued Statement No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities. The Statement amends and clarifies accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under Statement 133 --- http://www.fasb.org/news/nr043003.shtml 

Norwalk, CT, April 30, 2003—Today the Financial Accounting Standards Board (FASB) issued Statement No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities. The Statement amends and clarifies accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under Statement 133.

The new guidance amends Statement 133 for decisions made:

• as part of the Derivatives Implementation Group process that effectively required amendments to Statement 133,
• in connection with other Board projects dealing with financial instruments, and
• regarding implementation issues raised in relation to the application of the definition of a derivative, particularly regarding the meaning of an “underlying” and the characteristics of a derivative that contains financing components.

The amendments set forth in Statement 149 improve financial reporting by requiring that contracts with comparable characteristics be accounted for similarly. In particular, this Statement clarifies under what circumstances a contract with an initial net investment meets the characteristic of a derivative as discussed in Statement 133. In addition, it clarifies when a derivative contains a financing component that warrants special reporting in the statement of cash flows. Statement 149 amends certain other existing pronouncements. Those changes will result in more consistent reporting of contracts that are derivatives in their entirety or that contain embedded derivatives that warrant separate accounting.

October 1, 2003 Accounting Tutorial Provided to the Public by Fannie Mae --- http://www.fanniemae.com/ir/accountingtutorial.jhtml 

This virtual presentation is copyrighted material of Fannie Mae. No recording, broadcast, or other distribution of this virtual presentation, or any part of the virtual presentation, is permitted without Fannie Mae's permission. Your participation in this virtual presentation implies your consent.

October 29, 2003 Error Announcement:  FAS 133/149 Trips Up Fannie Mae

Statement by Jayne Shontell Fannie Mae Senior Vice President, Investor Relations October 30, 2003 --- http://www.fanniemae.com/ir/issues/financial/103003.jhtml 

As you know, yesterday Fannie Mae filed a Form 8-K/A with the SEC amending our third quarter press release to correct computational errors in that release. There were honest mistakes made in a spreadsheet used in the implementation of a new accounting standard.

As we also reported, we discovered the errors in the course of the standard review in preparation of the company's financial statements to be included in Form 10-Q for the third quarter, and were primarily made in conjunction with the implementation of FAS 149.

The bottom line is that the correction has no impact on our income statement, but resulted in increases to unrealized gains on securities, accumulated other comprehensive income, and total shareholder equity (of $1.279 billion, $1.136 billion, and $1.136 billion, respectively).

I would like to explain what happened yesterday regarding the release of the information.

We were preparing to file the Form 8-K/A as required, and to ensure the maximum disclosure, we also were preparing to issue a press release with a statement announcing the filing. We contacted the business service we use to distribute press releases to inform the service what we planned to do once the documents were finalized. Before we even sent the business service the documents to be disclosed, the service -- on its own and without our prior knowledge or authorization -- put forth a statement, attributed to Fannie Mae, "killing" our previously issued October 16 press release. Shortly thereafter, our stock began to trade down. We proceeded to file the 8-K/A and issued our statement as soon as we could.

Let me reiterate that the correction had to do with a computational error in performing complicated calculations required in the implementation of FAS 149.

FAS 149 was issued in April. It required Fannie Mae to mark to market the majority of mortgage commitments we had made, which were previously not part of our financial statements. The new requirement was effective July 1. In adopting a new accounting standard in a short period of time, Fannie Mae had to put in place a system and process to capture all open commitments and mark them to market. To implement this standard, Fannie Mae utilized information from its internal, automated systems in conjunction with spreadsheets that made additional calculations necessary under the new rule. Fannie Mae is already in the process of updating its automated systems to account for the mortgage commitments under FAS 149.

Our accounting team discovered the errors in the normal course of preparing our financial statements for inclusion in our 10-Q. They immediately notified management and our independent auditor, KPMG. Management in turn notified the Audit Committee of the Fannie Mae Board of Directors and our regulator.

We continue to be proud of our accounting processes and controls. Far from being a failure of our accounting system, this event demonstrates that our accounting processes and controls work as they should. While we would have obviously preferred the error did not occur in the October 16 press release, we are pleased that the error was corrected before we file our financial statements in our 10-Q.

October 31, 2003 Quotation from The Wall Street Journal

Fannie Mae had previously argued that it had a far better lock on its accounting than Freddie Mac, hoping to cast itself as a more responsible and sophisticated operation that didn't need much more scrutiny. Fannie Mae went so far as to hold an accounting "tutorial" earlier this month to explain derivatives accounting to investors, analysts and reporters. Yet it was in derivatives accounting that its stumble came.
Patrick Bartta and John D Mckinnon (See below)

Note from Bob Jensen
You can read Fannie Mae's Derivatives Accounting Tutorial at http://www.fanniemae.com/ir/pdf/tutorial10012003.pdf 

"Fannie Mae Made $1.1 Billion Error In Its Accounting:  Understatement of Equity Renews Calls For Oversight of Two Mortgage Giants," by Patrick Bartta and John D. McKinnon, The Wall Street Journal, October 31, 2003 --- http://online.wsj.com/article/0,,SB10674573311089700-search,00.html?collection=wsjie%2F30day&vql_string=Freddie%3Cin%3E%28article%2Dbody%29 

Fannie Mae, the mortgage-financing giant already facing a crescendo of criticism about its financial oversight, said it miscalculated the value of its mortgage commitments, forcing it to make a $1.1 billion restatement of its stockholder equity.

The government-chartered company, which bills itself as the world's largest nonbank financial institution, released a revised third-quarter financial statement Wednesday correcting what it called "computational errors" that appeared when the results were first reported earlier this month. The restated figures were higher and didn't alter the company's profit, which was $2.67 billion in the third quarter, up 168% from a year earlier.

But the episode instantly reinforced fears that Fannie Mae and its smaller sibling Freddie Mac lack the necessary skills to operate their massive and complex businesses, which some investors, rivals and political critics worry could pose risk to the nation's financial system if not properly managed. Though the companies are not formally backed by a government guarantee, investors generally assume the government would step in to bail the companies out in an emergency, given their critical importance to the housing and broader financial markets.

Spreads between most Fannie Mae debt issues and comparable Treasury securities widened Wednesday. Investors pummeled the stock after the news was announced, though the stock recovered some ground by the end of the day. In 4 p.m. New York Stock exchange composite trading, Fannie Mae's shares were down 2.4% at $73.10.

Lawmakers and Treasury officials were already debating whether to tighten oversight of Fannie and Freddie after Freddie Mac disclosed its own accounting problems earlier this year. Freddie Mac's problems, which involved understating income by at least $4.5 billion, led to a major management shake-up, including the ouster of two chief executive officers. Freddie Mac used financial transactions to shift excess earnings into the future and mask the company's volatility.

Both companies "have a credibility problem, and this only makes it worse," said James Bianco, president of Bianco Research LLC, a Chicago-based investment-research firm who has been critical of the two companies. He said it highlights how too few people have a firm grasp on Fannie Mae's arcane accounting and overall financial position, even as Wall Street analysts continue to tout the company's stock. "Investors look at this stuff, throw their arms up in the air [and say], 'We don't understand this stuff, you don't understand this stuff, and the companies don't understand this stuff, but it doesn't matter, because the government is going to back it anyway.' "

Fannie Mae had previously argued that it had a far better lock on its accounting than Freddie Mac, hoping to cast itself as a more responsible and sophisticated operation that didn't need much more scrutiny. Fannie Mae went so far as to hold an accounting "tutorial" earlier this month to explain derivatives accounting to investors, analysts and reporters. Yet it was in derivatives accounting that its stumble came.

Continued in the article.

Question
How can failure to book derivatives fair value of $1.1 billion not have any impact on earnings?  If this is the case, what's the big sweat over failure to book the derivatives?

Answer (I include the FAS 149 amendments of FAS 133 as being part and parcel to FAS 133 itself.)
If the unbooked $1.1  fair value of the derivatives had instead been properly booked according to FAS133/IAS39 rules, the balance sheet assets and liabilities would change by $1.1 billion.  If these derivatives had been speculations or did not otherwise qualify for special hedge accounting treatment under FAS133/IAS39 rules, they would have impacted earnings by $1.1 billion.  But these derivatives were apparently hedges, and Fannie Mae tries to imply that its accounting error is no big sweat.  The CEO of Fannie Mae asserts that derivatives are used primarily for two purposes:

... we use derivatives primarily for two purposes: as substitutes for notes and bonds we issue in the debt markets and to hedge against fluctuations in interest rates on planned debt issuances.
Statement from the CEO of Fannie Mae Regarding FAS 133 Reporting Prior to the October 29, 2003  Adverse News Report --- http://www.fanniemae.com/ceoanswers/derivativesaccounting.jhtml 

First I might note that when derivatives are used as substitutes for debt issuances, their changes in value would affect current earnings to the extent that they are not used for hedging purposes under FAS 133 rules.  However, I seriously doubt that Fannie Mae is allowed to speculate using derivatives?  As "hedges against fluctuations in interest rates" their changes in value would not affect current earnings to the extent that the hedges are effective.  The reason is that FAS 133 provides complex ways to avoid earnings impacts of changes in value of hedging derivatives.  This is complex in the sense how it is done varies with cash flow hedges versus fair value hedges of booked hedge items versus fair value hedges of unbooked hedge items such as "planned debt issuances."  In the case of forecasted transactions like "planned debt issuances," the hedges are most likely cash flow hedges of interest rate risk in forecasted transactions much like Example 5 in Appendix B of FAS 133.  See my video of Example 5:  

Video Tutorial:  Accounting for Interest Rate Swap Hedges and Valuation of Swaps --- 
030FAS133InterestRateSwapAccounting.wmv --- http://www.cs.trinity.edu/~rjensen/video/acct5341/fas133/WindowsMedia/030FAS133InterestRateSwap 

So where's the big sweat in FAS 133 and IAS reporting rules as they stand today?

The big sweat is that there are two types of hedges other than foreign currency hedges.  One type is a cash flow hedge and the other type is a fair value hedge.  What people often fail to realize is that you can't be hedged both ways.  If a company has cash flow risk and hedges that risk, it creates fair value risk.  If a company has fair value risk and hedges that risk, it creates cash flow risk.  If Fannie Mae hedged interest rate cash flow risk, then it created fair value risk on the combined fair value of its hedged items and hedging instruments.  If it hedged fair value, it created cash flow risk.

If Fannie Mae's erroneously unbooked derivatives qualified for special hedge accounting under FAS133/IAS39 rules, then the offset to changes in booked fair value would bypass earnings.   The ineffective portion of the hedge does impact current earnings.  However, since Fannie Mae primarily hedges interest rate movements (probably with interest rate swaps), the hedges most likely qualified for "The Shortcut Method" under FAS 133 (see Paragraph 132) and would be deemed to be perfectly effective at the beginning of the hedge.  

Hence Fannie Mae most likely is correct in contending that its failure to book the $1.1 billion in derivatives under FAS 133 would not have impacted earnings provided both the hedges and the hedged items were carried to maturity.  The risk in not booking the derivatives (in terms of earnings) lies in the likely case that the hedged items and the hedges might not be carried to maturity.  Failure to book the $1.1 billion hides the enormous risk of a hit on earnings if customers pay off loans early (as is likely the case if interest rates drop) or that Fannie Mae sells the loans before maturity (as is common with Fannie Mae).  

From The Wall Street Journal Accounting Educators' Reviews on November 7, 2003

TITLE: Fannie Mae Makes $1.1 Billion Error in Its Accounting 
REPORTER: Patrick Barta and John D. McKinnon 
DATE: Oct 30, 2003 
PAGE: A1 
LINK: http://online.wsj.com/article/0,,SB10674573311089700,00.html  
TOPICS: Advanced Financial Accounting, Audit Report, Auditing, Derivatives, Fair Value Accounting, Hedging

SUMMARY: Fannie Mae made an error in applying the new FAS149 requirements to mark loan commitments to market, in accordance with derivative accounting under FAS 133, that was required to be implemented in 3rd quarter reporting. Fannie Mae argues that this was not a systemic problem, but merely resulted from human error in manual systems that are being used temporarily in order to implement the new requirement quickly.

QUESTIONS: 
1.) The first paragraph describes the changes from revising their third quarter financial statements as a "restatement of stockholder equity"and the second paragraph indicates that "the restated figures...didn't alter the company's profit..." How is it possible to change total stockholders' equity and not affect net income? What measure of reported performance do you think was affected by this change? Support your answer and include definitions of appropriate terms in doing so.

2.) Cite statements from the article which characterize the reaction to Fannie Mae's announcement of the accounting error. Why has the reaction been so negative even though the impact of the accounting error on stockholders' equity was positive?

3.) At the end of the article, the author indicates that the problem giving rise to this restatement was "tied in part to an obscure accounting provision, known as Financial Accounting Standard No. 149." What is the subject of that standard? Do you think it is "obscure"? What do you think makes the popular business press use this description?

4.) The author describes the loan commitments that are the subject of this accounting error near the end of the article. What provision in FAS 49 requires that these commitments be marked to market value "and hence record any unrealized changes in value of those commitments despite whatever price the company agrees to pay for the loans"? What type of accounting treatment for such commitments could result in an impact on stockholders' equity, but not net income, as is the case at hand?

5.) The impact on stockholders' equity was positive--an unrealized gain on the value of the loan commitments undertaken by Fannie Mae. What does that say about the terms of these loan commitment contracts?

6.) Suppose you are an auditor and Fannie Mae is your client. What impact does this problem have on your plans for the year-end audit? Do you have any responsibility associated with the problematic third quarter report, even if that report was labeled "unaudited"?

Reviewed By: Judy Beckman, University of Rhode Island 
Reviewed By: Benson Wier, Virginia Commonwealth University 
Reviewed By: Kimberly Dunn, Florida Atlantic University

--- RELATED ARTICLES --- 
TITLE: Review & Outlook: Fannie's Black Box 
REPORTER: WSJ Editors 
PAGE: A12 
ISSUE: Oct 31, 2003 
LINK: http://online.wsj.com/article/0,,SB106755988050523700,00.html 

"Representative Stearn Calls for GAAP Overhaul," AccountingWeb, February 3, 2004 --- http://www.accountingweb.com/cgi-bin/item.cgi?id=98662 

In the course of holding hearings into the accounting issues at Freddie Mac, Rep. Cliff Stearns (R-FL) said there are fundamental flaws in generally accepted accounting principles (GAAP) that need to be addressed to prevent future abuses.

"Specifically, GAAP should not allow companies to change the characterization of an asset and thereby change its accounting," said Stearns. "I applaud the Federal Accounting Standards Board (FASB) for its efforts to change and reform the system over the last two years. Nevertheless, I intend to offer legislation in the next few weeks concerning FASB that will reform accounting standards."

As part of the hearings, Stearns asked Armando Falcon, director of the Office of Federal Housing Enterprise Oversight (OFHEO), which oversees Freddie Mac and the larger Frannie Mae, to look into whether compensation of the two agency’s 20 top officials contributed to accounting problems.

"Through our past hearings we learned that Freddie Mac disregarded accounting rules, internal controls, and disclosure standards to maintain a reputation for steady earnings," stated Stearns, chairman of the Commerce, Trade & Consumer Protection Subcommittee. "I appreciate hearing from Freddie Mac about the new controls it is instituting to guard against improper accounting. Given that Freddie Mac hid billions of dollars in income in a way that complied with GAAP (Generally Accepted Accounting Principles), this Subcommittee has a responsibility to look at improving these accounting standards."

Stearns pointed to an anomaly that allows Freddie Mac and some other financial companies to engage in earnings arbitrage: "So Called 'mixed-attribute accounting' allows companies to decide whether financial assets are carried at current market price or at historic cost." Freddie Mac shifted assets between categories to manipulate earnings, without any change in the underlying economics of its performance. Said Stearns, "Taxpayers do not have the option of changing the characterization of assets to change the tax treatment; I think GAAP should not allow this either."

Martin Bauman, chief financial officer, Freddie Mac, testified, "While the restatement represented an important milestone, now that it has been completed, Freddie Mac is focused on bringing our financials up-to-date." In reacting to Stearns' concerns over the adequacy of current standards, Bauman stated, "Freddie Mac recognizes the importance of transparent accounting and reporting standards and we are committed to providing investors with the information they need to understand how we view and manage our business. We fully support the Subcommittee's efforts to move toward a principles-based accounting framework."

May 6, 2005 message from Dennis Beresford [dberesfo@terry.uga.edu]

Bob,

I just finished listening to the GE web cast and it is fascinating. It's interesting to listen to the company's explanations of what happened and to the analysts' questions. The web cast is available at: http://phx.corporate-ir.net/phoenix.zhtml?c=118676&p=irol-eventdetails&EventId=1062945&WebCastId=443224&StreamId=533758  although these things usually get removed after a month or so. They also said that they would post a transcript of the web cast later today.

Denny

May 6, 2005 reply from Bob Jensen

Hi Denny,

I enjoyed part of the Webcast and appreciated the fact that the analysis of why GE is restating its financial statements came near the beginning of the Webcast.  I thought the explanation was direct and very clear.  The restatement tends to make a FAS 133 mountain out of an economic mole hill.

Scholars interested in the Shortcut Method for Interest Rate Swaps will find this GE Webcast interesting. FAS 133 makes a huge exception for having to test for hedge effectiveness of interest rate swaps. This is important, because typical tests of effectiveness such as the dollar offset test will often fail quarter to quarter for such swaps. Not having to test for effectiveness helps to avoid having to declare swap hedges ineffective when, in my viewpoint, they are perfectly effective over the life of the swap.

GE executives decided after the fact that they thought they were eligible for the Short Cut Method on some swaps that technically violated one SCM test. The impact is rather small and not a big deal even though GE is going to restate its financial statements to the tune of about $300 million.

The important point for academics and practitioners is to learn why GE decided they did not meet the SCM tests outlined under "Short Cut Method for Interest Rate Swaps" in my glossary at http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#S-Terms 

The important point for standard setters is to learn that this is yet another technicality in an accounting rule that has absolutely no impact on the actual economic performance or cash flows of a company. I think standard setters have to become more creative in distinguishing cash/economic outcomes versus fluctuations in financial performance that are transitory and have no ultimate impact on cash/economic performance.

This earnings restatement by GE due to derivatives is much less complex than the macro hedging complications of Fannie Mae and Freddie Mac --- http://www.trinity.edu/rjensen/caseans/000index.htm#FannieMae

Bob Jensen

May 6, 200r reply from Dennis Beresford [DBeresfo@Terry.UGA.Edu]

Bob,
What I found most interesting in the web cast were the comments by the CEO and CFO along the lines of "what we did back then was considered okay, but now everyone expects us to actually follow the specific rules." They cited materiality more than once - as long as what we did wasn't "materially different" than what the rules required, we and our auditors thought that was fine. In fairness to GE, SFAS 133 is incredibly complicated and they made clear in the web cast that it wouldn't have been a problem to modify the derivatives in order to meet the hedging rules if they thought that was necessary.

GE and many other companies are complaining about applying today's thinking to yesterday's issues - I guess this is what we usually call 20:20 hindsight. This is similar to the lease restatement problem that has affected about 300 companies. What they were doing didn't comport with GAAP but everybody was doing it so it was considered "generally acceptable."

I wouldn't be surprised if a few other large companies have to revise their accounting for derivatives, particularly if they are looked at carefully by PCAOB reviewers or the SEC.

Denny

"GE Restates Several Years Of Earnings:  Derivatives-Accounting Rule Applied Improperly Resulted In Less-Volatile Quarters," by Kathryn Kranhold and Deborah Solomon, The Wall Street Journal, May 9, 2005; Page A3 --- http://online.wsj.com/article/0,,SB111537976071026800,00.html?mod=todays_us_page_one

General Electric Co. said it restated its earnings for the years 2001 through 2004 and the first quarter of 2005, amid increasing scrutiny by regulators over how companies account for derivative transactions used to hedge financial risks such as interest-rate fluctuations.

GE, the largest U.S. company by market capitalization, said Friday it restated its earnings after misapplying a rule on how to account for certain derivative deals. The restatement had minimal impact on GE's yearly profits, lifting its per-share earnings by two cents in each of the past two years. Still, the revised figures show the company's earnings would have been volatile in some quarters and that GE would have missed analysts' estimates had the hedges been accounted for properly.

On Friday as part of its restatement, GE revealed that it had received a request from the Securities and Exchange Commission in January for general information about its hedging accounting. GE also is expected to face a formal inquiry, as federal regulators seek to subpoena specific documents and interview witnesses. Additionally, the SEC has requested information from GE's auditors, KPMG LLP. A KPMG spokesman declined to comment. (See related article.)

Continued in the article

November 29, 2004 message from Dennis Beresford [dberesfo@terry.uga.edu] 

Bob,

I tried to forward a Barron's article on derivatives to you yesterday. In case it didn't get through, you can access it at: http://online.barrons.com/article/SB110151620676084545.html?mod=b_this_weeks_magazine_main

It includes some interesting perspectives on SFAS 133 and Freddie Mac and Fannie Mae.

Denny

November 29, 2004 reply from Bob Jensen

Hi Denny,

The Barron's article is somewhat balanced and makes some very good points.

However, the capital market vested interests either do not or will not remember the bad stuff that was happening prior to FAS 133 (Orange County, Procter & Gamble, LT Capital, etc.) --- http://www.trinity.edu/rjensen/fraudRotten.htm#DerivativesFrauds 

Advocates of full disclosure in place of booking forget the "full disclosure" obfuscation about put options and SPEs in Enron's infamous Footnote 16 compliance --- http://www.trinity.edu/rjensen/FraudEnron.htm#Senator 

It's a never ending cycle of patch and unpatch when it comes to regulation versus corruption. When the scandals die out, the lobbyists buy off the cops to where industry owns the FDA, agribusiness owns the Department of Agriculture, power companies own the FPA, and Wall Street more or less owns the SEC (in spite of Donaldson's futile efforts). These agencies rise up when scandals surface and faith in the system is at stake. But when the media lays off, industry crawls back in the dead of night and takes over once again to rip off consumers and investors. Where was Levitt when all the Wall Street scandals were taking place in mutual funds, insurance companies, and investment banking? Where will the new head of the SEC be when they same companies once again commence to take advantage reduced incentives to play fair? Now that the FASB is more dependent upon government funding, I suspect that it too will water down controversial standards.

In the table below, I try to counter or elaborate on some of the claims made by Ales Pollock in the Baron's article.  I might note that Mr. Pollock was President of the Federal Home Loan Bank of Chicago until 2004.

Hi Brandon,

Funny you should send this message just now! My students may want to kill you as well as me after they read your message. Didn't I tell you so?

My students are currently bogged down in a current "ridiculous derivatives research assignment" on Freddie Mac and Fannie Mae.

It is great to hear from you. Please forward whatever you've got on derivatives.

Bob Jensen

-----Original Message----- 
From: Brandon_Lamb@eogresources.com [mailto:Brandon_Lamb@eogresources.com]  
Sent: Monday, April 05, 2004 9:31 AM 
To: Jensen, Robert Subject: FW: How to remove ink stains

Dr. Jensen,

I don't know if you remember - I was in your inaugural graduate Accounting Theory class (5341) where we discussed and discussed and discussed the upcoming SFAS No. 133 on derivatives, which hadn't been finalized yet. Luckily I haven't had to deal with it all that much, but I ran into a heck of a derivatives issue this past week, and of course I thought back to that class and that ridiculous derivatives research assignment!

If you like, once we finalize the entries, I can forward along all the parameters and you could use it in your class to demonstrate that you actually do use all that theory you tried to drill into our heads! Your students will kill me, but I'll worry about that later.

Hope all is well at Trinity.

Brandon Lamb

Hedging Paradox:  
In finance, there is no way to cover your Fannie without exposing your Fannie somewhere else.
Gypsy Rose Lee would've said her fan (hedge) can only cover one Fannie cheek at a time. 
Gypsy Rose Lee ( http://www.hollywoodlegends.com/gypsy-rose-lee.html ) decades ago was popular exotic dancer with high modesty tastes relative to today's riskier exposures.

$25 Billion in Dereivatives Losses at Fannie Mae --- http://worldvisionportal.org/WVPforum/viewtopic.php?t=192 

Fannie Mae paid a net $25.1bn on derivatives transactions in under four years - nearly all of which may represent losses that cannot be recouped, in turn depressing future earnings.

The potential scale of the liabilities, which have yet to be recognised in the company's earnings or in the minimum capital adequacy required by its regulator, raise fresh doubts about the financial health of the mortgage finance giant.

Regulation of Fannie Mae and its sibling Freddie Mac is rapidly moving up the agenda in Washington, amid concerns that the two goverment-sponsored entities have grown so big that they pose a systemic risk to the US financial system. The two entities own or guarantee mortgages totalling $4,000 billion.

On Tuesday John Snow, US Treasury secretary, renewed the criticism, saying: "We don't believe in a too-big-to-fail doctrine, but the reality is that the market treats the paper as if the government is backing it."

His comments follow similar warnings from Alan Greenspan, chairman of the Federal Reserve, and Gregory Mankiw, chairman of George W. Bush's council of economic advisers.

Fannie Mae acknowledges it has taken losses in its derivatives trading that have not yet been recognised it its earnings, but declines to disclose the amount. The reason, said Jonathan Boyles, vice-president of financial standards and taxes at Fannie Mae, is that "we don't believe it's all that meaningful".

Next Monday Fannie Mae is due to release its annual "fair value disclosure" - a statement of the current market value of its derivatives positions. Observers will be watching to see if the gap between the company's regulatory capital and fair value has widened further than the $6bn shortfall of a year ago.

An independent analysis of Fannie's accounts suggests it may have incurred losses on its derivatives trading of $24bn between 2000 and third-quarter 2003. That figure represents nearly all of the $25.1bn used to purchase or settle transactions in that period. Any net losses will eventually have to be recognised on Fannie Mae's balance sheet, depressing future profits.

Fannie Mae maintained that the losses from cashflow hedging will have no bearing on the capital adequacy required by its regulator.

However, critics increasingly question whether Fannie Mae's financial disclosure offers a complete picture of its fiscal health.

"They have used the derivative accounting rules for cash flow hedges to defer some losses that they have taken," said John Barnett, senior analyst at the Center for Financial Research & Analysis, an independent research firm. "They may not be as well-capitalised as they appear to be for regulatory purposes."

The Sidestep

Some of you I’m certain are not interested in how firms account for risk.  However, since great leaders like Alan Greenspan and Warren Buffet claim that the Freddie Mac Corporation is a serious threat that could bring down the entire U.S. economy, it may peak your interest in Freddie Mac just a bit.

Editorial on Freddie Mac's Sidestep
A Lesson From Derivatives 101

In the “Best Little Whorehouse in Texas ” Broadway show and movie, when asked what he was going to do about the “Chicken Ranch Whorehouse,” the Governor of Texas broke into a song and dance entitled “Sidestep.”

I hummed the Sidestep tune while listening to the Freddie Mac 2004 Shareholders Meeting.  You can listen to replays of the Freddie Mac Shareholders Meeting until midnight April 14 at http://www.freddiemac.com/news/archives/investors/2004/annualstockwebcast_032504.html 

I do think that Freddie Mac, with the help of PwC auditors, is making a genuine and sincere attempt to overcome the really bad shape of the accounting system that got most of its top executives fired.  The sins of the past were clearly acknowledged in the 2004 Shareholders Meeting.  

However, when it came to answer questions about interest rate risk and leveraged debt risk, especially those excellent questions from Mr. Jain in the audience, Freddie Mac launched into the Sidestep.

When asked about the concerns of Alan Greenspan and Warren Buffet (who sold all his holdings in Freddie Mac) concerning interest rate risk, Freddie Mac broke into a "Sidestep" by correctly stating that Freddie Mac hedges interest rate risk with interest rate risk derivatives to the tune of over $1 trillion in derivative hedges.

Let me give you a lesson from Derivatives 101

When any kind of price or interest rate risk is hedged, there are really two types of hedges.

• When there is cash flow risk such as the cash flow risk from investing in a variable rate mortgage, it is possible to hedge that risk so that there is no cash flow risk.  However, doing so creates market value risk for the entire period in which cash flow risk is hedged.  The same holds for borrowers who also hedge cash flows.
  
  

• Where there is fair value risk such as the market value risk from investing in a fixed rate mortgage, it is possible to hedge that risk so that the sum of the value of the investment plus the value of the derivative hedge will sum to the current market value of the investment.  However, doing so creates cash flow risk in that interest plus derivative revenue will increase if interest rates go up and plunge if interest rates go down.  The same holds for borrowers who also hedge value.
  
  

These two types of hedges apply to hedges of assets or liabilities.  Freddie Mac hedges its mortgage investments.  It also hedges its debt which is very high since Freddie Mac has about 67% debt in a very high leveraging operation on a thin equity.

The sad thing about price and interest rate risk is that it is impossible to hedge both at the same time.  Hedging cash flow risk causes and current value risk.  Hedging value causes cash flow risk.

Freddie Mac actually hedges "interest rate risk" with both cash flow and fair value hedges.  But doing so does not eliminate interest rate risk as implied throughout the Freddie Mac 2004 Shareholders Meeting.  Doing so merely changes the type of risk exposure.

When Freddie Mac hedges cash flow risk, the combined sum of the hedged item plus the hedging derivative values thereby become exposed to current value risk.  Cash-hedged mortgage investments protect revenues from interest rate fluctuations, but the value of the assets will plunge if interest rates soar and soar if interest rates plunge.

When Freddie Mac hedges value risk, the combined monthly cash flows from hedged item interest and hedging derivative cash flows will plunge if interest rates decline and soar if interest rates explode.  

Since many of Freddie Mac's fixed-rate mortgage investments are at relatively low interest rates, they have protected asset value with fair value hedges.  However, doing so created cash flow risk.

The point from Derivatives 101, it is a sidestep whenever a claim is made that "interest rate or any other price risk is hedged."  The correct response is that "we hedged cash flows" or "we hedged current value" but not that "we hedged both."  

When a corporation like Freddie Mac hedges both cash flow risk of some investments and current value risk of other assets, it is very difficult to evaluate the net risk exposure.

I do think that Freddie Mac, with the help of PwC auditors, is making a genuine and sincere attempt to overcome the really bad shape of the accounting system that got most of its top executives fired.  The sins of the past were clearly acknowledged in the 1004 Shareholders Meeting.  

However, when it came to answer questions about interest rate risk and leveraged debt risk, especially those excellent questions from Mr. Jain in the audience, Freddie Mac launched into the Sidestep.

In the final analysis with interest rates poised to soar, we really don’t know if Freddie Mac’s net hedged position will clobber its asset and debt values or its cash flows.  

Something must get clobbered!

March 31, 2004 reply from Robert B Walker [walkerrb@ACTRIX.CO.NZ] 

A good summary of why IAS 39 is meeting such resistance. Economically you are hedged - you just can't reflect it in your financial report. Might that not suggest that there is something wrong with FAS 133 and its progeny?

I have a client that has exactly this problem. It carries its mortgage book at amortised cost even though it may be able to sell it (after all it did buy a large chunk of it). However, the valuation problems are monumental. For this reason it does not revalue the related interest rate swaps it must hold to be prudent.

It can get away with this for the time being as IAS 39 is merely one of a number of sources of authority under NZ GAAP (one of the other sources being predominant industry practice - a bit of a self-fulfilling prophecy really). However soon it will not be able to avoid it as IAS 39 will be a mandatory component of NZ GAAP.

The problem is exacerbated in NZ as we, effectively, do not have the notion of comprehensive income. All movements in derivatives would be booked to profit. There would be no commensurate gain or loss from the related mortgage portfolio because the stringent conditions for hedge quality cannot be met nor practically can the portfolio be valued. This is an economic nonsense of course.

Personally I don't think mixed measurement accounting systems are conceptually coherent. It should be fair value for one class of financial element, fair value for them all. But then how can you practically measure the value of a mortgage portfolio ...

April 1, 2004 reply from Bob Jensen

Hi Robert,

You are correct when it comes to difficulties of valuing swaps.

However, there are some approaches that I discuss at http://www.trinity.edu/rjensen/acct5341/speakers/133swapvalue.htm 

Thanks,

Bob Jensen

And just how might Freddie Mac get clobbered by derivatives and derivatives accounting?
Bob Jensen’s threads on derivatives accounting are at http://www.trinity.edu/rjensen/caseans/000index.htm

Part 1:  Optimism

It is very easy to become overly pessimistic about derivatives when reading quotations from Greenspan and Buffet.  In some ways pessimism over financial instrument derivatives in the economy is analogous to pessimism over the use of antibiotics  since super-resistant microbes will evolve that might one day bring humanity to its knees.  But to cave into such fears and immediately ban all antibiotics would cause more immediate plagues and death in humanity.  Similarly to ban the use of derivatives for managing financial risk would bring modern economies to their knees overnight.

There are expensive derivatives strategy and accounting remedies such as those purportedly adopted by Fannie Mae.  Fannie Mae claims to have modified its derivative hedging strategy as a result of FAS 133 (so much for FASB standards neutrality) and has had a much better accounting system in place in spite of a brief snafu where it failed to report $1 billion in derivatives.  The snafu was rather quickly detected by Fannie's internal control system.  See an summary of this strategy at http://www.trinity.edu/rjensen/caseans/000index.htm#FannieMae 
Note how Fannie Mae makes every effort to avoid macro hedging that will not be allowed to get hedge accounting.  The result is that changes in derivative values do not create the wild earnings fluctuations that worries Buffet, because Fannie Mae gets hedge accounting much of the time.  

But such a strategy is a tremendously expensive and cumbersome in a company that owns mortgages of over 32 million households.  Note the use of Non-GAAP financial measures reported at http://www.fanniemae.com/ceoanswers/discussion.jhtml 

Fannie got smart when she watched her little brother Freddie fall to his knees because of bad compliance with FAS 133.   Now Freddie is trying to learn about accounting from his big sister.  Fanny Mae's  CEO claims the following in answer to the question "Why do you have confidence that you have done your derivative accounting properly?" --- http://www.trinity.edu/rjensen/caseans/000index.htm#FannieMae 

Let me walk through how we account for our derivatives:

• First, we use derivatives primarily for two purposes: as substitutes for notes and bonds we issue in the debt markets and to hedge against fluctuations in interest rates on planned debt issuances.
  
• Second, we have a very controlled process to ensure against management mistakes.
  • Importantly, our accounting function does NOT reside within the business units. Those entering into business transactions and accountable for the business results do not determine the accounting of those transactions.
    
  • In anticipation of adopting FAS 133, we catalogued each type of derivative transaction done by Fannie Mae. As part of our implementation process, we consulted with our independent auditors -- KPMG -- about the appropriateness of our FAS 133 accounting policies, interpretations, and systems.
    
  • We continue today to maintain a current catalogue of each type of derivative transaction done and to set our accounting policy at the transaction level. We don't assume that the correct treatment for one transaction is automatically the correct or best treatment for a different transaction.
    
  • Prior to entering into a new type of derivative transaction, the business unit will describe the intended transaction. Our Controller will then recommend an accounting treatment. Our policy is to have the Controllers Office discuss this recommended accounting treatment with our outside independent auditors and to update the derivatives accounting policy that governs the transactions the business units can enter into. Only when the policy is updated can the transaction be completed.
    
  • The hedge accounting treatment for each individual transaction is determined -- and documented in writing -- before we enter into the transaction. And it cannot subsequently be changed.
    
  • On a daily basis all hedging activity is reported to our Controllers Office, which monitors hedge performance and accounts for the hedge.
    
  • On an annual basis Fannie Mae's internal audit department performs a comprehensive audit of our hedging activity to ensure compliance with our Hedge Accounting Guidelines and that strong internal controls are in place. Fannie Mae's internal audit department reports directly to the fully independent Audit Committee of our Board of Directors, which reviews its work -- including the derivatives audit -- every year.

The positive derivatives strategy of Fannie Mae now being copied by Freddie Mac begs the question regarding whether any derivatives strategy can overcome the macro worries of Alan Greenspan and Warren Buffet regarding the use of derivatives to hedge enormous (trillion dollar magnitude) of risk.  We have seen so many "fiascos" in derivatives use at the hundred million dollar level (e.g, Proctor and Gamble), billion dollar level (e.g., Orange County), and multi-billion dollar level (e.g., Long-Term Capital).  For a summary of derivatives scandals, see http://www.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds 

Hi Calvin,

I don’t know of any that are worth mentioning.

There were a lot of bad disclosure illustrations in 2001 and 2001, most notably Enron.  Since then disclosures have gotten a lot better.  One example I like to use is Calpine --- http://www.calpine.com/

I guess the answer to your question is no.  Accounting professors have been pretty slow picking up on FAS 133 and textbooks and journals are still lacking in this area.

Other than what you find in my tutorials, I do not have anything particularly helpful to add --- http://www.trinity.edu/rjensen/caseans/000index.htm 

I just added the following interesting link to the above document.  

“http://www.rense.com/general50/cooking2.htm,

Note the $25 billion loss of Fannie Mae in derivatives 
(the company that is supposed to have the supreme hedging system.)
"Cooking The Books Part II - US $71 Trillion Casino Banks," by Michael Edward, Rense.com, March 27. 2004 --- http://www.rense.com/general50/cooking2.htm

Derivative holdings by U.S. banks increased nearly $4 TRILLION in just 3 months to now total over $71.1 TRILLION. JPMORGAN CHASE accounts for $3.1 TRILLION of this increase.

That's $ 71,100,000,000,000.

The first 7 banks listed below account for 96% of all commercial bank derivative holdings, with 90% of these derivatives in extremely risky OTC (Over the Counter) contracts.

As I said in Cooking the Books Part I, U.S. banks are giant gambling casinos, and now they have become even larger gambling addicts at the expense of all Americans.

DERIVATIVES CONTRACTS AS OF DECEMBER 31, 2003 (based on just released 03Q4 OCC Bank Derivatives report)

1. JPMORGAN CHASE BANK - $36,805,757,000,000 (Assets $628,662,000,000) Risk Ratio 58.5:1 ($58.54 of derivatives per $1 of assets). Credit exposure to Risk-Based Capital Ratio 844.6% OTC Derivatives 92.6%

2. BANK OF AMERICA - $14,869,220,000,000 (Assets $617,962,000,000) Risk Ratio 24:1 ($24.06 of derivatives per $1 of assets). Credit exposure to Risk-Based Capital Ratio 221.7% OTC Derivatives 83.4%

3. CITIBANK - $11,167,882,000,000 (Assets $582,123,000,000) Risk Ratio 19:1 ($19.18 of derivatives per $1 of assets). Credit exposure to Risk-Based Capital Ratio 267.1% OTC Derivatives 96.4%

4. WACHOVIA BANK - $2,326,465,000,000 (Assets $353,541,000,000) Risk Ratio 6.6:1 ($6.58 of derivatives per $1 of assets). Credit exposure to Risk-Based Capital Ratio 80.6% OTC Derivatives 70.2%

5. HSBC BANK USA - $1,353,741,000,000 (Assets $92,958,000,000) Risk Ratio 14.5:1 ($14.45 of derivatives per $1 of assets). Credit exposure to Risk-Based Capital Ratio 288.5% OTC Derivatives 88.7%

6. BANK ONE - $1,232,095,000,000 (Assets $256,787,000,000) Risk Ratio 4.8:1 ($4.79 of derivatives per $1 of assets). Credit exposure to Risk-Based Capital Ratio 58.7% OTC Derivatives 96.1%

7. BANK OF NEW YORK - $561,694,000,000 (Assets $89,258,000,000) Risk Ratio 6.3:1 ($6.29 of derivatives per $1 of assets). Credit exposure to Risk-Based Capital Ratio 77.7% OTC Derivatives 78.1%

8. WELLS FARGO BANK - $557,161,000,000 (Assets $250,474,000,000)

Risk Ratio 2.2:1 ($2.22 of derivatives per $1 of assets). Credit exposure to Risk-Based Capital Ratio 26.7% OTC Derivatives 66.3%

9. FLEET NATIONAL BANK - $443,708,000,000 (Assets $192,265,000,000) Risk Ratio 2.3:1 ($2.30 of derivatives per $1 of assets). Credit exposure to Risk-Based Capital Ratio 20.2% OTC Derivatives 64.1%

10. STATE STREET BANK - $369,843,000,000 (Assets $80,435,000,000) Risk Ratio 4.6:1 ($4.59 of derivatives per $1 of assets). Credit exposure to Risk-Based Capital Ratio 161.0% OTC Derivatives 89.2%

JPMORGAN CHASE is far past the point of no return. To put it in simple terms, JPMORGAN CHASE, BANK OF AMERICA, CITIBANK, and HSBC are already insolvent many times over. They have no liquidity, yet they are still operating as if they do.

This has now gone way beyond the imminent bursting of the US financial debt bubble... it has become an explosive financial weapon of mass destruction.

To understand the gambling risk U.S. banks have created, please read the following articles:

THE 3-D BOMB: DERIVATIVE DOMINO DESTRUCTION http://worldvisionportal.org/WVPforum/viewtopic.php?t=177

U.S. BANKS HAVE BECOME A PONZI SCHEME Most Bank Derivatives Have UNLIMITED Risk DERIVATIVES ARE THE KISS OF DEATH (scroll down to view these articles) http://worldvisionportal.org/WVPforum/viewtopic.php?t=160 

U.S. Bank Fraud Created Europe's Largest Bankruptcy http://worldvisionportal.org/WVPforum/viewtopic.php?t=176

$25 BILLION of Fannie Mae Derivative Losses http://worldvisionportal.org/WVPforum/viewtopic.php?t=192

Non-commercial reproduction allowed, otherwise copyright 2004 by WorldVisionPortal.Org

http://worldvisionportal.org/WVPforum/viewtopic.php?t=198

-----Original Message-----
From: Lin, Calvin (IT) [mailto:Calvin.Lin@morganstanley.com]
Sent: Friday, April 02, 2004 12:54 PM
To: Jensen, Robert
Subject: Any help is appreciated.

  Hi Bob,

  I came across your website while doing some research on the subject of FAS 133.  Basically I am trying to find a company to do a paper on how it used / mis-used FAS133 to account for its derivatives.  So far I have read some articles on your website for Fannie Mae and Freddie Mac and I may use those companies as my case studies.

Do you happen to know if there are any other documented cases where the use of FAS 133 were examined in detail?  If so where can I get more information about them?

Regards,

Calvin Lin
Institutional Securities Division
Morgan Stanley & Co.
New York, NY

Although most of those scandals entailed fraudulent scandals, some like Long-term Capital entailed having the top economists of the world (i.e., Nobel Prize winning economists Merton and Scholes) failing to understand the inevitable quicksand in managing derivatives hedging on a complex scale.  

In the end, derivatives are like antibiotics.  It's dangerous to live with them, but the world is better off because of them.  The same can be said about FAS 133 and its many implementation guides and amendments.  Booking derivatives at fair value is dangerous, but the economy would be worse off without it.  What we have to do is to strive night and day to improve upon reporting of value and risk in a world that relies more and more on derivative financial instruments to manage risks.

Part 2:  Pessimism  (Note that the negative articles about Freddie Mac apply to the old management that was fired.  Freddie Mac is now trying claw its way back up from the hole.)

Warren Buffet has a knee-jerk avoidance of investing in corporations that are heavy into derivative strategies for speculation or hedging purposes.  Warren Buffet claims:  "Derivatives are financial weapons of mass destruction.  The dangers are now latent--but they could be lethal."  See "Avoiding a 'Mega-Catastrophe' Derivatives ," by Warren Buffet, Fortune --- http://www.fortune.com/fortune/investing/articles/0,15114,427751,00.html 
In his 2002 Berkshire Hathaway Annual Report he provides more detail regarding his concerns.

Warren Buffet on Derivatives

Following are edited excerpts from the Berkshire Hathaway annual report for 2002 --- http://www.fintools.com/docs/Warren%20Buffet%20on%20Derivatives.pdf 

I view derivatives as time bombs, both for the parties that deal in them and the economic system.  Basically these instruments call for money to change hands at some future date, with the amount to be determined by one or more reference items, such as interest rates, stock prices, or currency values. For example, if you are either long or short an S&P 500 futures contract, you are a party to a very simple derivatives transaction, with your gain or loss derived from movements in the index. Derivatives contracts are of varying duration, running sometimes to 20 or more years, and their value is often tied to several variables.

Unless derivatives contracts are collateralized or guaranteed, their ultimate value also depends on the creditworthiness of the counter-parties to them. But before a contract is settled, the counter-parties record profits and losses – often huge in amount – in their current earnings statements without so much as a penny changing hands. Reported earnings on derivatives are often wildly overstated. That’s because today’s earnings are in a significant way based on estimates whose inaccuracy may not be exposed for many years.

The errors usually reflect the human tendency to take an optimistic view of one’s commitments. But the parties to derivatives also have enormous incentives to cheat in accounting for them. Those who trade derivatives are usually paid, in whole or part, on "earnings" calculated by mark-to-market accounting. But often there is no real market, and "mark-to-model" is utilized. This substitution can bring on large-scale mischief. As a general rule, contracts involving multiple reference items and distant settlement dates increase the opportunities for counter-parties to use fanciful assumptions. The two parties to the contract might well use differing models allowing both to show substantial profits for many years. In extreme cases, mark-to-model degenerates into what I would call mark-to-myth.

I can assure you that the marking errors in the derivatives business have not been symmetrical. Almost invariably, they have favored either the trader who was eyeing a multi-million dollar bonus or the CEO who wanted to report impressive "earnings" (or both). The bonuses were paid, and the CEO profited from his options. Only much later did shareholders learn that the reported earnings were a sham.

Another problem about derivatives is that they can exacerbate trouble that a corporation has run into for completely unrelated reasons. This pile-on effect occurs because many derivatives contracts require that a company suffering a credit downgrade immediately supply collateral to counter-parties. Imagine then that a company is downgraded because of general adversity and that its derivatives instantly kick in with their requirement, imposing an unexpected and enormous demand for cash collateral on the company. The need to meet this demand can then throw the company into a liquidity crisis that may, in some cases, trigger still more downgrades. It all becomes a spiral that can lead to a corporate meltdown.

Derivatives also create a daisy-chain risk that is akin to the risk run by insurers or reinsurers that lay off much of their business with others. In both cases, huge receivables from many counter-parties tend to build up over time. A participant may see himself as prudent, believing his large credit exposures to be diversified and therefore not dangerous. However under certain circumstances, an exogenous event that causes the receivable from Company A to go bad will also affect those from Companies B through Z.

In banking, the recognition of a "linkage" problem was one of the reasons for the formation of the Federal Reserve System. Before the Fed was established, the failure of weak banks would sometimes put sudden and unanticipated liquidity demands on previously-strong banks, causing them to fail in turn. The Fed now insulates the strong from the troubles of the weak. But there is no central bank assigned to the job of preventing the dominoes toppling in insurance or derivatives. In these industries, firms that are fundamentally solid can become troubled simply because of the travails of other firms further down the chain.

Continued in the article

"Greenspan Says Congress Should Limit Fannie, Freddie," by Dawn Kopecki and Josepth Rebello, The Wall Street Journal, February 24, 2004 --- http://online.wsj.com/article/0,,SB107763512493737729,00.html?mod=home_whats_news_us 

Mortgage giants Fannie Mae and Freddie Mac could pose a threat to the financial system, according to Federal Reserve Chairman Alan Greenspan.

Mr. Greenspan called on Congress Tuesday to impose stringent restrictions on the ability of Fannie Mae and Freddie Mac to issue debt and purchase assets, saying the growth of the institutions poses a risk to the safety of the U.S. financial system.

"The Federal Reserve is concerned about the growth and the scale of the [government-sponsored enterprises'] mortgage portfolios, which concentrate interest and prepayment risks at these two institutions," Mr. Greenspan said in written testimony to the Senate Banking Committee. Although he said he didn't think a crisis was imminent, "preventative actions are required sooner rather than later."

"GSEs need to be limited in the issuance of GSE debt and in the purchase of assets, both mortgages and non-mortgages, that they hold," he added in the written testimony.

In many ways, Freddie Mac provides a wonderful example of the difficulties of managing risk in complex companies and complex economies.  Note the following quotation in 2001 prior to the highly-publicized Year 2004 revisions of Freddie Mac's Year 2001 financial statements:

Mitchell Delk Senior Vice President Freddie Mac 
Written Statement Before the Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises of the Committee on Financial Services, U.S. House of Representatives 
July 11, 2001 (Note the Date) --- http://www.freddiemac.com/speeches/md071101.htm 

A pioneer in the use of risk-based stress tests, Freddie Mac believes that a well-implemented capital standard must produce specific and accurate determinations of required capital. Assigning too little capital or too much both have negative consequences. Too little capital could jeopardize our ability to withstand an extreme downturn in the economy. On the other hand, requiring too much capital would impose unnecessary costs on the nation’s families. Mortgage rates would rise, and mortgage products attractive to lower-income borrowers would become more expensive or unavailable.

Furthermore, it is critical that the test be operationally workable. For Freddie Mac to purchase mortgages on a daily basis, we must be able to calculate the amount of capital that will be required and incorporate it into our business planning and processes.

Finally, the stress test should recognize prudent risk management. For example, the test should not penalize the use of swaps and other securities contracts, the function of which is to manage interest-rate risk. This is an essential risk management strategy that we and other large, well-capitalized financial institutions use every day. A standard that ties capital to risk would appropriately recognize this strategy with a lower capital requirement. According to Chairman Greenspan, regulators must “develop ways to improve their tools while reinforcing incentives for sound risk management.”

The Word "Hedge" is the Most Misleading Term in Finance! FAS 133 and IAS 39 may be misleading the public into thinking that firm-wide risk is being accounted for when risk is merely being shifted about with hedging!

The FASB originally wanted (and still wants if the banking lobby will ever back off) FAS 133 to be simplified by requiring all changes in the value of booked derivatives to be charged directly to current earnings.  This is a simplistic solution that would have made Fannie Mae's error impact earnings by $1.1 billion.   The objection of the banking industry and other corporations to such current value accounting  is that current value accounting that takes changes in value directly into current earnings creates enormous volatility in reported earnings.  Earnings fluctuations, in turn, supposedly paint a picture of risk in stable companies that have in fact hedged risks.  The FASB compromised with bankers and other corporations in FAS 133 by requiring that all derivative financial instruments be booked at current value (including derivatives that were never before booked under previous rules) but allowing changes in current value be accounted for in a complicated way that does not affect current earnings when the derivatives qualify for special hedge accounting treatment under FAS 133.

An Illustration 

But the new FAS 133 rules (and the international IAS 39 counterparts) can be highly misleading in terms of risks that hedging itself causes.  By way of illustration, suppose XYZ company borrows $1 billion at variable interest rates to finance $1 billion in fixed-rate mortgage investments.  If the company wants to hedge all cash flows, it can enter into interest rate swaps to freeze the annual  interest expense cash flows on the $1 billion in debt.  Now the company and its investors sleep easy at night knowing that XYZ has locked in a net (interest revenue minus interest expense) fixed cash flow of say $50 million per year provided none of the investments or liabilities are settled prematurely.  Investors are supposed to breathe easier knowing that  XYZ has covered its backside with perfectly effective hedges.  But consider the risks that are not and cannot be hedged:

• When interest rates fall dramatically, XYZ's fixed-rate asset investments may be terminated prematurely by homeowners who want to refinance at lower fixed rates.  To simplify the illustration, suppose that XYZ simply refinances homeowner mortgages at the lower market rates.  XYZ thereby no longer enjoys the contracted "high" fixed rate interest revenue that would have kept flowing in if interest rates had not plunged.   
  
  
• If XYZ had not hedged its cash flow on the $1 billion in variable rate debt, the premature refinancings of its asset investments would not be so much of a problem, because XYZ's variable interest expense on debt might go down by roughly the same about that its interest revenue went down due to homeowner refinancing.  The current value of XYZ's variable rate debt is not impacted by changes in interest rates.  Only its interest expense is impacted, and when interest rates fall those expenses decline.  XYZ only hurts from unhedged variable rate debt when interest rates increase.  XYZ probably hedged its variable rate debt because it anticipated higher interest rates.  
  
  
• Risks may be hierarchical and obscure.  In the above XYZ example, the first level of hedging arises with the conversion of variable rate debt into fixed-rate debt much like is illustrated in FAS 133 Example 5 in Appendix B (See the 133ex05a.wmv video at http://www.cs.trinity.edu/~rjensen/video/acct5341/ ).  However, hedging the cash flow of interest expense for each debt item actually creates a higher level risk in terms of the entire portfolio of fixed-rate assets versus the portfolio of hedged variable rate debt.  Hedging each item of debt in the debt portfolio increases the aggregate level of risk in the combined asset and debt portfolios. The reason XYZ entered into a cash flow hedge of its variable rate debt is that it most likely anticipated increases in interest rates.  This locks in that $50 million in annual cash flow provided interest rates do not plunge.  However, if interest rates plunge, XYZ is stuck paying out far more in interest expense (on its debt and hedging instruments combined) than would otherwise be the case had it not hedged its debt cash flows.   The point is that hedging never eliminates all risks.  It merely substitutes one risk for another risk in accordance with what XYZ considers the most likely change in interest rates.  XYZ, however, cannot always forecast accurately since nobody can ever forecast interest rate fluctuations with 100% accuracy.  Hedging does not eliminate all risk even when the hedges are perfectly effective.
  
  

The bottom line here is that new FAS 133 and IAS 39 standards eliminated some very bad practices of companies, particularly banks, using derivative financial instruments for off-balance sheet accounting that hid enormous risks from the public even when derivative hedging instruments were used as hedging instruments.  However, these new and highly complicated standards do not go far enough in disclosing risk.  

An often overlooked issue in this entire debate is the problem of  disclosure rules that accompany the numbers.  Disclosures that accompany the FAS133/IAS39 numbers in financial reporting do not stress that hedging only changes the type of risk but never eliminates risk.  I propose that every company be required to make disclosures in a prescribed disclosure language that  more or less reads as follows for a company like Fannie Mae that lent money on mortgage notes held as assets and borrowed money to finance these investments:

In managing its assets and liabilities, XYZ must choose when to hedge cash flow risk and when to hedge fair value risk.   XYZ hedges both its investments and its debt in terms of forecasted trends in interest rates.  Investors should be aware, however, that hedging one type of risk exposes the company to the other type of risk and higher order portfolio levels of risk.  Even though reported earnings are not impacted by qualified hedges under FAS 133, there are risk exposures that remain and might affect future earnings.  Hedges of cash flow risk expose XYZ to current value risk of assets and liabilities.  Hedges of current value risk expose XYZ to cash flow risks from assets and liabilities.  Hedging entire portfolios may increase higher-order risks in terms of other portfolios.  It is prudent to nearly always hedge risks, but hedging does not imply elimination of higher order risk and risks other than those being explicitly hedges.  This is inherent in XYZ's line of business where risk management is a complicated process in which hedging changes risk exposures but never eliminates all risks.

Hence, Fannie Mae may have hedged in such a way that if it had correctly followed FAS 133/FAS149 rules there would have been no impact on Fannie Mae's reported earnings.  But the public should not be swayed to believe that Fannie Mae eliminates risks by hedging.  Fannie Mae merely substitutes one risk for another risk as some firms substitute cash flow risk with current value risk or vice versa.  

It should be noted in passing that both the FASB and the IASB are moving ever closer to requiring current value accounting for all financial instruments, such that many of the complications of FAS 133 and IAS 39 accounting will go away.  For example, the very complicated requirements for fair value hedge accounting virtually disappear.  What is important to note, however, is that current value accounting can still mask the problem of higher orders of risk.  Suppose that in the above XYZ example, the variable rate debt is not hedged for cash flows, i.e., there is increased cash flow risk but no fair value risk.  Further suppose that $1 billion in fixed-rate debt is hedged for fair value, thereby, having the hedged assets and the debt all frozen in terms of current value.  The assets and the debt thereby have no current value risk due to interest rate fluctuations.   This might be great if XYZ is going to be liquidated in the short term.  However, at the higher level of risk exposure of all assets and debt combined, the "hedged" XYZ firm is really exposed to cash flow and earnings risk.  Current value accounting, therefore, may be more misleading than helpful in disclosing "risk."

But for Freddie Mac, the other pillar of the colossal U.S. mortgage market, Freddie Mac's restatement has only caused headaches and has even raised new questions about the quality of financial reporting.
Patrick Barta, "Restatement by Freddie Mac Puts Fannie on the Spot," The Wall Street Journal, January 12, 2004, Page C1.

The problem is the companies' (Freddie Mac versus Fannie Mae) business and financial statements have become so complex that they are effectively "unanalyzable" says James Bianco, president of Bianco Research, a Chicago-based fixed-income research firm that has been critical of Fannie and Freddie in the past.  He says the same is becoming true of other large financial institutions, particularly those that, like Fannie and Freddie, use large volumes of derivatives, which are investment contracts that can be used by companies to offset risk from interest rate shifts.
Ibid

Mac (Fannie Mae's Brother) Paves the Way With Risk Stress Tests and Then Fails on Macro Hedge Accounting

Macro hedge accounting is generally not allowed for financial reporting under FAS 133 (read that as in Freddie Mac), but it is frowned upon by the IRS (read that as in Freddie Mac).  In November 2003 we are still awaiting the long delayed Year 2002 annual report of Freddie Mac.  Freddie applied macro hedge accounting in a way that was not appropriate under FAS 133, and we've been waiting for new auditors to complete the work in revising prior-year statements and issuing Year 2002 financial statements.  

Freddie Mac named Richard Syron, a former head of the American Stock Exchange, the Boston Fed, and tech firm Thermo Electron, as its new chairman and CEO. The executive succeeds Greg Parseghian, who was asked to step down after federal regulators determined he played a role in a string of accounting misdeeds.
See "Freddie Mac Appoints New Chief:  Syron May Bring Stability To Beleaguered Company; Toughness Is Questioned," by Patrick Barta and John D. McKinnon, The Wall Street Journal, December 8, 2003 ---  http://online.wsj.com/article/0,,SB107081511244443300,00.html?mod=home_whats_news_us

"Cost to Fix Freddie Mac Accounting Problems: $376 Million," AccountingWeb, July 2, 2004 --- http://www.accountingweb.com/cgi-bin/item.cgi?id=99428 

Freddie Mac executives told analysts Wednesday that it spent about $376 million last year to fix accounting errors that led to the ouster of three top executives and a massive financial restatement. Chief Financial Officer Martin Baumann said Freddie Mac spent $172 million last year just on its earnings restatement, which resulted in a $5.1 billion cumulative, net increase to earnings from 2000 through 2002, the Wall Street Journal reported

"That was just digging down, finding the accounting errors, fixing them, restating the results," Baumann said. Freddie Mac, the second largest U.S. mortgage buyer, spent an additional $79 million on new software in 2003. Upgrading the technology infrastructure has cost $80 million so far this year. Baumann predicted: "That number will at least double or more through the end of the year."

Freddie Mac’s new Chairman and Chief Executive Richard Syron told investors, "We have a lot of costs now that I think are a bubble, that go through dealing with a lot of the problems that I think are the result of under-investing in the past. The way you should think of this is a corporation that had some difficulties and is essentially going through a restructuring."

Observers say Freddie Mac is moving closer to fixing its accounting.

"They are seriously trying to bring it up to speed but it won't happen overnight," James McGlynn, a fund manager at Summit Investment Partners in Cincinnati, told Bloomberg. "I don't think Syron is trying to hide any facts and as long as the business holds up people should be content."

The company expects high costs to remain through 2005 in administration, technology and legal and regulatory matters.

Meanwhile, Bloomberg reported that Freddie Mac said Wednesday that its net income fell 52 percent in 2003. The decline came as rising interest rates in the second half of 2003 reduced the gains on contracts used to protect the value of its mortgage assets, said Michael Cosgrove, a Freddie Mac spokesman.

Freddie Mac named Richard Syron, a former head of the American Stock Exchange, the Boston Fed, and tech firm Thermo Electron, as its new chairman and CEO. The executive succeeds Greg Parseghian, who was asked to step down after federal regulators determined he played a role in a string of accounting misdeeds.
See "Freddie Mac Appoints New Chief:  Syron May Bring Stability To Beleaguered Company; Toughness Is Questioned," by Patrick Barta and John D. McKinnon, The Wall Street Journal, December 8, 2003 ---  http://online.wsj.com/article/0,,SB107081511244443300,00.html?mod=home_whats_news_us 

Question
Do you want to learn more about derivative financial instruments accounting in action?

Answer
Although nobody has yet to write up a case on Freddie Mac, the Appendices at this Freddie Mac site are a derivatives accounting education in and of themselves --- .  The link with the appendices is at http://www.freddiemac.com/investors/restatement/

 The Investor Relations site is at http://www.freddiemac.com/investors/ 

"Freddie Mac to Taint Hedge Accounting," June 26, 2003, By Joseph Neu --- http://www.fas133.com/search/search_article.cfm?page=1&areaid=1329 

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.

"Fair Value Accounting Back in the Spotlight,"  June 19, 2003 --- http://www.fas133.com/search/search_article.cfm?page=11&areaid=1321 

Two items in today’s news point to fair value accounting and why it’s returning to the spotlight.

The first item is the on-going investigation of what is behind the Freddie Mac earnings restatements. The second is a report on efforts by an insurance group led by AIG to derail IASB efforts at fair value accounting. Both items are part of developing stories that will soon impact corporates outside of the mortgage finance and insurance space.

FAS 133 flaws

As the Wall Street Journal is reporting, the Freddie Mac restatements will be in the billions, stemming from improper hedge accounting under FAS 133. There was always a greater likelihood that one of the mortgage finance giants would emerge as the FAS 133 Wall Street Journal headline, since the task of hedging the risks in mortgage finance, involving multiple interest, credit and optionality risks is a tough one, and Fannie and Freddie knew it would be tough to account for this.

At first, media reports painted as positive the fact that the Freddie Mac restatements were positive and not negative. In other words, the gains on the hedges that were deemed non-hedges for accounting purposes were no longer being deferred. This ignored the “hedging” notion that these gains were offsetting anticipated losses in the underlying (e.g. the mortgage paper), which presumably are still anticipated. The disconnect of hedge from hedged item in the accounting guidance was always the fundamental flaw in hedge accounting that FAS 133 inadequately addressed, preferring to focus on derivatives. This is also why it is difficult to glean the impact bringing forward the hedge gains will have on Freddie Mac’s future earnings.

Broader IASs

Just as Freddie Mac exposes flaws in a limited fair value approach, the insurance industry is aggressively seeking to counter acceleration of fair value accounting more broadly. According to the Wall Street Journal, an insurance group, led by AIG, is actively opposing international accounting standards (IAS 32/39) and the related IASB effort to push the fair value concept further into insurance accounting. These IASB efforts go further than FAS 133 and related FASB efforts to introduce fair value to a wider scope of accounting: financial instruments as opposed to just derivatives. Though the IASB has taken the lead on the fair value drive, FASB is set to follow, which is why the IASB trends should be followed closely by all concerned with US GAAP.

Fair value accounting has its flaws, not least of which is the AIG argument that it introduces meaningless volatility to earnings statements. However, insurance firms, aside from broker-dealer banking operators, have as good a shot as any at making fair value accounting work as a means of giving investors and the markets a more telling portrait of financial position.

Just as Freddie Mac has revealed how FAS 133 does not go far enough--it’s focus on derivatives has left financial statement readers in the dark on hedged items--the insurance firm complaints show how broadening the focus to financial assets and liabilities is not going to offer an easy solution. But, if accounting is going to move increasingly toward a fair value model, as its standard setters plan, they must use the IASB’s insurance market “test” to prove the model’s practical efficacy. The Exposure Draft of Phase I of this IASB project is due out in Q3, with a tight implementation timetable to become effective for EU adoption of IASB standards in 2005.

If fair value accounting cannot be made to work with insurance firms, it cannot be made to work with non-financial corporations, and the current course to fair value accounting should be reversed. Further, by establishing guidelines for accounting for insurance risk management activities, the IASB effort will help define accounting for all risk management activities. For example, at its meeting earlier this week, the IASB discussed the definition of insurance risk “as risk other than financial risk” (defined by IAS 39), along with other pre-ballot items to become part of the exposure draft.

This is a high stakes experiment that all should watch closely for its broader impact, not to mention its transforming effects on an insurance market already in the midst of a paradigm shift.

"Freddie Mac hit with fine," by Marcy Gordon, The San Antonio Express News, December 11, 2003 --- http://news.mysanantonio.com/story.cfm?xla=saen&xlb=110&xlc=1097161&xld=110

Freddie Mac is paying a $125 million civil fine and is being threatened with possible curbs on its growth as federal regulators blame management misconduct for the mortgage giant's $5 billion misstatement of earnings. In a report issued Wednesday, regulators accused the government-sponsored company of violating its public trust.

A pliant board of directors and a system of compensating executives tied to annual earnings targets also contributed to the accounting crisis at Freddie Mac, which has brought the ouster of four top executives since early June, the Office of Federal Housing Enterprise Oversight found in its months-long investigation.

Freddie Mac agreed to pay the record fine in a settlement with the federal agency announced Wednesday.

The agency, which supervises Freddie Mac and its larger rival Fannie Mae in the multitrillion-dollar home mortgage market, cited "a pattern of inappropriate conduct and improper management of earnings" at the company and even "a disdain for appropriate disclosure standards" among former top executives.

The second-largest U.S. buyer of home mortgages "disregarded accounting rules, internal controls, disclosure standards, and ultimately, the public trust in pursuit of steady earnings growth," the agency's report found.

Its director, Armando Falcon, told reporters the agency already is considering imposing on both mortgage companies new requirements recommended in the report, including splitting the chairman and chief executive positions and limiting directors' terms.

Another recommendation is to restrain the growth of Freddie Mac's mortgage portfolio if it fails to disclose its financial situation more quickly and accurately — a prospect likely to unnerve shareholders.

Freddie Mac and Fannie Mae were created by Congress to pump money into the home mortgage market by buying home loans from banks and other lenders and bundling them into securities for sale on Wall Street.

The two corporations, whose stock is publicly traded, have grown explosively in recent years and are among the nation's largest financial institutions.

Freddie Mac's settlement with regulators still leaves to be resolved a criminal investigation by the Justice Department and a civil inquiry by the Securities and Exchange Commission.

Falcon said his agency's examination didn't find evidence of criminal misconduct. The report did cite evidence that one or more of the investment banks that engaged in transactions that Freddie Mac used to manipulate its earnings "may not have acted properly."

McLean, Va.-based Freddie Mac, with $40 billion revenue a year, has acknowledged understating its earnings by $5 billion for 2000-2002 to smooth out volatility in profits and uphold its image on Wall Street as a steady performer.

In addition, the company last month admitted inflating 2001 earnings by nearly $1 billion and said it may not be able to complete its accounting for 2003 until next June.

The company Sunday named Richard Syron, a Wall Street veteran and former Federal Reserve official, as chairman and chief executive. The board of directors in June forced out Freddie Mac's then-chairman and CEO, Leland Brendsel, and the company's president and chief financial officer.

In August, the federal regulators ordered the ouster of Brendsel's replacement, Gregory Parseghian — who had played a role in some of the company's questionable financial transactions, according to a report by attorneys hired by the board.

Parseghian earned $1 million in salary and $750,000 in bonuses in 2001.

The company didn't admit to or deny wrongdoing in the settlement, involving the first such fine in the agency's 10-year history. Freddie Mac also said it did not consent to any part of the agency's report and that it "strongly disagrees" with some of the findings.

The $125 million fine will be paid from the company's revenues, potentially reducing its bottom line.

The restatement by company auditors of Freddie Mac's 2000-2002 earnings, a massive project first announced in January and completed last month, cost the company $100 million.

Freddie Mac shares rose 25 cents to $54.25 in trading Wednesday on the New York Stock Exchange.

Under the settlement, Freddie Mac also agreed to strengthen its internal controls and accounting practices and to improve its disclosure of information to the investing public — steps the company already had undertaken after its accounting and management turmoil came to light in early June.

Also see The Wall Street Journal on December 11, 2003 --- http://online.wsj.com/article/0,,SB107106680095083900,00.html?mod=mkts_main_news_hs_h 

"Freddie Regulator Seeks $100 Million In Settlement Deal," by Patrick Barta and John D. McKinnon, The Wall Street Journal, December 9. 2003 --- http://online.wsj.com/article/0,,SB107092962387997400,00.html?mod=home_whats_news_us

Federal regulators looking into Freddie Mac's accounting woes are seeking $100 million or more from the company in settlement of possible civil charges stemming from its accounting misdeeds, people familiar with the matter said.

These people stressed that the negotiations between Freddie Mac and its regulator, the Office of Federal Housing Enterprise Oversight, are continuing, and that the final settlement could be far less. However, analysts who closely follow the mortgage-finance company believe that Freddie Mac officials are eager to reach a deal quickly. The payment likely would be in settlement of charges that the regulator could bring against the company for engaging in the accounting abuses.

The company already has taken several steps in its bid to restore credibility. Late last month, Freddie Mac completed a long-delayed restatement of past earnings, concluding that it understated results through 2002 by nearly $5 billion. And on Sunday, the company said it selected a new chief executive, former American Stock Exchange head Richard Syron.

"The settlement is another big piece" that Freddie Mac needs to put its woes behind it, said Howard Glaser, a Washington, D.C., mortgage-industry consultant who has done work for Freddie Mac.

Continued in the article.

"Freddie Mac Attack Critics are calling for greater oversight -- or even a breakup," Business Week, July 7, 2003 --- http://www.businessweek.com/magazine/content/03_27/b3840057.htm 

The improper use of hedge accounting to amortize gains -- and thus smooth ragged ups and downs in quarterly earnings -- was Freddie's downfall. As a June 25 press release deadpanned: "Certain capital market transactions and accounting policies had been implemented with a view to their effect on earnings in the context of Freddie Mac's goal of achieving steady earnings growth." Translation: Steady earnings help Freddie convince investors and lenders that management has its eye on the ball. They also help ward off politicians who might point to volatility as a reason to tighten regulation or even break Freddie up. 

The company's quest for smooth earnings, plus its admitted lack of accounting expertise and weak management controls, proved to be a fateful combination. That became clear to PricewaterhouseCoopers auditors soon after they replaced longtime Freddie auditor Andersen LLC in 2002. The new audit team soon discovered suspicious hedge accounting involving Treasury securities.

November 6, 2003
Freddie Mac, the nation's number two mortgage finance company, has estimated it will owe as much as $30 million in back taxes. That figure is just a fraction of the $4.5 billion the company expects to report in income when it restates earnings. http://www.accountingweb.com/item/98300 

Freddie Mac, the nation's number two mortgage finance company, has estimated it will owe as much as $30 million in back taxes. That figure is just a fraction of the $4.5 billion the company expects to report in income when it restates earnings. http://www.accountingweb.com/item/98300 

Mitchell Delk Senior Vice President Freddie Mac 
Written Statement Before the Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises of the Committee on Financial Services, U.S. House of Representatives 
July 11, 2001 (Note the Date) --- http://www.freddiemac.com/speeches/md071101.htm 

A pioneer in the use of risk-based stress tests, Freddie Mac believes that a well-implemented capital standard must produce specific and accurate determinations of required capital. Assigning too little capital or too much both have negative consequences. Too little capital could jeopardize our ability to withstand an extreme downturn in the economy. On the other hand, requiring too much capital would impose unnecessary costs on the nation’s families. Mortgage rates would rise, and mortgage products attractive to lower-income borrowers would become more expensive or unavailable.

Furthermore, it is critical that the test be operationally workable. For Freddie Mac to purchase mortgages on a daily basis, we must be able to calculate the amount of capital that will be required and incorporate it into our business planning and processes.

Finally, the stress test should recognize prudent risk management. For example, the test should not penalize the use of swaps and other securities contracts, the function of which is to manage interest-rate risk. This is an essential risk management strategy that we and other large, well-capitalized financial institutions use every day. A standard that ties capital to risk would appropriately recognize this strategy with a lower capital requirement. According to Chairman Greenspan, regulators must “develop ways to improve their tools while reinforcing incentives for sound risk management.”

Tripped Up by FAS 133
"Freddie Mac Overstated Results By as Much as $1 Billion in 2001," by Patrick Barta and John D. McKinnon, The Wall Street Journal, November 20, 2003 --- 

Freddie Mac is expected to report that it overstated earnings by as much as $1 billion in 2001 when it releases a much-anticipated restatement of past earnings in the next several days, people familiar with the situation said.

The mortgage-finance company, which has been embroiled in an accounting scandal since June, is still expected to conclude that it undercounted earnings by $4.5 billion or more during the entire three-year period of its restatement, which covers 2000, 2001 and 2002. But an overstatement during one of those years would be significant because it would further highlight the volatility of Freddie Mac's financial results, something the company had tried to hide. Freddie Mac initially reported that it earned $4.1 billion in 2001.

Some details of Freddie Mac's restatement remained in flux in advance of its release, and some people with knowledge of the situation cautioned that the numbers could change, although likely not enough to erase the troublesome overstatement. Some also believe that the overstatement could be limited to one quarter.

David Palombi, a spokesman for Freddie Mac, said he couldn't provide details on the restatement, though he noted that company officials have long stressed that it would reveal more volatile results. He said that the restatement is expected to significantly boost shareholder equity at the company.

Still, the possibility that Freddie Mac may have overstated its results in one of the years under review could make life harder for the company on Wall Street and in Washington, where legislators have been working to place Freddie Mac under stricter regulation. Companies that understate earnings are often treated more gingerly on Wall Street and elsewhere, analysts said, since correcting the errors results in more income for shareholders.

"They set up this belief that what they did was they understated earnings, and apparently they did on a cumulative basis, but it's not going to go over well that in one of the years they overstated earnings," said Mike McMahon, a financial-services industry analyst at Sandler O'Neill & Partners in San Francisco.

Freddie Mac is under investigation by several government agencies after it revealed that it used improper accounting tactics to smooth earnings to better please Wall Street. In some cases, the company pushed unwanted earnings into the future, or hid gains it thought would make the company appear to be too volatile. But an internal investigation revealed the company also used accounting gimmicks to mask some losses that resulted from accounting rules it thought were unfair.

The government-sponsored, publicly traded company exists to buy mortgages from lenders, providing needed capital to keep the U.S. mortgage market operating smoothly.

Freddie Mac's financial statements can be downloaded from http://www.freddiemac.com/investors/ 

Illustration of a Currency Swap
It costs Freddie Mac more to sell the euro debt than comparable bonds in dollars, but the agency gets to diversify its funding base. That benefit offsets the short-term pain of borrowing in euros and swapping back into dollars.
Margot Patrick and Henry J. Pulizzi, "Freddie Mac Returns to Europe To Diversify Debt," The Wall Street Journal, January 18, 2004 --- http://online.wsj.com/article/0,,SB107446591506604646,00.html?mod=mkts%5Fmain%5Fnews%5Fhs%5Fh 

Fannie Mae has a bigger brother named Freddie Mac whose failure to properly implement FAS 133 following a vigorous fight with the FASB to derail FAS 133 from becoming a standard.   It comes as no surprise that the external auditor for Freddie Mac was the infamous Arthur Andersen. 

"At Freddie Mac, It's Hard To Lay Claim to Innocence," by Jerry Knight, The Washington Post, 
July 28, 2003 (Note the Date) --- http://www.washingtonpost.com/ac2/wp-dyn/A51391-2003Jul26?language=printer 
"The intent was to deceive investors, and for that, everyone involved ought to take a fall."

When the accounting and management failures at Freddie Mac first surfaced last month, the board of directors proclaimed that it was throwing out all the executives tainted by the scandal and installing a new CEO.

Chief executive Leland C. Brendsel and Chief Financial Officer Vaughn A. Clark were allowed to resign. President David W. Glenn was fired.

Gregory J. Parseghian, 42, Freddie's chief investment officer, was promoted to president and chief executive. It was inferred that Parseghian had nothing to do with cooking the books and would restore the company's credibility.

As we now know, the idea that Parseghian is squeaky clean is tough to swallow after reading last week's report on the internal investigation of Freddie's phony financial reports.

The new chief executive's name turns up repeatedly in the investigative report detailing the dubious deals that Freddie Mac used to hide as much as $4.5 billion in profits.

According to the report of the internal investigation initiated by Freddie's board:

• Parseghian was directly involved with finding ways for Freddie Mac to circumvent new accounting industry rules that were written to help investors understand the impact on corporate finances of exotic transactions known as derivatives. James R. Doty, the lawyer who prepared the report, came to the conclusion that Parseghian was told by Freddie's auditors that the transactions the working groups recommended passed accounting muster, and were therefore completely above board.

• Parseghian was among several senior executives who approved a memo implementing a $700 million transaction known as the Coupon Trade-Up Giant, or CTUG, that was specifically designed to offset the impact of the new derivatives accounting rules.

• Parseghian, who was responsible for briefing the investment committee of Freddie's board of directors about major transactions, helped come up with a way to divide the CTUG into pieces small enough that the board wasn't required to be informed of them individually, even though all together they were part of one grand plan. "This division had the effect of avoiding the need for Board authorization," the report said. As a result, "the company failed to adhere to its own governance requirements."

• Parseghian participated in one meeting at which top Freddie Mac executives discussed five other ways in which they could get around the new derivatives accounting rules. He also supervised several junior executives who participated in two "working groups" that coordinated efforts to minimize the impact of the derivative accounting rules on the bottom line.

Freddie Mac won't say whether Parseghian was officially a member of those groups. Parseghian has declined to comment on the report.

Be that as it may, the report makes clear he was a central character in events that could lead to as much as $4.5 billion in restatements. It is hard to believe he can restore Freddie's credibility. The report portrays Freddie Mac as an organization that single-mindedly set out to circumvent new rules drafted by the accounting industry to demystify derivatives, the generic name for a menagerie of financial creations.

Dreamed up a couple of decades ago by mathematicians and PhD economists, derivatives offer clever ways for corporations to protect themselves against changes in interest rates and other unpredictable economic events.

They can also be used to cheat on income taxes, government prosecutors contend in a high-profile tax shelter trial now underway. They can and were used by Enron Corp. to create phantom profits. And at Freddie Mac they were used to hide profits, creating a convenient rainy-day fund that the company could tap whenever its operations failed to produce enough profit to satisfy Wall Street. Ever since derivatives were invented, people have struggled to figure out how they ought to be accounted for on a corporation's books. For years most companies simply pretended their dealings in derivatives didn't exist, making little or no mention of them in financial reports.

Finally the Financial Accounting Standards Board, which writes the official guidelines for keeping the books of U.S. corporations, came up with a rule that for lack of a simpler moniker will have to go by its official name: Statement of Financial Accounting Standard No. 133, known in colloquial accountants-speak as SFAS 133.

The basic rule is simple: Starting Jan. 1, 2001, companies must disclose the fair market value of their derivatives.

Freddie Mac fought that rule when it was being written, and when it was implemented the organization "devoted considerable resources to exploring strategies that would mitigate the effects of the rule change," the internal investigation found. Elsewhere, the report states simply, "Management believed that SFAS 133 should be 'transacted around.' " It's impossible to read the internal investigation report without being struck by Freddie Mac's arrogance. Nowhere in it is any evidence that anybody at Freddie Mac ever suggested the company ought to play by the same accounting rules as everybody else. The pervasive corporate value was that our business is different, these rules should not apply to us. So while other companies complied with the new rules and fairly disclosed the market value of their derivatives, Freddie devoted vast resources to a "transition" strategy designed to ensure that SFAS 133 would have as little impact as possible on the financial statements issued to investors.

That was no easy task, because in 2001, Freddie Mac was sitting on billions of dollars of gains in the market value of its derivative portfolio, a condition that would have ballooned its profit.

Freddie didn't want to report that windfall all at once, as accounting rules required, but wanted to move the "profit" into future quarters when it wouldn't just be seen as a fluke of accounting but real, sustained growth in the bottom line.

Investors wouldn't understand the one-time gain, Freddie feared. Somebody might see those billions and buy the stock, pushing up the price.

If the stock went up because of this windfall, it would fall when the derivatives profits evaporated, as they inevitably would under SFAS 133 accounting.

In dozens of pages, the report spells out how far Freddie went to avoid reporting a windfall when the new accounting rules kicked in. Elaborate deals were cooked up using "results-oriented, reverse engineering." In other words: Here's how much profit we want to report to shareholders, let's figure out how we can do it.

Some of the things that were done clearly violated accounting rules, and for that heads rolled -- Brendsel, Vaughn and Glenn. Other transactions were more creative, bending the rules without breaking them. But Parseghian was promoted.

The report states that Parseghian was assured by Arthur Andersen, then Freddie's auditor, that the transactions were allowed, that they followed the letter of accounting standards. Within the rules or not, it doesn't make much difference. The intent was to deceive investors, and for that, everyone involved ought to take a fall.

Restoring Freddie's credibility ought to mean getting rid of everybody involved -- up to and including the board of directors. That's what WorldCom Inc. did, and it was a crucial step in that company clawing its way out of its own accounting scandals.

As Washington Post reporters Kathleen Day and David S. Hilzenrath have pointed out, the boards of Freddie Mac and its corporate cousin Fannie Mae each have five seats reserved for political appointments. Because the two giant mortgage companies were created by the government, the president himself gets to pick a batch of board members.

Over the years, some of the presidential appointees have been distinguished citizens, others have been distinguished by their political credentials.

For example, then-President Bill Clinton gave a seat on the Fannie board to Garry Mauro, who ran for governor of Texas and lost. President Bush gave one to Molly H. Bordonaro, who ran for Congress from Oregon and lost.

Lobbyists, loyalists, politicians and politicians' spouses have all been entrusted with overseeing the two biggest financial institutions in the United States. The non-political board members cover a similar range of résumés.

It would be fun to call up each of the Freddie Mac board members this morning and give them a pop quiz on the internal investigation that was completed last week.

1) Define CTUG, swaptions portfolio valuation and J-Deals.

2) Explain the key provisions of SFAS 133.

3) Compare and contrast the implied volatility of swaptions based on the Black Rock valuation model with the historical volatility model created by the company.

All Washington investors need to know is that No. 1 are transactions Freddie Mac officials used to get around No. 2.

All they need to know about No. 3 is that by switching from one valuation model to another, and then switching back 39 days later, Freddie conveniently managed to hide millions of dollar worth of profits.

Board members, on the other hand, ought to be able to expound on these topics in great detail. Doty told The Washington Post last week that the directors were not given enough information about the these matters to prompt questions at the time. A major transaction that was later found to be highly questionable "simply passed under the radar screen" of the board, Doty said.

Rather than a pop quiz , the board members ought to be called before Congress and examined in depth on their knowledge of how Freddie Mac does business, why this accounting scandal happened, what they knew and when they knew.

Bob Jensen's threads on other derivative financial instruments frauds --- http://www.trinity.edu/rjensen/fraud.htm

FREDDIE MAC 2001 INFORMATION STATEMENT PROVIDES ENHANCED DISCLOSURE OF USE OF DERIVATIVES, RISK MANAGEMENT PRACTICES McLean, VA --- http://www.freddiemac.com/news/archives2002/infostat_040102.htm 
APRIL 1, 2002 (Note the Date)
CONTACT: corprel@freddiemac.com
or (703) 903-3933

Freddie Mac (NYSE:FRE) today announced the publication of its 2001 financial Information Statement, which includes new, in-depth disclosures about the company's use of derivatives, risk-counterparties, and other risk management practices. The enhanced disclosures demonstrate that Freddie Mac is among the world's best-managed financial institutions.

The Information Statement for 2001, which meets or exceeds the Securities and Exchange Commission's disclosure requirements for publicly traded companies, provides shareholders, analysts, and the public with a detailed report on the company's financial condition. Freddie Mac's Information Statement is available at www.freddiemac.com .

Perhaps most important, the new Information Statement presents more clearly and comprehensively than ever before information about Freddie Mac's use of derivative financial instruments to manage interest rate risk on its portfolio of residential mortgages. The disclosure shows that Freddie Mac uses derivatives to manage its portfolio risk and not to speculate in the capital markets. It also contains important new information regarding how Freddie Mac effectively manages the credit risk associated with its derivatives counterparties.

For example, the Information Statement includes a new chart showing a summary by credit rating of the counterparties used in the company's derivative transactions, the notional balance of outstanding contracts, Freddie Mac's total counterparty credit risk exposure, and its exposure net of collateral.

It also shows that, as of the end of 2001, the simultaneous default by all of Freddie Mac's over-the-counter derivative counterparties would result in a loss of just $69 million—less than one week's worth of Freddie Mac's total earnings in 2001. This is an unusually low exposure, especially when compared to the risk exposures of other publicly traded financial institutions.

Other key disclosures being made for the first time in Freddie Mac's Information Statement for 2001 include:

A new table that shows the quantitative benefit of derivatives on the company's average level of portfolio market value sensitivity (a key measure of interest rate exposure) for 2001. A new section that provides an in-depth discussion of Freddie Mac's critical accounting policies in accordance with recent SEC guidance. Specifically, this section discusses policies that concern the establishment of loan loss reserves, the determination of the fair value of assets and liabilities (including derivatives), resecuritization transactions, and the application of SFAS 133 to Freddie Mac's hedging activities. A new section that significantly expands Freddie Mac's discussion of its principal hedging strategies, including its hedges of forecasted debt issuances, foreign currency exposure, existing long-term fixed rate debt, and embedded prepayment options in its retained pass-through mortgage securities. Today's announcement builds on the six voluntary commitments Freddie Mac made in October 2000 to ensure it remains in the vanguard of financial risk management and disclosure practice. These commitments include monthly interest rate risk disclosures, quarterly credit risk disclosures, obtaining and publicly disclosing a risk-to-the-government rating, and meeting the Basel Committee's principles for sound management of liquidity.

The 2001 Information Statement is available within our Shareholder Relations content area.

Freddie Mac is a stockholder-owned corporation established by Congress in support of homeownership and rental housing. Freddie Mac purchases single-family and multifamily residential mortgages and mortgage-related securities, which it finances primarily by issuing mortgage passthrough securities and debt instruments in the capital markets. Over the years, Freddie Mac has opened doors for one in six homebuyers and more than two million renters across America.

"Greenspan Says Congress Should Limit Fannie, Freddie," by Dawn Kopecki and Josepth Rebello, The Wall Street Journal, February 24, 2004 --- http://online.wsj.com/article/0,,SB107763512493737729,00.html?mod=home_whats_news_us 

Mortgage giants Fannie Mae and Freddie Mac could pose a threat to the financial system, according to Federal Reserve Chairman Alan Greenspan.

Mr. Greenspan called on Congress Tuesday to impose stringent restrictions on the ability of Fannie Mae and Freddie Mac to issue debt and purchase assets, saying the growth of the institutions poses a risk to the safety of the U.S. financial system.

"The Federal Reserve is concerned about the growth and the scale of the [government-sponsored enterprises'] mortgage portfolios, which concentrate interest and prepayment risks at these two institutions," Mr. Greenspan said in written testimony to the Senate Banking Committee. Although he said he didn't think a crisis was imminent, "preventative actions are required sooner rather than later."

"GSEs need to be limited in the issuance of GSE debt and in the purchase of assets, both mortgages and non-mortgages, that they hold," he added in the written testimony.

"Fannie Mae Scolded for Relying On Obsolete Accounting System," by John D. McKinnon and James R. Hagerty, The Wall Street Journal, February 26, 2004 --- http://online.wsj.com/article/0,,SB107774602918839236,00.html?mod=home_whats_news_us 

Federal financial regulators said that Fannie Mae relies on 70 outmoded manual accounting systems that could lead to more problems similar to October's $1.1 billion error.

In a letter to the company Tuesday, the Office of Federal Housing Enterprise Oversight said the mortgage giant's use of so many manual systems, as opposed to fully automated and integrated ones, raises concern. The agency told Fannie Mae officials to submit a remediation plan within 30 days.

The letter marks the latest rebuke by regulators against Fannie Mae and its mortgage-market sibling, Freddie Mac. Last year, Ofheo imposed a $125 million penalty on Freddie Mac after the federally sponsored company was forced to restate its accounting by almost $5 billion. Chief among Freddie Mac's sins was deliberate manipulation of its books by executives, but investigators also found sloppy accounting methods, including overreliance on manual systems.

Manual accounting systems typically refer to computer programs that are separate from the main accounting program, and allow for manual overrides. They are a concern to regulators because they create more room for human error, and thus require more review and controls, sapping resources from other accounting duties.

In July, soon after Freddie's problems came to light, Fannie Chairman Franklin Raines held a news conference to distance his company from the mess at Freddie Mac, where employees were sifting through years of old transactions while also reviewing and sometimes reversing longstanding accounting policies.

At the time, Mr. Raines said that unlike Freddie, Fannie had strong internal accounting controls. Last October, though, Fannie Mae had to correct a $1.1 billion accounting mistake that it briefly made in its financial reports. The error stemmed from a manual system that was being used to account for part of the company's derivatives business. Now the Ofheo letter suggests that the company has many more such manual systems. Fannie also faces a full-scale review by Ofheo of its accounting policies.

In response, a Fannie Mae spokesman, Chuck Greener, said the company is "a leader in the use of technology in financial services," and added that "virtually every financial institution in America" has similar manual systems, also known as end-user systems. Mr. Greener said the company is "very comfortable we will be able to respond to Ofheo's request fully."

In written testimony prepared for a Senate Banking Committee hearing Wednesday, Mr. Raines said: "We have effective controls in place to protect against mistakes, and we have effective protections in place in the rare chance that something dramatic does happen."

The committee is preparing legislation that would tighten regulation of Fannie, Freddie Mac and the Federal Home Loan Bank System.

A day earlier, Federal Reserve Chairman Alan Greenspan told the same committee that Fannie and Freddie pose "very serious" risks to the U.S. financial system because of the large amounts of mortgage loans they hold on their books, and the large amounts of federally subsidized debt they use to buy them up. Mr. Greenspan suggested explicit curbs on their debt. But Mr. Raines asserted that Fannie does a better job of hedging against risk than do banks. Both he and Richard F. Syron, Freddie's chairman and chief executive, urged Congress to avoid putting undue constraints on their growth.

Continued in the article

Risk stress testing at Freddie Mac preceded highly publicized controversies regarding the use of derivatives for speculation and risk management in Freddie Mac.  Between 2000 and 2001, Freddie Mac doubled its derivatives holding
to above $1 trillion, as it aggressively turned to derivatives --- http://www.larouchepub.com/pr/2003/030610freddie_mac.html 

Freddie Mac and Fannie Mae: Where the Domain of the Housing Bubble and the Domain of the Derivatives Bubble Intersect June 9, 2003 

Freddie and Fannie function to buy housing mortgages from mortgage lending institutions. By doing so, a mortgage lending institution, which has just issued a mortgage, can sell that mortgage to Freddie or Fannie for cash; it can then use the cash to make a new mortgage, and sell that mortgage to Freddie and Fannie, and so on, in the same manner several times over. During normal times, this activity would be merely liquefying the housing market; but since 1995, it has been used to allow mortgage lending institutions to make mortgages to finance the sale of houses priced up to the current limit of $310,000; the mortgage lending institutions sell the mortgage to Freddie or Fannie, and then make another mortgage loan for up to $310,000, etc.

This mechanism is crucial for the perpetuation of the housing bubble, providing lending institutions the vast scale of liquidity needed to provide households the financing to purchase vastly over-priced homes.

As a result of this process, Freddie and Fannie have become gigantic. In terms of asset size, the four largest financial institutions in America are: 1) Citigroup, $1.1 trillion in assets; 2) Fannie Mae, $822 billion in assets; 3) JP Morgan Chase, $720 billion in assets; and 4) Freddie Mac, $708 billion in assets. Thus Fannie and Freddie are two of the top 4 financial institutions in America.

As indicated in yesterday's briefing, Freddie and Fannie can carry out this operation by issuing three types of highly risky obligations:

 1. corporate bonds that Freddie and Fannie issue; 

2. Mortgage Backed Securities (MBS), in which Freddie and Fannie pool a group of mortgages together, put a guaranty on it (for which they earn a fee), and then they package these MBS to insurance companies, pension funds, international investors; etc; and 

3. outright derivatives, which Fannie and Freddie have.

Derivatives Holdings of Fannie and Freddie
($ billions)

	Fannie Mae	Freddie Mac
1997	161	96
1998	188	313
1999	275	424
2000	320	474
2001	533	1,052
2002	657	NA

The table shows the domain where the highly leveraged housing bubble and the highly leveraged bubble of derivatives intersect. Freddie and Fannie have turned to the use of derivatives to manage the housing bubble, to prevent it from exploding. Between 2000 and 2001, Freddie Mac doubled its derivatives holding to above $1 trillion, as it aggressively turned to derivatives. Freddie Mac has delayed the release of its 2002 annual report, but it is believed that its derivatives portfolio exceeds $1.3 trillion.

Federal Reserve Board chairman Alan Greenspan is the other key ingredient to the housing bubble: he has used his power at the Fed to lower interest rates so that the rate on a 30-year mortgage hit 5.32 percent, the lowest rate in four decades. However, the success of this whole scheme depends, among other things, upon continuing to keep interest rates low. Were interest rates to spike up, this would convulse the Mortgage-Backed Securities market, and the derivatives market of Freddie and Fannie. In 1994, a half percent increase in interest rates blew out the MBS market, which was then far smaller. Further, the derivatives market in general, is alreay producing instabilities. An interest rate increase would serve as a trigger to de-leverage the hypothecated $11.2 trillion U.S. housing bubble.

Derivative Financial Instruments

Derivative financial instruments ("derivatives") are financial instruments whose value is based upon an underlying asset, index or reference rate. Over-the-counter derivatives are privately negotiated contractual agreements that can be customized to meet specific needs. Exchange-traded derivatives are standardized contracts executed through organized exchanges. Freddie Mac enters into derivatives as an end user to obtain lower-cost financing, reduce risk and protect market value. Freddie Mac does not engage in such transactions for speculative purposes. By using derivatives, Freddie Mac is better able to match the expected cash flows of its assets and liabilities and reduce the corporation’s exposure to interest-rate and/or foreign-currency risk.

Accounting for Derivatives in 2001

On January 1, 2001, Freddie Mac implemented Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities," as amended ("SFAS 133"), which requires the corporation to recognize all derivatives on its balance sheet as either assets or liabilities measured at their fair value. The adoption of this standard did not affect the corporation’s previously issued financial statements up to and including the December 31, 2000 financial results. The one-time, net cumulative after-tax adjustments required upon adoption of SFAS 133 resulted in a $5 million increase to "Net income" and a $2.5 billion reduction to AOCI. The reduction to AOCI primarily resulted from SFAS 133’s requirement to recognize the derivatives designated as cash flow hedges, principally pay fixed swaps, on the balance sheet at fair value. Consistent with other GAAP-based equity valuation adjustments, changes in GAAP-based equity due to SFAS 133 AOCI adjustments do not affect Freddie Mac’s regulatory core capital, which is equal to "Stockholders’ equity," excluding AOCI.

When derivatives meet specific criteria, they are accounted for as either fair value hedges or cash flow hedges. Although Freddie Mac does not execute derivatives for trading or speculative purposes, in some cases, certain derivatives either do not satisfy SFAS 133’s hedge criteria or because hedge accounting has not been elected. Changes in fair value of those derivatives are reported in "Other income, net." The amortization of hedged item basis adjustments occurs over the life of the hedged item (for example, the estimated mortgage life in the case of hedged PCs), and must begin no later than when the hedge relationship terminates. A hedge relationship is deemed to be terminated when (i) the hedge no longer meets the SFAS 133 hedging criteria, (ii) hedge accounting is no longer elected, (iii) the derivative is sold or terminated, or (iv) the derivative is redesignated to another hedge relationship. Freddie Mac frequently redesignates derivatives from one hedge relationship to another or otherwise adjusts its hedging relationships in order to maximize the effectiveness of its hedging strategies in response to changing interest rates and other market factors, asset and liability paydowns, and changes in the composition of its derivatives, mortgage assets and debt obligations. Accordingly, the amortization of basis adjustments as a component of net interest income is begun each month for a substantial portion of Freddie Mac’s hedging relationships.

There are many other sections of the Year 2001 annual report that are too extensive to quote here.

As of November 2, 2003, the Year 2002 Annual Report of Freddie Mac is not yet available at http://www.freddiemac.com/investors/ar/ 

Also see http://www.freddiemac.com/investors/reports.html 

Improper Use of Hedge Accounting for Portfolios In a Manner Not Allowed in FAS 133

"Freddie Mac Attack Critics are calling for greater oversight -- or even a breakup," Business Week, July 7, 2003 --- http://www.businessweek.com/magazine/content/03_27/b3840057.htm 

Mistakes were made -- lots of them. Management controls were weak, disclosures were misleading, and accounting in many cases was flat-out wrong. Despite all that, the company's future is rosy. That was the message from Freddie Mac (FRE ) on June 25, when it announced that an upcoming restatement could total $4.5 billion. "The company remains safe and sound," Freddie Mac Chairman Shaun F. O'Malley declared.

The market, too, focused on the good news: The restatement, expected in September, will boost Freddie's past earnings and increase surplus capital. That raises the possibility of bigger dividend payouts or even a share repurchase to reward stockholders. Freddie's shares rose 1.6%, to $50.83.

But no matter how hard Freddie tries to spin billion-dollar accounting errors, the housing-finance agency's admissions are fueling critics. Freddie made so many mistakes in applying derivative accounting rules that "a majority of the corporation's derivatives in 2001 and 2002 will not qualify as accounting hedges," the company said. And while Freddie Mac will correct financial statements back to 2000, the errors date from the mid-'90s, says new Chief Financial Officer Martin F. Baumann.

Not everyone is as sanguine as the stock market, however. What, for instance, would have happened had Freddie bet the wrong way on interest-rate movements, or if banks, fearing further problems, refused to buy its debt? Freddie's problems reveal just how little is known about its inner workings -- and highlight the risks should the markets lose confidence in its ability to manage its huge derivatives portfolio."  Even if they're not trying to cook their books," says Michigan State University accounting professor Thomas J. Linsmeier, Freddie's mistakes show that "there could be a systemic problem requiring a taxpayer bailout."

That's exactly why a small but vocal group of banks, politicians, and academics for years have argued that Freddie and its larger cousin, Fannie Mae (FNM ), be subject to tougher regulation, including Securities & Exchange Commission oversight. Now, Freddie's revelations will make it harder -- though not impossible -- for either of the two government-sponsored enterprises to block reforms. They have also raised anew the question of whether these giants should be split up or even privatized.

Freddie and Fannie are crucial cogs in the housing market because they buy mortgages from commercial banks and other lenders and resell them to investors as mortgage-backed securities. That frees lenders to lend again. And thanks to the three-year-old housing boom, Fannie and Freddie now carry an astronomical $1.6 trillion in assets on their balance sheets, up from $962 billion in 1999. But as Freddie has shown, what lies behind those numbers is often a mystery.

The reason, in a word, is derivatives. The root of Freddie's problems can be found in a dense document called Statement of Financial Accounting Standards 133, which determines accounting rules when derivatives are used as hedges. The rules require companies to assign current market values to the interest-rate swaps, options, and other derivatives they hold and to reflect any changes in their value on the balance sheet. FAS 133 also contains a sweetener: Companies can offset any gains (or losses) on an asset with a similar loss (or gain) on the derivative used as a hedge. And here's the real grabber: Any changes in a derivative's value can be recognized over the life of the hedge, allowing companies to avoid the volatility that market-value accounting creates.

The improper use of hedge accounting to amortize gains -- and thus smooth ragged ups and downs in quarterly earnings -- was Freddie's downfall. As a June 25 press release deadpanned: "Certain capital market transactions and accounting policies had been implemented with a view to their effect on earnings in the context of Freddie Mac's goal of achieving steady earnings growth." Translation: Steady earnings help Freddie convince investors and lenders that management has its eye on the ball. They also help ward off politicians who might point to volatility as a reason to tighten regulation or even break Freddie up.

The company's quest for smooth earnings, plus its admitted lack of accounting expertise and weak management controls, proved to be a fateful combination. That became clear to PricewaterhouseCoopers auditors soon after they replaced longtime Freddie auditor Andersen LLC in 2002. The new audit team soon discovered suspicious hedge accounting involving Treasury securities.

Freddie, it turns out, had sought to lock in favorable spreads between the lower interest rate it pays to holders of its debt and the higher rate it gets for the home mortgages in its portfolio. Typically, financial institutions lock in such spreads with standard interest-rate swaps. But in an attempt to lower hedging costs, Freddie used Treasury securities instead of swaps. At the end of 2002, Freddie held some $16 billion in Treasuries on its books as debt hedges.

The net effect was the same -- holding Treasuries can protect against interest-rate changes as well as an interest-rate swap. There the similarities end. Because Treasuries are cash instruments, they aren't eligible for hedge accounting under FAS 133. So by designating Treasuries as derivatives and accounting for them as hedges, Freddie violated FAS 133 and now must reverse that treatment by recognizing gains in past years. Although Freddie at the time tried to document the transactions as true hedges, and even got Andersen's O.K., Baumann says: "The accounting was wrong. It just didn't qualify" for hedge treatment.

Once the new auditors dove deeper, they found a disturbing pattern: Most of the derivatives were incorrectly accounted for. Another big error concerns what are called "held-to-maturity," or HTM, securities. Freddie's portfolio includes $260 billion worth of mortgage securities that it classifies as HTM. As long as companies promise not to sell such securities before they mature, they can record them on the balance sheet at their original cost instead of revaluing them each quarter.

But Freddie used some of its HTM securities as collateral for short-term borrowings. It later repurchased the securities, and in doing so, tried to classify the sale and repurchase as a simple repurchase. But once sold, HTM securities do not qualify for hedge accounting. By selling a portion of the HTM portfolio, Freddie tainted its entire $260 billion portfolio. That means Freddie must record any value changes on more than 100,000 securities in either the income statement or shareholders' equity.

Freddie's board and new management team -- besides O'Malley and Baumann, it includes former Chief Investment Officer Gregory J. Parseghian as CEO and President -- have vowed to put the books in order. They are adding to Freddie's accounting staff and increasing the level of internal oversight. Executives overseeing risk-management functions now report directly to Baumann.

But that won't be enough to mollify critics. Longtime Fannie and Freddie foe Representative Richard H. Baker (R-La.) on June 24 unveiled a measure to move their regulator, the Office of Federal Housing Enterprise Oversight, from the Housing & Urban Development Dept. to the Treasury Dept. and to expand its powers. Treasury Secretary John W. Snow refuses to comment on any specific proposal, but he may be warming to the idea. "[We want] a regime of greater transparency so the investment community will know what's going on," says Snow. Freddie's effort to come clean may be just the start of hard times ahead for the GSEs.

Prepared Remarks
Greg Parseghian
CEO and President of Freddie Mac
Equity Lunch/Debt Dinner
Boston, MA
August 20, 2003 (Note the Date)

Good evening, and thanks to all of you for joining me here in Boston.

It's been over two months since the Board of Directors of Freddie Mac asked me to be CEO. At that time, I promised to keep you updated on our progress. As part of that commitment, I have been on the "road" a lot in the past few weeks.

At each event, I have described my vision for Freddie Mac – and how we are going to achieve it.

Simply put, we aspire to be the premier financial institution in the world.

The reason for this bold vision is the critical importance of our mission to lower costs and increase access to quality housing for more of America's families. Our mission has never been more relevant or important-and we can only achieve it by being the best at everything we do.

Now let me describe my top priorities for becoming the premier financial institution. They are:

• Get our financial statements right;

• Build long-term shareholder value;

• Communicate effectively so that the public understands our business and results; and

• Foster an open culture

Get Our Financial Statements Right

When I took this job, I told you that "Job One is getting our financial statements right." But that is only the beginning. Several months ago, we embarked on a remediation plan to address the issues that led to the need to restate earnings.

My goal is for Freddie Mac to be recognized as the best in class for accounting, reporting, controls and financial disclosures.

We have recently sharpened the focus of this plan in light of the review conducted by Baker Botts. The report raised serious concerns about the company's past accounting, controls and disclosure processes and practices.

In response, I directed CFO Marty Baumann to expand his remediation effort to ensure that each issue identified in the report is addressed with an action plan to correct the deficiency.

In addition, we have retained the immediate past Director of the SEC's Division of Corporation Finance to benchmark the disclosure processes and practices of high-quality reporting firms – and replicate them at Freddie Mac.

These steps will enable us to make a seamless transition to an SEC reporting company. I reaffirmed our commitment to SEC registration in a letter to Treasury Secretary Snow in July.

Build Long-Term Shareholder Value

My second priority is to build long-term shareholder value.

Three core competencies are critical to our ability to do this: asset selection, risk management and low-cost financing.

First, asset selection is critical to maintaining a high-quality mortgage portfolio in both our investment and securitization businesses. It ensures we are well positioned to participate in the broad array of products that characterize mortgage debt outstanding.

Second, risk management has been - and will continue to be – a core competency at Freddie Mac.

When I arrived in 1996, I was determined to develop an interest-rate risk management framework that would allow us to grow in a safe and sound manner and fulfill our mission – regardless of where interest rates happened to be.

Since 1998, we have managed through six cycles where interest rates moved between 150 and 250 basis points in a relatively short period of time. Throughout these extreme interest-rate moves, Freddie Mac's risk profile remained low.

This is not news to investors because of the frequency of our interest-rate disclosures.

Freddie Mac is one of only two financial institutions that disclose duration gap on a monthly basis. And to my knowledge, Freddie Mac is the only financial institution that discloses both duration gap and portfolio market value sensitivity – or PMVS – on a monthly basis.

PMVS is important because it considers the potential loss of market value due to both duration and optionality risk.

In the fall of 2001, rates rose by about 100 basis points in a one-month period – similar to the move we experienced in July.

Because we were extremely well hedged, our duration gap moved by only one month and our PMVS averaged 4 percent during that time period.

Experiences like these give me great confidence in Freddie Mac's ability to weather significant market volatility. When we release our monthly volume summary for July, you will see that – despite the tremendous rise in interest rates – Freddie Mac continued to maintain a low risk profile.

In sum, we strive to maximize shareholder value while taking the lowest possible risk.

Very few institutions can claim such a strong risk position – one that I am determined to maintain.

Our third core competency is low-cost financing. Freddie Mac's ability to lower the cost of homeownership is a direct consequence of our charter, our disciplined approach to risk management and the superior performance of our mortgage-backed and debt securities.

Every day we strive to be the premier global non-sovereign credit, attracting low-cost funds from around the world to support homeownership in America.

By bringing Wall Street to Main Street, we enable homeowners to compete alongside the largest and most creditworthy institutions in the world for financing.

I want to emphasize that we are focused on creating long-term shareholder value, and not on short-term objectives, such as earnings targets. As CEO, I will not compromise long-term value objectives for the sake of reducing volatility in short-term earnings results.

Communicate Effectively So that the Public Understands Our Business and Results

My next priority is to ensure that investors fully understand whether we are fulfilling our objective of building shareholder value and operating in a safe and sound manner.

To enhance investor understanding, we will provide three sets of results: GAAP, a non-GAAP supplemental measure and fair value. Since I look at all three of these measures in evaluating Freddie Mac's performance – I believe you should have them, too.

GAAP will be the primary measure of our financial results.

GAAP is important because it is the gold standard mandated for all public reporting companies, as well as the basis of our regulatory capital requirements.

Investors also need to understand the drivers of our GAAP results. Because of the different accounting treatment of economically similar instruments like callable debt and option-based derivatives, we expect to provide a supplemental, non-GAAP book-based measure.

We will round out the picture by providing a quarterly fair value balance sheet.

Fair value represents the net marked-to-market value of all financial instruments. Over the long term, fair value closely reflects the underlying economics of our business. It will be particularly helpful in understanding our performance during – and immediately following – the restatement period.

Although all these measures are important, long-term value creation is the touchstone of our business philosophy. That's why we want to provide you fair value metrics more frequently than required by the FASB.

If we are successful at generating world-class risk adjusted returns (and I am confident we will), we will maximize earnings over the long term regardless of how they are measured.

Foster an Open Culture

My fourth priority is to foster an open culture at Freddie Mac. I hope that many of you believe as I do, that our June 25 press release marked the beginning of a new era of open communication. As difficult as it was, I am proud that, when there was bad news to communicate, you heard it from me first.

Going forward, we intend to be more outward facing in the way we do business. We're going to talk to and – more importantly – listen to our investors, customers, business partners and employees.

In the brief time I have been CEO, I have been very pleased with the response I have received by simply picking up the phone and talking to people. I am confident that we have a huge opportunity to build profitable business partnerships that will enhance our ability to serve homeowners and renters.

Conclusion

In closing, let me say that Freddie Mac has a bright future. Freddie Mac is a great American company with a great mission. I am determined to lead our company to be the best at everything we do. And we will do it in a manner marked by openness, transparency and candor. On behalf of the Freddie Mac employees and myself, we are committed to achieving the mission and vision I described today.

This concludes my formal remarks. Let me now open the floor to questions. I'll ask the first one: "Why are you the right person to lead Freddie Mac?"

The IASB opens a very small crack in the door for Macro Hedging --- http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#M-Terms 

To the IASB’s dismay in the summer of 2003, certain key aspects of FAS 133 incorporated in the international IAS 39 standard have riled European banks and other EU businesses to a point where, for the first time, there was a serious political movement underway in Europe to veto acceptance of a portion of an IASB standard in the EU.  A news article in the August 21, 2003 edition of The Wall Street Journal on Page C5 reads as follows:

This accounting battle centers on the IASB's insistence that derivatives should be valued at their fair value, rather than at cost, which is generally immaterial or even zero and is often how European companies treat them. Banks have argued that the outcome of the IASB's plan would be unnecessary volatility in their earnings and net worth, a point echoed by Mr. Chirac.

IASB Vice Chairman Tom Jones argued that the current system merely pretends that the earnings volatility doesn't exist. Trying to smooth earnings is what got Freddie Mac into trouble in the U.S., he said.

"Bank results in Europe are a fiction: No volatility, and derivatives are nonexistent (at least appearing to be nonexistent in financial statements)," he said.

The new IASB proposal (compromise) would now make it easier for banks to lump bundles of securities or loans together and hedge a fraction of the overall risk, a process known in the industry as macro hedging. This isn't allowed in the U.S., which requires (in FAS 133) companies to show the individual items being hedged. The original IASB draft had taken a similar stance.

But the body didn't give in on two other bones of contention: when banks should take a charge to earnings because hedge strategies are ineffective and whether banks can include money deposited in bank accounts that is available on demand in accounting for their hedges. The IASB argues that the money has to be treated for accounting purposes as if it could all be withdrawn the next day, although that doesn't happen in practice. It also argues that its concessions on macro hedging should help the banks accomplish similar results, and its board members have shown little willingness to budge.

The IASB’s Exposure Draft of the macro hedging compromise is entitled “Amendments to IAS 39:  Recognition and Measurement Fair Value Hedge Accounting for a Portfolio Hedge of Interest Rate” and for a short time can be downloaded free from http://www.iasc.org.uk/docs/ed-ias39mh/ed-ias39mh.pdf

It should be noted that this compromise does not apply to cash flow hedging or other types of hedging other than interest rate hedges.

It’s highly unfortunate that the proposed macro hedging compromise of IAS 39 mentioned above puts the IASB international standard on a somewhat non-divergent course with the FASB/SEC in the United States .   The FASB currently shows no interest to date in compromising FAS 133 with respect to macro hedging, although the complaints of the European companies apply to U.S. firms as well.  Two paragraphs from FAS 133 from the FASB are quoted below:

Paragraph 448.
The Board (FASB) considered alternative approaches that would require amortizing the hedge accounting adjustments to earnings based on the average holding period, average maturity or duration of the items in the hedged portfolio, or in some other manner that would not allocate adjustments to the individual items in the hedged portfolio. The Board rejected those approaches because determining the carrying amount for an individual item when it is (a) impaired or (b) sold, settled, or otherwise removed from the hedged portfolio would ignore its related hedge accounting adjustment, if any. Additionally, it was not clear how those approaches would work for certain portfolios, such as a portfolio of equity securities.

Paragraph 449.
Advocates of macro hedging generally believe that it is a more effective and efficient way of managing an entity's risk than hedging on an individual-item basis. Macro hedging seems to imply a notion of entity-wide risk reduction. The Board also believes that permitting hedge accounting for a portfolio of dissimilar items would be appropriate only if risk were required to be assessed on an entity-wide basis. As discussed in paragraph 357, the Board decided not to
include entity-wide risk reduction as a criterion for hedge accounting.

For more details, go to http://www.trinity.edu/rjensen/acct5341/speakers/133macro.htm 

October 29, 2003 question from Dennis Ratliff

-----Original Message----- 
From: Ratliff, Dennis J [mailto:dratlif@ju.edu]  
Sent: Wednesday, October 29, 2003 10:16 PM 
To: Jensen, Robert 
Subject: SFAS 133

Bob, I know you are real familiar with SFAS 133, do you think the standard has had much effect on business decisions?? thanks. 
Dennis.

Hi Dennis,

FAS 133 is hands down the least neutral FASB standard ever issued, as is IAS 39 in the international scene.  FAS 133 has had an enormous impact upon decisions, particularly in banks where newer types of hedging instruments had to be devised in order to conform to FAS 133 accounting rules.  For example, companies used to hedge with cross-currency derivatives that were not eligible for hedge accounting under FAS 133.  They then had to hedge with more complicated concatenations of instruments (FAS 138 relieved this somewhat).  In particular you might listen to the audio laments of Mike Kogler (Chase Bank) who absolutely despises FAS 133 --- http://www.cs.trinity.edu/~rjensen/000overview/mp3/133summ.htm

Probably the most significant impact, however, is the loss of many former off-balance-sheet financing (OBSF) ploys.  Derivatives, particularly swaps, were among the most popular OBSF ploys used by corporations until FAS 133 went into effect.  After FAS 133, companies either could look to other on-balance sheet financing alternatives (other than derivatives) since derivatives could not be OBSF or they could seek alternate OBSF ploys, particularly SPVs --- http://www.trinity.edu/rjensen//theory/00overview/speOverview.htm

You might also be interested in the following message from Ira Kawaller (a member of the DIG) that I keep posted at http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm

Message from Ira Kawaller on August 4, 2002

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Hi Bob,

I posted a new article on the Kawaller & Company website: “What’s ‘ Normal ’ in Derivatives Accounting,” originally published in Financial Executive, July / August 2002. It is most relevant for financial managers of non-financial companies, who seek to avoid FAS 133 treatment for their purchase and sales contracts. The point of the article is that this treatment may mask some pertinent risks and opportunities. To view the article, click on http://www.kawaller.com/pdf/FE.pdf   .

I ' d be happy to hear from you if you have any questions or comments.

Thanks for your consideration.

Ira Kawaller Kawaller & Company, LLC http://www.kawaller.com 
kawaller@kawaller.com  717-694-6270

********************************************

Hope this helps!

Bob Jensen

Huge Growth in Derivatives Trading

March 21, 2003 message from Risk Waters Group [RiskWaters@lb.bcentral.com]

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The OTC derivatives market continued to grow strongly in the first half of the year, according to the International Swaps and Derivatives Association. The credit derivatives market grew 37%, with total notional outstandings reaching $2.15 trillion during the first half of 2002, the trade body said. Notional outstanding volume in interest rate and currency derivatives increased 20%, to $99.83 trillion, in the first half, while equity derivatives outstanding volumes rose to $2.45 trillion - up 6%. "The continued pace of growth in the over-the-counter derivatives markets during times of economic and political uncertainty demonstrates their importance as a mechanism for mitigation and dispersion of the risks our members encounter in the course of their business," said Bob Pickel, Isda chief executive. "The acceleration in use of credit derivatives in particular is testimony to the effectiveness of this product set in the redistribution of credit exposures to those firms desirous of adopting them."
**************

But Warren Buffett and others warn of looming disasters in the enormous derivatives markets!
See http://www.trinity.edu/rjensen/fraud033103.htm#DerivativesUpdate

My response to an inquiry about FAS 133 tutorials:

Angela asked me to reply to your message. In the late 1990s there were quite a few alternatives for FAS 133 training around the nation. I was asked to chair several of these myself and have some audio modules that I captured from speakers that I lined up for these various training workshops. See http://www.cs.trinity.edu/~rjensen/000overview/mp3/133summ.htm 

Since then the momentum for such training workshops has died down, although some accounting firms are still providing some workshops. For live workshop information, I suggest that you contact Ira Kawaller --- http://www.kawaller.com/

I have a tutorial guide section near the top of my glossary on derivatives and FAS 133 terminology --- http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm 

I also have my own free tutorials and cases at http://www.trinity.edu/rjensen/caseans/000index.htm 

In particular, you might note the 133ex01a.xls and other Excel workbooks at http://www.cs.trinity.edu/~rjensen/ 

Hope this helps!

Bob Jensen

"How FAS 133 Cost Sears $270 Million:  How many more companies will get nailed by the new derivatives accounting rule?" 
CFO.com, March 23, 2001 --- http://www.cfo.com/article/1%2C5309%2C2374||A|7|7%2C00.html 

The $270 million charge against earnings that Sears, Roebuck reported this week in its 10-K filing with the Securities and Exchange Commission stems from the 1997 termination of an interest rate swap in its credit card portfolio, a company spokeswoman said.

But precise details on the terms of the swap or why Sears canceled it were not immediately available. The spokeswoman said Jeffrey Boyer, Sears' senior vice president and CFO, was not available for comment.

The spokeswoman also said that Sears did not view the $270 million as a material loss, but rather a "balance sheet reclassification."

Some accounting experts familiar with the Financial Accounting Standards Board Statement 133 said the Sears situation underscores exactly why the ruling was adopted in the first place.

Despite the opposition of many auditors and financial executives, both FASB and the SEC argued that the rule was necessary to protect investors.

Jim Leisenring, the FASB staff member who chairs the Derivatives Implementation Group and oversaw the drafting of FAS 133, says, "People said the disclosures were already accurate, and a lot of people said there were no surprises."

But if there are no unwelcome surprises buried in corporate financial statements, then companies won't be harmed by spelling out their exposure under FAS 133, Leisenring reasons. If there are losses, then companies have an obligation to alert shareholders.

It's entirely probable that Sears' management already had a good grasp of its derivatives' exposure, but the reclassifying of the hedging write-off makes the extent of the loss transparent to investors.

Jeff Wallace, managing partner for Greenwich Treasury Advisors in Greenwich, Connecticut, says the huge derivatives losses in the mid- 1990s by Orange County and Procter & Gamble spurred the initial movement to draft 133 in the first place. The fact that companies are identifying the true size of their derivatives losses is a sign that the rule is working as planned.

What's more, Sears is not likely to be the last company to report a large charge stemming from the rule. Last year, Microsoft reported that it had a charge of $375 million, Wallace says.

But Microsoft is on a June fiscal year, and Sears, like most of the rest of corporate America is on a calendar year. As more 10-Ks for 2000 are submitted to the SEC in the next few weeks, more derivatives losses will be revealed.

"We haven't seen an end to the surprises," Wallace says.

But Wallace also says it's also important to keep the loss in perspective. While $270 million is a large number by any standard, it amounts to barely 1 percent of Sears' $26 billion credit card portfolio. The loss, while painful, is not catastrophic by that measure.

The spokeswoman said that when Sears terminated the interest-rate swap in 1997, it began amortizing the $270 million write-off on a 20-year schedule. The adoption of FAS 133 this year forced Sears to accelerate the charge-off and recognize the entire amount still outstanding in the first quarter.

According to Sears' 10-K, the "transition adjustment includes the effect of recording an existing cash flow hedging relationship on the balance sheet and reclassifying deferred losses from previously terminated interest rate swaps from other assets to other comprehensive income." The hedge caused a pre-tax charge of $56 million, or $34 million after taxes. The terminated swap had a pre-tax charge $389 million, or $236 million after taxes.

Sears' filing said it will write off the derivative losses over the next 17 years "as a yield adjustment of the hedged debt obligations."

Ira Kawaller, a Brooklyn, NY, consultant who specializes in derivatives, says, that although he's not familiar with the specifics of the Sears' charge-off, the company's classification of the impact of the swap as other comprehensive income, or OCI, suggests that it funded some of its credit card portfolio with a variable-rate liability and hedged it with a fixed-rate contract. As the market moved against it in 1997, the retailer decided to unwind the contract rather than expose itself to further losses.

Continued in the article.

Question:  How should Southwest Airlines account for these derivatives?
"Trying to Make Fuel Prices Less of a Wartime Gamble," by Daniel Altman, The New York Times, March 23, 2003 --- http://www.nytimes.com/2003/03/23/business/yourmoney/23HEDG.html 

Now that the war in Iraq has begun, oil prices could go $10 a barrel higher — or lower — by this time next month. How can a company that uses a lot of oil or its byproducts protect itself?

Because the risks run in both directions, businesses in several industries face a complex task: guarding against a price spike while staying open to the benefits of falling prices.

The companies' methods run the gamut. Some have been actively hedging, using complex financial instruments, while others have preferred to manage fuel inventories or pass along costs to consumers.

Last September, Southwest Airlines decided to prepare for the possibility of war in the Persian Gulf. The company bought financial derivatives to ensure that it would never pay much more than 70 cents a gallon for jet fuel — the equivalent of a bit more than $23 for a barrel of crude oil, compared with the price of $28.80 today — for its fuel supply this quarter. More than 75 percent of its fuel needs for the remainder of 2003 and all of 2004 are similarly protected, and some of its hedges extend all the way to 2008.

Southwest's hedges mostly take the form of common but sophisticated derivatives called collars and swaps, said Gary C. Kelly, the airline's chief financial officer. In the near term, about two-thirds of the derivatives are based on prices for heating oil, which follow rates for jet fuel more closely than those for crude oil.

The cost of price protection amounts to about 1 or 2 cents for each gallon of jet fuel, Mr. Kelly said. With jet fuel being traded for more than $1 a gallon lately, he added, "it's obviously a very substantial saving."

Southwest, though, may be the exception rather than the rule.

"It varies tremendously from firm to firm," said Edward N. Krapels, an expert on risk management at Energy Security Analysis, a research firm in Wakefield, Mass. "In the airline industry, you'll find some who are quite aggressive hedgers, and others who are not."

Mr. Krapels said some companies might have become wary of hedging after buying derivatives to protect themselves, only to find that oil prices would fall. In the Persian Gulf war of 1991, for example, the sudden drop in prices that accompanied the build-up of coalition forces and their early victories took many companies by surprise.

As a result, Mr. Krapels explained, "most large consumers are underhedged, with some very significant exceptions." He added, "The impact of an oil price increase on these guys will be very significant."

Companies that routinely engage in hedging tend to be in the middle of the petroleum supply chain, said Neal L. Wolkoff, the chief operating officer of the New York Mercantile Exchange, where energy derivatives are traded. "The greatest participation tends not to be from the ultimate consumer," he said. "It's more either merchants and refiners or integrated oil companies."

The Valero Energy Corporation, a top refiner, contracts in advance for cargoes of oil from China, Russia and other countries. The company uses simple mechanisms to guarantee oil prices into the near future. Because of the uncertainty about oil prices in the next few months, Valero has tried to insure itself in case market rates fall below those in its long-term contracts.

"We are concerned that prices are going to fall off after this whole Iraqi thing is resolved, so any extra barrels we have, we hedge them," said Gene Edwards, Valero's senior vice president for supply and trading.

 
ATHER than buying options to sell oil at fixed prices, as protection against prices falling, Valero sells future contracts for oil. For example, it might buy oil at $35 a barrel today and promise to sell oil at $32 a barrel next month. If the price of oil next month falls below $32, then Valero can buy oil from the market and sell it at a profit.

Mr. Edwards said that investment banks often approach Valero with more complicated derivatives, but that the futures generally offer a less expensive solution.

In addition to buying and selling futures, Valero has been engaging in a more tangible form of hedging — limiting its own stocks of oil so it can take advantage of prices if they fall. "You try to keep inventories low, because you don't want to be sitting on extra barrels," Mr. Edwards said.

That kind of activity has kept volume on the New York Mercantile Exchange near normal levels, Mr. Wolkoff said. "A lot of companies are, in effect, hedging through their physical business," he said. "That means there appears to be a reticence to hold inventory. That's one way of hedging, simply by reducing your exposure."

Some companies that use a lot of fuel have an even simpler way of dealing with high and low prices. The Roadway Corporation, the trucking-line operator, passes along the high cost of fuel to customers through a surcharge. Each week, the company updates the surcharge automatically, using the Energy Department's diesel price index.

"It makes fuel a pass-through for us," said John M. Hyre, a spokesman for Roadway. "We don't benefit by it, and we're not negatively impacted by it. We do have concern for the impact that rising fuel costs have on our customers, though."

The company can benefit, however, when fuel prices drop steeply. "If we encounter good pricing, we will work on getting long-term contracts under that good pricing," Mr. Hyre said.

If the war in Iraq does not go as the Pentagon has planned, any sudden spike in oil prices could have the harshest effects on some people who have little use for petroleum products, except on the drive to work. Hedge-fund managers and other speculators who sell financial protection to companies like Valero could be at risk, Mr. Krapels said.

"If the war goes badly, and the oil price goes significantly higher than it is today, how well can the people who took the short side of that bet withstand it?" he asked. "There could be some very big credit exposures." 

The dangers of derivatives abuse and the excessive amounts of derivatives now in the markets --- http://www.trinity.edu/rjensen/fraud.htm#DerivativesFraud 

"The Impact of FAS 133 on the Risk Management Practices of End Users of Derivatives," Association for Financial Professionals, September 2002 --- http://www.kawaller.com/pdf/AFP_2002.pdf 

The Financial Accounting Standards Board (FASB) issued new accounting rules for derivatives and hedging transactions (Financial Accounting Statement 133, or FAS 133) in June 1998 that were effective on June 15, 2000. Most companies, however, did not implement the standard until the first quarter of 2001. Because the transition from the previously accepted accounting treatment was dramatic and controversial, many reporting entities — along with FASB and the Securities and Exchange Commission (SEC) — were concerned about the impact that these new rules might have on the hedging activities of corporations. To gain a clearer perspective on the impact of FAS 133, the Association for Financial Professionals (AFP) surveyed its members in January 2001.

This original survey had several major conclusions.

• First, two-thirds of respondents believed that FAS 133 had imposed an "excessive burden" on reporting companies.
  
  
• Second, a quarter of respondents indicated that they expected to apply regular derivatives accounting—as opposed to applying special hedge accounting — to a significant portion of their derivatives holdings.
  
  
• Third, the new accounting requirements fostered a small reduction in hedging activity.
  
  
• Fourth, only a quarter of respondents believed that FAS 133 imposed a beneficial discipline on risk management activities.

The 2001 survey was conducted in early January, just a few months after companies started complying with FAS 133 requirements, but since then, FAS 133 has continued to evolve. FASB has posted additional guidance on its web site ( http://www.fasb.org ); and on May 1 2002, released a new exposure draft containing proposed amendments to FAS 133. AFP decided to survey its membership again, to see whether companies have altered their use of derivatives two years after the effective date of FAS 133.

Survey Methodology

AFP mailed an eight-page questionnaire to select corporate practitioner members¹ in May 2002 and received 175 valid responses. Respondents represented a wide variety of companies throughout the United States, with respondents typically working for company with annual revenues between $1 and $5 billion Treasury and finance professionals of varying job titles completed the questionnaire. Most survey respondents identified themselves as treasurers (29 percent), assistant treasurers (25 per-cent), CFOs (19 percent), and risk managers (10 percent). Respondents also identified the person charged with overall responsibility for FAS 133 implementation as controller/comptrollers (25 percent), CFOs (20 percent), treasurers (19 percent) and assistant treasurers (15 percent).

Footnote 1 
Surveys were sent to corporate members holding titles of CFO, treasurer, or controller and to members who identified any of the following as one of their five primary job responsibilities: accounting/financial reporting, hedging, risk management, and financial risk management.

Executive Summary 

The 2002 survey asked many detailed questions concerning the use of derivative tools and the impact of FAS 133 on company behavior. The principal findings and conclusions are as follows: 

• Sixty-three percent of companies report that they use derivatives to address interest rate and currency exposures, respectively. However, only a third of responding companies indicate that they hedge commodity or raw material price exposures. 
  
• Respondents report lower levels of hedging activity for the vast majority of derivatives tools and strategies, compared to levels reported in last year’s survey. 
  
• Despite this reduced hedging activity, seven out of 10 respondents claim that their company’s use of derivatives has not changed as a result of FAS 133. 
  
• Some of the decline in hedging activity may be due to a perception that market conditions have mitigated the need for hedging activities over the past year. This perception was likely based on relatively lower interest rates, mild currency fluctuations and smaller commodity price swings. 
  
• Even after the process of initial implementation of FAS 133 accounting had been completed — a process that imposed special, one-time time start-up costs — nearly half of the respondents still report that complying with FAS 133 rules is “excessively burdensome.” This result is especially significant in that it comes despite an overwhelming reliance and preference for the simplest, most plain vanilla derivatives. 
  
• Almost a quarter of the respondents say that their company has decided to forgo hedge accounting on “significant portions” of derivative positions as a result of FAS 133. 
  
• Companies generally use hedge accounting. However, when they decide to avoid hedge accounting, it is because either they feel it is not necessary (i.e., the cost and effort outweigh the benefits) or that the companies’ exposures are not eligible for hedge accounting. 
  
• Significant portions of companies who were eligible for special accounting treatments described in DIG issues G20 and H15 — treatments that would likely lead to less income volatility — choose not to avail themselves of this opportunity. This choice may reflect a per-ception that more onerous documentation and valuation requirements are associated with these treatments.

Bob Jensen’s documents (including audio and video) on FAS 133 are at http://www.cs.trinity.edu/~rjensen/000overview/mp3/133intro.htm 

Update on Derivative Financial Instruments and FAS 133

Letters to the Editor
An Eye on Derivatives
The New York Times
March 10, 2002

To the Editor:

Re: "Contracts So Complex They Imperil the System", NY Times, February 24, 2002

To characterize derivatives as not being transparent is a mistake. Derivatives are transparent. They are carried on the balance sheet at their market value, and changes in value are explicitly recorded in financial statements. If derivatives are used in special purpose vehicles or by subsidiaries, however, they won t be apparent at the consolidated statement level. This lack of transparency is not a function of the derivative. Rather, it s a function of the consolidation process.

Ira Kawaller --- http://www.kawaller.com/pdf/Times.pdf