Fannie's Hedging Deals Look Thorny

Timeline

Fannie appears to have committed its most serious abuses when accounting for the changes in the value of derivatives, which are financial instruments used to hedge the company against adverse interest rate movements.

Any theoretical case against Fannie would simply argue that Fannie kept losses on those derivatives out of earnings by misapplying the provisions of an accounting rule known as FAS 133. To see how that may well have happened, it helps to approach the issue chronologically. The Fannie mess didn't come out of nowhere.

First, we have to understand Fannie's basic business. Though Fannie is a private company, it is also known as a government-sponsored enterprise because it operates under special advantages granted by Congress. It was set up to provide support to the housing market by buying mortgages from lenders like banks and thrifts. Because of Fannie's so-called GSE status, the market has come to treat the company almost like a government institution, assuming that the debt Fannie issues carries a government guarantee. This implicit government guarantee allows Fannie to borrow more cheaply than other financial institutions.

Fannie then uses those cheap funds to buy billions of dollars of mortgages each year. If the payments on the mortgages bought by Fannie are higher than the payments on the debt it borrows, the company makes money. A drop in profitability can occur, however, when borrowers decide to prepay their mortgages.

Why can that hurt profits? If Fannie borrowed at 5% to pay for 30-year mortgages yielding 6%, the 1 percentage-point difference is its profit. But if rates come down and mortgages start to yield 5%, Fannie has to be borrowing at 4% to make the same profit. It's not that easy to get debt costs down quickly simply by issuing new debt, so Fannie has to find a way of cutting its borrowing costs quickly. It uses billions of dollars of derivatives to do that.

And the accounting for these derivatives are central to the anti-Fannie case.

Hedge Clippers

The use of derivatives has ballooned over the past 20 years, especially in the financial sector of the economy. There is nothing inherently wrong with derivatives, just as there is nothing inherently wrong with stocks or bonds. It makes much sense for Fannie, as well as other mortgage holders, to use them to hedge against the big losses that changes in interest rates can cause in the mortgage buying business.

Because derivatives use became widespread so quickly, especially in the '80s and '90s, accounting rulemakers found it hard to keep up, and an utterly intolerable situation developed: Companies were holding huge amounts of derivatives, but their books barely reflected their presence. Losses could pile up on them and this wouldn't be properly reflected in financial statements.

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In keeping with TSC's editorial policy, Peter Eavis doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He welcomes your feedback and invites you to send any to [e-mail].