Fannie's Hedging Deals Look Thorny

After some very nasty derivatives-related scandals, the Securities and Exchange Commission, as well as the Financial Accounting Standards Board, the U.S. body that formulates accounting rules, started in the late '90s to draw up a rule that would make companies reflect the change in value of derivatives much more accurately and fully on their income statements and balance sheets.

That rule came to be known as FAS 133 -- and Fannie fought it harder than any other company in America, often leading the lobbying effort against it. FASB, quite understandably, wanted to have companies' income statements reflect the changes in the value of derivatives each quarter. That caused howls of protest, from Fannie and others.

In December 2000, just before the rule became effective on Jan. 1, 2001, Fannie CFO Howard gave a presentation to investors about FAS 133. In it, he noted that FASB wanted to "put all derivatives on the balance sheet, and to reflect changes in their market values either in the income statement or the equity account."

An alternative method, Howard wrote, was to "require supplemental disclosure of a company's use of derivatives while leaving the income statement and balance sheet alone." Howard announced: "Fannie Mae was in favor of the second alternative."

In the end, a compromise was reached: Companies didn't have to include gains and losses on derivatives that had a very close hedging relationship with a real asset, like a mortgage, or a real liability, for example, a bond. If a company could very clearly and rigorously prove that a derivative's decline in value was closely offset by a rise in the value of an asset or liability, that derivative loss would not have to flow through earnings in the period the value change took place.

Once it had failed to get all derivatives onto the income statement, FASB wanted to avoid the situation in which a company would have a loss on some derivatives and then, after the fact, pretend that it was offset by some increase in the value of an asset. That's why FAS 133 demands very detailed and contemporaneous documentation of derivatives that a company elects to keep out of earnings calculations.

The OFHEO report on Fannie makes a simple, but chilling, allegation: Fannie has claimed close hedging relationships for most of its derivatives and thus kept losses on them out of earnings, but it appears to OFHEO that most of those derivatives don't in fact qualify for exclusion. In other words, it appears that Fannie has done what FASB always feared, which is wrongfully claiming that loss-making derivatives deserve to be kept out of earnings to make the company look stronger than it really is.