Fannie's Hedging Deals Look Thorny

Forked Road

What might be the reasons for Fannie choosing this possible path? The best likely explanation so far is that Fannie hated FAS 133 so much that it never seriously set out to implement it. Maybe it thought it was too big to have to use FAS 133 properly.

After all, Fannie may never have set out to specifically hide losses. The OFHEO report has a memo that shows that the chief guiding principle for FAS 133 implementation was to limit volatility in earnings, i.e., to protect earnings against both gains and losses on derivatives. Most accounting-abuse cases start out at the top of a slippery slope. The first infraction might seem rather inconsequential, like "limiting volatility."

But this possibly deliberate misapplication of FAS 133 could have come in handy when losses, and not gains, started to pile up on Fannie's derivatives after the Federal Reserve slashed interest rates following the Sept. 11, 2001, attacks. Fannie, unlike GSE sibling Freddie Mac(FRE Quote), was inadequately hedged for lower rates, and failed to get proper protection for the new low-rate environment. As a result, derivatives losses continued to balloon, and losses on FAS 133-related derivatives climbed to dangerous levels in 2002 and 2003.

Did earnings get hurt in the period when the huge losses were sustained? Nope, because of the way Fannie applied FAS 133.

And FAS 133 wasn't the only area in which Fannie appears to have made grave missteps. OFHEO has shown in scrupulous detail how another rule, called FAS 91, was allegedly misapplied to smooth out earnings. An ex-Fannie employee named Roger Barnes aided that segment of the OFHEO report. And in testimony before the House committee hearing last week, Barnes described what he saw as the culture within key accounting units at Fannie.