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Freddie 101: How to Spot a Derivative

The mortgage giant might need a refresher course.

If you're going to be a major player in the derivatives market, it helps to know what a derivative is.

By its own admission,

Freddie Mac's


own accounts had their hands full with that chore. And that's a big reason the nation's second-biggest mortgage buyer is in the process of restating its earnings, with regulators and federal prosecutors breathing down its neck.

To be sure, Freddie executives weren't so blunt Wednesday in providing investors with an update on the restatement, which the firm now expects will boost prior earnings by up to $4.5 billion, while lowering future earnings. But derivatives experts say that's the clear meaning of Freddie's acknowledgement that it "treated certain cash market instruments as derivatives that did not meet the GAAP accounting definition of a derivative."

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The experts say there's a lot about the accounting treatment for derivatives that's difficult to comprehend. But the accounting rule on what qualifies as a derivative -- a sophisticated financial instrument whose value depends on the performance of an underlying security -- is crystal clear.

"A sixth grader could figure this out," said Stephen Ryan, a business professor at New York University's Stern School of Business, who recently wrote a book about derivative accounting techniques. "This is not a subtle thing. This is completely obvious."

Ryan said there's nothing mysterious about Freddie's use of the phraseology "cash market instruments." He said that could be just about anything ranging from a bond, a loan or a Treasury note. What makes something a derivative is when a contract is specifically written that either speculates or hedges against a change in the value of that underlying bond, loan or Treasury note.

Of course, Freddie's supporters on Wall Street contend the definition of a derivative is not really so cut and dry.

They point out that what Freddie often did was create so-called "synthetic derivatives," which involves the matching of two cash market instruments. An example of this might be the matching-up of several different Treasury notes to create a hedge against a change in interest rates. The end effect, Freddie supporters contend, is the same as a traditional derivative such as an interest rate swap -- a deal in which parties make payments to each other based on a variety of preset interest rates.

But Ryan said the accounting rules also are pretty clear on what constitutes an acceptable synthetic derivative.

It may be up to the regulators to settle this debate once and for all.