Fannie's Hedging Deals Look Thorny

Federal probes surely will focus on Fannie's accounting for the derivatives bets it made on interest rates.
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Fannie Mae


,fending off serious accounting allegations by itsregulator, said Tuesday that it is now the subject of a JusticeDepartment investigation.

The question everyone's going to be asking is this: What might end upin any criminal complaint against Fannie, the nation's largestmortgage buyer?

In fact, thanks to some serious digging by Fannie's regulator, theOffice of Federal Housing Enterprise Oversight, there now appears tobe enough material in the public domain to assemble a stronghypothetical case against Fannie, whose management team is led by CEOFranklin Raines and finance chief Tim Howard.

Raines and Howard, as well as some Fannie supporters, have madebroad-brush criticisms of the findings contained in OFHEO's Sept. 22report on Fannie's accounting. But no one in the Fannie camp has sofar made a convincing effort to defend the company against theparticular allegations of the OFHEO report. At congressional hearingslast week on OFHEO's report, Howard had to answer detailed accountingquestions, but often tied himself in self-contradictory knots.

Using what is known so far, a prosecutor could make a simple andserious case against Fannie. There's much in the OFHEO report tosuggest that Fannie misapplied accounting rules to make both itsearnings and regulatory capital look a lot stronger than they actuallywere. According to some estimates, Fannie may have excluded

as much as$12 billion of losses from its income statement.

Fannie's defenders have every interest in making the issues seem ascomplex as possible. First, so that people get lost in the details andswitch off. And second, to make it look like the accounting rules areso open to interpretation that there is no one right approach and thatFannie and OFHEO merely had a difference of opinion.

But a prosecutor would have no problems drawing out simpleand clear-cut abuses. As with nearly all accounting scandals, Fannie'salleged abuses aimed to do one thing: Make the books look betterthan they really were.


ruses were sometimes complex, but after along gestation period, the Justice Department hasn't had any real troubleputting together a convincing case against ex-Enron employees. Don't expectit to be any different when it comes to Fannie.


Fannie appears to have committed its most serious abuses whenaccounting for the changes in the value of derivatives, which arefinancial instruments used to hedge the company against adverseinterest rate movements.

Any theoretical case against Fannie wouldsimply argue that Fannie kept losses on those derivatives out ofearnings by misapplying the provisions of an accounting rule known asFAS 133. To see how that may well have happened, it helps to approachthe issue chronologically. The Fannie mess didn't come out ofnowhere.

First, we have to understand Fannie's basic business. Though Fannie isa private company, it is also known as a government-sponsoredenterprise because it operates under special advantages granted byCongress. It was set up to provide support to the housing market bybuying mortgages from lenders like banks and thrifts. Because of Fannie'sso-called GSE status, the market has come to treat the company almost likea government institution, assuming that the debt Fannie issuescarries a government guarantee. This implicit government guaranteeallows Fannie to borrow more cheaply than other financialinstitutions.

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

Why can that hurt profits? If Fannie borrowed at 5% to pay for 30-yearmortgages yielding 6%, the 1 percentage-point difference is its profit. Butif rates come down and mortgages start to yield 5%, Fannie has to beborrowing at 4% to make the same profit. It's not that easy to get debtcosts down quickly simply by issuing new debt, so Fannie has to find a wayof 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 nothinginherently wrong with derivatives, just as there is nothing inherentlywrong with stocks or bonds. It makes much sense for Fannie, as well asother mortgage holders, to use them to hedge against the big lossesthat changes in interest rates can cause in the mortgage buyingbusiness.

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

After some very nasty derivatives-related scandals,the

Securities andExchange Commission

, as well as the Financial Accounting StandardsBoard, the U.S. body that formulates accounting rules, started in thelate '90s to draw up a rule that would make companies reflect thechange in value of derivatives much more accurately and fully on theirincome statements and balance sheets.

That rule came to be known as FAS 133 -- and Fannie fought it harderthan any other company in America, often leading the lobbying effortagainst it. FASB, quite understandably, wanted to have companies'income statements reflect the changes in the value of derivativeseach 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 FAS133. In it, he noted that FASB wanted to "put all derivatives on thebalance sheet, and to reflect changes in their market values either inthe 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 toinclude gains and losses on derivatives that had a very close hedgingrelationship with a real asset, like a mortgage, or a real liability,for example, a bond. If a company could very clearly and rigorouslyprove that a derivative's decline in value was closely offset by arise in the value of an asset or liability, that derivative loss wouldnot have to flow through earnings in the period the value change tookplace.

Once it had failed to get all derivatives onto the income statement,FASB wanted to avoid the situation in which a company would havea loss on some derivatives and then, after the fact, pretend that itwas offset by some increase in the value of an asset. That's why FAS133 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 itsderivatives and thus kept losses on them out of earnings, but itappears to OFHEO that most of those derivatives don't in fact qualifyfor exclusion. In other words, it appears that Fannie has done whatFASB always feared, which is wrongfully claiming that loss-makingderivatives deserve to be kept out of earnings to make the companylook stronger than it really is.

Forked Road

What might be the reasons for Fannie choosing this possible path? Thebest likely explanation so far is that Fannie hated FAS 133 so muchthat it never seriously set out to implement it. Maybe it thought itwas 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 forFAS 133 implementation was to limit volatility in earnings, i.e., toprotect earnings against both gains and losses on derivatives. Mostaccounting-abuse cases start out at the top ofa slippery slope. The first infraction might seem ratherinconsequential, like "limiting volatility."

But this possibly deliberate misapplication of FAS 133 could havecome in handy when losses, and not gains, started to pile up onFannie's derivatives after the

Federal Reserve

slashed interest ratesfollowing the Sept. 11, 2001, attacks. Fannie, unlike GSE sibling

Freddie Mac


, was inadequately hedged for lower rates, and

failed to getproper protection for the new low-rate environment. As a result,derivatives losses continued to balloon, and losses on FAS 133-relatedderivatives climbed to dangerous levels in 2002 and 2003.

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

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

"The atmosphere and culture ... is one ofintimidation, restraint of dissenting opinions, and pressure to bepart of the 'Team,' giving Chairman Franklin Raines and Vice ChairmanTim Howard the numbers the Office of the Chairman desired to pleasethe markets," according to Barnes.

If the office of the chairman did in fact misuse FAS 91 to helpearnings, there is every reason to suppose that it could have done thesame with FAS 133.

Fannie said Tuesday that the Justice Department told the company "topreserve certain documents, including documents relating to thematters discussed in the OFHEO report." No doubt the feds are headingstraight for the FAS 133 file.

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