Bob Jensen's New Bookmarks

A NYT reporter asked me to comment on the Treasury Department’s final report on the accounting/auditing profession --- http://www.ustreas.gov/press/releases/hp1159.htm

I only spent 15 minutes on this and am not especially proud of anything I do off the cuff and extemporaneously. But since reporters only quote about one percent or less of what you give them, perhaps more of what I said may be of value to some readers.

Robert (Bob) Jensen
Emeritus Accounting Professor From Trinity University
190 Sunset Hill Road
Sugar Hill, NH 03586
603-823-8482
http://www.trinity.edu/rjensen/

From: Jensen, Robert
Sent: Friday, September 26, 2008 4:07 PM
To: '
Cc: Jensen, Robert
Subject: RE: treasury report on auditing

Hi XXXXX,

I made brief responses directly onto the summary you sent to me. My main point is for you to look into the Accounting Court idea.
Especially note http://www.nysscpa.org/cpajournal/2004/304/perspectives/nv6.htm

Please forgive me for only devoting 15 minutes to this effort. I’m very, very busy at the moment.

One of my best friends and former professor and former Deputy Chief Accountant at the SEC submitted a long input letter. He allowed me to serve it up at my Website --- http://www.trinity.edu/rjensen/Bailey2008.htm
Although I don’t agree with him on some issues, you perhaps should seek Andy Bailey’s input on this as well --- jabaile@uiuc.edu
Andy’s input is much more complete than my few comments in this email message.

Hope this helps!

Robert (Bob) Jensen
Emeritus Accounting Professor From Trinity University
190 Sunset Hill Road
Sugar Hill, NH 03586
603-823-8482
http://www.trinity.edu/rjensen/

American Accounting Association members should visit the AAA Commons today --- http://commons.aaahq.org

The U.S. Treasury Department Advisory Committee of the Auditing Profession issued its final report on September 26, 2008 --- http://www.treas.gov/offices/domestic-finance/acap/index.shtml

A summary is provided below with Bob Jensen's comments in blue.

September 26, 2008
HP-1158

Fact Sheet: Final Report of the Advisory Committee on the Auditing Profession

The U.S. Treasury Department's Advisory Committee on the Auditing Profession adopted a Final Report containing more than 30 recommendations to improve the sustainability of the public company auditing profession. The report is separated into three sections by principal areas of focus.

Human Capital recommendations focused on improving accounting education and strengthening human capital, including:

Implementation of accounting education curricula and content that continuously evolves to reflect current market developments to help prepare new entrants to the profession.
This is motherhood and apple pie, but keep in mind that the financial accounting part of the curriculum is 95% driven by the CPA examination. To change the curriculum all NASBA has to do is change the CPA Exam, which I will now have to do since all FASB standards will be trashed in favor of IFRS standards because Chris Cox abused his authority as Chair of the SEC --- http://www.trinity.edu/rjensen/theory01.htm#MethodsForSetting
Improvement of the representation and retention of minorities in the auditing profession through mentoring programs and recruiting at community colleges.
Some progress is being made in the effort to get more minority professors and role models, but the CPA examination is a tough, tough hurdle for entry into the public accounting profession --- http://www.kpmgfoundation.org/foundinit.asp
Also see http://www.aicpa.org/members/div/career/mini/index.htm
Great progress is being made for women since 60% of the new hires are women --- http://www.trinity.edu/rjensen/bookbob1.htm#careers
Ensuring an adequate supply of qualified accounting faculty through public and private sector funding to meet future demands and help prepare students to execute high quality audits.
This is an enormous failure because virtually all doctoral programs wanted to become mathematics programs more than accounting programs --- http://www.trinity.edu/rjensen/theory01.htm#DoctoralPrograms
Development and maintenance of demographic data on the accounting profession so that the profession can understand the human capital situation and its impact on the profession's future and sustainability.
The AICPA keeps a pretty good database for this.
Study of the future of education for the accounting profession, including the potential for graduate schools of accounting, to determine the best way to educate students to deal with the challenging financial reporting and auditing environment.
The AICPA is so concerned about the shortage of auditing and tax professors that it just now created a fund to provide five years of full ride funding to each of 30 doctoral students who will commit to auditing and tax specialties
Requests for applications and additional information may be obtained online from the AICPA Foundation at ADSprogram@AICPA.org. or by calling 919-402-4524

Firm Structure and Finances recommendations focused on enhancing auditing firm governance, transparency, responsibility, communications, and audit quality, including:

Creation of a national center at the Public Company Accounting Oversight Board to provide a forum for auditing firms and other market participants to share their fraud detection experiences in order to improve audit quality.
Probably a good idea, but I doubt that firms will devote a whole lot of hours making this a success.
Granting accountants licensed in one state with reciprocity to practice in other states to foster a more efficient operation of the capital markets given the multi-state operations of many public companies and multi-state practices of many auditing firms.
This has some real problems. For example, most but not all states now require five-years (150 semester credits) to sit for the CPA examination, but there are some states that only require four years. Should students will four-year degrees become licensed in states that have tougher standards? Also there’s a huge problem with varying experience requirements among states. And there are societal problems. Florida does not want all the semi-retired CPAs from NY to set up shop in Florida.
Exploration of the feasibility of appointing independent members with full voting power to firm boards and/or advisory boards to improve the governance and transparency of auditing firms.
Probably a good idea, but there are problems with confidentiality of client information.
Enhancement of disclosure requirements regarding public company auditor changes will improve transparency and enhance investor confidence.
There has been progress here with SEC rules, but more could be accomplished. It’s hard to separate reasons from excuses.
Enhancements to make the auditor's standard reporting model more useful to investors by including more relevant information, such as key accounting estimates and judgments.
The estimation process is so complex, that “more relevant information” might only add trees in front of somebody already lost in the forest.
Mandating the engagement partner's signature on the auditor's report to improve accountability among auditing firms.
A good idea, but not as important as rotating the engagement partner more frequently, including bringing in new engagement partners from other offices.
Requirement for larger auditing firms to produce a public annual report with relevant firm information and file on a confidential basis with the PCAOB audited financial statements to improve transparency at auditing firms.
Yes, yes, yes.

The Concentration and Competition recommendations focused on ways to increase audit market competition and auditor choice, including:

Having the PCAOB monitor potential sources of catastrophic risk at auditing firms to prevent reduced auditor choice and significant market disruptions.
At the moment really large clients like Bank of America can create a catastrophe by dropping their auditing firm. The audit model is basically broken since audit firms are chosen by and paid by executives of firms that they audit. I’m not saying that government auditors would be an improvement, because we all know that industries pretty much get control of the government agencies that regulate them. But there should be some type of “accounting court” for resolving auditor-client conflicts in confidentiality. This was first proposed in a big way by a managing partner of Arthur Andersen named Leonard Spacek --- http://fisher.osu.edu/departments/accounting-and-mis/the-accounting-hall-of-fame/membership-in-hall/leonard-paul-spacek/
Especially note --- http://www.nysscpa.org/cpajournal/2004/304/perspectives/nv6.htm
Creation of a mechanism for the preservation and rehabilitation of troubled larger public company auditing firms to prevent reduced auditor choice and significant market disruptions.
Especially note --- http://www.nysscpa.org/cpajournal/2004/304/perspectives/nv6.htm
Development and publication of key indicators of audit quality and effectiveness to promote competition and choice in the industry based on audit quality.
The PCAOB is doing a pretty good job in this department. For example it has found deficiencies in some of the audits of public accounting firms of all sizes, including the recent PCAOB fine of $1 million for Deloitte --- http://www.pcaobus.org/Inspections/index.aspx
Promotion of the understanding of and compliance with auditor independence requirements to enhance investor confidence in the quality of audit processes and audits.
Academics have been clamoring about this for years, but it’s almost impossible to make significant progress beyond the litigation threat. At the moment, the risk of being sued in the U.S. is probably the biggest factor keeping auditing firms professional and honest, but there are many failures --- http://www.trinity.edu/rjensen/Fraud001.htm
It should be noted that most of the litigation of CPA firms centers on mistakes, incompetence, and cost-saving practices that were not a good idea such as substituting substantive testing with analytical reviews. There have been some, but very few, outright frauds and collusions of auditors in frauds.
Adoption of annual shareholder ratification of public company auditors by all public companies to enhance the audit committee's oversight to ensure that the auditor is suitable for the company's size and financial reporting needs.
Shareholder ratifications are a pile of crap since most of the shares are held by enormous funds (pension funds, mutual funds, etc.). The ideal that Main Street will thereby have a huge input into the choice of an auditor is nonsense. Most individuals don’t know one auditor from another. And for huge clients there are only about six choices anyway.
Enhancement of collaboration and coordination between the PCAOB and its foreign counterparts so that investors can be confident that auditing firms of all sizes are contributing effectively to audit quality.
Sounds great but this is motherhood and apple pie that’s difficult to implement effectively in practice. Mostly it sounds good on paper.

Closing Comment
What’s really needed is an Accounting Court much like operates in The Netherlands, although it will be much more difficult to operate in the U.S. because of the much greater size of the U.S. I still like Spacek’s basic idea of an Accounting Court.
Especially note --- http://www.nysscpa.org/cpajournal/2004/304/perspectives/nv6.htm

The main advantage of an Accounting Court is that auditors could get more backing from experts when confronting clients on some sticky issues, and clients would have a more difficult time bullying their auditors.

THE MAIN PROBLEM WITH OUR BROKEN AUDITING MODEL IS THAT IT ENCOURAGES CLIENTS TO BECOME BULLIES JUST TO HAVE THEIR OWN WAYS!

The most serious problem in the U.S. audit model is that clients are becoming bigger and bigger due to non-enforcement of anti-trust laws. For example, the merger of Mobile and Exxon created an even larger single client. The merger of Bear Stearns and JP Morgan created a much larger client. The number of potential clients is shrinking while the size of the clients is exploding. According to the CEO of Bank of America, in a CBS Sixty Minutes interview on October 19, 2008, half of all banking customers in the United States now have accounts with Bank of America. That was before Bank of America bought out Merrill Lynch.

As these giants merge to become bigger giants, it gets to a point where their auditors cannot afford to lose a giant client producing upwards of $100 million in audit revenue each year. Real independence of audits breaks down because a giant client can become a bully with its audit firm fearful of losing giant clients.

Enron was an extreme but not necessarily an outlier. It will most likely be alleged in court over the next few years that giant Wall Street banks bullied their auditors into going along with understating financial risk before the 2008 banking meltdown. We certainly witnessed the understating of financial risk in 2007 and 2008.

It must be kept in mind that the statements certified are not ours but are our clients--and our clients do not care to mix explanations of accounting theory with explanations of their business nor can we pass onto our readers the responsibility for appraisal of differences in accounting theory. Those fields are for you and me to grapple with, not the public. In general, clients are not primarily interested in arguments of accounting theory at the time of preparing their reports. The companies whose accounts are certified are chiefly interested in what is said to their shareholders, and in the hard practical facts of how accounting rules affect them, their competitors and other companies. Usually they are very critical of what we call accounting principles when these called principles are unrealistic, inconsistent, or do not protect or distinguish scrupulous management from the scrupulous.
"The Need for An Accounting Court," by Leonard Spacek, The Accounting Review, 1958, Pages 368-379 --- http://www.trinity.edu/rjensen/FraudSpacek01.htm

Jensen Comment
Fifty years later I'm a strong advocate of an accounting court, but I envision a somewhat different court than than envisioned by the great Leonard Spacek in 1958. Since 1958, the failure of anti-trust enforcement has allowed business firms to merge into enormous multi-billion or even trillion dollar clients who've become powerful bullies that put extreme pressures on auditors to bend accounting and auditing principles. For example see the way executives of Fannie Mae pressured KPMG to bend the rules (an act that eventually got KPMG fired from the audit).

In my opinion the time has come where auditors and clients can take their major disputes to an Accounting Court that will use expert independent judges to resolve these disputes much like the Derivatives Implementation Group (DIG) resolved technical issues for the implementation of FAS 133. The main difference, however, is that an Accounting Court should hear and resolve disputes in private confidence that allows auditors and clients to keep these disputes away from the media. The main advantage of such an Accounting Court is that it might restrain clients from bullying auditors such as became the case when Fannie Mae bullied KPMG.

"Market and Political/Regulatory Perspectives on the Recent Accounting Scandals," by Ray Ball at the University of Chicago, SSRN, September 17, 2008 --- (free download) --- http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1272804

Jensen Comment
Although Professor Ball is best known for empirical research of capital markets data, the above article is best described as a commentary of his personal opinion. On many issues I agree with him, but on some issues I disagree.

Would market forces have killed Enron even if there was no criminal case for document destruction?

Infectious Greed: How Deceit and Risk Corrupted the Financial Markets (Henry Holt and Company, 2003, Page 77, ISBN 0-8050-7510-0)

The process of transferring receivables to a new company and issuing new bonds became known as securitization, which became a major part of the structured finance industry . . . One of the most significant innovations in structured finance was a deal called the Collateralized Bond Obligation, or CBO. CBOs are one of the threads that run through the past fifteen years of financial markets, ranging from Michael Milken to First Boston to Enron and WorldCom. CBOs would mutate into various types of credit derivatives --- financial instruments tied to the creditworthiness of companies --- which would play and important role in the aftermath of the collapse of numerous companies in 2001and 2002.

. . .

In simple terms, here is how a CBO works. A bank transfers a portfolio of junk bonds to a Special Purpose Entity, typically a newly created company, partnership, or trust domiciled in a balmy tax haven, such as the Cayman Islands. This entity then issues several securities, backed by bonds, effectively splitting the junk bonds into pieces. Investors (hopefully) buy the pieces.

. . .

The first CBO was TriCapital Ltc., a $420 million deal sold in July 1988. There were about $900 million CBOs in 1988, and almost $ $3 billion in 1989. Notwithstanding the bad press junk bonds had been getting, analysts from all three of the credit-rating agencies began pushing CBOs. Ther were very profitable for the rating agencies, which received fees for rating the various pieces.

. . .

With the various types of structured-finance deals, a trend began of companies using Special Purpose Entities (SPEs) to hide risks. From an accounting perspective, the key question was whether a company that owned particular financial assets needed to disclose those assets in its financial statements even after it transferred them to an SPE. Just as derivatives dealers had argued that swaps should not be included in their balance sheets, financial companies began arguing that their interest in SPEs did not need to be disclosed . . . In 1991. the acting chief accountant of the SEC, concerned that companies might abuse this accounting standard, wrote a letter saying the outside investment had to be at least three percent (a requirement that helped implode Enron and its auditor Andersen because the three percent investments were phony):

Frank Partnoy introduces Chapter 7 of Infectious Greed as follows:

Pages 187-188

The regulatory changes of 1994-95 sent three messages to corporate CEOs. First, you are not likely to be punished for "massaging" your firm's accounting numbers. Prosecutors rarely go after financial fraud and, even when they do, the typical punishment is a small fine; almost no one goes to prison. Moreover, even a fraudulent scheme could be recast as mere earnings management--the practice of smoothing a company's earnings--which most executives did, and regarded as perfectly legal.

Second, you should use new financial instruments--including options, swaps, and other derivatives--to increase your own pay and to avoid costly regulation. If complex derivatives are too much for you to handle--as they were for many CEOs during the years immediately following the 1994 losses--you should at least pay yourself in stock options, which don't need to be disclosed as an expense and have a greater upside than cash bonuses or stock.

Third, you don't need to worry about whether accountants or securities analysts will tell investors about any hidden losses or excessive options pay. Now that Congress and the Supreme Court have insulated accounting firms and investment banks from liability--with the Central Bank decision and the Private Securities Litigation Reform Act--they will be much more willing to look the other way. If you pay them enough in fees, they might even be willing to help.

Of course, not every corporate executive heeded these messages. For example, Warren Buffett argued that managers should ensure that their companies' share prices were accurate, not try to inflate prices artificially, and he criticized the use of stock options as compensation. Having been a major shareholder of Salomon Brothers, Buffett also criticized accounting and securities firms for conflicts of interest.

But for every Warren Buffett, there were many less scrupulous CEOs. This chapter considers four of them: Walter Forbes of CUC International, Dean Buntrock of Waste Management, Al Dunlap of Sunbeam, and Martin Grass of Rite Aid. They are not all well-known among investors, but their stories capture the changes in CEO behavior during the mid-1990s. Unlike the "rocket scientists" at Bankers Trust, First Boston, and Salomon Brothers, these four had undistinguished backgrounds and little training in mathematics or finance. Instead, they were hardworking, hard-driving men who ran companies that met basic consumer needs: they sold clothes, barbecue grills, and prescription medicine, and cleaned up garbage. They certainly didn't buy swaps linked to LIBOR-squared.

I do agree with Ray Ball that regulation in and of itself is not panacea when either preventing or detecting fraud.

"Greater Regulation of Financial Markets?" by Richard Posner, The Becker-Posner Blog, April 28, 2008 ---
http://www.becker-posner-blog.com/

Re-Regulate Financial Markets?--Posner's Comment I no longer believe that deregulation has been a complete, an unqualified, success. As I indicated in my posting of last week, deregulation of the airline industry appears to be a factor in the serious deterioration of service, which I believe has imposed substantial costs on travelers, particularly but not only business travelers; and the partial deregulation of electricity supply may have been a factor in the western energy crisis of 2000 to 2001 and the ensuing Enron debacle. The deregulation of trucking, natural gas, and pipelines has, in contrast, probably been an unqualified success, and likewise the deregulation of the long-distance telecommunications and telecommunications terminal equipment markets, achieved by a combination of deregulatory moves by the Federal Communications Commission beginning in 1968 and the government antitrust suit that culminated in the breakup of AT&T in 1983.

Although one must be tentative in evaluating current events, I suspect that the deregulation (though again partial) of banking has been a factor in the current credit crisis. The reason is related to Becker's very sensible suggestion that, given the moral hazard created by government bailouts of failing financial institutions, a tighter ceiling should be placed on the risks that banks are permitted to take. Because of federal deposit insurance, banks are able to borrow at low rates and depositors (the lenders) have no incentive to monitor what the banks do with their money. This encourages risk taking that is excessive from an overall social standpoint and was the major factor in the savings and loan collapse of the 1980s. Deregulation, by removing a variety of restrictions on permitted banking activities, has allowed commercial banks to engage in riskier activities than they previously had been allowed to engage in, such as investing in derivatives and in subprime mortgages, and thus deregulation helped to bring on the current credit crunch. At the same time, investment banks such as Bear Sterns have been allowed to engage in what is functionally commercial banking; their lenders do not have deposit insurance--but their lenders are banks that for the reason stated above are happy to make risky loans.

The Federal Deposit Insurance Reform Act of 2005 required the FDIC to base deposit insurance premiums on an assessment of the riskiness of each banking institution, and last year the Commission issued regulations implementing the statutory directive. But, as far as I can judge, the risk-assessed premiums vary within a very narrow band and are not based on an in-depth assessment of the individual bank’s riskiness.

Now it is tempting to think that deregulation has nothing to do with this, that the problem is that the banks mistakenly believed that their lending was not risky. I am skeptical. I do not think that bubbles are primarily due to avoidable error. I think they are due to inherent uncertainty about when the bubble will burst. You don't want to sell (or lend, in the case of banks) when the bubble is still growing, because then you may be leaving a lot of money on the table. There were warnings about an impending collapse of housing prices years ago, but anyone who heeded them lost a great deal of money before his ship came in. (Remember how Warren Buffett was criticized in the late 1990s for missing out on the high-tech stock boom.) I suspect that the commercial and investment banks and hedge funds were engaged in rational risk taking, but that (except in the case of the smaller hedge funds--the largest, judging from the bailout of Long-Term Capital Management in 1998, are also considered by federal regulators too large to be permitted to go broke) they took excessive risks because of the moral hazard created by deposit insurance and bailout prospects.

Perhaps what the savings and loan and now the broader financial-industry crises reveal is the danger of partial deregulation. Full deregulation would entail eliminating both government deposit insurance (especially insurance that is not experience-rated or otherwise proportioned to risk) and bailouts. Partial deregulation can create the worst of all possible worlds, as the western energy crisis may also illustrate, by encouraging firms to take risks secure in the knowledge that the downside risk is truncated.

There has I think been a tendency of recent Administrations, both Republican and Democratic but especially the former, not to take regulation very seriously. This tendency expresses itself in deep cuts in staff and in the appointment of regulatory administrators who are either political hacks or are ideologically opposed to regulation. (I have long thought it troublesome that Alan Greenspan was a follower of Ayn Rand.) This would be fine if zero regulation were the social desideratum, but it is not. The correct approach is to carve down regulation to the optimal level but then finance and staff and enforce the remaining regulatory duties competently and in good faith. Judging by the number of scandals in recent years involving the regulation of health, safety, and the environment, this is not being done. And to these examples should probably be added the weak regulation of questionable mortgage practices and of rating agencies' conflicts of interest and, more basically, a failure to appreciate the gravity of the moral hazard problem in the financial industry.

If auditors and their clients do not take there professional and ethical responsibilities more seriously then neither market forces nor regulators will prevent frauds from increasingly undermining our prized capital markets.

The Largest Earnings Management Fraud in History and Congressional Efforts to Cover it Up

Without trying to place the blame on Democrats or Republicans, here are some of the facts that led to the eventual fining of Fannie Mae executives for accounting fraud and the firing of KPMG as the auditor on one of the largest and most lucrative audit clients in the history of KPMG. The restated earnings purportedly took upwards of a million journal entries, many of which were re-valuations of derivatives being manipulated by Fannie Mae accountants and auditors (PwC was charged with overseeing the financial statement revisions.

Fannie Mae may have conducted the largest earnings management scheme in the history of accounting.

You can read the following at http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm

. . . flexibility also gave Fannie the ability to manipulate earnings to hit -- within pennies -- target numbers for executive bonuses. Ofheo details an example from 1998, the year the Russian financial crisis sent interest rates tumbling. Lower rates caused a lot of mortgage holders to prepay their existing home mortgages. And Fannie was suddenly facing an estimated expense of $400 million.
Well, in its wisdom, Fannie decided to recognize only $200 million, deferring the other half. That allowed Fannie's executives -- whose bonus plan is linked to earnings-per-share -- to meet the target for maximum bonus payouts. The target EPS for maximum payout was $3.23 and Fannie reported exactly . . . $3.2309. This bull's-eye was worth $1.932 million to then-CEO James Johnson, $1.19 million to then-CEO-designate Franklin Raines, and $779,625 to then-Vice Chairman Jamie Gorelick.

That same year Fannie installed software that allowed management to produce multiple scenarios under different assumptions that, according to a Fannie executive, "strengthens the earnings management that is necessary when dealing with a volatile book of business." Over the years, Fannie designed and added software that allowed it to assess the impact of recognizing income or expense on securities and loans. This practice fits with a Fannie corporate culture that the report says considered volatility "artificial" and measures of precision "spurious."

This disturbing culture was apparent in Fannie's manipulation of its derivative accounting. Fannie runs a giant derivative book in an attempt to hedge its massive exposure to interest-rate risk. Derivatives must be marked-to-market, carried on the balance sheet at fair value. The problem is that changes in fair-value can cause some nasty volatility in earnings.

So, Fannie decided to classify a huge amount of its derivatives as hedging transactions, thereby avoiding any impact on earnings. (And we mean huge: In December 2003, Fan's derivatives had a notional value of $1.04 trillion of which only a notional $43 million was not classified in hedging relationships.) This misapplication continued when Fannie closed out positions. The company did not record the fair-value changes in earnings, but only in Accumulated Other Comprehensive Income (AOCI) where losses can be amortized over a long period.

Fannie had some $12.2 billion in deferred losses in the AOCI balance at year-end 2003. If this amount must be reclassified into retained earnings, it might punish Fannie's earnings for various periods over the past three years, leaving its capital well below what is required by regulators.

In all, the Ofheo report notes, "The misapplications of GAAP are not limited occurrences, but appear to be pervasive . . . [and] raise serious doubts as to the validity of previously reported financial results, as well as adequacy of regulatory capital, management supervision and overall safety and soundness. . . ." In an agreement reached with Ofheo last week, Fannie promised to change the methods involved in both the cookie-jar and derivative accounting and to change its compensation "to avoid any inappropriate incentives."

But we don't think this goes nearly far enough for a company whose executives have for years derided anyone who raised a doubt about either its accounting or its growing risk profile. At a minimum these executives are not the sort anyone would want running the U.S. Treasury under John Kerry. With the Justice Department already starting a criminal probe, we find it hard to comprehend that the Fannie board still believes that investors can trust its management team.

Fannie Mae isn't an ordinary company and this isn't a run-of-the-mill accounting scandal. The U.S. government had no financial stake in the failure of Enron or WorldCom. But because of Fannie's implicit subsidy from the federal government, taxpayers are on the hook if its capital cushion is insufficient to absorb big losses. Private profit, public risk. That's quite a confidence game -- and it's time to call it.

**********************************

:"Sometimes the Wrong 'Notion': Lender Fannie Mae Used A Too-Simple Standard For Its Complex Portfolio," by Michael MacKenzie, The Wall Street Journal, October 5, 2004, Page C3

Lender Fannie Mae Used A Too-Simple Standard For Its Complex Portfolio

What exactly did Fannie Mae do wrong?

Much has been made of the accounting improprieties alleged by Fannie's regulator, the Office of Federal Housing Enterprise Oversight.

Some investors may even be aware the matter centers on the mortgage giant's $1 trillion "notional" portfolio of derivatives -- notional being the Wall Street way of saying that that is how much those options and other derivatives are worth on paper.

But understanding exactly what is supposed to be wrong with Fannie's handling of these instruments takes some doing. Herewith, an effort to touch on what's what -- a notion of the problems with that notional amount, if you will.

Ofheo alleges that, in order to keep its earnings steady, Fannie used the wrong accounting standards for these derivatives, classifying them under complex (to put it mildly) requirements laid out by the Financial Accounting Standards Board's rule 133, or FAS 133.

For most companies using derivatives, FAS 133 has clear advantages, helping to smooth out reported income. However, accounting experts say FAS 133 works best for companies that follow relatively simple hedging programs, whereas Fannie Mae's huge cash needs and giant portfolio requires constant fine-tuning as market rates change.

A Fannie spokesman last week declined to comment on the issue of hedge accounting for derivatives, but Fannie Mae has maintained that it uses derivatives to manage its balance sheet of debt and mortgage assets and doesn't take outright speculative positions. It also uses swaps -- derivatives that generally are agreements to exchange fixed- and floating-rate payments -- to protect its mortgage assets against large swings in rates.

Under FAS 133, if a swap is being used to hedge risk against another item on the balance sheet, special hedge accounting is applied to any gains and losses that result from the use of the swap. Within the application of this accounting there are two separate classifications: fair-value hedges and cash-flow hedges.

Fannie's fair-value hedges generally aim to get fixed-rate payments by agreeing to pay a counterparty floating interest rates, the idea being to offset the risk of homeowners refinancing their mortgages for lower rates. Any gain or loss, along with that of the asset or liability being hedged, is supposed to go straight into earnings as income. In other words, if the swap loses money but is being applied against a mortgage that has risen in value, the gain and loss cancel each other out, which actually smoothes the company's income.

Cash-flow hedges, on the other hand, generally involve Fannie entering an agreement to pay fixed rates in order to get floating-rates. The profit or loss on these hedges don't immediately flow to earnings. Instead, they go into the balance sheet under a line called accumulated other comprehensive income, or AOCI, and are allocated into earnings over time, a process known as amortization.

Ofheo claims that instead of terminating swaps and amortizing gains and losses over the life of the original asset or liability that the swap was used to hedge, Fannie Mae had been entering swap transactions that offset each other and keeping both the swaps under the hedge classifications. That was a no-go, the regulator says.

"The major risk facing Fannie is that by tainting a certain portion of the portfolio with redesignations and improper documentation, it may well lose hedge accounting for the whole derivatives portfolio," said Gerald Lucas, a bond strategist at Banc of America Securities in New York.

The bottom line is that both the FASB and the IASB must someday soon take another look at how the real world hedges portfolios rather than individual securities. The problem is complex, but the problem has come to roost in Fannie Mae's $1 trillion in hedging contracts. How the SEC acts may well override the FASB. How the SEC acts may be a vindication or a damnation for Fannie Mae and Fannie's auditor KPMG who let Fannie violate the rules of IAS 133.

"The U.S. government has selected two major accounting firms to help it manage the $700 billion rescue program for the financial system," SmartPros, October 21, 2008 --- http://lyris.smartpros.com/t/1725105/7762913/5979/0/

"The Crisis over How to Audit in a Crisis: The PCAOB's standing advisory committee examines the task of recession-time auditing, including the likelihood that fraud will be a growing problem," by Alan Rappeport, CFO.com, October 22, 2008 --- http://www.cfo.com/article.cfm/12465140/c_12469997

The most serious problem in the U.S. audit model is that clients are becoming bigger and bigger due to under-enforcement of anti-trust laws. For example, the merger of Mobile and Exxon created an even larger single client. The merger of Bear Stearns and JP Morgan created a much larger client. The number of potential clients is shrinking while the size of the clients is exploding.

Bankers (Men in Black) bet with their bank's capital, not their own. If the bet goes right, they get a huge bonus; if it misfires, that's the shareholders' problem.
Sebastian Mallaby. Council on Foreign Relations, as quoted by Avital Louria Hahn, "Missing: How Poor Risk-Management Techniques Contributed to the Subprime Mess," CFO Magazine, March 2008, Page 53 --- http://www.cfo.com/article.cfm/10755469/c_10788146?f=magazine_featured
Jensen Comment
Now that the Government is going to bail out these speculators with taxpayer funds makes it all the worse. I received an email message claiming that if you had purchased $1,000 of AIG stock one year ago, you would have $42 left; with Lehman, you would have $6.60 left; with Fannie or Freddie, you would have less than $5 left. But if you had purchased $1,000 worth of beer one year ago, drank all of the beer, then turned in the cans for the aluminum recycling REFUND, you would have had $214. Based on the above, the best current investment advice is to drink heavily and recycle. It's called the 401-Keg. Why let others gamble your money away when you can piss it away on your own?

Not only have individual financial institutions become less vulnerable to shocks from underlying risk factors, but also the financial system as a whole has become more resilient.
Alan Greenspan in 2004 as quoted by Peter S. Goodman, Taking a Good Look at the Greenspan Legacy," The New York Times, October 8, 2008 --- http://www.nytimes.com/2008/10/09/business/economy/09greenspan.html?em