Accounting for Derivative Financial Instruments and Hedging Activities
Bob Jensen at Trinity University

Derivative Financial Instrument Frauds --- http://www.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds

FAS 133 and IAS 39 Glossary and Transcriptions of Experts Accounting for Derivative Instruments and Hedging Activities --- http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm

A Condensed Multimedia Overview With Video and Audio from Experts --- http://www.cs.trinity.edu/~rjensen/000overview/mp3/133summ.htm
 This file has video and audio clips of experts! 

A Longer and More Boring Introduction to FAS 133, FAS 138, and IAS 39 --- http://www.cs.trinity.edu/~rjensen/000overview/mp3/133intro.htm 
This file has audio clips of experts!

Video Tutorials on Accounting for Derivative Financial Instruments and Hedging Activities per FAS 133 in the U.S. and IAS 39 internationally --- http://www.cs.trinity.edu/~rjensen/video/acct5341/fas133/WindowsMedia/ 

Flow Chart for FAS 133 Accounting --- http://www.trinity.edu/rjensen/acct5341/speakers/133flow.htm
Flow Chart for IAS 39    Accounting --- http://www.trinity.edu/rjensen/acct5341/speakers/39flow.htm

Differences between FAS 133 and IAS 39 --- http://www.trinity.edu/rjensen/caseans/canada.htm

Intrinsic Value Versus Full Value Hedge Accounting --- http://www.trinity.edu/rjensen/caseans/IntrinsicValue.htm 

I'm sharing some old (well relatively old) accounting theory quiz and exam material that I added to a folder at http://www.cs.trinity.edu/~rjensen/Calgary/CD/

Derivative Financial Instruments Frauds ---
http://www.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds  

FAS 133 Trips Up Fannie Mae 

Hedging Paradox:  
In finance, there is no way to cover your Fannie without exposing your Fannie somewhere else.
Gypsy Rose Lee would've said her fan (hedge) can only cover one Fannie cheek at a time. 

Freddie Mac Paves the Way With Risk Stress Tests and Then Fails on Macro Hedge Accounting  

Yield Burning Frauds 

Introduction to FAS 138 (Amendments to FAS 133) and some key DIG issues at http://www.cs.trinity.edu/~rjensen/000overview/mp3/138intro.htm 

Canadian Workshop Topics --- http://www.trinity.edu/rjensen/caseans/000indexLinks.htm

Tutorials and Helpers --- http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#Tutorials 

Accounting for Executory Contracts Such as Purchase/Sale Commitments and Loan Commitments ---
http://www.trinity.edu/rjensen/TheoryOnFirmCommitments.htm  

”Testing and Accounting for Hedge Ineffectiveness Under FAS 133, by Angela L.J. Huang and  Robert E. Jensen, Derivatives Report, February 2003, pp. 1-10.  http://www.riahome.com/estore/detail.asp?ID=TDVN

I have a draft paper entitled "The Theory of Interest Rate Swap Overhedging" at http://www.trinity.edu/rjensen/315wp/315wp.htm 
This is a very rough start on developing this theory.  I would appreciate any feedback you can give on this paper.

This is a Good Summary of Various Forms of Business Risk  --- http://www.erisk.com/portal/Resources/resources_archive.asp 

  1. Enterprise Risk Management

  2. Credit Risk

  3. Market Risk

  4. Operational Risk

  5. Business Risk

  6. Other Types of Risk?

 

iGAAP (International GAAP) 2007 Financial Instruments: IAS 32, IAS 39 and IFRS 7 Explained (Third Edition)
Deloitte & Touche LLP (United Kingdom) has developed iGAAP 2007 Financial Instruments: IAS 32, IAS 39 and IFRS 7 Explained (Third Edition), which has been published by CCH. This publication is the authoritative guide for financial instruments accounting under IFRSs. The 2007 edition expands last year's edition with further interpretations, examples, discussions from the IASB and the IFRIC, updates on comparisons of IFRSs with US GAAP for financial instruments, as well as a new chapter on IFRS 7 Financial Instruments Disclosures including illustrative disclosures. iGAAP 2007 Financial Instruments: IAS 32, IAS 39 and IFRS 7 Explained (628 pages, March 2007) can be purchased through CCH Online or by phone at +44 (0) 870 777 2906 or by email: customer.services@cch.co.uk .
IAS Plus, March 24, 2007 --- http://www.iasplus.com/index.htm

Bob Jensen's threads on the differences between U.S. and International GAAP are at http://www.trinity.edu/rjensen//theory/00overview/theory01.htm#FASBvsIASB

Video Tutorials on Accounting for Derivative Financial Instruments and Hedging Activities per FAS 133 in the U.S. and IAS 39 internationally --- http://www.cs.trinity.edu/~rjensen/video/acct5341/fas133/WindowsMedia/ 

My SFAS 133 and IAS 39 Glossary and Transcriptions of Experts
http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm

Some Other Helpers for Accountants and Accounting Educators

Helpers for Accounting Educators --- http://www.trinity.edu/rjensen/default3.htm 

Accounting Theory --- http://www.trinity.edu/rjensen/theory.htm 

XBRL and XML --- http://www.trinity.edu/rjensen/XBRLandOLAP.htm 

Electronic Commerce --- http://www.trinity.edu/rjensen/ecommerce.htm 

"The Fallout from FAS 133: Should Congress Change Tax Law to Match New Accounting Standards?" by Ira Kawaller and John J. Ensminger: --- http://papers.ssrn.com/sol3/papers.cfm?abstract_id=256752

Suggested Citation
Kawaller, Ira G. and Ensminger, John J., "The Fallout from FAS 133: Should Congress Change Tax Law to Match New Accounting Standards?" . Regulation, Vol. 23, No. 4 Available at SSRN: http://ssrn.com/abstract=256752 or DOI: 10.2139/ssrn.256752

Abstract: Last June, the private Financial Accounting Standards Board implemented a new standard that requires companies that compile balance sheets to show changes in a derivative's value as an asset or loss, even if the derivative remains in an open position. This new standard radically conflicts with U.S. tax law, which largely leaves derivatives unreported on tax returns. Given this difference, lawmakers may now wonder if they should change tax law to require reporting of all derivates and other fair value financial assessments. Critics of such a change will argue that it radically departs from the current structure. But, despite this difficulty, the change would bring such advantages as simplifying tax law, unifying accounting practices, and - perhaps most importantly - closing a number of tax loopholes that creative accountants use to shelter clients' assets.

Where can you learn more about FAS 133?

February 15, 2006 message from XXXXX

Bob,

. . . .The purpose of my email is to solicit your opinion on the best resources I can leverage to answer various issues that arise and generally broaden my understanding of FAS 133. work in risk management but have difficulties with the accounting side of FAS 133.  [Other portions of message deleted]

Thanks for your time!

XXXXX

February 15, 2006 reply from Bob Jensen

Hi XXXXX,

I receive inquiries like this almost daily. Usually these questions come from accountants who do not have sufficient background in derivative instruments contracting and economic hedging and, as a result, have not been able to tackle FAS 133 and IAS 39. Sometimes the inquiries come from people like your self who have good background in finance and risk management but cannot comprehend the quirks of accounting that led to this monstrous set of incomprehensible rules for booking and/or disclosing derivative financial instruments.

When accountants do not understand derivatives and risk management, I tell them to work through one of the best textbooks I've ever seen (which has no accounting whatsoever inside):
Derivatives:  An Introduction by Robert A Strong, Edition 2
(Thomson South-Western, 2005, ISBN 0-324-27302-9)

When people like yourself who understand derivatives and risk management but cannot understand the quirks of accounting, I begin with an illustration of a basic quirk in accounting--- a quirk discussion that also introduces the concepts of "forecasted transaction" and "firm commitment" hedging under FAS 133 rules.

Unbooked Financial Risks
One of the first things we learned in Accounting 101 is that accountants traditionally do not book (and usually do not even disclose) purchase/sales contracts until legal title to the goods and services actually changes hands. Reasons are complicated, but the most fundamental reason is that defaulted purchase/sales contracts are usually settled in court or out of court for a small fraction of contracted amounts, i.e., settlements are usually based upon damages rather than contracted amounts in full. For example, when Dow Jones contracts with St. Regis Paper Company for paper purchases over the next 50 years of publishing The Wall Street Journal it would be absurd to try to book a soft estimate of the billions of the actual contracted dollars of this contract. Damage estimates are virtually impossible to estimate and change from month to month as more trees for paper harvesting are planted.

Hence the biggest problem finance and economics professors have with accounting professors is that purchase/sales contracts entail financial risks that accounting professors refuse to book. Furthermore these purchase/sales contract risks are commonly hedged. When the notional (quantity) and underlying (price or rate) are contracted, the purchase/sales contract is called a "firm commitment" under FAS 133. There is no cash flow risk in firm commitments, but they can be hedged for fair value (when future spot prices differ from contracted prices). When the notional (quantity) is contracted or otherwise reasonably certain and the underlying is not specified there is cash flow risk that can be hedged with a cash flow hedge defined in FAS 133. Also firm commitments and forecasted transactions can be hedged for foreign currency (FX) risk apart from U.S. dollar risks. Most accountants do not even understand that it is impossible to simultaneously hedge for fair value and cash flow.

FAS 133 as Source Material for Comedy Central TV
My purpose here is not to launch into a tutorial about purchase/sales contract hedge accounting rules under FAS 133. Rather my purpose is to illustrate the dilemma caused by traditional quirks in accounting. Where finance and accounting professors differ is on the basic concept of financial risk. Finance professors are confused when there are financial risks that can be hedged even though those risks are virtually ignored by accountants because legal title has not changed hands. Then along comes FAS 133 that declares the hedge contracts for unbooked hedged items must be booked and maintained at fair value even though the hedged items themselves are not booked until title passes. This begins to sound like great source material for Comedy Central TV --- perhaps the Cobert Report!

Where To Begin
Adding pain to misery is the fact that FAS 133 rules for fair value hedges differ greatly from rules for cash flow and FX hedges. Finance professors find the stated reasons in FAS 133 incomprehensible. Accounting professors don't bother to open FAS 133 and never get out of the starting gate in understanding derivatives, hedging, risk management, and FAS 133.

So where do you begin to understand the accounting quirks in FAS 133? My first piece of advice is to totally ignore accounting textbooks, including those that may claim to be derivatives accounting textbooks. These are worthless. Second ignore the finance and economics textbooks since authors of these books do not understand accounting quirks.

You mentioned Ira Kawaller. Ira is an economist who admits to having difficulties understanding accounting quirks. This is why he sometimes brings me into partner with him on teaching FAS 133 --- my role is to teach accounting quirks of FAS 133. I also give my own workshops on this topic --- http://www.trinity.edu/rjensen/resume.htm#Presentations

I also provide free online FAS 133 and IAS 39 tutorials and videos --- http://www.trinity.edu/rjensen/caseans/000index.htm

But the bottom line is that my audiences and my readers conclude that my biggest success in life is confusing them about accounting for derivatives. My defense is that it is very difficult to explain the huge gap between financial risk versus what accountants book. I get a lot of compliments for what I provide online, but the most common complaint is that my online materials are a nightmare to navigate

Where should you dig into to learn about the accounting quirks of FAS 133? The bottom line is that I don't know! You can pay thousands of dollars to attend one of our seminars, but these are so broad brushed that our audiences feel like they've just had a meal on hors'deovers.

The bottom line is that it is probably best to dig into the FASB's "Green Book" line for line as painful as that becomes for 873 pages of jargon ---
http://fasbpubs.stores.yahoo.net/dc133-3.html
 

Also request the FASB's supplemental documentation (119 pages to date) of error corrections in the Green Book.

Secondly, memorize the FAS 133 and IAS39 rules rather than try to find a rationale. For example, it is utterly frustrating trying to reason why hedge accounting for cash flow/FX hedges use OCI offsets that are verboten  fair value hedges (never OCI for FV hedges). You should just to do or die, not reason why.

I do suggest that you especially look at my Excel workbooks at http://www.cs.trinity.edu/~rjensen/Calgary/CD/FAS133AppendixB/

I also suggest that you look at my PowerPoint files at http://www.cs.trinity.edu/~rjensen/Calgary/CD/ 

There is much pressure outside and within the FASB and the IASB to simplify rules for accounting for derivative financial instruments. This is a bit like appeals to reduce felony statutes to a mere Ten Commandments on stone tablets. Simplification sounds great as a principle, but in my viewpoint oversimplification will be disastrous. The reason is that there are thousands of different kinds of risk management contracts, and it's impossible to derive ten commandments covering all the variations arising in the practice of risk management.

Some argue that fair value accounting (in place of historical cost accounting) is the answer, but I have my doubts about this oversimplification ---
http://www.trinity.edu/rjensen/FairValueDraft.htm
Also see
http://www.trinity.edu/rjensen//theory/00overview/theory01.htm#FairValue

For example, fair value accounting is no panacea to accounting for purchase/sales contracts.

Bob Jensen

The name of the game is derivatives!

Will your bonus for last year come anywhere close to $9 million?  
Global commercial banks are expected to award bumper bonuses in the next three months, following a pattern set by the US investment banks in December. Forex dealers anticipate year-on-year increases of up to 50% in their annual packages, on the back of a highly lucrative year in foreign exchange as major and emerging markets currencies went haywire. An unusually active fourth quarter in particular boosted many traders' profit and loss accounts as they wound down for year-end, sending up bonus expectations accordingly. Goldman Sachs, Merrill Lynch, Morgan Stanley and Lehman Brothers were among the banks that announced their bonus payouts in December. Peers at rival banks reported that forex dealers at Morgan Stanley saw average year-on-year rises of 20%, while the very top staff in foreign exchange and derivatives may have seen as much as $9 million each. "This type of figure is not inconceivable at the top three or four banks," said one head of foreign exchange at a US bank in New York.
RiskNews Weekly on January 9, 2004


An Illustration of FAS 133 Implementation and Hedging Complexities

The bookkeeping error in which Fannie Mae failed to book $1.1 billion in derivative financial statements was reported as a computer error when implementing a new FAS 149 set of amendments to FAS 133 at Fannie Mae.  The explanation is plausible, the importance of this error were probably overblown by the media.  

However, Fannie May's otherwise impeccable attempts to implement FAS 133 and its amendments illustrate what a complicated complicated mess we are in today when implementing FAS 133 issued by the Financial Accounting Standards Board (FASB).  The same can be said about its IAS 39 counterpart issued by the International Accounting Standards Board (IASB).  These two standards and their various amendments are widely criticized and have tended to create more confusion than help among investors, analysts, accountants, banks, and other corporations.

A large part of the confusion that exists centers around the public perception of hedging.  Hedging suggests elimination of risks that are hedged.  In fact, however, hedging is merely a transfer from one type of risk to another type of risk.  Before getting into this, however, let's review the Fannie Mae example of a really solid effort to implement FAS 133 and its amendments.

What is Fannie Mae? --- Federal National Mortgage Association --- http://www.primecoastmortgage.com/Fannie_Mae.htm 

The role of Fannie Mae and the secondary mortgage market in housing finance
Fannie Mae plays a vital role in financing mortgages and increasing homeownership opportunities for more Americans. A privatization success story, Fannie Mae began in 1938 as an agency of the federal government, created to bring stability to the U.S. housing market. In 1968, Fannie Mae became a privately-owned and - managed corporation. At that time, the U.S. Congress rechartered Fannie Mae as a private company, mandating that it operate with private capital on a self-sustaining basis to enhance the flow of funds through the secondary market to American home buyers.

Fannie Mae operates exclusively in the secondary mortgage market - providing support to mortgage lending institutions in the primary market. Lenders who originate loans in the primary mortgage market may either hold the loans in their portfolios or sell them in the secondary mortgage market. By selling their loans in the secondary market, lenders are able to obtain additional funds with which to make more loans to home buyers.

The secondary mortgage market helps accomplish the following important housing objectives:

Fannie Mae's impact on housing needs
Fannie Mae is the nation's largest investor in home mortgages today. The corporation has provided home financing for over 32 million American families since its creation in 1938. Fannie Mae currently owns in its portfolio, or holds in trust for investors, one out of every five mortgages in the United States.

In 1994, Fannie Mae announced its Trillion Dollar Commitment to provide $1 trillion by the year 2000 to finance homes for over 10 million families most in need. This targeted housing finance initiative is serving families with incomes below the median for their area, minorities and new immigrants, families who live in central cities and distressed communities, and people with special housing needs.

Through its Trillion Dollar Commitment, Fannie Mae provides renters in America the information they need to buy homes, develops specialized products and services to break down arbitrary barriers to getting home mortgages, and focuses on eliminating lending discrimination in the housing finance industry.

Fannie Mae's homepage is at http://www.fanniemae.com/index.jhtml 

Fannie Mae FAQs --- http://www.fanniemae.com/faq/index.jhtml?p=FAQ 

It just gets deeper and deeper for KPMG

Fannie Mae Sues KPMG
The mortgage lending company Fannie Mae filed suit on Tuesday against its former auditor KPMG, accusing the firm of negligence and breach of contract for its part in the flawed accounting that led to a $6.3 billion restatement of earnings. Fannie Mae states in its complaint that KPMG applied more than 30 flawed principles and cost it more than $2 billion in damages. Fannie Mae fired the accounting firm in mid-December 2004, just a week after the Securities and Exchange Commission ordered the company to restate more than two years of flawed earnings. A KPMG spokesman, Tom Fitzgerald, said the company planned to “pursue our own claims against Fannie Mae.”
"Fannie Mae Sues KPMG," The New York Times, December 13, 2006 --- http://www.nytimes.com/2006/12/13/business/13kpmg.html?_r=1&oref=slogin

Bob Jensen's threads on KPMG are at --- http://www.trinity.edu/rjensen/Fraud001.htm#KPMG

"Fannie Mae Faces Work After Restatement," by Marcy Gordon, SmartPros, December 8, 2006 --- http://accounting.smartpros.com/x55766.xml

Mortgage giant Fannie Mae has taken a significant stride in its march out of an accounting scandal by completing a restatement of past earnings but still faces tough work to make its financial reporting current.

The restatement for 2001 through June 30, 2004, made public on Wednesday, wiped out $6.3 billion in profit for the government-sponsored company, which finances one of every five home loans in the United States. But it was well below Fannie Mae's earlier estimate of $10.8 billion. Ordered by the government two years ago, the massive reworking of its accounting has cost the company some $1 billion this year to carry out.

Shares of Fannie Mae rose $1.64, or almost 3 percent, to $60.14 in early trading Thursday on the New York Stock Exchange. It has traded in a range of $46.17 to $62.37 over the last 52 weeks, compared with its peak of around $80 in early 2004.

It was the first earnings statement filed by Fannie Mae since late 2004. The scandal erupted in the fall of that year when federal regulators accused Washington-based Fannie Mae - with its long-standing prestige, vaunted political clout and reputation for financial excellence - of serious accounting problems and earnings manipulation to meet Wall Street targets.

Fannie Mae also announced Wednesday an increase in its quarterly dividend to 40 cents from 26 cents, where it had been since being slashed in half in January 2005.

"We believe that returning higher levels of capital back to shareholders is a top priority at Fannie Mae, and this marks an important first step," Moshe Orenbuch, an analyst at Credit Suisse, said in a research note issued Thursday.

The company hasn't said when it will get caught up and report its results for 2005 and 2006; it could take a year or two.

The restatement "is a key step forward for the company and represents two years of hard work," James B. Lockhart, director of the Office of Federal Housing Enterprise Oversight, said in a statement Wednesday. "Much remains to be done. ... Fannie Mae faces enormous challenges in fixing its operational and risk management systems, in (financial controls) compliance, and in producing audited financial statements for 2005 and 2006."

Jim Vogel, an analyst with FTN Financial Capital Markets, said in a research note that for Wall Street, the concern is "if there's a pattern of sustained quarterly losses that appear to reflect more difficulties in risk management than the market had thought."

OFHEO is the federal agency that regulates Fannie Mae and Freddie Mac, its smaller sibling in the $8 trillion home-mortgage market. Last May, it issued a blistering report alleging a six-year accounting fraud at Fannie Mae, the second-largest U.S. financial institution after Citigroup Inc. Regulators said the scheme included manipulations to reach quarterly earnings targets so that company executives could pocket hundreds of millions in bonuses from 1998 to 2004.

Lockhart also said Wednesday the agency plans to file a lawsuit before year's end to recover tainted bonus money from former Fannie Mae officials, including ex-chief executive Franklin Raines and chief financial officer Timothy Howard. Raines, a prominent Washington figure who was White House budget director in the Clinton administration, was swept out of office in December 2004 along with Howard. A number of senior executives and board directors have left the company.

Fannie Mae paid a record $400 million civil fine in a settlement with OFHEO and the Securities and Exchange Commission. It also agreed to limit the growth of its multibillion-dollar mortgage holdings, capping them at $727 billion, and to make top-to-bottom changes in its corporate culture, accounting procedures and ways of managing risk.

The company also disclosed Wednesday that its chief executive, Daniel Mudd, received a pay package of $13.1 million, including a $2.6 million bonus, for 2005. Mudd, who was the top operations official at the time of the accounting misdeeds, was elevated to the CEO in a management shakeup in December 2004.

In detailing its restatement, Fannie Mae cited a $7 billion net decrease from previously reported earnings for periods prior to 2002, a $705 million reduction for 2002, a $176 million increase for 2003 and a $1.2 billion increase for the first six months of 2004.

Over the last two years, Fannie Mae has disclosed a passel of new accounting problems that had been uncovered in several areas, including its core business of issuing securities backed by the billions of dollars of home mortgages annually that it buys from lenders and bundles together for resale to investors worldwide. Other problems were revealed in loans, houses acquired through foreclosures, interest on delinquent home loans and reverse mortgages.

They all were in addition to the accounting-rule violations that came to light in September 2004 involving derivatives, the financial instruments that Fannie Mae and Freddie Mac use to hedge against swings in interest rates.

Fannie Mae escaped criminal prosecution over the accounting failure. The Justice Department had pursued a criminal investigation, but federal prosecutors said in August that they had shut down their probe without bringing any action. The SEC still could bring civil actions against individual executives, including people no longer at Fannie Mae, with the burden of proof less stringent than in criminal prosecutions. Several shareholder lawsuits have been filed against the company and current and former executives.

Fannie Mae and Freddie Mac were created by Congress to pump money into the home-mortgage market to keep interest rates low and make home ownership affordable for low- and moderate-income people.

Freddie Mac, which also is government-sponsored and has its stock publicly traded, had its own accounting scandal that came to light in June 2003. The company misstated earnings by some $5 billion - mostly underreported - for 2000-2002 to smooth out volatility in profit and uphold its image on Wall Street as a steady performer.

Statement from the CEO of Fannie Mae Regarding FAS 133 Reporting Prior to the October 29, 2003  Adverse News Report --- http://www.fanniemae.com/ceoanswers/derivativesaccounting.jhtml 

Why do you have confidence that you have done your derivative accounting properly?

First, Fannie Mae filed fully audited financial statements with the SEC when we filed our Form 10 and Form 10-K on March 31, 2003. And as part of the registration process, the SEC reviewed our financial disclosures and critical accounting policies. As CEO of an SEC-registered company, I personally certified that our financial statements are accurate, as did our Chief Financial Officer, Tim Howard. Further, on May 14, 2003, Fannie Mae filed its Form 10-Q and will file all required SEC reports going forward.

More specifically, years before the FAS 133 accounting practices pertaining to derivatives were adopted, we worked closely with the Financial Accounting Standards Board (FASB) to make sure we understood how the new requirements would apply to our business. We then made substantial investments in additional accounting staff and new systems to track our derivatives transactions, given the unique challenges of these transactions. For example, we need to match up each derivative transaction -- one by one -- with the liability that we use the derivative to hedge.

Let me walk through how we account for our derivatives:


It is because of our disciplined approach to accounting that we have experienced such large swings in our GAAP income over the past two years. In our use of derivatives, we look to execute the most efficient hedge for the business -- we don't approach our hedging with a specific accounting result in mind. We fully disclose the accounting implications of our decisions, and each quarter we report to investors both our core business earnings and our GAAP earnings, and reconcile the two.

To date, of the 14 housing GSEs (including the 12 Federal Home Loan Banks), Fannie Mae is the only one to have filed its fully audited -- and management certified -- financial statements with the SEC. The fully independent Audit Committee of our Board of Directors oversees our internal auditor, outside auditor, and our financial reporting. That gives us additional confidence in our financial statements, and should give investors confidence too.

Fannie Mae provides a comparison of our GAAP results to our non-GAAP financial measures.

In May of 2003, the Financial Accounting Standards Board (FASB) issued Statement No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities. The Statement amends and clarifies accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under Statement 133 --- http://www.fasb.org/news/nr043003.shtml 

Norwalk, CT, April 30, 2003—Today the Financial Accounting Standards Board (FASB) issued Statement No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities. The Statement amends and clarifies accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under Statement 133.

The new guidance amends Statement 133 for decisions made:

The amendments set forth in Statement 149 improve financial reporting by requiring that contracts with comparable characteristics be accounted for similarly. In particular, this Statement clarifies under what circumstances a contract with an initial net investment meets the characteristic of a derivative as discussed in Statement 133. In addition, it clarifies when a derivative contains a financing component that warrants special reporting in the statement of cash flows. Statement 149 amends certain other existing pronouncements. Those changes will result in more consistent reporting of contracts that are derivatives in their entirety or that contain embedded derivatives that warrant separate accounting.

October 1, 2003 Accounting Tutorial Provided to the Public by Fannie Mae --- http://www.fanniemae.com/ir/accountingtutorial.jhtml 

This virtual presentation is copyrighted material of Fannie Mae. No recording, broadcast, or other distribution of this virtual presentation, or any part of the virtual presentation, is permitted without Fannie Mae's permission. Your participation in this virtual presentation implies your consent.

October 29, 2003 Error Announcement:  FAS 133/149 Trips Up Fannie Mae

Statement by Jayne Shontell Fannie Mae Senior Vice President, Investor Relations October 30, 2003 --- http://www.fanniemae.com/ir/issues/financial/103003.jhtml 

As you know, yesterday Fannie Mae filed a Form 8-K/A with the SEC amending our third quarter press release to correct computational errors in that release. There were honest mistakes made in a spreadsheet used in the implementation of a new accounting standard.

As we also reported, we discovered the errors in the course of the standard review in preparation of the company's financial statements to be included in Form 10-Q for the third quarter, and were primarily made in conjunction with the implementation of FAS 149.

The bottom line is that the correction has no impact on our income statement, but resulted in increases to unrealized gains on securities, accumulated other comprehensive income, and total shareholder equity (of $1.279 billion, $1.136 billion, and $1.136 billion, respectively).

I would like to explain what happened yesterday regarding the release of the information.

We were preparing to file the Form 8-K/A as required, and to ensure the maximum disclosure, we also were preparing to issue a press release with a statement announcing the filing. We contacted the business service we use to distribute press releases to inform the service what we planned to do once the documents were finalized. Before we even sent the business service the documents to be disclosed, the service -- on its own and without our prior knowledge or authorization -- put forth a statement, attributed to Fannie Mae, "killing" our previously issued October 16 press release. Shortly thereafter, our stock began to trade down. We proceeded to file the 8-K/A and issued our statement as soon as we could.

Let me reiterate that the correction had to do with a computational error in performing complicated calculations required in the implementation of FAS 149.

FAS 149 was issued in April. It required Fannie Mae to mark to market the majority of mortgage commitments we had made, which were previously not part of our financial statements. The new requirement was effective July 1. In adopting a new accounting standard in a short period of time, Fannie Mae had to put in place a system and process to capture all open commitments and mark them to market. To implement this standard, Fannie Mae utilized information from its internal, automated systems in conjunction with spreadsheets that made additional calculations necessary under the new rule. Fannie Mae is already in the process of updating its automated systems to account for the mortgage commitments under FAS 149.

Our accounting team discovered the errors in the normal course of preparing our financial statements for inclusion in our 10-Q. They immediately notified management and our independent auditor, KPMG. Management in turn notified the Audit Committee of the Fannie Mae Board of Directors and our regulator.

We continue to be proud of our accounting processes and controls. Far from being a failure of our accounting system, this event demonstrates that our accounting processes and controls work as they should. While we would have obviously preferred the error did not occur in the October 16 press release, we are pleased that the error was corrected before we file our financial statements in our 10-Q.

October 31, 2003 Quotation from The Wall Street Journal

Fannie Mae had previously argued that it had a far better lock on its accounting than Freddie Mac, hoping to cast itself as a more responsible and sophisticated operation that didn't need much more scrutiny. Fannie Mae went so far as to hold an accounting "tutorial" earlier this month to explain derivatives accounting to investors, analysts and reporters. Yet it was in derivatives accounting that its stumble came.
Patrick Bartta and John D Mckinnon (See below)

Note from Bob Jensen
You can read Fannie Mae's Derivatives Accounting Tutorial at http://www.fanniemae.com/ir/pdf/tutorial10012003.pdf 

"Fannie Mae Made $1.1 Billion Error In Its Accounting:  Understatement of Equity Renews Calls For Oversight of Two Mortgage Giants," by Patrick Bartta and John D. McKinnon, The Wall Street Journal, October 31, 2003 --- http://online.wsj.com/article/0,,SB10674573311089700-search,00.html?collection=wsjie%2F30day&vql_string=Freddie%3Cin%3E%28article%2Dbody%29 

Fannie Mae, the mortgage-financing giant already facing a crescendo of criticism about its financial oversight, said it miscalculated the value of its mortgage commitments, forcing it to make a $1.1 billion restatement of its stockholder equity.

The government-chartered company, which bills itself as the world's largest nonbank financial institution, released a revised third-quarter financial statement Wednesday correcting what it called "computational errors" that appeared when the results were first reported earlier this month. The restated figures were higher and didn't alter the company's profit, which was $2.67 billion in the third quarter, up 168% from a year earlier.

But the episode instantly reinforced fears that Fannie Mae and its smaller sibling Freddie Mac lack the necessary skills to operate their massive and complex businesses, which some investors, rivals and political critics worry could pose risk to the nation's financial system if not properly managed. Though the companies are not formally backed by a government guarantee, investors generally assume the government would step in to bail the companies out in an emergency, given their critical importance to the housing and broader financial markets.

Spreads between most Fannie Mae debt issues and comparable Treasury securities widened Wednesday. Investors pummeled the stock after the news was announced, though the stock recovered some ground by the end of the day. In 4 p.m. New York Stock exchange composite trading, Fannie Mae's shares were down 2.4% at $73.10.

Lawmakers and Treasury officials were already debating whether to tighten oversight of Fannie and Freddie after Freddie Mac disclosed its own accounting problems earlier this year. Freddie Mac's problems, which involved understating income by at least $4.5 billion, led to a major management shake-up, including the ouster of two chief executive officers. Freddie Mac used financial transactions to shift excess earnings into the future and mask the company's volatility.

Both companies "have a credibility problem, and this only makes it worse," said James Bianco, president of Bianco Research LLC, a Chicago-based investment-research firm who has been critical of the two companies. He said it highlights how too few people have a firm grasp on Fannie Mae's arcane accounting and overall financial position, even as Wall Street analysts continue to tout the company's stock. "Investors look at this stuff, throw their arms up in the air [and say], 'We don't understand this stuff, you don't understand this stuff, and the companies don't understand this stuff, but it doesn't matter, because the government is going to back it anyway.' "

Fannie Mae had previously argued that it had a far better lock on its accounting than Freddie Mac, hoping to cast itself as a more responsible and sophisticated operation that didn't need much more scrutiny. Fannie Mae went so far as to hold an accounting "tutorial" earlier this month to explain derivatives accounting to investors, analysts and reporters. Yet it was in derivatives accounting that its stumble came.

Continued in the article.

Question
How can failure to book derivatives fair value of $1.1 billion not have any impact on earnings?  If this is the case, what's the big sweat over failure to book the derivatives?

Answer (I include the FAS 149 amendments of FAS 133 as being part and parcel to FAS 133 itself.)
If the unbooked $1.1  fair value of the derivatives had instead been properly booked according to FAS133/IAS39 rules, the balance sheet assets and liabilities would change by $1.1 billion.  If these derivatives had been speculations or did not otherwise qualify for special hedge accounting treatment under FAS133/IAS39 rules, they would have impacted earnings by $1.1 billion.  But these derivatives were apparently hedges, and Fannie Mae tries to imply that its accounting error is no big sweat.  The CEO of Fannie Mae asserts that derivatives are used primarily for two purposes:

... we use derivatives primarily for two purposes: as substitutes for notes and bonds we issue in the debt markets and to hedge against fluctuations in interest rates on planned debt issuances.
Statement from the CEO of Fannie Mae Regarding FAS 133 Reporting Prior to the October 29, 2003  Adverse News Report --- http://www.fanniemae.com/ceoanswers/derivativesaccounting.jhtml 

First I might note that when derivatives are used as substitutes for debt issuances, their changes in value would affect current earnings to the extent that they are not used for hedging purposes under FAS 133 rules.  However, I seriously doubt that Fannie Mae is allowed to speculate using derivatives?  As "hedges against fluctuations in interest rates" their changes in value would not affect current earnings to the extent that the hedges are effective.  The reason is that FAS 133 provides complex ways to avoid earnings impacts of changes in value of hedging derivatives.  This is complex in the sense how it is done varies with cash flow hedges versus fair value hedges of booked hedge items versus fair value hedges of unbooked hedge items such as "planned debt issuances."  In the case of forecasted transactions like "planned debt issuances," the hedges are most likely cash flow hedges of interest rate risk in forecasted transactions much like Example 5 in Appendix B of FAS 133.  See my video of Example 5:  

Video Tutorial:  Accounting for Interest Rate Swap Hedges and Valuation of Swaps --- 
030FAS133InterestRateSwapAccounting.wmv --- http://www.cs.trinity.edu/~rjensen/video/acct5341/fas133/WindowsMedia/  
Choose file 030FAS133InterestRateSwap.wmv

 

So where's the big sweat in FAS 133 and IAS reporting rules as they stand today?

The big sweat is that there are two types of hedges other than foreign currency hedges.  One type is a cash flow hedge and the other type is a fair value hedge.  What people often fail to realize is that you can't be hedged both ways.  If a company has cash flow risk and hedges that risk, it creates fair value risk.  If a company has fair value risk and hedges that risk, it creates cash flow risk.  If Fannie Mae hedged interest rate cash flow risk, then it created fair value risk on the combined fair value of its hedged items and hedging instruments.  If it hedged fair value, it created cash flow risk.

If Fannie Mae's erroneously unbooked derivatives qualified for special hedge accounting under FAS133/IAS39 rules, then the offset to changes in booked fair value would bypass earnings.   The ineffective portion of the hedge does impact current earnings.  However, since Fannie Mae primarily hedges interest rate movements (probably with interest rate swaps), the hedges most likely qualified for "The Shortcut Method" under FAS 133 (see Paragraph 132) and would be deemed to be perfectly effective at the beginning of the hedge.  

Hence Fannie Mae most likely is correct in contending that its failure to book the $1.1 billion in derivatives under FAS 133 would not have impacted earnings provided both the hedges and the hedged items were carried to maturity.  The risk in not booking the derivatives (in terms of earnings) lies in the likely case that the hedged items and the hedges might not be carried to maturity.  Failure to book the $1.1 billion hides the enormous risk of a hit on earnings if customers pay off loans early (as is likely the case if interest rates drop) or that Fannie Mae sells the loans before maturity (as is common with Fannie Mae).  

From The Wall Street Journal Accounting Educators' Reviews on November 7, 2003

TITLE: Fannie Mae Makes $1.1 Billion Error in Its Accounting 
REPORTER: Patrick Barta and John D. McKinnon 
DATE: Oct 30, 2003 
PAGE: A1 
LINK: http://online.wsj.com/article/0,,SB10674573311089700,00.html  
TOPICS: Advanced Financial Accounting, Audit Report, Auditing, Derivatives, Fair Value Accounting, Hedging

SUMMARY: Fannie Mae made an error in applying the new FAS149 requirements to mark loan commitments to market, in accordance with derivative accounting under FAS 133, that was required to be implemented in 3rd quarter reporting. Fannie Mae argues that this was not a systemic problem, but merely resulted from human error in manual systems that are being used temporarily in order to implement the new requirement quickly.

QUESTIONS: 
1.) The first paragraph describes the changes from revising their third quarter financial statements as a "restatement of stockholder equity"and the second paragraph indicates that "the restated figures...didn't alter the company's profit..." How is it possible to change total stockholders' equity and not affect net income? What measure of reported performance do you think was affected by this change? Support your answer and include definitions of appropriate terms in doing so.

2.) Cite statements from the article which characterize the reaction to Fannie Mae's announcement of the accounting error. Why has the reaction been so negative even though the impact of the accounting error on stockholders' equity was positive?

3.) At the end of the article, the author indicates that the problem giving rise to this restatement was "tied in part to an obscure accounting provision, known as Financial Accounting Standard No. 149." What is the subject of that standard? Do you think it is "obscure"? What do you think makes the popular business press use this description?

4.) The author describes the loan commitments that are the subject of this accounting error near the end of the article. What provision in FAS 49 requires that these commitments be marked to market value "and hence record any unrealized changes in value of those commitments despite whatever price the company agrees to pay for the loans"? What type of accounting treatment for such commitments could result in an impact on stockholders' equity, but not net income, as is the case at hand?

5.) The impact on stockholders' equity was positive--an unrealized gain on the value of the loan commitments undertaken by Fannie Mae. What does that say about the terms of these loan commitment contracts?

6.) Suppose you are an auditor and Fannie Mae is your client. What impact does this problem have on your plans for the year-end audit? Do you have any responsibility associated with the problematic third quarter report, even if that report was labeled "unaudited"?

Reviewed By: Judy Beckman, University of Rhode Island 
Reviewed By: Benson Wier, Virginia Commonwealth University 
Reviewed By: Kimberly Dunn, Florida Atlantic University

--- RELATED ARTICLES --- 
TITLE: Review & Outlook: Fannie's Black Box 
REPORTER: WSJ Editors 
PAGE: A12 
ISSUE: Oct 31, 2003 
LINK: http://online.wsj.com/article/0,,SB106755988050523700,00.html 

"Representative Stearn Calls for GAAP Overhaul," AccountingWeb, February 3, 2004 --- http://www.accountingweb.com/cgi-bin/item.cgi?id=98662 

 

In the course of holding hearings into the accounting issues at Freddie Mac, Rep. Cliff Stearns (R-FL) said there are fundamental flaws in generally accepted accounting principles (GAAP) that need to be addressed to prevent future abuses.

"Specifically, GAAP should not allow companies to change the characterization of an asset and thereby change its accounting," said Stearns. "I applaud the Federal Accounting Standards Board (FASB) for its efforts to change and reform the system over the last two years. Nevertheless, I intend to offer legislation in the next few weeks concerning FASB that will reform accounting standards."

As part of the hearings, Stearns asked Armando Falcon, director of the Office of Federal Housing Enterprise Oversight (OFHEO), which oversees Freddie Mac and the larger Frannie Mae, to look into whether compensation of the two agency’s 20 top officials contributed to accounting problems.

"Through our past hearings we learned that Freddie Mac disregarded accounting rules, internal controls, and disclosure standards to maintain a reputation for steady earnings," stated Stearns, chairman of the Commerce, Trade & Consumer Protection Subcommittee. "I appreciate hearing from Freddie Mac about the new controls it is instituting to guard against improper accounting. Given that Freddie Mac hid billions of dollars in income in a way that complied with GAAP (Generally Accepted Accounting Principles), this Subcommittee has a responsibility to look at improving these accounting standards."

Stearns pointed to an anomaly that allows Freddie Mac and some other financial companies to engage in earnings arbitrage: "So Called 'mixed-attribute accounting' allows companies to decide whether financial assets are carried at current market price or at historic cost." Freddie Mac shifted assets between categories to manipulate earnings, without any change in the underlying economics of its performance. Said Stearns, "Taxpayers do not have the option of changing the characterization of assets to change the tax treatment; I think GAAP should not allow this either."

Martin Bauman, chief financial officer, Freddie Mac, testified, "While the restatement represented an important milestone, now that it has been completed, Freddie Mac is focused on bringing our financials up-to-date." In reacting to Stearns' concerns over the adequacy of current standards, Bauman stated, "Freddie Mac recognizes the importance of transparent accounting and reporting standards and we are committed to providing investors with the information they need to understand how we view and manage our business. We fully support the Subcommittee's efforts to move toward a principles-based accounting framework."

 

Hedging Paradox:  
In finance, there is no way to cover your Fannie without exposing your Fannie somewhere else.
Gypsy Rose Lee would've said her fan (hedge) can only cover one Fannie cheek at a time. 
Gypsy Rose Lee ( http://www.hollywoodlegends.com/gypsy-rose-lee.html ) decades ago was popular exotic dancer with high modesty tastes relative to today's riskier exposures.

The Word "Hedge" is the Most Misleading Term in Finance! FAS 133 and IAS 39 may be misleading the public into thinking that firm-wide risk is being accounted for when risk is merely being shifted about with hedging!

The FASB originally wanted (and still wants if the banking lobby will ever back off) FAS 133 to be simplified by requiring all changes in the value of booked derivatives to be charged directly to current earnings.  This is a simplistic solution that would have made Fannie Mae's error impact earnings by $1.1 billion.   The objection of the banking industry and other corporations to such current value accounting  is that current value accounting that takes changes in value directly into current earnings creates enormous volatility in reported earnings.  Earnings fluctuations, in turn, supposedly paint a picture of risk in stable companies that have in fact hedged risks.  The FASB compromised with bankers and other corporations in FAS 133 by requiring that all derivative financial instruments be booked at current value (including derivatives that were never before booked under previous rules) but allowing changes in current value be accounted for in a complicated way that does not affect current earnings when the derivatives qualify for special hedge accounting treatment under FAS 133.

An Illustration 

But the new FAS 133 rules (and the international IAS 39 counterparts) can be highly misleading in terms of risks that hedging itself causes.  By way of illustration, suppose XYZ company borrows $1 billion at variable interest rates to finance $1 billion in fixed-rate mortgage investments.  If the company wants to hedge all cash flows, it can enter into interest rate swaps to freeze the annual  interest expense cash flows on the $1 billion in debt.  Now the company and its investors sleep easy at night knowing that XYZ has locked in a net (interest revenue minus interest expense) fixed cash flow of say $50 million per year provided none of the investments or liabilities are settled prematurely.  Investors are supposed to breathe easier knowing that  XYZ has covered its backside with perfectly effective hedges.  But consider the risks that are not and cannot be hedged:

The bottom line here is that new FAS 133 and IAS 39 standards eliminated some very bad practices of companies, particularly banks, using derivative financial instruments for off-balance sheet accounting that hid enormous risks from the public even when derivative hedging instruments were used as hedging instruments.  However, these new and highly complicated standards do not go far enough in disclosing risk.  

An often overlooked issue in this entire debate is the problem of  disclosure rules that accompany the numbers.  Disclosures that accompany the FAS133/IAS39 numbers in financial reporting do not stress that hedging only changes the type of risk but never eliminates risk.  I propose that every company be required to make disclosures in a prescribed disclosure language that  more or less reads as follows for a company like Fannie Mae that lent money on mortgage notes held as assets and borrowed money to finance these investments:

In managing its assets and liabilities, XYZ must choose when to hedge cash flow risk and when to hedge fair value risk.   XYZ hedges both its investments and its debt in terms of forecasted trends in interest rates.  Investors should be aware, however, that hedging one type of risk exposes the company to the other type of risk and higher order portfolio levels of risk.  Even though reported earnings are not impacted by qualified hedges under FAS 133, there are risk exposures that remain and might affect future earnings.  Hedges of cash flow risk expose XYZ to current value risk of assets and liabilities.  Hedges of current value risk expose XYZ to cash flow risks from assets and liabilities.  Hedging entire portfolios may increase higher-order risks in terms of other portfolios.  It is prudent to nearly always hedge risks, but hedging does not imply elimination of higher order risk and risks other than those being explicitly hedges.  This is inherent in XYZ's line of business where risk management is a complicated process in which hedging changes risk exposures but never eliminates all risks.

Hence, Fannie Mae may have hedged in such a way that if it had correctly followed FAS 133/FAS149 rules there would have been no impact on Fannie Mae's reported earnings.  But the public should not be swayed to believe that Fannie Mae eliminates risks by hedging.  Fannie Mae merely substitutes one risk for another risk as some firms substitute cash flow risk with current value risk or vice versa.  

It should be noted in passing that both the FASB and the IASB are moving ever closer to requiring current value accounting for all financial instruments, such that many of the complications of FAS 133 and IAS 39 accounting will go away.  For example, the very complicated requirements for fair value hedge accounting virtually disappear.  What is important to note, however, is that current value accounting can still mask the problem of higher orders of risk.  Suppose that in the above XYZ example, the variable rate debt is not hedged for cash flows, i.e., there is increased cash flow risk but no fair value risk.  Further suppose that $1 billion in fixed-rate debt is hedged for fair value, thereby, having the hedged assets and the debt all frozen in terms of current value.  The assets and the debt thereby have no current value risk due to interest rate fluctuations.   This might be great if XYZ is going to be liquidated in the short term.  However, at the higher level of risk exposure of all assets and debt combined, the "hedged" XYZ firm is really exposed to cash flow and earnings risk.  Current value accounting, therefore, may be more misleading than helpful in disclosing "risk."

"FASB Proposes Improved Derivatives, Hedging Disclosures," SmartPros, December 11, 2006 --- http://accounting.smartpros.com/x55778.xml

The Financial Accounting Standards Board issued a proposal that would provide investors and others with better information about the effects of derivative and hedging activities on a company's financial statements.

The proposed statement specifically addresses constituents' concerns that existing disclosure requirements associated with FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities, do not provide adequate information to financial statement users.

"The proposed disclosure requirements are intended to enhance understanding of how and why entities use derivatives, how they are accounted for in an entity's financial statements, and how they affect an entity's financial position, results of operations, and cash flows," said Kevin Stoklosa, FASB Project Manager.

The exposure draft would enhance the current disclosure framework by requiring that objectives and strategies for using derivative instruments be discussed in terms of underlying risk and accounting designation. The exposure draft would require tabular disclosure of notional and fair value amounts of derivatives instruments and the gains and losses on derivatives instruments and related hedged items. Additionally, the proposed statement would require disclosure of information about counterparty credit risk and the existence and nature of contingent features in derivative instruments.

The requirements of the proposed Statement would be effective for financial statements issued for fiscal years and interim periods ending after Dec. 15, 2007, with early application encouraged. The proposed statement would encourage but would not require disclosures for earlier periods at initial adoption. In years after initial adoption, the proposed statement would require disclosures for earlier periods.

The board is seeking written comments on the proposal by March 2, 2007.

For a short time you can download the proposed FAS 133 amendment from http://www.fasb.org/draft/ed_derivatives_disclosure.pdf

A slide show on FAS 133 and IAS 39 disclosure rules is available at http://www.cs.trinity.edu/~rjensen/Calgary/CD/JensenPowerPoint/

Summary of Statement No. 161---
http://www.fasb.org/st/index.shtml#fas161

Also see http://www.cs.trinity.edu/~rjensen/Calgary/CD/fasb/sfas161/

Disclosures about Derivative Instruments and Hedging Activities—an amendment of FASB Statement No. 133

Bob Jensen's FAS 133 and IAS 39 Glossary is at http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm 

Bob Jensen's PowerPoint Show on Derivative Financial Instrument Disclosure Requirements  --- http://www.cs.trinity.edu/~rjensen/Calgary/CD/JensenPowerPoint/

But for Freddie Mac, the other pillar of the colossal U.S. mortgage market, Freddie Mac's restatement has only caused headaches and has even raised new questions about the quality of financial reporting.
Patrick Barta, "Restatement by Freddie Mac Puts Fannie on the Spot," The Wall Street Journal, January 12, 2004, Page C1.

The problem is the companies' (Freddie Mac versus Fannie Mae) business and financial statements have become so complex that they are effectively "unanalyzable" says James Bianco, president of Bianco Research, a Chicago-based fixed-income research firm that has been critical of Fannie and Freddie in the past.  He says the same is becoming true of other large financial institutions, particularly those that, like Fannie and Freddie, use large volumes of derivatives, which are investment contracts that can be used by companies to offset risk from interest rate shifts.
Ibid

Earnings (but not cash flow) Volatility Caused Largely by FAS 133
Freddie Mac and its main rival, Fannie Mae, are recovering from scandals several years ago in which they were found to have violated accounting rules to make their results look less choppy. Because they have adopted stricter practices, their results tend to fluctuate widely, as changes in interest rates and default expectations whipsaw the value of mortgage-related assets. Last year, for instance, Freddie had big losses in the third and fourth quarters but still managed to report net income of $2.21 billion for the year. In the latest quarter, "accounting developments exacerbated the appearance of some of these developments" in the mortgage market, said Richard Syron, Freddie's chairman and chief executive.
Damian Paletta and James R. Hagerty, "Freddie's Stricter Accounting Renders a Loss," The Wall Street Journal, June 15, 2007; Page A2 --- http://online.wsj.com/article/SB118182226301335242.html?mod=todays_us_page_one

Freddie Mac (Fannie Mae's Brother) Paves the Way With Risk Stress Tests and Then Fails on Macro Hedge Accounting

Macro hedge accounting is generally not allowed for financial reporting under FAS 133 (read that as in Freddie Mac), but it is frowned upon by the IRS (read that as in Freddie Mac).  In November 2003 we are still awaiting the long delayed Year 2002 annual report of Freddie Mac.  Freddie applied macro hedge accounting in a way that was not appropriate under FAS 133, and we've been waiting for new auditors to complete the work in revising prior-year statements and issuing Year 2002 financial statements.  

Freddie Mac named Richard Syron, a former head of the American Stock Exchange, the Boston Fed, and tech firm Thermo Electron, as its new chairman and CEO. The executive succeeds Greg Parseghian, who was asked to step down after federal regulators determined he played a role in a string of accounting misdeeds.
See "Freddie Mac Appoints New Chief:  Syron May Bring Stability To Beleaguered Company; Toughness Is Questioned," by Patrick Barta and John D. McKinnon, The Wall Street Journal, December 8, 2003 ---  http://online.wsj.com/article/0,,SB107081511244443300,00.html?mod=home_whats_news_us

Freddie Mac named Richard Syron, a former head of the American Stock Exchange, the Boston Fed, and tech firm Thermo Electron, as its new chairman and CEO. The executive succeeds Greg Parseghian, who was asked to step down after federal regulators determined he played a role in a string of accounting misdeeds.
See "Freddie Mac Appoints New Chief:  Syron May Bring Stability To Beleaguered Company; Toughness Is Questioned," by Patrick Barta and John D. McKinnon, The Wall Street Journal, December 8, 2003 ---  http://online.wsj.com/article/0,,SB107081511244443300,00.html?mod=home_whats_news_us 

Question
Do you want to learn more about derivative financial instruments accounting in action?

Answer
Although nobody has yet to write up a case on Freddie Mac, the Appendices at this Freddie Mac site are a derivatives accounting education in and of themselves --- .  The link with the appendices is at http://www.freddiemac.com/investors/restatement/

 The Investor Relations site is at http://www.freddiemac.com/investors/ 

"Freddie Mac hit with fine," by Marcy Gordon, The San Antonio Express News, December 11, 2003 --- http://news.mysanantonio.com/story.cfm?xla=saen&xlb=110&xlc=1097161&xld=110

Freddie Mac is paying a $125 million civil fine and is being threatened with possible curbs on its growth as federal regulators blame management misconduct for the mortgage giant's $5 billion misstatement of earnings. In a report issued Wednesday, regulators accused the government-sponsored company of violating its public trust.

A pliant board of directors and a system of compensating executives tied to annual earnings targets also contributed to the accounting crisis at Freddie Mac, which has brought the ouster of four top executives since early June, the Office of Federal Housing Enterprise Oversight found in its months-long investigation.

Freddie Mac agreed to pay the record fine in a settlement with the federal agency announced Wednesday.

The agency, which supervises Freddie Mac and its larger rival Fannie Mae in the multitrillion-dollar home mortgage market, cited "a pattern of inappropriate conduct and improper management of earnings" at the company and even "a disdain for appropriate disclosure standards" among former top executives.

The second-largest U.S. buyer of home mortgages "disregarded accounting rules, internal controls, disclosure standards, and ultimately, the public trust in pursuit of steady earnings growth," the agency's report found.

Its director, Armando Falcon, told reporters the agency already is considering imposing on both mortgage companies new requirements recommended in the report, including splitting the chairman and chief executive positions and limiting directors' terms.

Another recommendation is to restrain the growth of Freddie Mac's mortgage portfolio if it fails to disclose its financial situation more quickly and accurately — a prospect likely to unnerve shareholders.

Freddie Mac and Fannie Mae were created by Congress to pump money into the home mortgage market by buying home loans from banks and other lenders and bundling them into securities for sale on Wall Street.

The two corporations, whose stock is publicly traded, have grown explosively in recent years and are among the nation's largest financial institutions.

Freddie Mac's settlement with regulators still leaves to be resolved a criminal investigation by the Justice Department and a civil inquiry by the Securities and Exchange Commission.

Falcon said his agency's examination didn't find evidence of criminal misconduct. The report did cite evidence that one or more of the investment banks that engaged in transactions that Freddie Mac used to manipulate its earnings "may not have acted properly."

McLean, Va.-based Freddie Mac, with $40 billion revenue a year, has acknowledged understating its earnings by $5 billion for 2000-2002 to smooth out volatility in profits and uphold its image on Wall Street as a steady performer.

In addition, the company last month admitted inflating 2001 earnings by nearly $1 billion and said it may not be able to complete its accounting for 2003 until next June.

The company Sunday named Richard Syron, a Wall Street veteran and former Federal Reserve official, as chairman and chief executive. The board of directors in June forced out Freddie Mac's then-chairman and CEO, Leland Brendsel, and the company's president and chief financial officer.

In August, the federal regulators ordered the ouster of Brendsel's replacement, Gregory Parseghian — who had played a role in some of the company's questionable financial transactions, according to a report by attorneys hired by the board.

Parseghian earned $1 million in salary and $750,000 in bonuses in 2001.

The company didn't admit to or deny wrongdoing in the settlement, involving the first such fine in the agency's 10-year history. Freddie Mac also said it did not consent to any part of the agency's report and that it "strongly disagrees" with some of the findings.

The $125 million fine will be paid from the company's revenues, potentially reducing its bottom line.

The restatement by company auditors of Freddie Mac's 2000-2002 earnings, a massive project first announced in January and completed last month, cost the company $100 million.

Freddie Mac shares rose 25 cents to $54.25 in trading Wednesday on the New York Stock Exchange.

Under the settlement, Freddie Mac also agreed to strengthen its internal controls and accounting practices and to improve its disclosure of information to the investing public — steps the company already had undertaken after its accounting and management turmoil came to light in early June.

Also see The Wall Street Journal on December 11, 2003 --- http://online.wsj.com/article/0,,SB107106680095083900,00.html?mod=mkts_main_news_hs_h 

"Freddie Regulator Seeks $100 Million In Settlement Deal," by Patrick Barta and John D. McKinnon, The Wall Street Journal, December 9. 2003 --- http://online.wsj.com/article/0,,SB107092962387997400,00.html?mod=home_whats_news_us

Federal regulators looking into Freddie Mac's accounting woes are seeking $100 million or more from the company in settlement of possible civil charges stemming from its accounting misdeeds, people familiar with the matter said.

These people stressed that the negotiations between Freddie Mac and its regulator, the Office of Federal Housing Enterprise Oversight, are continuing, and that the final settlement could be far less. However, analysts who closely follow the mortgage-finance company believe that Freddie Mac officials are eager to reach a deal quickly. The payment likely would be in settlement of charges that the regulator could bring against the company for engaging in the accounting abuses.

The company already has taken several steps in its bid to restore credibility. Late last month, Freddie Mac completed a long-delayed restatement of past earnings, concluding that it understated results through 2002 by nearly $5 billion. And on Sunday, the company said it selected a new chief executive, former American Stock Exchange head Richard Syron.

"The settlement is another big piece" that Freddie Mac needs to put its woes behind it, said Howard Glaser, a Washington, D.C., mortgage-industry consultant who has done work for Freddie Mac.

Continued in the article.

"Freddie Mac Attack Critics are calling for greater oversight -- or even a breakup," Business Week, July 7, 2003 --- http://www.businessweek.com/magazine/content/03_27/b3840057.htm 

The improper use of hedge accounting to amortize gains -- and thus smooth ragged ups and downs in quarterly earnings -- was Freddie's downfall. As a June 25 press release deadpanned: "Certain capital market transactions and accounting policies had been implemented with a view to their effect on earnings in the context of Freddie Mac's goal of achieving steady earnings growth." Translation: Steady earnings help Freddie convince investors and lenders that management has its eye on the ball. They also help ward off politicians who might point to volatility as a reason to tighten regulation or even break Freddie up. 

The company's quest for smooth earnings, plus its admitted lack of accounting expertise and weak management controls, proved to be a fateful combination. That became clear to PricewaterhouseCoopers auditors soon after they replaced longtime Freddie auditor Andersen LLC in 2002. The new audit team soon discovered suspicious hedge accounting involving Treasury securities.

November 6, 2003
Freddie Mac, the nation's number two mortgage finance company, has estimated it will owe as much as $30 million in back taxes. That figure is just a fraction of the $4.5 billion the company expects to report in income when it restates earnings. http://www.accountingweb.com/item/98300 


Freddie Mac, the nation's number two mortgage finance company, has estimated it will owe as much as $30 million in back taxes. That figure is just a fraction of the $4.5 billion the company expects to report in income when it restates earnings. http://www.accountingweb.com/item/98300 

Mitchell Delk Senior Vice President Freddie Mac 
Written Statement Before the Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises of the Committee on Financial Services, U.S. House of Representatives 
July 11, 2001 (Note the Date) --- http://www.freddiemac.com/speeches/md071101.htm 

A pioneer in the use of risk-based stress tests, Freddie Mac believes that a well-implemented capital standard must produce specific and accurate determinations of required capital. Assigning too little capital or too much both have negative consequences. Too little capital could jeopardize our ability to withstand an extreme downturn in the economy. On the other hand, requiring too much capital would impose unnecessary costs on the nation’s families. Mortgage rates would rise, and mortgage products attractive to lower-income borrowers would become more expensive or unavailable.

Furthermore, it is critical that the test be operationally workable. For Freddie Mac to purchase mortgages on a daily basis, we must be able to calculate the amount of capital that will be required and incorporate it into our business planning and processes.

Finally, the stress test should recognize prudent risk management. For example, the test should not penalize the use of swaps and other securities contracts, the function of which is to manage interest-rate risk. This is an essential risk management strategy that we and other large, well-capitalized financial institutions use every day. A standard that ties capital to risk would appropriately recognize this strategy with a lower capital requirement. According to Chairman Greenspan, regulators must “develop ways to improve their tools while reinforcing incentives for sound risk management.”

Tripped Up by FAS 133
"Freddie Mac Overstated Results By as Much as $1 Billion in 2001," by Patrick Barta and John D. McKinnon, The Wall Street Journal, November 20, 2003 --- 

Freddie Mac is expected to report that it overstated earnings by as much as $1 billion in 2001 when it releases a much-anticipated restatement of past earnings in the next several days, people familiar with the situation said.

The mortgage-finance company, which has been embroiled in an accounting scandal since June, is still expected to conclude that it undercounted earnings by $4.5 billion or more during the entire three-year period of its restatement, which covers 2000, 2001 and 2002. But an overstatement during one of those years would be significant because it would further highlight the volatility of Freddie Mac's financial results, something the company had tried to hide. Freddie Mac initially reported that it earned $4.1 billion in 2001.

Some details of Freddie Mac's restatement remained in flux in advance of its release, and some people with knowledge of the situation cautioned that the numbers could change, although likely not enough to erase the troublesome overstatement. Some also believe that the overstatement could be limited to one quarter.

David Palombi, a spokesman for Freddie Mac, said he couldn't provide details on the restatement, though he noted that company officials have long stressed that it would reveal more volatile results. He said that the restatement is expected to significantly boost shareholder equity at the company.

Still, the possibility that Freddie Mac may have overstated its results in one of the years under review could make life harder for the company on Wall Street and in Washington, where legislators have been working to place Freddie Mac under stricter regulation. Companies that understate earnings are often treated more gingerly on Wall Street and elsewhere, analysts said, since correcting the errors results in more income for shareholders.

"They set up this belief that what they did was they understated earnings, and apparently they did on a cumulative basis, but it's not going to go over well that in one of the years they overstated earnings," said Mike McMahon, a financial-services industry analyst at Sandler O'Neill & Partners in San Francisco.

Freddie Mac is under investigation by several government agencies after it revealed that it used improper accounting tactics to smooth earnings to better please Wall Street. In some cases, the company pushed unwanted earnings into the future, or hid gains it thought would make the company appear to be too volatile. But an internal investigation revealed the company also used accounting gimmicks to mask some losses that resulted from accounting rules it thought were unfair.

The government-sponsored, publicly traded company exists to buy mortgages from lenders, providing needed capital to keep the U.S. mortgage market operating smoothly.

Freddie Mac's financial statements can be downloaded from http://www.freddiemac.com/investors/ 

Illustration of a Currency Swap
It costs Freddie Mac more to sell the euro debt than comparable bonds in dollars, but the agency gets to diversify its funding base. That benefit offsets the short-term pain of borrowing in euros and swapping back into dollars.
Margot Patrick and Henry J. Pulizzi, "Freddie Mac Returns to Europe To Diversify Debt," The Wall Street Journal, January 18, 2004 --- http://online.wsj.com/article/0,,SB107446591506604646,00.html?mod=mkts%5Fmain%5Fnews%5Fhs%5Fh 

Fannie Mae has a bigger brother named Freddie Mac whose failure to properly implement FAS 133 following a vigorous fight with the FASB to derail FAS 133 from becoming a standard.   It comes as no surprise that the external auditor for Freddie Mac was the infamous Arthur Andersen. 

"At Freddie Mac, It's Hard To Lay Claim to Innocence," by Jerry Knight, The Washington Post, 
July 28, 2003 (Note the Date) --- http://www.washingtonpost.com/ac2/wp-dyn/A51391-2003Jul26?language=printer 
"The intent was to deceive investors, and for that, everyone involved ought to take a fall."

When the accounting and management failures at Freddie Mac first surfaced last month, the board of directors proclaimed that it was throwing out all the executives tainted by the scandal and installing a new CEO.

Chief executive Leland C. Brendsel and Chief Financial Officer Vaughn A. Clark were allowed to resign. President David W. Glenn was fired.

Gregory J. Parseghian, 42, Freddie's chief investment officer, was promoted to president and chief executive. It was inferred that Parseghian had nothing to do with cooking the books and would restore the company's credibility.

As we now know, the idea that Parseghian is squeaky clean is tough to swallow after reading last week's report on the internal investigation of Freddie's phony financial reports.

The new chief executive's name turns up repeatedly in the investigative report detailing the dubious deals that Freddie Mac used to hide as much as $4.5 billion in profits.

According to the report of the internal investigation initiated by Freddie's board:

• Parseghian was directly involved with finding ways for Freddie Mac to circumvent new accounting industry rules that were written to help investors understand the impact on corporate finances of exotic transactions known as derivatives. James R. Doty, the lawyer who prepared the report, came to the conclusion that Parseghian was told by Freddie's auditors that the transactions the working groups recommended passed accounting muster, and were therefore completely above board.

• Parseghian was among several senior executives who approved a memo implementing a $700 million transaction known as the Coupon Trade-Up Giant, or CTUG, that was specifically designed to offset the impact of the new derivatives accounting rules.

• Parseghian, who was responsible for briefing the investment committee of Freddie's board of directors about major transactions, helped come up with a way to divide the CTUG into pieces small enough that the board wasn't required to be informed of them individually, even though all together they were part of one grand plan. "This division had the effect of avoiding the need for Board authorization," the report said. As a result, "the company failed to adhere to its own governance requirements."

• Parseghian participated in one meeting at which top Freddie Mac executives discussed five other ways in which they could get around the new derivatives accounting rules. He also supervised several junior executives who participated in two "working groups" that coordinated efforts to minimize the impact of the derivative accounting rules on the bottom line.

Freddie Mac won't say whether Parseghian was officially a member of those groups. Parseghian has declined to comment on the report.

Be that as it may, the report makes clear he was a central character in events that could lead to as much as $4.5 billion in restatements. It is hard to believe he can restore Freddie's credibility. The report portrays Freddie Mac as an organization that single-mindedly set out to circumvent new rules drafted by the accounting industry to demystify derivatives, the generic name for a menagerie of financial creations.

Dreamed up a couple of decades ago by mathematicians and PhD economists, derivatives offer clever ways for corporations to protect themselves against changes in interest rates and other unpredictable economic events.

They can also be used to cheat on income taxes, government prosecutors contend in a high-profile tax shelter trial now underway. They can and were used by Enron Corp. to create phantom profits. And at Freddie Mac they were used to hide profits, creating a convenient rainy-day fund that the company could tap whenever its operations failed to produce enough profit to satisfy Wall Street. Ever since derivatives were invented, people have struggled to figure out how they ought to be accounted for on a corporation's books. For years most companies simply pretended their dealings in derivatives didn't exist, making little or no mention of them in financial reports.

Finally the Financial Accounting Standards Board, which writes the official guidelines for keeping the books of U.S. corporations, came up with a rule that for lack of a simpler moniker will have to go by its official name: Statement of Financial Accounting Standard No. 133, known in colloquial accountants-speak as SFAS 133.

The basic rule is simple: Starting Jan. 1, 2001, companies must disclose the fair market value of their derivatives.

Freddie Mac fought that rule when it was being written, and when it was implemented the organization "devoted considerable resources to exploring strategies that would mitigate the effects of the rule change," the internal investigation found. Elsewhere, the report states simply, "Management believed that SFAS 133 should be 'transacted around.' " It's impossible to read the internal investigation report without being struck by Freddie Mac's arrogance. Nowhere in it is any evidence that anybody at Freddie Mac ever suggested the company ought to play by the same accounting rules as everybody else. The pervasive corporate value was that our business is different, these rules should not apply to us. So while other companies complied with the new rules and fairly disclosed the market value of their derivatives, Freddie devoted vast resources to a "transition" strategy designed to ensure that SFAS 133 would have as little impact as possible on the financial statements issued to investors.

That was no easy task, because in 2001, Freddie Mac was sitting on billions of dollars of gains in the market value of its derivative portfolio, a condition that would have ballooned its profit.

Freddie didn't want to report that windfall all at once, as accounting rules required, but wanted to move the "profit" into future quarters when it wouldn't just be seen as a fluke of accounting but real, sustained growth in the bottom line.

Investors wouldn't understand the one-time gain, Freddie feared. Somebody might see those billions and buy the stock, pushing up the price.

If the stock went up because of this windfall, it would fall when the derivatives profits evaporated, as they inevitably would under SFAS 133 accounting.

In dozens of pages, the report spells out how far Freddie went to avoid reporting a windfall when the new accounting rules kicked in. Elaborate deals were cooked up using "results-oriented, reverse engineering." In other words: Here's how much profit we want to report to shareholders, let's figure out how we can do it.

Some of the things that were done clearly violated accounting rules, and for that heads rolled -- Brendsel, Vaughn and Glenn. Other transactions were more creative, bending the rules without breaking them. But Parseghian was promoted.

The report states that Parseghian was assured by Arthur Andersen, then Freddie's auditor, that the transactions were allowed, that they followed the letter of accounting standards. Within the rules or not, it doesn't make much difference. The intent was to deceive investors, and for that, everyone involved ought to take a fall.

Restoring Freddie's credibility ought to mean getting rid of everybody involved -- up to and including the board of directors. That's what WorldCom Inc. did, and it was a crucial step in that company clawing its way out of its own accounting scandals.

As Washington Post reporters Kathleen Day and David S. Hilzenrath have pointed out, the boards of Freddie Mac and its corporate cousin Fannie Mae each have five seats reserved for political appointments. Because the two giant mortgage companies were created by the government, the president himself gets to pick a batch of board members.

Over the years, some of the presidential appointees have been distinguished citizens, others have been distinguished by their political credentials.

For example, then-President Bill Clinton gave a seat on the Fannie board to Garry Mauro, who ran for governor of Texas and lost. President Bush gave one to Molly H. Bordonaro, who ran for Congress from Oregon and lost.

Lobbyists, loyalists, politicians and politicians' spouses have all been entrusted with overseeing the two biggest financial institutions in the United States. The non-political board members cover a similar range of résumés.

It would be fun to call up each of the Freddie Mac board members this morning and give them a pop quiz on the internal investigation that was completed last week.

1) Define CTUG, swaptions portfolio valuation and J-Deals.

2) Explain the key provisions of SFAS 133.

3) Compare and contrast the implied volatility of swaptions based on the Black Rock valuation model with the historical volatility model created by the company.

All Washington investors need to know is that No. 1 are transactions Freddie Mac officials used to get around No. 2.

All they need to know about No. 3 is that by switching from one valuation model to another, and then switching back 39 days later, Freddie conveniently managed to hide millions of dollar worth of profits.

Board members, on the other hand, ought to be able to expound on these topics in great detail. Doty told The Washington Post last week that the directors were not given enough information about the these matters to prompt questions at the time. A major transaction that was later found to be highly questionable "simply passed under the radar screen" of the board, Doty said.

Rather than a pop quiz , the board members ought to be called before Congress and examined in depth on their knowledge of how Freddie Mac does business, why this accounting scandal happened, what they knew and when they knew.

Bob Jensen's threads on other derivative financial instruments frauds --- http://www.trinity.edu/rjensen/fraud.htm

FREDDIE MAC 2001 INFORMATION STATEMENT PROVIDES ENHANCED DISCLOSURE OF USE OF DERIVATIVES, RISK MANAGEMENT PRACTICES McLean, VA --- http://www.freddiemac.com/news/archives2002/infostat_040102.htm 
APRIL 1, 2002 (Note the Date)
CONTACT: corprel@freddiemac.com
or (703) 903-3933

Freddie Mac (NYSE:FRE) today announced the publication of its 2001 financial Information Statement, which includes new, in-depth disclosures about the company's use of derivatives, risk-counterparties, and other risk management practices. The enhanced disclosures demonstrate that Freddie Mac is among the world's best-managed financial institutions.

The Information Statement for 2001, which meets or exceeds the Securities and Exchange Commission's disclosure requirements for publicly traded companies, provides shareholders, analysts, and the public with a detailed report on the company's financial condition. Freddie Mac's Information Statement is available at www.freddiemac.com .

Perhaps most important, the new Information Statement presents more clearly and comprehensively than ever before information about Freddie Mac's use of derivative financial instruments to manage interest rate risk on its portfolio of residential mortgages. The disclosure shows that Freddie Mac uses derivatives to manage its portfolio risk and not to speculate in the capital markets. It also contains important new information regarding how Freddie Mac effectively manages the credit risk associated with its derivatives counterparties.

For example, the Information Statement includes a new chart showing a summary by credit rating of the counterparties used in the company's derivative transactions, the notional balance of outstanding contracts, Freddie Mac's total counterparty credit risk exposure, and its exposure net of collateral.

It also shows that, as of the end of 2001, the simultaneous default by all of Freddie Mac's over-the-counter derivative counterparties would result in a loss of just $69 million—less than one week's worth of Freddie Mac's total earnings in 2001. This is an unusually low exposure, especially when compared to the risk exposures of other publicly traded financial institutions.

Other key disclosures being made for the first time in Freddie Mac's Information Statement for 2001 include:

A new table that shows the quantitative benefit of derivatives on the company's average level of portfolio market value sensitivity (a key measure of interest rate exposure) for 2001. A new section that provides an in-depth discussion of Freddie Mac's critical accounting policies in accordance with recent SEC guidance. Specifically, this section discusses policies that concern the establishment of loan loss reserves, the determination of the fair value of assets and liabilities (including derivatives), resecuritization transactions, and the application of SFAS 133 to Freddie Mac's hedging activities. A new section that significantly expands Freddie Mac's discussion of its principal hedging strategies, including its hedges of forecasted debt issuances, foreign currency exposure, existing long-term fixed rate debt, and embedded prepayment options in its retained pass-through mortgage securities. Today's announcement builds on the six voluntary commitments Freddie Mac made in October 2000 to ensure it remains in the vanguard of financial risk management and disclosure practice. These commitments include monthly interest rate risk disclosures, quarterly credit risk disclosures, obtaining and publicly disclosing a risk-to-the-government rating,