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

Don't toss hedge accounting just because it's complicated

I have trouble with Tom’s argument to toss out hedge accounting in FAS 133 and IAS 39 --- Click Here
 http://accountingonion.typepad.com/theaccountingonion/2009/06/regulate-derivatives-start-with-better-accounting.html

It’s foolish not to book and maintain derivatives at fair value since in the 1980s and early 1990s derivatives were becoming the primary means of off-balance-sheet financing with enormous risks unreported financial risks, especially interest rate swaps and forward contracts and written options. Purchased options were less of a problem since risk was capped.

Tom’s argument for maintaining derivatives at fair value even if they are hedges is not a problem if the hedged items are booked and maintained at fair value such as when a company enters into a forward contracts to hedge its inventories of precious metals.

But Tom and I part company when the hedged item is not even booked, which is the case for the majority of hedging contracts. Accounting tradition for the most part does not hedge forecasted transactions such as plans to purchase a million gallons of jet fuel in 18 months or plans to sell $10 million notionals in bonds three months from now. Hedged items cannot be carried on the balance sheet at fair value if they are not even booked. And there is good reason why we do not want purchase contracts and forecasted transactions booked. Reason number 1 is that we do not want to book executory contracts and forecasted transactions that are easily broken for zero or at most a nominal penalties relative to the notionals involved. For example, when Dow Jones contracted to buy newsprint (paper) from St Regis Paper Company for the next 20 years, some trees to be used for the paper were not yet planted. If Dow Jones should break the contract, the penalty damages might be less than one percent of the value of a completed transaction.

Now suppose Southwest Airlines has a forecasted transaction (not even a contract) to purchase a million gallons of jet fuel in 18 months. Since it has cash flow risk, it enters into a derivative contract (usually purchased option in the case of Southwest) to hedge the unknown fuel price of this forecasted transaction. FAS 133 and IAS 39 require the booking of the derivative as a cash flow hedge and maintaining it at fair value. The hedged item is not booked. Hence, the impact on earnings for changes in the value would be asymmetrical unless the changes in value of the derivative were “deferred” in OCI as permitted as “hedge accounting” under FAS 133 and IAS 39.

If there were no “hedge accounting,” Southwest Airlines would be greatly punished for hedging cash flow by having to report possibly huge variations in earnings at least quarterly when in fact there is no cash flow risk because of the hedge. Reported interim earnings would be much more stable if Southwest did not hedge cash flow risk. But not hedging cash flow risk due to financial reporting penalties is highly problematic. Economic and accounting hit head on for no good reason, and this collision was avoided by FAS 133 and IAS 39.

Since the majority of hedging transactions are designed to hedge cash flow or fair value risk, it makes no sense to me to punish companies for hedging and encouraging them to instead speculate in forecasted transactions and firm commitments (unbooked purchase contracts at fixed prices).

The FASB originally, when the FAS 133 project was commenced, wanted to book all derivative contracts and maintain them at fair value with no alternatives for hedge accounting. FAS 133 would’ve been about 20 pages long and simple to implement. But companies that hedge voiced huge and very well-reasoned objections. The forced FAS 133 and its amending standards to be over 2,000 pages and hellishly complicated.

But this is one instance where hellish complications are essential in my viewpoint. We should not make the mistake of tossing out hedge accounting because the standards are complicated. There are some ways to simplify the standards, but hedge accounting standards cannot be as simple as most other standards. The reason is that there are thousands of different types of hedging contracts, and a simple baby formula for nutrition just will not suffice in the case of all these types of hedging contracts.

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 

The Timeline of the Recent History of Fannie Mae Scandals 2002-2008
 "Fannie Mayhem: A History," The Wall Street Journal, July 14, 2008 --- http://online.wsj.com/article/SB121599777668249845.html?mod=djemEditorialPage

 

• Fannie Mae Ugly 07/12/08 – Investors continued to flee Fannie Mae and Freddie Mac almost as frantically as the political class tried to reassure everybody there was nothing to worry about.
 
 

 

• The Price of Fannie Mae 07/10/08 – It's time Americans understood the price they could soon pay for the Beltway's confidence game with these high-risk "government-sponsored enterprises."
 
 

 

• Too Political to Fail 04/21/08 – Fannie Mae and Freddie Mac aren't held to the same standards of accountability as everyone else.
 
 

 

• Fannie Mayhem 11/20/07 – Chuck Schumer is lucky Congress ignored his idea that Fannie Mae and Freddie Mac should ride to the rescue of the housing market.
 
 

 

• Fannie More 10/23/07 – Barney Frank and Chuck Schumer have come up with a proposal that would increase the risk to taxpayers from Fannie Mae and Freddie Mac.
 
 

 

• Fannie to the Rescue? 09/29/07 – Fannie and Freddie went up the Hill to fetch a pail of money.
 
 

 

• Freddie Krueger Mac 05/10/07 – Just when you think they're defeated, Fannie Mae and Freddie Mac arise in Congress to kill any attempt to clean up their dangerous habits.
 
 

 

• The Fannie Tax 04/12/07 – Democrat Barney Frank and the Bush Administration seem to have found common ground on new rules for Fannie Mae and Freddie Mac. Naturally, there's a catch.
 
 

 

• Memo to Fannie 06/14/06 – A joke in Washington these days goes like this: "What's the difference between Enron and Fannie Mae? Answer: The guys at Enron have been convicted."
 
 

 

• Freddie's Friends on the Hill 04/27/06 – The Federal Election Commission sheds some light on how Freddie Mac rewards its friends.
 
 

 

• Fannie Mae's House 10/25/05 – Every Congressional session can be counted on to produce its share of bad bills. But the "reform" bill for Fannie Mae and Freddie Mac is in a class of its own.
 
 

 

• Fannie's Friends on the Hill 05/09/05 – Congress finally seemed ready to protect taxpayers from Fannie Mae and Freddie Mac. Then Republican Mike Oxley decided to ride to their rescue.
 
 

 

• Fannie Turns a Page 12/23/04 – Fannie Mae – a slick, semiprivate firm operating with the patronage of politicians – is the kind of institution one still expects to find in a country like France.
 
 

 

• Fannie the Centaur 12/17/04 – Understanding their half-man, half-beast nature is crucial to fixing Fannie Mae and Freddie Mac in the wake of their recent financial scandals.
 
 

 

• Fannie Mae Liberals 10/14/04 – There were many moments of high entertainment during the House hearings on Fannie Mae's creative accounting. But our favorite was the Mister Magoo performance given by Barney Frank (D., Massachusetts).
 
 

 

• Fannie Mae Enron? 10/04/04 – The company was cooking the books. Big time.
 
 

 

• Fannie Uncovered 09/23/04 – The housing-finance giant has been engaging in some accounting funny business.
 
 

 

• Fannie's Risky Business 02/25/04 – Alan Greenspan puts his credibility behind the cause of reforming Fannie Mae and Freddie Mac.
 
 

 

• Christmas for Fannie Mae 12/23/03 – The Federal Reserve Board releases a new staff study about the impact of taxpayer subsidies for Fannie Mae and Freddie Mac.
 
 

 

• White House Fannie Pack 11/11/03 – White House chief economist N. Gregory Mankiw dares to tell the truth about Fannie Mae and Freddie Mac. The mortgage giants were not amused, which means we're getting somewhere.
 
 

 

• Fannie Takes the Hill 10/09/03 – When the House of Representatives can't get even a modest regulatory bill out of committee, the dangers of Fannie Mae become clear in reality.
 
 

 

• Speaking Truth to Fannie 03/12/03 – The president of the Federal Reserve Bank of St. Louis warns of a potential crisis arising from Fannie Mae and Freddie Mac.
 
 

 

• Fan and Fred Get the Business 02/19/03 – The year has not started auspiciously for the two mortgage-finance behemoths.
 
 

 

• Fannie Mae's Risky Business 09/23/02 – We've been suggesting that Fannie Mae was exposed to too much interest-rate risk. All of a sudden investors seem to agree with us.
 
 

 

• Fannie Capitulates, Sort Of 07/15/02 – Fannie Mae and Freddie Mac end months of resistance, stonewalling and downright crankiness and agree to register their common stock with the Securities and Exchange Commission.
 
 

 

• Fannie's Inside Info 07/01/02 – Even in this post-Enron world, Fan and Fred do not provide as much information about these securities as private mortgage lenders do.
 
 

 

• Inside Fannie 03/19/02 – Fan and Fred don't function like other companies. They're allowed to pile up debt, implicitly guaranteed by taxpayers, without being held to even the minimum of corporate governance standards.
 
 

 

• Frantic Fannie 02/28/02 – Companies taking on so much risk and debt, and backed by taxpayers, ought to be more transparent in what they tell the world.
 
 

 

• Fannie Mae Enron? 02/20/02 – Fan and Fred look like poorly run hedge funds: lots of leverage and snarkily hedged risk. Does the word Enron ring any bells?
 

 

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, and meeting the Basel Committee's principles for sound management of liquidity.

The 2001 Information Statement is available within our Shareholder Relations content area.

Freddie Mac is a stockholder-owned corporation established by Congress in support of homeownership and rental housing. Freddie Mac purchases single-family and multifamily residential mortgages and mortgage-related securities, which it finances primarily by issuing mortgage passthrough securities and debt instruments in the capital markets. Over the years, Freddie Mac has opened doors for one in six homebuyers and more than two million renters across America.

Risk stress testing at Freddie Mac preceded highly publicized controversies regarding the use of derivatives for speculation and risk management in Freddie Mac.  Between 2000 and 2001, Freddie Mac doubled its derivatives holding
to above $1 trillion, as it aggressively turned to derivatives --- http://www.larouchepub.com/pr/2003/030610freddie_mac.html 

Freddie Mac and Fannie Mae: Where the Domain of the Housing Bubble and the Domain of the Derivatives Bubble Intersect June 9, 2003 

Freddie and Fannie function to buy housing mortgages from mortgage lending institutions. By doing so, a mortgage lending institution, which has just issued a mortgage, can sell that mortgage to Freddie or Fannie for cash; it can then use the cash to make a new mortgage, and sell that mortgage to Freddie and Fannie, and so on, in the same manner several times over. During normal times, this activity would be merely liquefying the housing market; but since 1995, it has been used to allow mortgage lending institutions to make mortgages to finance the sale of houses priced up to the current limit of $310,000; the mortgage lending institutions sell the mortgage to Freddie or Fannie, and then make another mortgage loan for up to $310,000, etc.

This mechanism is crucial for the perpetuation of the housing bubble, providing lending institutions the vast scale of liquidity needed to provide households the financing to purchase vastly over-priced homes.

As a result of this process, Freddie and Fannie have become gigantic. In terms of asset size, the four largest financial institutions in America are: 1) Citigroup, $1.1 trillion in assets; 2) Fannie Mae, $822 billion in assets; 3) JP Morgan Chase, $720 billion in assets; and 4) Freddie Mac, $708 billion in assets. Thus Fannie and Freddie are two of the top 4 financial institutions in America.

As indicated in yesterday's briefing, Freddie and Fannie can carry out this operation by issuing three types of highly risky obligations:

 1. corporate bonds that Freddie and Fannie issue; 

2. Mortgage Backed Securities (MBS), in which Freddie and Fannie pool a group of mortgages together, put a guaranty on it (for which they earn a fee), and then they package these MBS to insurance companies, pension funds, international investors; etc; and 

3. outright derivatives, which Fannie and Freddie have.

Derivatives Holdings of Fannie and Freddie
($ billions)

 
Fannie Mae
Freddie Mac
1997
161
96
1998
188
313
1999
275
424
2000
320
474
2001
533
1,052
2002
657
NA

The table shows the domain where the highly leveraged housing bubble and the highly leveraged bubble of derivatives intersect. Freddie and Fannie have turned to the use of derivatives to manage the housing bubble, to prevent it from exploding. Between 2000 and 2001, Freddie Mac doubled its derivatives holding to above $1 trillion, as it aggressively turned to derivatives. Freddie Mac has delayed the release of its 2002 annual report, but it is believed that its derivatives portfolio exceeds $1.3 trillion.

Federal Reserve Board chairman Alan Greenspan is the other key ingredient to the housing bubble: he has used his power at the Fed to lower interest rates so that the rate on a 30-year mortgage hit 5.32 percent, the lowest rate in four decades. However, the success of this whole scheme depends, among other things, upon continuing to keep interest rates low. Were interest rates to spike up, this would convulse the Mortgage-Backed Securities market, and the derivatives market of Freddie and Fannie. In 1994, a half percent increase in interest rates blew out the MBS market, which was then far smaller. Further, the derivatives market in general, is alreay producing instabilities. An interest rate increase would serve as a trigger to de-leverage the hypothecated $11.2 trillion U.S. housing bubble.

From Notes to the Financial Statements in the Year 2001 Annual Report of Freddie Mac --- http://www.freddiemac.com/investors/ar/ 

Derivative Financial Instruments

Derivative financial instruments ("derivatives") are financial instruments whose value is based upon an underlying asset, index or reference rate. Over-the-counter derivatives are privately negotiated contractual agreements that can be customized to meet specific needs. Exchange-traded derivatives are standardized contracts executed through organized exchanges. Freddie Mac enters into derivatives as an end user to obtain lower-cost financing, reduce risk and protect market value. Freddie Mac does not engage in such transactions for speculative purposes. By using derivatives, Freddie Mac is better able to match the expected cash flows of its assets and liabilities and reduce the corporation’s exposure to interest-rate and/or foreign-currency risk.

Accounting for Derivatives in 2001

On January 1, 2001, Freddie Mac implemented Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities," as amended ("SFAS 133"), which requires the corporation to recognize all derivatives on its balance sheet as either assets or liabilities measured at their fair value. The adoption of this standard did not affect the corporation’s previously issued financial statements up to and including the December 31, 2000 financial results. The one-time, net cumulative after-tax adjustments required upon adoption of SFAS 133 resulted in a $5 million increase to "Net income" and a $2.5 billion reduction to AOCI. The reduction to AOCI primarily resulted from SFAS 133’s requirement to recognize the derivatives designated as cash flow hedges, principally pay fixed swaps, on the balance sheet at fair value. Consistent with other GAAP-based equity valuation adjustments, changes in GAAP-based equity due to SFAS 133 AOCI adjustments do not affect Freddie Mac’s regulatory core capital, which is equal to "Stockholders’ equity," excluding AOCI.

When derivatives meet specific criteria, they are accounted for as either fair value hedges or cash flow hedges. Although Freddie Mac does not execute derivatives for trading or speculative purposes, in some cases, certain derivatives either do not satisfy SFAS 133’s hedge criteria or because hedge accounting has not been elected. Changes in fair value of those derivatives are reported in "Other income, net." The amortization of hedged item basis adjustments occurs over the life of the hedged item (for example, the estimated mortgage life in the case of hedged PCs), and must begin no later than when the hedge relationship terminates. A hedge relationship is deemed to be terminated when (i) the hedge no longer meets the SFAS 133 hedging criteria, (ii) hedge accounting is no longer elected, (iii) the derivative is sold or terminated, or (iv) the derivative is redesignated to another hedge relationship. Freddie Mac frequently redesignates derivatives from one hedge relationship to another or otherwise adjusts its hedging relationships in order to maximize the effectiveness of its hedging strategies in response to changing interest rates and other market factors, asset and liability paydowns, and changes in the composition of its derivatives, mortgage assets and debt obligations. Accordingly, the amortization of basis adjustments as a component of net interest income is begun each month for a substantial portion of Freddie Mac’s hedging relationships.

There are many other sections of the Year 2001 annual report that are too extensive to quote here.

As of November 2, 2003, the Year 2002 Annual Report of Freddie Mac is not yet available at http://www.freddiemac.com/investors/ar/ 

Also see http://www.freddiemac.com/investors/reports.html 

 

Improper Use of Hedge Accounting for Portfolios In a Manner Not Allowed in FAS 133

"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 

Mistakes were made -- lots of them. Management controls were weak, disclosures were misleading, and accounting in many cases was flat-out wrong. Despite all that, the company's future is rosy. That was the message from Freddie Mac (FRE ) on June 25, when it announced that an upcoming restatement could total $4.5 billion. "The company remains safe and sound," Freddie Mac Chairman Shaun F. O'Malley declared.

The market, too, focused on the good news: The restatement, expected in September, will boost Freddie's past earnings and increase surplus capital. That raises the possibility of bigger dividend payouts or even a share repurchase to reward stockholders. Freddie's shares rose 1.6%, to $50.83.

But no matter how hard Freddie tries to spin billion-dollar accounting errors, the housing-finance agency's admissions are fueling critics. Freddie made so many mistakes in applying derivative accounting rules that "a majority of the corporation's derivatives in 2001 and 2002 will not qualify as accounting hedges," the company said. And while Freddie Mac will correct financial statements back to 2000, the errors date from the mid-'90s, says new Chief Financial Officer Martin F. Baumann.

Not everyone is as sanguine as the stock market, however. What, for instance, would have happened had Freddie bet the wrong way on interest-rate movements, or if banks, fearing further problems, refused to buy its debt? Freddie's problems reveal just how little is known about its inner workings -- and highlight the risks should the markets lose confidence in its ability to manage its huge derivatives portfolio."  Even if they're not trying to cook their books," says Michigan State University accounting professor Thomas J. Linsmeier, Freddie's mistakes show that "there could be a systemic problem requiring a taxpayer bailout."

That's exactly why a small but vocal group of banks, politicians, and academics for years have argued that Freddie and its larger cousin, Fannie Mae (FNM ), be subject to tougher regulation, including Securities & Exchange Commission oversight. Now, Freddie's revelations will make it harder -- though not impossible -- for either of the two government-sponsored enterprises to block reforms. They have also raised anew the question of whether these giants should be split up or even privatized.

Freddie and Fannie are crucial cogs in the housing market because they buy mortgages from commercial banks and other lenders and resell them to investors as mortgage-backed securities. That frees lenders to lend again. And thanks to the three-year-old housing boom, Fannie and Freddie now carry an astronomical $1.6 trillion in assets on their balance sheets, up from $962 billion in 1999. But as Freddie has shown, what lies behind those numbers is often a mystery.

The reason, in a word, is derivatives. The root of Freddie's problems can be found in a dense document called Statement of Financial Accounting Standards 133, which determines accounting rules when derivatives are used as hedges. The rules require companies to assign current market values to the interest-rate swaps, options, and other derivatives they hold and to reflect any changes in their value on the balance sheet. FAS 133 also contains a sweetener: Companies can offset any gains (or losses) on an asset with a similar loss (or gain) on the derivative used as a hedge. And here's the real grabber: Any changes in a derivative's value can be recognized over the life of the hedge, allowing companies to avoid the volatility that market-value accounting creates.

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.

Freddie, it turns out, had sought to lock in favorable spreads between the lower interest rate it pays to holders of its debt and the higher rate it gets for the home mortgages in its portfolio. Typically, financial institutions lock in such spreads with standard interest-rate swaps. But in an attempt to lower hedging costs, Freddie used Treasury securities instead of swaps. At the end of 2002, Freddie held some $16 billion in Treasuries on its books as debt hedges.

The net effect was the same -- holding Treasuries can protect against interest-rate changes as well as an interest-rate swap. There the similarities end. Because Treasuries are cash instruments, they aren't eligible for hedge accounting under FAS 133. So by designating Treasuries as derivatives and accounting for them as hedges, Freddie violated FAS 133 and now must reverse that treatment by recognizing gains in past years. Although Freddie at the time tried to document the transactions as true hedges, and even got Andersen's O.K., Baumann says: "The accounting was wrong. It just didn't qualify" for hedge treatment.

Once the new auditors dove deeper, they found a disturbing pattern: Most of the derivatives were incorrectly accounted for. Another big error concerns what are called "held-to-maturity," or HTM, securities. Freddie's portfolio includes $260 billion worth of mortgage securities that it classifies as HTM. As long as companies promise not to sell such securities before they mature, they can record them on the balance sheet at their original cost instead of revaluing them each quarter.

But Freddie used some of its HTM securities as collateral for short-term borrowings. It later repurchased the securities, and in doing so, tried to classify the sale and repurchase as a simple repurchase. But once sold, HTM securities do not qualify for hedge accounting. By selling a portion of the HTM portfolio, Freddie tainted its entire $260 billion portfolio. That means Freddie must record any value changes on more than 100,000 securities in either the income statement or shareholders' equity.

Freddie's board and new management team -- besides O'Malley and Baumann, it includes former Chief Investment Officer Gregory J. Parseghian as CEO and President -- have vowed to put the books in order. They are adding to Freddie's accounting staff and increasing the level of internal oversight. Executives overseeing risk-management functions now report directly to Baumann.

But that won't be enough to mollify critics. Longtime Fannie and Freddie foe Representative Richard H. Baker (R-La.) on June 24 unveiled a measure to move their regulator, the Office of Federal Housing Enterprise Oversight, from the Housing & Urban Development Dept. to the Treasury Dept. and to expand its powers. Treasury Secretary John W. Snow refuses to comment on any specific proposal, but he may be warming to the idea. "[We want] a regime of greater transparency so the investment community will know what's going on," says Snow. Freddie's effort to come clean may be just the start of hard times ahead for the GSEs.

Prepared Remarks
Greg Parseghian
CEO and President of Freddie Mac
Equity Lunch/Debt Dinner
Boston, MA
August 20, 2003 (Note the Date)

Good evening, and thanks to all of you for joining me here in Boston.

It's been over two months since the Board of Directors of Freddie Mac asked me to be CEO. At that time, I promised to keep you updated on our progress. As part of that commitment, I have been on the "road" a lot in the past few weeks.

At each event, I have described my vision for Freddie Mac – and how we are going to achieve it.

Simply put, we aspire to be the premier financial institution in the world.

The reason for this bold vision is the critical importance of our mission to lower costs and increase access to quality housing for more of America's families. Our mission has never been more relevant or important-and we can only achieve it by being the best at everything we do.

Now let me describe my top priorities for becoming the premier financial institution. They are:

Get Our Financial Statements Right

When I took this job, I told you that "Job One is getting our financial statements right." But that is only the beginning. Several months ago, we embarked on a remediation plan to address the issues that led to the need to restate earnings.

My goal is for Freddie Mac to be recognized as the best in class for accounting, reporting, controls and financial disclosures.

We have recently sharpened the focus of this plan in light of the review conducted by Baker Botts. The report raised serious concerns about the company's past accounting, controls and disclosure processes and practices.

In response, I directed CFO Marty Baumann to expand his remediation effort to ensure that each issue identified in the report is addressed with an action plan to correct the deficiency.

In addition, we have retained the immediate past Director of the SEC's Division of Corporation Finance to benchmark the disclosure processes and practices of high-quality reporting firms – and replicate them at Freddie Mac.

These steps will enable us to make a seamless transition to an SEC reporting company. I reaffirmed our commitment to SEC registration in a letter to Treasury Secretary Snow in July.

Build Long-Term Shareholder Value

My second priority is to build long-term shareholder value.

Three core competencies are critical to our ability to do this: asset selection, risk management and low-cost financing.

First, asset selection is critical to maintaining a high-quality mortgage portfolio in both our investment and securitization businesses. It ensures we are well positioned to participate in the broad array of products that characterize mortgage debt outstanding.

Second, risk management has been - and will continue to be – a core competency at Freddie Mac.

When I arrived in 1996, I was determined to develop an interest-rate risk management framework that would allow us to grow in a safe and sound manner and fulfill our mission – regardless of where interest rates happened to be.

Since 1998, we have managed through six cycles where interest rates moved between 150 and 250 basis points in a relatively short period of time. Throughout these extreme interest-rate moves, Freddie Mac's risk profile remained low.

This is not news to investors because of the frequency of our interest-rate disclosures.

Freddie Mac is one of only two financial institutions that disclose duration gap on a monthly basis. And to my knowledge, Freddie Mac is the only financial institution that discloses both duration gap and portfolio market value sensitivity – or PMVS – on a monthly basis.

PMVS is important because it considers the potential loss of market value due to both duration and optionality risk.

In the fall of 2001, rates rose by about 100 basis points in a one-month period – similar to the move we experienced in July.

Because we were extremely well hedged, our duration gap moved by only one month and our PMVS averaged 4 percent during that time period.

Experiences like these give me great confidence in Freddie Mac's ability to weather significant market volatility. When we release our monthly volume summary for July, you will see that – despite the tremendous rise in interest rates – Freddie Mac continued to maintain a low risk profile.

In sum, we strive to maximize shareholder value while taking the lowest possible risk.

Very few institutions can claim such a strong risk position – one that I am determined to maintain.

Our third core competency is low-cost financing. Freddie Mac's ability to lower the cost of homeownership is a direct consequence of our charter, our disciplined approach to risk management and the superior performance of our mortgage-backed and debt securities.

Every day we strive to be the premier global non-sovereign credit, attracting low-cost funds from around the world to support homeownership in America.

By bringing Wall Street to Main Street, we enable homeowners to compete alongside the largest and most creditworthy institutions in the world for financing.

I want to emphasize that we are focused on creating long-term shareholder value, and not on short-term objectives, such as earnings targets. As CEO, I will not compromise long-term value objectives for the sake of reducing volatility in short-term earnings results.

Communicate Effectively So that the Public Understands Our Business and Results

My next priority is to ensure that investors fully understand whether we are fulfilling our objective of building shareholder value and operating in a safe and sound manner.

To enhance investor understanding, we will provide three sets of results: GAAP, a non-GAAP supplemental measure and fair value. Since I look at all three of these measures in evaluating Freddie Mac's performance – I believe you should have them, too.

GAAP will be the primary measure of our financial results.

GAAP is important because it is the gold standard mandated for all public reporting companies, as well as the basis of our regulatory capital requirements.

Investors also need to understand the drivers of our GAAP results. Because of the different accounting treatment of economically similar instruments like callable debt and option-based derivatives, we expect to provide a supplemental, non-GAAP book-based measure.

We will round out the picture by providing a quarterly fair value balance sheet.

Fair value represents the net marked-to-market value of all financial instruments. Over the long term, fair value closely reflects the underlying economics of our business. It will be particularly helpful in understanding our performance during – and immediately following – the restatement period.

Although all these measures are important, long-term value creation is the touchstone of our business philosophy. That's why we want to provide you fair value metrics more frequently than required by the FASB.

If we are successful at generating world-class risk adjusted returns (and I am confident we will), we will maximize earnings over the long term regardless of how they are measured.

Foster an Open Culture

My fourth priority is to foster an open culture at Freddie Mac. I hope that many of you believe as I do, that our June 25 press release marked the beginning of a new era of open communication. As difficult as it was, I am proud that, when there was bad news to communicate, you heard it from me first.

Going forward, we intend to be more outward facing in the way we do business. We're going to talk to and – more importantly – listen to our investors, customers, business partners and employees.

In the brief time I have been CEO, I have been very pleased with the response I have received by simply picking up the phone and talking to people. I am confident that we have a huge opportunity to build profitable business partnerships that will enhance our ability to serve homeowners and renters.

Conclusion

In closing, let me say that Freddie Mac has a bright future. Freddie Mac is a great American company with a great mission. I am determined to lead our company to be the best at everything we do. And we will do it in a manner marked by openness, transparency and candor. On behalf of the Freddie Mac employees and myself, we are committed to achieving the mission and vision I described today.

This concludes my formal remarks. Let me now open the floor to questions. I'll ask the first one: "Why are you the right person to lead Freddie Mac?"

 

The IASB opens a very small crack in the door for Macro Hedging --- http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#M-Terms 

To the IASB’s dismay in the summer of 2003, certain key aspects of FAS 133 incorporated in the international IAS 39 standard have riled European banks and other EU businesses to a point where, for the first time, there was a serious political movement underway in Europe to veto acceptance of a portion of an IASB standard in the EU.  A news article in the August 21, 2003 edition of The Wall Street Journal on Page C5 reads as follows:

This accounting battle centers on the IASB's insistence that derivatives should be valued at their fair value, rather than at cost, which is generally immaterial or even zero and is often how European companies treat them. Banks have argued that the outcome of the IASB's plan would be unnecessary volatility in their earnings and net worth, a point echoed by Mr. Chirac.

IASB Vice Chairman Tom Jones argued that the current system merely pretends that the earnings volatility doesn't exist. Trying to smooth earnings is what got Freddie Mac into trouble in the U.S., he said.

"Bank results in Europe are a fiction: No volatility, and derivatives are nonexistent (at least appearing to be nonexistent in financial statements)," he said.

The new IASB proposal (compromise) would now make it easier for banks to lump bundles of securities or loans together and hedge a fraction of the overall risk, a process known in the industry as macro hedging. This isn't allowed in the U.S., which requires (in FAS 133) companies to show the individual items being hedged. The original IASB draft had taken a similar stance.

But the body didn't give in on two other bones of contention: when banks should take a charge to earnings because hedge strategies are ineffective and whether banks can include money deposited in bank accounts that is available on demand in accounting for their hedges. The IASB argues that the money has to be treated for accounting purposes as if it could all be withdrawn the next day, although that doesn't happen in practice. It also argues that its concessions on macro hedging should help the banks accomplish similar results, and its board members have shown little willingness to budge.

 

The IASB’s Exposure Draft of the macro hedging compromise is entitled “Amendments to IAS 39:  Recognition and Measurement Fair Value Hedge Accounting for a Portfolio Hedge of Interest Rate” and for a short time can be downloaded free from http://www.iasc.org.uk/docs/ed-ias39mh/ed-ias39mh.pdf

It should be noted that this compromise does not apply to cash flow hedging or other types of hedging other than interest rate hedges.

It’s highly unfortunate that the proposed macro hedging compromise of IAS 39 mentioned above puts the IASB international standard on a somewhat non-divergent course with the FASB/SEC in the United States .   The FASB currently shows no interest to date in compromising FAS 133 with respect to macro hedging, although the complaints of the European companies apply to U.S. firms as well.  Two paragraphs from FAS 133 from the FASB are quoted below:

Paragraph 448.
The Board (FASB) considered alternative approaches that would require amortizing the hedge accounting adjustments to earnings based on the average holding period, average maturity or duration of the items in the hedged portfolio, or in some other manner that would not allocate adjustments to the individual items in the hedged portfolio. The Board rejected those approaches because determining the carrying amount for an individual item when it is (a) impaired or (b) sold, settled, or otherwise removed from the hedged portfolio would ignore its related hedge accounting adjustment, if any. Additionally, it was not clear how those approaches would work for certain portfolios, such as a portfolio of equity securities.


Paragraph 449.
Advocates of macro hedging generally believe that it is a more effective and efficient way of managing an entity's risk than hedging on an individual-item basis. Macro hedging seems to imply a notion of entity-wide risk reduction. The Board also believes that permitting hedge accounting for a portfolio of dissimilar items would be appropriate only if risk were required to be assessed on an entity-wide basis. As discussed in paragraph 357, the Board decided not to
include entity-wide risk reduction as a criterion for hedge accounting.

For more details, go to http://www.trinity.edu/rjensen/acct5341/speakers/133macro.htm 

October 29, 2003 question from Dennis Ratliff

-----Original Message----- 
From: Ratliff, Dennis J [mailto:dratlif@ju.edu]  
Sent: Wednesday, October 29, 2003 10:16 PM 
To: Jensen, Robert 
Subject: SFAS 133

Bob, I know you are real familiar with SFAS 133, do you think the standard has had much effect on business decisions?? thanks. 
Dennis.

Hi Dennis,

FAS 133 is hands down the least neutral FASB standard ever issued, as is IAS 39 in the international scene.  FAS 133 has had an enormous impact upon decisions, particularly in banks where newer types of hedging instruments had to be devised in order to conform to FAS 133 accounting rules.  For example, companies used to hedge with cross-currency derivatives that were not eligible for hedge accounting under FAS 133.  They then had to hedge with more complicated concatenations of instruments (FAS 138 relieved this somewhat).  In particular you might listen to the audio laments of Mike Kogler (Chase Bank) who absolutely despises FAS 133 --- http://www.cs.trinity.edu/~rjensen/000overview/mp3/133summ.htm

Probably the most significant impact, however, is the loss of many former off-balance-sheet financing (OBSF) ploys.  Derivatives, particularly swaps, were among the most popular OBSF ploys used by corporations until FAS 133 went into effect.  After FAS 133, companies either could look to other on-balance sheet financing alternatives (other than derivatives) since derivatives could not be OBSF or they could seek alternate OBSF ploys, particularly SPVs --- http://www.trinity.edu/rjensen//theory/00overview/speOverview.htm

You might also be interested in the following message from Ira Kawaller (a member of the DIG) that I keep posted at http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm

Message from Ira Kawaller on August 4, 2002

*********************************
Hi Bob,

I posted a new article on the Kawaller & Company website: “What’s ‘ Normal ’ in Derivatives Accounting,” originally published in Financial Executive, July / August 2002. It is most relevant for financial managers of non-financial companies, who seek to avoid FAS 133 treatment for their purchase and sales contracts. The point of the article is that this treatment may mask some pertinent risks and opportunities. To view the article, click on http://www.kawaller.com/pdf/FE.pdf   .

I ' d be happy to hear from you if you have any questions or comments.

Thanks for your consideration.

Ira Kawaller Kawaller & Company, LLC http://www.kawaller.com 
kawaller@kawaller.com  717-694-6270

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

Hope this helps!

Bob Jensen

Huge Growth in Derivatives Trading

March 21, 2003 message from Risk Waters Group [RiskWaters@lb.bcentral.com]

**************
The OTC derivatives market continued to grow strongly in the first half of the year, according to the International Swaps and Derivatives Association. The credit derivatives market grew 37%, with total notional outstandings reaching $2.15 trillion during the first half of 2002, the trade body said. Notional outstanding volume in interest rate and currency derivatives increased 20%, to $99.83 trillion, in the first half, while equity derivatives outstanding volumes rose to $2.45 trillion - up 6%. "The continued pace of growth in the over-the-counter derivatives markets during times of economic and political uncertainty demonstrates their importance as a mechanism for mitigation and dispersion of the risks our members encounter in the course of their business," said Bob Pickel, Isda chief executive. "The acceleration in use of credit derivatives in particular is testimony to the effectiveness of this product set in the redistribution of credit exposures to those firms desirous of adopting them."
**************

But Warren Buffett and others warn of looming disasters in the enormous derivatives markets!
See http://www.trinity.edu/rjensen/fraud033103.htm#DerivativesUpdate

My response to an inquiry about FAS 133 tutorials:

Angela asked me to reply to your message. In the late 1990s there were quite a few alternatives for FAS 133 training around the nation. I was asked to chair several of these myself and have some audio modules that I captured from speakers that I lined up for these various training workshops. See http://www.cs.trinity.edu/~rjensen/000overview/mp3/133summ.htm 

Since then the momentum for such training workshops has died down, although some accounting firms are still providing some workshops. For live workshop information, I suggest that you contact Ira Kawaller --- http://www.kawaller.com/

I have a tutorial guide section near the top of my glossary on derivatives and FAS 133 terminology --- http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm 

I also have my own free tutorials and cases at http://www.trinity.edu/rjensen/caseans/000index.htm 

In particular, you might note the 133ex01a.xls and other Excel workbooks at http://www.cs.trinity.edu/~rjensen/ 

Hope this helps!

Bob Jensen

"How FAS 133 Cost Sears $270 Million:  How many more companies will get nailed by the new derivatives accounting rule?" 
CFO.com, March 23, 2001 --- http://www.cfo.com/article/1%2C5309%2C2374||A|7|7%2C00.html 

The $270 million charge against earnings that Sears, Roebuck reported this week in its 10-K filing with the Securities and Exchange Commission stems from the 1997 termination of an interest rate swap in its credit card portfolio, a company spokeswoman said.

But precise details on the terms of the swap or why Sears canceled it were not immediately available. The spokeswoman said Jeffrey Boyer, Sears' senior vice president and CFO, was not available for comment.

The spokeswoman also said that Sears did not view the $270 million as a material loss, but rather a "balance sheet reclassification."

Some accounting experts familiar with the Financial Accounting Standards Board Statement 133 said the Sears situation underscores exactly why the ruling was adopted in the first place.

Despite the opposition of many auditors and financial executives, both FASB and the SEC argued that the rule was necessary to protect investors.

Jim Leisenring, the FASB staff member who chairs the Derivatives Implementation Group and oversaw the drafting of FAS 133, says, "People said the disclosures were already accurate, and a lot of people said there were no surprises."

But if there are no unwelcome surprises buried in corporate financial statements, then companies won't be harmed by spelling out their exposure under FAS 133, Leisenring reasons. If there are losses, then companies have an obligation to alert shareholders.

It's entirely probable that Sears' management already had a good grasp of its derivatives' exposure, but the reclassifying of the hedging write-off makes the extent of the loss transparent to investors.

Jeff Wallace, managing partner for Greenwich Treasury Advisors in Greenwich, Connecticut, says the huge derivatives losses in the mid- 1990s by Orange County and Procter & Gamble spurred the initial movement to draft 133 in the first place. The fact that companies are identifying the true size of their derivatives losses is a sign that the rule is working as planned.

What's more, Sears is not likely to be the last company to report a large charge stemming from the rule. Last year, Microsoft reported that it had a charge of $375 million, Wallace says.

But Microsoft is on a June fiscal year, and Sears, like most of the rest of corporate America is on a calendar year. As more 10-Ks for 2000 are submitted to the SEC in the next few weeks, more derivatives losses will be revealed.

"We haven't seen an end to the surprises," Wallace says.

But Wallace also says it's also important to keep the loss in perspective. While $270 million is a large number by any standard, it amounts to barely 1 percent of Sears' $26 billion credit card portfolio. The loss, while painful, is not catastrophic by that measure.

The spokeswoman said that when Sears terminated the interest-rate swap in 1997, it began amortizing the $270 million write-off on a 20-year schedule. The adoption of FAS 133 this year forced Sears to accelerate the charge-off and recognize the entire amount still outstanding in the first quarter.

According to Sears' 10-K, the "transition adjustment includes the effect of recording an existing cash flow hedging relationship on the balance sheet and reclassifying deferred losses from previously terminated interest rate swaps from other assets to other comprehensive income." The hedge caused a pre-tax charge of $56 million, or $34 million after taxes. The terminated swap had a pre-tax charge $389 million, or $236 million after taxes.

Sears' filing said it will write off the derivative losses over the next 17 years "as a yield adjustment of the hedged debt obligations."

Ira Kawaller, a Brooklyn, NY, consultant who specializes in derivatives, says, that although he's not familiar with the specifics of the Sears' charge-off, the company's classification of the impact of the swap as other comprehensive income, or OCI, suggests that it funded some of its credit card portfolio with a variable-rate liability and hedged it with a fixed-rate contract. As the market moved against it in 1997, the retailer decided to unwind the contract rather than expose itself to further losses.

Continued in the article.

Question:  How should Southwest Airlines account for these derivatives?
"Trying to Make Fuel Prices Less of a Wartime Gamble," by Daniel Altman, The New York Times, March 23, 2003 --- http://www.nytimes.com/2003/03/23/business/yourmoney/23HEDG.html 

Now that the war in Iraq has begun, oil prices could go $10 a barrel higher — or lower — by this time next month. How can a company that uses a lot of oil or its byproducts protect itself?

Because the risks run in both directions, businesses in several industries face a complex task: guarding against a price spike while staying open to the benefits of falling prices.

The companies' methods run the gamut. Some have been actively hedging, using complex financial instruments, while others have preferred to manage fuel inventories or pass along costs to consumers.

Last September, Southwest Airlines decided to prepare for the possibility of war in the Persian Gulf. The company bought financial derivatives to ensure that it would never pay much more than 70 cents a gallon for jet fuel — the equivalent of a bit more than $23 for a barrel of crude oil, compared with the price of $28.80 today — for its fuel supply this quarter. More than 75 percent of its fuel needs for the remainder of 2003 and all of 2004 are similarly protected, and some of its hedges extend all the way to 2008.

Southwest's hedges mostly take the form of common but sophisticated derivatives called collars and swaps, said Gary C. Kelly, the airline's chief financial officer. In the near term, about two-thirds of the derivatives are based on prices for heating oil, which follow rates for jet fuel more closely than those for crude oil.

The cost of price protection amounts to about 1 or 2 cents for each gallon of jet fuel, Mr. Kelly said. With jet fuel being traded for more than $1 a gallon lately, he added, "it's obviously a very substantial saving."

Southwest, though, may be the exception rather than the rule.

"It varies tremendously from firm to firm," said Edward N. Krapels, an expert on risk management at Energy Security Analysis, a research firm in Wakefield, Mass. "In the airline industry, you'll find some who are quite aggressive hedgers, and others who are not."

Mr. Krapels said some companies might have become wary of hedging after buying derivatives to protect themselves, only to find that oil prices would fall. In the Persian Gulf war of 1991, for example, the sudden drop in prices that accompanied the build-up of coalition forces and their early victories took many companies by surprise.

As a result, Mr. Krapels explained, "most large consumers are underhedged, with some very significant exceptions." He added, "The impact of an oil price increase on these guys will be very significant."

Companies that routinely engage in hedging tend to be in the middle of the petroleum supply chain, said Neal L. Wolkoff, the chief operating officer of the New York Mercantile Exchange, where energy derivatives are traded. "The greatest participation tends not to be from the ultimate consumer," he said. "It's more either merchants and refiners or integrated oil companies."

The Valero Energy Corporation, a top refiner, contracts in advance for cargoes of oil from China, Russia and other countries. The company uses simple mechanisms to guarantee oil prices into the near future. Because of the uncertainty about oil prices in the next few months, Valero has tried to insure itself in case market rates fall below those in its long-term contracts.

"We are concerned that prices are going to fall off after this whole Iraqi thing is resolved, so any extra barrels we have, we hedge them," said Gene Edwards, Valero's senior vice president for supply and trading.

 
ATHER than buying options to sell oil at fixed prices, as protection against prices falling, Valero sells future contracts for oil. For example, it might buy oil at $35 a barrel today and promise to sell oil at $32 a barrel next month. If the price of oil next month falls below $32, then Valero can buy oil from the market and sell it at a profit.

Mr. Edwards said that investment banks often approach Valero with more complicated derivatives, but that the futures generally offer a less expensive solution.

In addition to buying and selling futures, Valero has been engaging in a more tangible form of hedging — limiting its own stocks of oil so it can take advantage of prices if they fall. "You try to keep inventories low, because you don't want to be sitting on extra barrels," Mr. Edwards said.

That kind of activity has kept volume on the New York Mercantile Exchange near normal levels, Mr. Wolkoff said. "A lot of companies are, in effect, hedging through their physical business," he said. "That means there appears to be a reticence to hold inventory. That's one way of hedging, simply by reducing your exposure."

Some companies that use a lot of fuel have an even simpler way of dealing with high and low prices. The Roadway Corporation, the trucking-line operator, passes along the high cost of fuel to customers through a surcharge. Each week, the company updates the surcharge automatically, using the Energy Department's diesel price index.

"It makes fuel a pass-through for us," said John M. Hyre, a spokesman for Roadway. "We don't benefit by it, and we're not negatively impacted by it. We do have concern for the impact that rising fuel costs have on our customers, though."

The company can benefit, however, when fuel prices drop steeply. "If we encounter good pricing, we will work on getting long-term contracts under that good pricing," Mr. Hyre said.

If the war in Iraq does not go as the Pentagon has planned, any sudden spike in oil prices could have the harshest effects on some people who have little use for petroleum products, except on the drive to work. Hedge-fund managers and other speculators who sell financial protection to companies like Valero could be at risk, Mr. Krapels said.

"If the war goes badly, and the oil price goes significantly higher than it is today, how well can the people who took the short side of that bet withstand it?" he asked. "There could be some very big credit exposures." 

The dangers of derivatives abuse and the excessive amounts of derivatives now in the markets --- http://www.trinity.edu/rjensen/fraud.htm#DerivativesFraud 

"The Impact of FAS 133 on the Risk Management Practices of End Users of Derivatives," Association for Financial Professionals, September 2002 --- http://www.kawaller.com/pdf/AFP_2002.pdf 

The Financial Accounting Standards Board (FASB) issued new accounting rules for derivatives and hedging transactions (Financial Accounting Statement 133, or FAS 133) in June 1998 that were effective on June 15, 2000. Most companies, however, did not implement the standard until the first quarter of 2001. Because the transition from the previously accepted accounting treatment was dramatic and controversial, many reporting entities — along with FASB and the Securities and Exchange Commission (SEC) — were concerned about the impact that these new rules might have on the hedging activities of corporations. To gain a clearer perspective on the impact of FAS 133, the Association for Financial Professionals (AFP) surveyed its members in January 2001.

This original survey had several major conclusions.

The 2001 survey was conducted in early January, just a few months after companies started complying with FAS 133 requirements, but since then, FAS 133 has continued to evolve. FASB has posted additional guidance on its web site ( http://www.fasb.org ); and on May 1 2002, released a new exposure draft containing proposed amendments to FAS 133. AFP decided to survey its membership again, to see whether companies have altered their use of derivatives two years after the effective date of FAS 133.

Survey Methodology

AFP mailed an eight-page questionnaire to select corporate practitioner members1 in May 2002 and received 175 valid responses. Respondents represented a wide variety of companies throughout the United States, with respondents typically working for company with annual revenues between $1 and $5 billion Treasury and finance professionals of varying job titles completed the questionnaire. Most survey respondents identified themselves as treasurers (29 percent), assistant treasurers (25 per-cent), CFOs (19 percent), and risk managers (10 percent). Respondents also identified the person charged with overall responsibility for FAS 133 implementation as controller/comptrollers (25 percent), CFOs (20 percent), treasurers (19 percent) and assistant treasurers (15 percent).

Footnote 1 
Surveys were sent to corporate members holding titles of CFO, treasurer, or controller and to members who identified any of the following as one of their five primary job responsibilities: accounting/financial reporting, hedging, risk management, and financial risk management.

Executive Summary 

The 2002 survey asked many detailed questions concerning the use of derivative tools and the impact of FAS 133 on company behavior. The principal findings and conclusions are as follows: 

Bob Jensen’s documents (including audio and video) on FAS 133 are at http://www.cs.trinity.edu/~rjensen/000overview/mp3/133intro.htm 

Update on Derivative Financial Instruments and FAS 133

Letters to the Editor
An Eye on Derivatives
The New York Times
March 10, 2002

To the Editor:

Re: "Contracts So Complex They Imperil the System", NY Times, February 24, 2002

To characterize derivatives as not being transparent is a mistake. Derivatives are transparent. They are carried on the balance sheet at their market value, and changes in value are explicitly recorded in financial statements. If derivatives are used in special purpose vehicles or by subsidiaries, however, they won t be apparent at the consolidated statement level. This lack of transparency is not a function of the derivative. Rather, it s a function of the consolidation process.

Ira Kawaller --- http://www.kawaller.com/pdf/Times.pdf 

Some December 2002 Updates on Accounting for Derivative Financial Instruments and Hedging Activities

"A Pain in the FAS," by Jay Sherman, March 2002 --- http://www.kawaller.com/pdf/TRMMar02.pdf 

Ask Jay Fitzsimmons what he thinks about Financial market derivative holdings and record gains or losses into the profit-and-loss statement, has resulted in the execution of deals that are less than optimal. "There are a lot of good treasury deals that have to be rethought because they won’t get P&L treatment" under FAS 133, Fitzsimmons says.

He ought to know. Fitzsimmons, senior vice president of finance and treasurer at retail giant Wal-Mart Stores Inc., cites two seemingly similar derivatives transactions with like risk profiles that wound up getting very different accounting treatment for the Bentonville, Ark.-based company, thanks to FAS 133. The first involved a European subsidiary issuing debt through a swap. Last year, that deal—a £500 million, 30-year bond offering— generated a gain for Wal-Mart and received P&L treatment. Yet when Wal-Mart set up a British subsidiary solely to raise funds in Britain through a transaction that would swap U.S. dollars for sterling, FAS 133 rules said the emergence of the rule (T&RM, October 2001).

From Ira at http://www.kawaller.com/more_news.htm 

More Kawaller & Company in the News

Complete Book --- http://www.afponline.org/Information_Center/Publications/Principles_and_Practices_for_T/principles_and_practices_for_t.html 
Association for Financial Professionals

Principles and Practices for The Oversight & Management
of Financial Risk

Table of Contents

Acknowledgment

Chapter 1 - Introduction

Chapter 2 - Financial Governance and Oversight

  • The Role of Senior Management in the Risk Management Process

  • A Board Level Checklist for Risk Management

  • Policy and Control Guidelines

  • Organizational Roles and Responsibilities -- Centralized versus Decentralized Treasury Structures

  • Risk Measurement and Reporting

Chapter 3 - Accounting and Disclosure Developments

  • SEC Risk Disclosure Requirements

  • Financial Accounting Standards Board Proposed Standard for: Accounting for Derivatives and Hedging Activities

  • Significant Changes from Current Accounting and the Impact on Financial Risk Management

Chapter 4 - Other Issues in Financial Risk Management

  • Credit Risk Management

  • Enterprise-Wide Risk Management

Appendix I
SEC Market Risk Disclosure Rule -- Accounting Policy Disclosures

Appendix II
FASB - Proposed Standards for Accounting for Derivatives and Hedging Activities

 

Accounting Tax Rules for Derivatives --- http://www.investmentbooks.com/tek9.asp?pg=products&specific=joongngrm 
by Mark J.P. Anson
Publisher's Price: $150
ISBN#: 1883249694
Catalog #: B14982W

Accounting for Derivatives and Hedging --- http://www.amazon.com/exec/obidos/ASIN/0072440449/ref%3Dnosim/rbookshop-20/102-9630658-3132135#product-details 
by Mark A. Trombley (Paperback) 

  • Paperback: 240 pages

  • Publisher: McGraw-Hill/Irwin; 
    ISBN: 0072440449; (April 26, 2002)

The right tools for the job --- http://www.accountancysa.org.za/archives/2002aug/features/tools.htm 

Magnus Orrell is a Project Manager at IASB. For more information, visit www.iasb.org.uk.

The International Accounting Standards Board (IASB) issued proposals for improvements to the two international accounting standards on financial instruments that affect derivatives – IAS32 and IAS39 – in June. How will these proposals affect accounting for derivatives?

Greg Gupton's site is a major convergence point of research on credit risk and credit derivatives --- http://www.credit-deriv.com/crelink.htm 

Bob Jensen's tutorials on FAS 133 can be found at http://www.trinity.edu/rjensen/caseans/000index.htm 

When I first began reading a novel about derivatives, two paragraphs in the Preface really caught my attention.  They seem to apply more so today in the aftermath of Enron's trading disasters. Those  paragraphs written in 1997 read as follows::

Derivatives have become the largest market in the world.  The size of the derivatives market, estimated at $55 trillion in 1996, is double the value of all U.S. stocks and more than ten times the entire U.S. national debt.  Meanwhile, derivative losses continue to multiply.  

Of course, plenty of firms made money on derivatives, including Morgan Stanley, and the firm's derivatives group is thriving, even as derivatives purchases lick their wounds.  Some clients tired of having their faces ripped off or being blown up, and business declined briefly in 1995 and 1996.  Many of us quit during this period, some leaving for less brutish firms.  
(Continued on Page 15)
Frank Partnoy in FIASCO:  The Inside Story of a Wall Street Trader (New York:  Penguin Putnam, 1997, ISBN 0 14 02 7879 6)

We have been following the transition of public accountants from the most trusted profession in the United States to one of the least trusted.  It is interesting how this transition is taking place amidst a somewhat similar transition in investment banking and securities trading in general.  The following quotation from the above Preface may really open your eyes:

From 1993 to 1995, I (Frank Parnoy) sold derivatives on Wall Street.  During that time, the seventy or so people I worked with in the derivatives group at Morgan Stanley in New York, London, and Tokyo generated total fees of about $1 billion --- an average of almost $15 million a person.  We were arguably the most profitable group of people in the world.

My group was the biggest moneymaker at the firm by far.  Morgan Stanley is the oldest and most prestigious of the top investment banks, and the derivatives group was the engine that drove Morgan Stanley.  The $1 billion we made was enough to pay the salaries of most of the firm's ten thousand worldwide employees, with plenty left for us.  The managers in my group received millions and millions in bonuses;  even our lowest level employees had six-figure incomes.  An many of us, including me, were still in our twenties.

How did we make so much money?  In part, it was because we were smart.  I worked with the greatest minds in the derivatives business.  We mastered the complexities of modern finance, and it is no coincidence that we were called "rocket scientists."  (Page 15)

This is the part that indirectly relates to the changing business model of public accountants.

This was not the Morgan Stanley of yore.  In the 1920s, the white-shoe (in auditing that would be black-shoe) investment bank developed a reputation for gentility and was renowned for fresh flowers and fine furniture (recall that Arthur Andersen offices featured those magnificent wooden doors), an elegant partners' dining room, and conservative business practices.  The firm's credo was "First class business in a first class way."

However, during the banking heyday of the 1980s, the firm faced intense competition from other banks and slipped from its number one spot.  In response, Morgan Stanley's partners shifted their focus from prestige to profits --- and thereby transformed the firm.  (Emphasis added)  Morgan Stanley had swapped its fine heritage for slick sales-and-trading operation --- and made a lot more money.

Other banks --- including First Boston, where I worked before I joined Morgan Stanley --- could not match Morgan Stanley's aggressive sales tactics.  By every measure, the firm had been recast.  The flowers were gone.  The furniture was Formica.  Busy managers ingested lunch, if at all, at a crowded donut stand jammed between two hallways along the trading floor.  Aggressive business practices inspired a new credo:  "First class business in a second class way."  After decades of politesse, there were savages at Morgan Stanley."  
(Continued on Page 14 of the book cited above).

Added notes from Bob Jensen

I was sitting in Times Square (where I was Program Director for the 1994 American Accounting Association Annual Meetings in the Marriott Marquis Hotel) and captured an address by the Chairman of the Financial Accounting Standards Board (Denny Beresford) quoting that until 1993 he thought derivatives were "something a person his age took when prunes did not quite do the job."  You can hear my MP3 recording of Denny's remarks (along with related and free audio and video clips) at http://www.cs.trinity.edu/~rjensen/000overview/mp3/133summ.htm#Introduction 

Bob Jensen's overviews of accounting for derivative financial instruments, including cases and case solutions, can be found at the following two links:

http://www.trinity.edu/rjensen/caseans/000index.htm 

http://www.cs.trinity.edu/~rjensen/ 

Bob Jensen's threads on derivatives frauds can be found at http://www.trinity.edu/rjensen/fraud.htm#DerivativesFraud

How the professions of financial analysis and investment banking became rotten to the core is elaborated upon at http://www.trinity.edu/rjensen/fraud.htm#Cleland 

Bob Jensen's spreadsheets on my KPMG workshop cases.  Open the 0000KPMG folder at http://www.cs.trinity.edu/~rjensen/

New and Revised Already!

FAS 133 Hedge Accounting Ineffectiveness Testing Short Cases --- http://www.cs.trinity.edu/~rjensen/000overview/mp3/000ineff.htm  
The above document was specially prepared for my Year 2000 KPMG Workshops that I am conducting with Ira Kawaller in Chicago October 12-13, New York City November 2-3, and Las Vegas November 30-December 1. Persons interested in attending these workshops may contact Lysle Hollenbeck at  [lhollenbeck@kpmg.com] 

If you previously downloaded the Excel workbook copy of my three "short" cases on testing for hedge ineffectiveness using futures (Case B7), Forwards (Case A7), and foreign currency forward contracts (Case A1), please download a fresh copy from  by downloading the Excel Workbook 133ex07a.xls file.  This file has been temporarily removed so that my students may temporarily not access the answers.  If you are not one of my students, you may contact me for a the solution file at rjensen@trinity.edu .

There may be other corrections and additions after the rest of you give me feedback.  One reason I really love the Internet is that people using my cases point out their flaws and shortcomings.  Robert Steeindt pointed out that in my Case A1 the spot and forward prices did not converge at maturity for Nation 2 foreign currency.  I fixed this.  There was also confusion over the DELTA(t) definitions.  I added commentaries and made some corrections.

Case B7 features a a hedge effectiveness test based upon DELTA(t) defined as the absolute value of the change in futures prices divided by the change in spot prices of corn.

Case A7 features a a hedge effectiveness test based upon DELTA(t) defined as the absolute value of the change in forward prices of Columbian coffee divided by the change in forward prices of Brazilian coffee.

Case A1 features a a hedge effectiveness test based upon DELTA(t) defined as the absolute value of the change spot prices of Nation 2 currency divided by the change spot prices of Nation 1 currency. Since spot prices are used, Paragraph 63(c ) is invoked where effectiveness testing excludes the difference between forward and spot prices.

Case A1 also adds a test for hedge ineffectiveness materiality.   Hedge accounting in Case A1 is denied only when the hedge ineffectiveness is material in dollar amount as well as violates the 0.80-1.25 Rule for DELTA(t).

Note in particular that I have some relatively short (relatively short in terms of the cases listed below) that expand upon FAS 133 Appendix A Problem 7 versus Appendix B Problem 7.  You can proceed directly to those short cases by downloading the Excel Workbook 133ex07a.xls file at http://www.cs.trinity.edu/~rjensen/  This file has been temporarily removed so that my students may temporarily not access the answers.  If you are not one of my students, you may contact me for a the solution file at rjensen@trinity.edu .

In that same workbook, I extended a KPMG example on foreign currency hedging of an equipment purchase.  Whereas KPMG assumed perfect hedge effectiveness, I added examples of both immaterial and material hedge ineffectiveness.  Go to my 133ex07a.xls file at http://www.cs.trinity.edu/~rjensen/ 

I have also improved by Excel Workbook expansions of Appendix B Examples 9 and 10.  These are in files 133ex09.xls and 133ex10.xls files that can be downloaded from http://www.cs.trinity.edu/~rjensen/ 

Warning:  If you downloaded the following case and/or its accompanying Excel Workbook prior to August 22, please discard those files and download the updated files.  Both the case and the Excel Workbook contained some serious errors that (hopefully) have been corrected.

I am sharing my latest working draft of a case entitled FAS 138 Benchmark Interest Value-Locked Debt Accounting Case.  This is accompanied by a rather complicated Excel workbook.  The link to everything is now available at http://www.cs.trinity.edu/~rjensen/000overview/mp3/138bench.htm.  However, the way I keep revising both the case and the worksheet, it is probably best to wait until I make an announcement that I am at last happy with my work (that I mistakenly posted before it made sense.)

One feature of the case is a focus on accounting for hedge ineffectiveness.  In addition to the familiar 0.80-1.25 DELTA(t) Rule, I introduce a parameter for hedge amount ineffectiveness.  Testing for ineffectiveness significance only on the 0.80-1.25 rule ignores hedge materiality.  I propose a joint test for materiality and significance.  If C(t) depicts the carrying value of the debt, A(t) depicts the current discount/premium amortization, and I(t) depicts the present value of the the index rate present values as specified in FAS 138, most firms want economic hedges to qualify for FAS 138 hedge accounting in order to adjust carrying value of the debt by [I(t)-I(t-1)] to offset the booking of changes in hedge (e.g., swap) values required under FAS 133.  Suppose -V(0) proceeds are received when the debt is issued for a market rate liability of V(0).

With No Qualifying Hedge or a Hedge that Combines Ineffectiveness Materiality and Significance in Terms of the 0.80-1.25 Rule for DELTA(t). 

C(t)= C(t-1)+A(t)  
      = V(0)-[V(0)+SA(t) to date]

With A Qualifying Hedge or a Hedge that Combines Ineffectiveness Immateriality and Insignificance in Terms of the 0.80-1.25 Rule for DELTA(t). 

C(t)= C(t-1)+A(t)+[I(t)-I(t-1)]  
      = V(0)-[V(0)+SA(t) to date]+[I(t)-I(t-1)] 

A long last I think I have my Excel Workbook hedge ineffectiveness Materiality and Significance tests working in the Excel Workbook accompanying my originally error-bound case at http://www.cs.trinity.edu/~rjensen/000overview/mp3/138bench.htm.

One question never addressed by standard setters is what do do about hedge ineffectiveness that is material in amount but also has a DELTA(t) ratio falling within the 0.80-1.25 Rule bounds.  In my case, I do not deny hedge accounting in those outcomes, although the reason has me staring at the wall and wondering why.

I apologize for my confusions passed along to students and faculty in early versions of this case that were released before being fixed up.  In addition I apologize that even without the Excel Workbook, the case is over 70 pages long.  That also makes me stare at the wall and wonder why.

I am sharing the first draft of Working Paper 288 entitled Overhedging Foreign Currencies With a Swap: The FAS 133 Controversy.  At this point the HTML version is merely a pasting of one spreadsheet from the 288wp.xls Excel workbook.  I suggest that interested readers download the Excel workbook.  You can obtain download information from http://www.cs.trinity.edu/~rjensen/288wp.htm 

I would really appreciate feedback on this case.  I went out on a limb and need more assurance that I am on the right track in this controversy.

I am sharing the first draft of Working Paper 287 entitled Underhedging Foreign Currencies With a Swap: The FAS 133 Controversy.  At this point the HTML version is merely a pasting of one spreadsheet from the 288wp.xls Excel workbook.  I suggest that interested readers download the Excel workbook.  You can obtain download information from http://www.cs.trinity.edu/~rjensen/287wp.htm 

I would really appreciate feedback on this case.  I went out on a limb and need more assurance that I am on the right track in this controversy.

It is probably best to begin with Examples 1-10 in Appendix B of FAS 133. Then I would like them to read the following two documents about Examples 2 and 5:

http://www.trinity.edu/rjensen/caseans/294wp.doc 
The Excel workbook is at http://www.cs.trinity.edu/~rjensen/133ex02a.xls 

http://www.trinity.edu/rjensen/caseans/133ex05.htm 
The Excel workbook is at http://www.cs.trinity.edu/~rjensen/133ex05a.xls 

This above files have been temporarily removed so that my students may temporarily not access the answers.  If you are not one of my students, you may contact me for a the solution files at rjensen@trinity.edu .

The links to five cases on hedging strategies and accounting under new rules for accounting for derivative financial instruments and hedging activities are as follows:

MarginWHEW Bank Case (interest rate profit hedging with 30 Eurodollar futures contracts)
http://www.trinity.edu/rjensen/caseans/285case.htm
 The Excel spreadsheet is at http://www.trinity.edu/rjensen/caseans/xls/285wp/285wp.xls 

Margin OOPS Bank Case (interest rate profit hedging with 75 Eurodollar futures contracts)
http://www.trinity.edu/rjensen/caseans/285case.htm
You can access the MarginOOPS Bank Case with buttons at the bottom of the screen.
The Excel spreadsheet is at http://www.trinity.edu/rjensen/caseans/xls/286wp/286wp.xls 

CapIT Corporation Case (interest rate caps with Eurodollar interest rate put options taken from the Wall Street Journal)
http://www.trinity.edu/rjensen/caseans/ccase.htm
 The Excel spreadsheet is at http://www.trinity.edu/rjensen/caseans/xls/283wp/283wp.xls 

FloorIT Bank Case (interest rate floors with Eurodollar interest rate call options taken from the Wall Street Journal)
http://www.trinity.edu/rjensen/caseans/ccase.htm
You can access the FloorIT Bank Case with buttons at the bottom of the screen.
The Excel spreadsheet is at http://www.trinity.edu/rjensen/caseans/xls/284wp/284wp.xls 

Mexcobre Case (a complex international hedging case involving a copper price swap)
http://www.trinity.edu/rjensen/caseans/133sp.htm
The Excel spreadsheet is at http://www.trinity.edu/rjensen/caseans/xls/mexcobre/133spans.xls

Big Wheels Cross-Currency Swap Case, Student Project by Rachel Grant, Accounting 5341, Trinity University, Spring 2000 
http://www.trinity.edu/rjensen/acct5341/projects/sp2000/grant/StartPage.htm 

The Hubbard and Jensen paper on Example 5 of FAS 133 (that points out some errors in the Example 5) can be downloaded as follows:

http://www.trinity.edu/rjensen/caseans/133ex05.htm 
The Excel workbook is at http://www.cs.trinity.edu/~rjensen/133ex05a.xls 

The Hubbard and Jensen explanation of Example 2 of FAS 133 can be downloaded as follows:

http://www.trinity.edu/rjensen/caseans/294wp.doc 
The Excel workbook is at http://www.cs.trinity.edu/~rjensen/133ex02a.xls 

Readers may want to download one or more of my Excel files linked at http://www.cs.trinity.edu/~rjensen/13300tut.htm

Some solution files have  been temporarily removed so that my students may temporarily not access the answers.  In particular, my Excel spreadsheets for FAS 133 Appendix B Examples 1-10 have temporarily been removed.  If you are not one of my students, you may contact me for a the solution files at rjensen@trinity.edu . 

I wrote a document (screen play? short story? tutorial? case?) that is a takeoff on the Muppets.  It is entitled "Clyde Gives Brother Hat a Lesson in Arbitrage" and can be found at http://www.trinity.edu/rjensen/acct5341/speakers/muppets.htm 

Readers may also want to download the excellent FAS 133 cases by Teets and Uhl at http://www.gonzaga.edu/faculty/teets/index0.html

A listing of various solution files can be found at http://www.cs.trinity.edu/~rjensen/ 
These include my spreadsheet extensions of the FAS 133 examples.  For example, file names for some of these examples are as follows:

Excel Spreadsheet Example File Name
FAS 133 Example 01 133ex0a1.xls
FAS 133 Example 02 133ex02a.xls
FAS 133 Example 03 133ex03a.xls
FAS 133 Example 04 133ex04a.xls
FAS 133 Example 05 133ex0a5.xls
FAS 133 Example 06 133ex06a.xls
FAS 133 Example 07 133ex07a.xls
FAS 133 Example 08 133ex08a.xls
FAS 133 Example 09 133ex09a.xls
FAS 133 Example 10 133ex10a.xls
Others are available  

Instructions are given at http://www.cs.trinity.edu/~rjensen/13300tut.htm 

Some solution files have  been temporarily removed so that my students may temporarily not access the answers.  In particular, my Excel spreadsheets for FAS 133 Appendix B Examples 1-10 have temporarily been removed.  If you are not one of my students, you may contact me for a the solution files at rjensen@trinity.edu .  

My course syllabus, helpers, and assignments --- http://www.trinity.edu/rjensen/acct5341/index.htm

Recommended Tutorials on Derivative Financial Instruments (but not about FAS 133 or IAS 39)

CBOE --- http://www.cboe.com/education/ 

CBOT --- http://www.cbot.com/ourproducts/index.html 

CME --- http://www.cme.com/educational/index.html 

Recommended Tutorials on FAS 133

 

Question
What does yield burning mean?

 

Answer

"IRS Examines Derivatives Schemes." by John Connor, The Wall Street Journal, December 4, 2003 --- http://online.wsj.com/article/0,,SB107049507430505200,00.html?mod=mkts_main_news_hs_h 

The Internal Revenue Service is investigating the use of derivatives to implement suspected "yield-burning" schemes in the municipal-bond market.

In addition, the agency is seeing instances of apparent bid-rigging of derivatives, a senior IRS muni-enforcement official said.

The IRS several years ago joined with the Securities and Exchange Commission and the Justice Department in taking enforcement action against many Wall Street and regional brokerage firms for alleged yield-burning abuses -- slapping excessive markups on Treasury securities used in escrow accounts created in connection with muni advance refunding transactions. These deals were done in the early 1990s.

The new crop of transactions under scrutiny seem to be from 1998 forward, IRS officials said. The SEC also is investigating some of these transactions, according to people familiar with the matter.

A common denominator in these more recent transactions is the use of derivatives -- financial contracts whose value is designed to track the value of stocks, bonds, currencies, commodities or some other benchmark -- to divert arbitrage profits to investment bankers and lawyers, said Mark Scott, director of the IRS's tax-exempt bond program.

Arbitrage is generally barred in the muni market, where it is earned by investing tax-exempt bond proceeds in higher-yielding instruments. Arbitrage profits are supposed to be rebated to the Treasury Department. Yield-burning is a form of arbitrage abuse.

The IRS's Mr. Scott said it's not yet clear how pervasive the new, derivatives-related abuses are. But he said, "We are finding more problems than I expected." He said the agency's investigation is expanding.

One specific concern involves the use of put options in advance-refunding escrow accounts. A put option is a provision in a bond contract under which the investor has the right -- on specified dates after required notification -- to return the securities to the issuer or trustee at a predetermined price.

"Recent examinations involving advance-refunding bonds with put options in the escrow highlight increasing concerns about the use of derivative-type products as a more-sophisticated yield-burning or general abusive arbitrage scheme," said Charles Anderson, manager of the IRS's tax-exempt-bond field operations. "In the case of a put-option escrow, there is simply no reasonable need for the purchase of a put in an escrow that is already sufficient for defeasance of earlier bonds." He said that "any time people can sell products paid for with money normally rebatable to Uncle Sam, you will see the sharks circling."

Messrs. Scott and Anderson declined to comment on specific cases or securities firms or law firms.

The IRS settled at least one put-option escrow case recently and is inviting parties involved in similar deals to come forward and seek settlements through the agency's voluntary closing agreement program.

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

Recommended Glossaries

Bob Jensen's FAS 133 Glossary on Derivative Financial Instruments and Hedging Activities

Also see comprehensive risk and trading glossaries such as the ones listed below that provide broader coverage of derivatives instruments terminology but almost nothing in terms of FAS 133, FAS 138, and IAS39: