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The Fannie Mae
Derivatives Reporting Debacle
A Case Study in FAS 133 Pitfalls
December 2004
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Overview
• Background on Fannie Mae
• What Happened?
– Magnitude of the Disaster
• FAS 133 Rules & Revisions
– Major Pitfalls
• Shortcut Method
•
Observations
&
Conclusions
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Who Is Fannie Mae?
• Fannie Mae Is The Giant Housing-Finance
Company
– A private, shareholder-owned company whose stock
is traded on the New York Stock Exchange
– Not a government entity now
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Who Is Fannie Mae?
• Created by Congress in 1938 operating under Federal
control
– Privatized by legislation enacted in 1968 and became fully
private in 1970
– Operates under a federal charter, called the Federal National
Mortgage Association Charter Act
– Mission is to increase liquidity in the residential mortgage
finance market and promote access to mortgage credit
• Second largest U.S. corporation, in terms of assets
– Since 1968, provided 63 million homeowners with more
than $6.3 trillion in housing finance
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RISK LIMITED CORPORATION
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What Was Fannie Mae’s
Derivatives Reporting Debacle?
• It Is Alleged That Fannie Mae Incorrectly
Reported The Financial Results On Their
Derivative Instruments Used For Interest
Rate Hedging
– Incorrect FAS 133 Application
– Alleged Abuse Of Accounting ‘Shortcut’ Method
– The Magnitude Of Earnings Affect Is Staggering
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What Was Fannie Mae’s
Derivatives Reporting Debacle?
• 12/15/04 findings by SEC’s chief accountant that
Fannie Mae should correct its earnings for the past
several years
– Such a restatement would wipe out $9 billion in earnings;
38 percent of FM’s profit since FAS 133 went into effect
– Bigger than the restatement that lead to the Enron
collapse
• FM’s regulator, the Office of Federal Housing
Enterprise Oversight, in a September 2004 report
accused the company of pervasive accounting
violations
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Outcome of Fannie Mae’s
Derivatives Reporting Debacle
• At the urging of the regulator and due to the
response after the Congressional hearing on
FM’s 133 problem, the CEO and CFO of
Fannie Mae have been forced to resign
• It appears likely that Fannie Mae will have to
comply with the SEC findings and restate all
prior years earnings since they began FAS
133 reporting
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FAS 133 Overview
• FAS 133 passed by FASB in June 1998
– Effective for fiscal years beginning after 6/99
• Controversial rule. Considered since the
early 1990’s
• Exposure draft provisions differed from
final Statement, but considerable opposition
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Evolution of the Rules
• FAS 133 Rules Have Not Remained Static
• Continual Evolution With Adoption By The
Financial Accounting Standards Board of...
– FAS 138 and FAS 149
– Various Derivatives Implementation Group (DIG)
Rules
– Various Emerging Issues Task Force (EITF) Rules
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Evolution of the Rules
• FAS 149
– Address apparent conflicts between certain DIG
Issues and the technical definition of a derivative
– Clarify “smaller initial net investment”
– Application of ‘Shortcut’ Method
– Potential changes to DIG Issue C15
– Effective for transactions after June 30, 2003
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Evolution of the Rules
• EITF 98-10 & EITF 02-03
– EITF 98-10, “Accounting for Contracts Involved in Energy Trading and Risk
Management Activities”
• First discussed May 1998
• Intended to give guidance on Gross vs. Net Presentation in Income
Statement
– EITF 02-03, “Issues Involved in Accounting for Derivative Contracts Held
for Trading Purposes and Contracts Involved in Energy Trading and Risk
Management Activities”
•
•
•
•
First discussed June 2002
Rescinds EITF 98-10
Net Presentation of Trading Activity
10/02 consensus effective
– New contracts and inventory purchases after 10/25/02
– Old contracts periods beginning after 12/15/02
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Evolution of the Rules
• DIG Issue C20 – “Scope Exceptions: Interpretation of
Clearly and Closely Related in Contracts That Qualify for
the Normal Purchases and Normal Sales Exception”
– EITF reconsidered issue and released tentative guidance
– Certain new circumstances where use of CPI index would
result in transaction qualifying for scope exception
– Percentage change in index must be within 80 – 120
percentage of the percentage change in the fair value of the
electricity being sold under the contract
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The Shortcut Method
• The Provision That Has Gotten Fannie Mae Into Trouble
• What Is It? And When Can It Be Used?
– Very Narrowly Applied
– Under Certain Stringent Conditions, Can Simply Assume That Hedges
Remain Perfectly Effective
– Avoids The Extensive Documentation & Quarterly Testing, And Still
Excludes Gains Or Losses From Earnings
• Zero-Value Initially For The Derivative When Designated As
A Hedge
– Issue For Re-application Or Restructuring Of Hedges
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The Shortcut Method
• Fannie Mae's auditor, KPMG LLP, flagged FM's
use of the Shortcut Method as a “Difference” and
point of concern
• But FM estimated that the accounting effect of
using the Shortcut instead of the traditional longhaul method would be "minor" and "immaterial”
– Impact on FM earnings appears now to be within the
range of the potential $9 billion restatement demanded
by the SEC
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Observations from the
Fannie Mae Debacle
• Obtaining Hedge Accounting Was Fannie
Mae’s Objective
– Which Would Likely Have Reflected Economic
Reality
– At Least Portions Of Transaction Portfolio Could
Likely Have Qualified For Hedge Accounting, If
Full Long-Haul Rules Had Been Carefully
Followed
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RISK LIMITED CORPORATION
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Observations from the
Fannie Mae Debacle
• Fannie Mae Apparently Was Motivated Partly By
The Objective Of Avoiding The Infrastructure
Cost Of FAS 133 Compliance Through Full
Requirements Of Hedge Rules
– Creation of Systems, Documentation, Quarterly
Effectiveness Testing
• Illustrates The Complexity And Effort Required
For Ongoing FAS 133 Compliance
– Challenge For Both Big And Small Organizations
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RISK LIMITED CORPORATION
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Conclusions from the
Fannie Mae Debacle
• Rules Are Rules - FAS 133 Included
– In The Post-Enron World, Caution Is In Order
When It Comes To Financial Reporting &
Disclosure
– Especially, For Derivatives
– Economic Reality Argument Doesn’t Change
Accounting Requirements Or Application
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RISK LIMITED CORPORATION
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Conclusions from the
Fannie Mae Debacle
• FAS 133 Rules Have Continually Evolved
– Subsequent Issue Of FAS 138 & FAS 149
– DIG & EITF
– Complex Set Of Rules
• However, FM Doesn’t Seem To Now Argue That
They Did Not Understand the 133 Rules
– Just Decided Not To Apply Them Since A ‘Gray Zone’
– According To CEO In Congressional Testimony, The
Disputed Rules Involve Complex Decisions About
Which Experts Often Disagree
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RISK LIMITED CORPORATION
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Conclusions from the
Fannie Mae Debacle
• FM Debacle Has Prompted Review &
Vetting Of FAS 133 Application At Many
Companies
– Documentation For Designated Hedges
– Quarterly Hedge Effectiveness Testing
– Risk Control Systems
• Evolution Of The 133 Rules Creates Both
Opportunities And Risks
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RISK LIMITED CORPORATION
 Copyright 2004
…innovation & expertise
RISK LIMITED CORPORATION
...innovation and expertise