Fannie Accused of Disregarding Rules on Derivatives

To smooth earnings, Fannie Mae managers intentionally disregarded accounting rules so that changes in the value of its derivatives used to hedge its giant mortgage portfolio would not impact earnings, according to a report by federal regulators.

The report by the Office of Federal Housing Enterprise Oversight says Fannie's misapplication of derivative accounting rules "appears to be pervasive and reinforced by management whose objective is to reduce earnings volatility."

The regulator also raises "serious doubts" about the validity of the mortgage company's financial statements for 2001, 2002 and 2003.

But so far, OFHEO officials have not called for a restatement of earnings because they don't know the magnitude of the quarterly losses or gains that Fannie Mae obscured by its accounting practices.

"That is something that will be determined in the future," an OFHEO official told reporters last week.

OFHEO is still conducting a special examination of Fannie's accounting policies and practices. But it issued an interim report to alert Fannie's board of directors and the Securities and Exchange Commission about serious accounting problems at the government-sponsored enterprise.

The report shows that Fannie classified 99% of its $1.04 trillion derivative portfolio as "perfectly effective" hedges so that that losses or gains on the derivative transactions would not show up in quarterly earnings.

The regulator contends that Fannie failed to properly document the effectiveness and ineffectiveness of its hedging transactions and many transactions do not qualify for hedge accounting under Financial Accounting Standard 133.

This could have a "significant impact on Fannie Mae's reported financial results, both prospectively and historically," the report says.

When the Freddie Mac accounting scandal broke in the summer of 2003, the company was already going through a restatement process. But OFHEO officials have just started discussions with Fannie's board and the SEC about the need for a restatement.

Nevertheless, OFHEO is questioning the validity of $12.2 billion in deferred losses related to cash flow hedges, which the regulator claims did not qualify for hedge accounting. Most of Fannie's derivatives transactions are cash-flow hedges.

"In order to determine the actual impact of the matters discussed within, a substantial investment of resources and management's commitment will be required," the OFHEO report says.

In the summer of 2003, an internal investigation at Freddie Mac revealed that senior managers developed a strategy to "neutralize" and "transact around" the accounting rules for derivatives (FAS 133) and smooth earnings.

Shortly afterwards, Fannie Mae chairman and chief executive Franklin Raines met with reporters to assure them that the same accounting stunts are not going on at his shop.

"We made no effort to try to smooth FAS 133 earnings or in any way to distort what the actual impact of FAS 133 has on Fannie Mae," Mr. Raines told reporters on July 30, 2003.

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