Hedge Accounting Issues Dog Fannie Mae

Think hedge accounting is easy? Just take a look at who did it wrong.

Secondary market giant Fannie Mae - it of the billions in annual earnings, heavyweight political clout and gigantic size - apparently didn't have the expertise to implement FAS 133, the accounting rule for hedging and derivative instruments, correctly. Or else, as its regulator alleges, Fannie Mae deliberately bent accounting rules to smooth out earnings volatility. Some say the regulators don't know what they are talking about. Others say Fannie Mae could be in big trouble for manipulating earnings.

It will take time - and millions of dollars from Fannie Mae's coffers, if not the heads of its top executives - for the secondary market agency and policymakers to sort out the accounting controversy at one of the world's most influential financial corporations. In the meantime, the mess at Fannie Mae is a reminder to mortgage servicers that accounting snafus might mushroom into major scandals.

Remember, nobody can afford to hire more accounting experts than Fannie Mae. And few corporations have more at stake in protecting their reputation than Fannie. If Fannie can fail to pass muster on hedge accounting, it isn't easy. And everyone who uses hedge accounting had better double check to make sure they aren't vulnerable to the sort of charges being leveled against the secondary market agency.

Hedge accounting is not the only issue that the Office of Federal Housing Enterprise Oversight criticized in its blistering report on Fannie Mae's accounting. In fact, most of the publicity about the report centered on allegations that Fannie manipulated the timing of loss recognition under another accounting rule - moving a $200 million loss recognition to a later period - to achieve executive bonus targets.

But a good chunk of the OFHEO report deals with FAS 133, an accounting rule of key concern for mortgage servicers that hedge their interest rate risk using derivative securities. And the accusations against Fannie perhaps serve as a warning to big mortgage servicers.

OFHEO noted that FAS 133, which became effective in 2001, presented Fannie Mae with "the potential for significant volatility in earnings and several operational challenges." To qualify for hedge accounting treatment under the new rule, Fannie Mae had to make significant changes to its administrative, documentation and accounting systems.

OFHEO said its allegations "raise serious doubts as to the validity of previously reported financial results, as well as adequacy of regulatory capital, management supervision, and overall safety and soundness of the enterprise."

Strong words - and not the sort of review any chief executive wants to read in a report from the company's regulator.

Part of the problem is that Fannie Mae's hedging practices are more dynamic and complicated than most. Implementing FAS 133 is easier if an entity engages in simple, passive hedging in which hedges are established and allowed to run their course, the regulatory report said.

Specifically, OFHEO alleges that Fannie Mae has not properly assessed and measured the effectiveness of its hedges as required under FAS 133. OFHEO says Fannie Mae has many hedge relationships that do not qualify as "perfectly effective," but have been treated as such.

OFHEO says that even after Fannie Mae had unsuccessfully lobbied the Financial Accounting Standards Board for changes in FAS 133, Fannie Mae sometimes disregarded the FASB's guidance and used accounting practices that were not approved.

How serious the allegations about accounting abuses are remains to be sorted out. But the consequences have already been damaging enough so that one thing is almost certainly true: Fannie Mae leaders wish they'd done things a little differently when it comes to hedge accounting.

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