Freddie Opts Out of Hedge Accounting

Freddie Mac may be recovering from the biggest controversy in its history, an accounting mess that cost most of its top officers their jobs, but you'd still expect the secondary market giant to have more accounting expertise than just about anyone else in the business. So when Freddie Mac decides to voluntarily end hedge accounting treatment for some of its derivatives, it may say more about the complexity of those accounting rules than it does about Freddie Mac.

During a conference call to update investors about third-quarter business developments, Freddie Mac announced changes to its hedge accounting practices. The company said that it has determined that pay-fixed interest rate swaps and other derivatives that had previously been reported in cash-flow hedge accounting relationships no longer meet the hedge accounting requirements under Financial Accounting Standard 133.

As a result, Freddie Mac expects to discontinue hedge accounting for these relationships effective with the second quarter of 2004. A spokesperson for Freddie Mac said that changing interest rate conditions were a factor in the determination that the derivatives no longer qualify for hedge accounting.

Freddie Mac also said it is voluntarily discontinuing hedge accounting treatment for the majority of its receive-fixed interest rate swaps, saying that this step will help the company address period-to-period volatility in the total portfolio of no hedge designation derivatives. A receive-fixed swap results in the corporation's receipt of a fixed interest-rate payment from its counterparty in exchange for a variable rate payment to the counterparty. Conversely, a pay-fixed swap requires Freddie Mac to make a fixed interest-rate payment in exchange for a variable rate payment.

Generally, receive-fixed swaps increase in value increase in value and pay-fixed swaps decrease in value when interest rates decline, Freddie Mac explained in its 2003 annual report.

Freddie Mac said the changes in hedge policy have no impact on prior audited financial results or interest rate risk measures.

"We believe that this voluntarily discontinuance of hedge accounting treatment for receive-fixed swaps will help us to address the periodic volatility in the total no-hedge designation portfolio of derivatives and to reduce operational complexity in our accounting and reporting functions," said Martin Baumann, executive vice president and chief financial officer, during Freddie Mac's teleconference to update investors about activity at Freddie Mac.

He went on to say that the accounting change "has absolutely nothing to do with the economics of the business. It has nothing to do with interest rate management."

The decisions regarding hedge accounting reflect accounting rules and do not, of course, mean that Freddie Mac will stop using these or other derivatives to hedge its interest rate risk exposure. But the way some of that risk management is reported in financial results will change.

While Freddie Mac has faced stiff competition in the market to purchase mortgage loans, its portfolio continues to grow. And in turn, its need to manage interest rate risk exposure has grown as well.

As Freddie Mac pointed out in its 2003 annual report, derivatives are an important part of the corporation's risk management strategy. But they may increase the volatility of reported net income, especially when they don't qualify for hedge accounting treatment.

Freddie Mac said that since the beginning of this year, its total mortgage portfolio has grown at an annualized rate of 7.1% to $1.489 trillion as of Sept. 30.

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