The FAS 133 Guillotine: Could You Be Next?
First, it happened at Freddie Mac. Next, it was Fannie Mae's turn. The question mortgage servicers should be asking is "could it happen to me."
The senior most executives at both of the housing GSEs have lost their jobs over the past two years, involuntarily in almost all cases, in response to accounting scandals that centered around the implementation of complex new accounting rules for the treatment of hedging vehicles and derivative securities. While both GSEs remain strong, with growing earnings and solid prospects, that wasn't enough to save former Freddie Mac CEO Leland Brendsel or Fannie Mae chief Franklin Raines. Both of these distinguished executives and their top deputies were ushered out the door with little thanks and an ensuing controversy about severance compensation.
Why do we think mortgage servicing executives, and senior management at your parent companies, should be worried?
Because nobody really knows how to implement FAS 133 properly, and a growing chorus of critics believe that the accounting rules themselves may be to blame for at least some of the controversy that has engulfed Fannie Mae and Freddie Mac. FAS 133 was designed to make balance sheets more "transparent," but in effect it is making it increasingly difficult for lenders to hedge complicated assets like mortgage servicing rights from an economic perspective. That's because some executives believe if they get the economics of hedging right, they risk running afoul of accounting rules.
Lenders should be allowed to manage their business based on economic and market considerations. The accounting rules should be designed to give investors a clear view into what is going on. But when the accounting rules become so complex that the most sophisticated financial institutions in the world, including Fannie Mae and Freddie Mac, cannot get it right, you have to wonder how mortgage servicers would feel about having their hedge practices scrutinized by regulators. Remember, Fannie Mae and Freddie Mac had no trouble getting accounting firms to sign off on their financial statements. The accounting problems went undetected for years, and the businesses continue to operate soundly and profitably despite the crisis. If it is so tough to get the accounting right that Fannie Mae and Freddie Mac can't do it, one has to suspect that an awful lot of mortgage servicing managers have reservations about trying to comply with FAS 133. That could leave some lenders reluctant to hedge their mortgage servicing rights, even if economic conditions suggest that they should be hedging.
Getting the economics of hedging right is no excuse for getting the accounting wrong, the experts seem to be saying. As Fannie Mae found out, it does little good to be sitting on unrecognized gains in one part of your balance sheet if regulators say you are undercapitalized in another part.
As stock analyst Jonathan Gray with Sanford C. Bernstein & Co. has pointed out, even the chairman of the Financial Accounting Standards Board has cast doubt on the wisdom of FAS 133, the rule that governs accounting of derivatives and hedging instruments. If he thinks it's a bad rule, why should the mortgage industry have confidence in FAS 133% ?
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