Risk-Sharing's Success Creates Accounting Conundrum for GSEs
The government-sponsored enterprises' risk-sharing deals are being hailed as an innovative approach for Fannie Mae and Freddie Mac to offload credit exposure to private markets. But their growing popularity is raising questions about how these transactions should be reported in financial statements.
Currently, the risk-sharing bond transactions costs are included in net interest income, a metric defined by generally accepted accounting principles. And so far, the transactions haven't been deemed material enough to break out as a standalone item in its non-GAAP financial details. But if these activities become a more significant component of the GSEs' businesses, it's unclear at this point how they would be reported.
"[W]e don't issue specific measures because there are no standards out there as exactly how to measure this," Freddie Mac CEO Donald Layton said about the risk-sharing deals during a conference call on the company's first quarter financial results.
A more immediate question for Freddie Mac, however, is whether it should re-evaluate which subset of non-GAAP breakouts it classifies the credit-risk transfer deals' costs.
"It probably should be more part of the management guarantee income at some point when it becomes very large," said Layton, referring to a non-GAAP measure of G-fee revenue.
Freddie is considering reclassifying the risk-sharing deals as part of G-fee revenue because the transactions result in a reduction to G-fee income.
"Instead of them earning that guarantee fee, someone else is earning at least a portion of the guarantee fee," explained Andrew Davidson, an industry analyst and consultant who helped develop the structure for some of the GSEs' risk-sharing products.
While the G-fee reduction is offset by a reduction in credit reserves, the upside of the risk-sharing deals primarily shows up when losses on loans hit certain triggers down the road. Most of the CRT transactions have been done on Freddie Mac's new book of business, which has better performance than its legacy book.
Non-GAAP reporting provides companies more flexibility than the GAAP measures designed to provide consistent standards across myriad companies and industries. But non-GAAP reporting has been under some scrutiny due to concerns that it could be used more to mislead than inform. Freddie and Fannie Mae have reported similar business-line breakouts of non-GAAP segment earnings since at least 2008.
Layton said Freddie's non-GAAP reporting is transparent.
"Total segment earnings net income and comprehensive income are the exact same as GAAP net income and comprehensive income — there is no difference in the bottom line," said Layton. "What is different is that our segment presentation changes the geographic location of certain line items on the income statement, all to better align with how we view the economics of the business and to make the numbers more understandable."
For example, the guarantee fee business that has been increasingly central to GSE profits is a component of GAAP net interest income, but only broken out in non-GAAP reporting, said Ekalavya Prakash, Freddie's vice president of financial planning and analysis.
"We're a guarantee business, and if you look at our financial statement under U.S. GAAP you can't even see where that business is sitting," he said.
The GSEs' conservator, the Federal Housing Finance Agency, is aware of the non-GAAP reporting and monitors it, Prakash said.
"They do have an understanding of what we do, and I'm sure if there was something they would disagree with, they might escalate it to us," said Prakash.
While Freddie has been contemplating changes to non-GAAP earnings, Fannie said it has not.
"We have no intention at this time to change," said Pete Bakel, director of financial communications at Fannie Mae.
But Freddie thinks if newer business lines are added or become more material, change to non-GAAP reporting is likely.
"We could come up with different types of transactions," Prakash said. "At that point in time you would have to again address, where do we place them?"
In addition to bond deals, there have been risk-sharing insurance transactions recorded elsewhere in earnings. In total, the GSEs have transferred a significant amount of risk on more than $1 trillion in unpaid principal balance on loans using a combination of risk-sharing bond and insurance deals.