In the spring of 2000, Fannie Mae, the giant housing-finance company, was pleading with accounting rulemakers to preserve a "shortcut" around new requirements that would be costly to implement while making earnings less predictable.
"Fannie Mae, along with many other entities, intends to rely on the 'shortcut' method," Chief Financial Officer J. Timothy Howard wrote in a letter to the rulemaking board. The rulemakers preserved the shortcut -- with restrictions -- and, in the years that followed, Fannie made extensive use of it.
Fannie Mae Chairman Franklin D. Raines, left, and J. Timothy Howard, the chief financial officer, testified at a House committee hearing in October.
(Dennis Cook -- AP)
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The requirements Fannie wanted to bypass are at the heart of last night's finding by the Securities and Exchange Commission's chief accountant that Fannie Mae should correct its earnings for the past several years. Fannie has estimated that such a restatement would wipe out $9 billion -- 38 percent of its profit since the rule went into effect in 2001.
Fannie's alleged abuse of the shortcut was one of the main issues its regulator, the Office of Federal Housing Enterprise Oversight, cited in a September report that accused the District-based company of pervasive accounting violations. The issue involves Fannie's treatment of complex financial instruments known as derivatives, which it uses to hedge against movements in interest rates.
Fannie's earlier lobbying of the rulemakers shows that the company was closely following developments at the Financial Accounting Standards Board as it drafted the controversial rule during the 1990s.
In testimony to Congress last month defending Fannie Mae's accounting, chief executive Franklin D. Raines said, in effect, that the issues fall in a gray zone. He said the dispute involves complex decisions about which experts often disagree.
OFHEO Director Armando Falcon Jr. told the same hearing that Fannie knew the rules and deliberately violated them. He said the company committed "black and white" accounting violations.
"They fully understood the rules. That's not in doubt," Wanda DeLeo, OFHEO's chief accountant, added at the hearing. "Their systems are not capable at this point of doing what we're calling long-haul accounting. . . . They could have built systems to do that, but that was not done."
In its September report on Fannie's accounting, OFHEO said, "At times, even though the FASB had rejected the requested treatment, Fannie Mae disregarded the FASB's guidance and accounted for their transactions the way they had originally proposed. "This sheds some light on the culture and attitude within Fannie Mae -- a determination to do things 'their way.' "
Accounting experts agree that the rule at issue, a 213-page opus known as FAS 133, is complex. But some experts interviewed for this story said a particular provision at the heart of OFHEO's criticism is clear-cut.
Commenting on the rule -- without judging the way Fannie applied it -- some specialists echoed the regulator's phrase, describing a key restriction on use of the shortcut as "black and white."
Fannie Mae spokesman Charles V. Greener declined to comment for this story.
To understand the debate over Fannie Mae's accounting, it helps to return to the 1990s. That's when the esoteric financial instruments known as derivatives were assuming a powerful role in the financial system and contributing to a series of financial disasters.
Derivatives are financial contracts whose terms are derived from the value of other benchmarks, such as commodity prices, stock prices or interest rates. They allow companies to place bets on the direction in which markets will move.
Derivatives can be used to speculate for profit or to hedge against risks. For example, if a company has investments that will decline in value if interest rates rise, it can protect itself by investing in derivatives that will increase in value if interest rates rise. In a perfect hedge, the derivative, and the risk it is meant to mitigate, balance each other like people of equal weight on opposite ends of a seesaw.
The nature of Fannie's business makes it a heavy user of derivatives. Chartered by the government to ensure that lenders have enough funds to meet the demand for home mortgages, Fannie borrows money by issuing bonds and uses that money to purchase mortgages from lenders. The company pays interest to its bondholders and receives interest payments on mortgages, leaving it vulnerable to both upward and downward swings in interest rates.
For example, if Fannie is paying 6 percent interest to bondholders and rates fall to 5 percent, Fannie is stuck paying an above-market rate. If Fannie is receiving 5 percent interest on mortgages and rates climb to 6 percent, Fannie is stuck receiving a below-market return on its investment. And, if interest rates fall significantly, as they have in recent years, homeowners will refinance their loans, prematurely terminating the mortgages in Fannie's portfolio and cutting short the stream of interest Fannie would have received at the higher rate.
Derivatives help Fannie modulate the effect of rate fluctuations. In a typical arrangement known as a "swap," Fannie might agree to pay a fixed interest rate to a counterparty for a fixed number of years in return for so-called variable interest payments, which change with the prevailing rates.
In the 1990s, Wall Street firms were making huge profits selling derivatives, and some big users of the devices such as Procter & Gamble Co. surprised the public with disclosures that they had incurred large losses on derivatives. In California, such losses drove Orange County into bankruptcy protection.
When companies use derivatives to speculate, the risks can be huge -- it is like gambling with borrowed money, which enables the gambler to place outsized bets.
In the 1990s, concern grew that derivatives posed hidden risks for shareholders. Accounting rulemakers worried that companies could use derivatives to manipulate earnings. Rulemakers also worried that companies were using different methods to account for derivatives, making it hard to compare businesses' performance.
To standardize accounting for derivatives and to make them more transparent to the public, FASB drafted the rule that came to be known as FAS 133. Its main thrust was to require companies to include in their quarterly earnings the amount by which their derivatives rose or fell in value, even if the contracts remained open and the company had not yet locked in the gain or loss.
Heavy users such as Fannie Mae, which strives to deliver the steady earnings growth that many investors favor, protested that those quarterly adjustments threatened to cause artificial spikes in the company's earnings. The unpredictability could require the company to keep more capital in reserve against potential financial shocks, thereby cutting into profit.
To accommodate such concerns, FASB carved out a major exception. It declared that companies could exclude gains and losses on derivatives from earnings if they could prove that they were using the derivatives to balance risks and not to speculate. To qualify for that special treatment, known as hedge accounting, a company must document that the derivative was paired with a specific asset or liability.
In addition, the rule said, the company must conduct quarterly tests to confirm that the derivative continues to counter the risk. To the extent that the derivative has fallen out of balance with that risk, the company must adjust its earnings. The testing requirement can be a costly burden, especially for companies using derivatives on a grand scale.
But again, FASB provided an exception. The rulemakers declared that, under certain stringent conditions, companies could simply assume that their hedges remained perfectly effective, avoid the extensive quarterly testing, and exclude the gains or losses from earnings.
In accounting parlance, that is known as taking the "shortcut" instead of the "long haul."
The testing and documentation requirements of long-haul accounting were meant to prevent companies from cherry-picking -- waiting to see how derivatives perform and then claiming profit from the successful transactions while saying the losers were actually hedges and should not be counted against earnings, said Daniel B. Thornton, an accounting professor at Queen's University in Kingston, Ontario, and a former academic fellow at the SEC.
To take the shortcut, companies must show that when a hedge was put in place, the value of the derivative was zero -- the normal starting point for a new hedge. OFHEO alleges that Fannie routinely violated that condition when it changed financial strategies and, with no new testing or proof of effectiveness, took derivatives that were initially paired with one liability and paired them with another.
OFHEO and some private-sector experts say that when derivatives from preexisting hedge arrangements are recycled into new arrangements, only by coincidence would the value of the derivative be zero.
Thornton of Queen's University put the odds at "one chance in a billion that it would stay at zero for the whole time, a trillion even."
Based on that requirement, Impac Mortgage Holdings Inc. recently said it had improperly accounted for derivatives and corrected its financial statements. "It's very clear in the literature that if the value of the hedge is not zero at the time you designate it, you cannot use the shortcut method," said Impac's chief financial officer, Richard J. Johnson. "That's black and white."
Robert C. Wilkins, a senior project manager at FASB who helped develop the rule, said he thought the requirement was well understood -- partly because companies complained about it.
As originally adopted, FAS 133 would have allowed Fannie to use the shortcut when it was reusing a derivative from a discontinued hedge in combination with a new derivative. To illustrate that point, the rule presented a scenario almost identical to one Fannie had submitted in a 1997 letter to FASB.
However, before the rule took effect, FASB changed its mind and passed an amendment, FAS 138, deleting the wording that would have allowed that use of the shortcut.
Jonathan Boyles, Fannie's senior vice president for financial standards and corporate tax, told regulators that Fannie knew the sentence was deleted but decided to use the shortcut anyway, according to the OFHEO report.
Fannie's auditor, KPMG LLP, flagged Fannie's use of the shortcut as a "difference" -- a point of concern in auditor jargon -- when it reviewed the company's books, Boyles told regulators. But the company estimated that the accounting effect of using the long haul instead of the shortcut would be "minor" and "immaterial," Boyles said, according to the OFHEO report.
Regulators faulted Fannie's conclusion that the stakes were insignificant. The impact on company earnings, the agency said in its report, "could be in the billions of dollars," within the range of the potential $9 billion overall correction Fannie described.