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Banks Scrutinize Their Accounting

Daily Recalculations Mean Likely Avoidance of Fannie's Woes

By Kathleen Day
Washington Post Staff Writer
Friday, December 17, 2004; Page E03

The nation's banks are heavy users of the complex financial contracts at the heart of Fannie Mae's accounting woes, but bank regulators and financial experts said banks likely will avoid Fannie's troubles.

That's because the banks usually recalculate the value of their derivative contracts daily, as required by accounting rules, and they use a more diverse range of derivatives than Fannie does.

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"I think Fannie was very much of an outlier or renegade in terms of how it was doing its accounting," said Bert Ely, a financial services consultant who has been a longtime critic of Fannie Mae and its smaller rival Freddie Mac.

Fannie Mae, based in the District, and Freddie Mac, based in McLean, are the nation's largest mortgage finance companies.

A government regulator familiar with how banks use and account for these contracts said U.S. banks revalue 97 percent of the contracts they hold daily, which creates volatility in their financial results. The remaining 3 percent of the derivatives held by banks, which can be accounted for in a manner that doesn't change earnings so quickly, has been closely watched by bank examiners since the late 1990s to ensure compliance with generally accepted accounting rules.

But others wonder whether there are hidden problems that will come to light because of the Securities and Exchange Commission's pronouncement this week on accounting for the contracts, which firms use to hedge against fluctuations in interest rates and other risks.

"It is very much going to be a company-specific or company-by-company evaluation as to whether they are complying with this accounting standard or not," said Lynn E. Turner, a director at a financial research firm and a former SEC chief accountant. "I think the result of the SEC's decision on Fannie Mae will result in a lot more scrutiny; that its message is to tell the auditors they have to take a close look at the accounting for derivatives at the companies they are auditing."

Many financial companies -- including the 12 Federal Home Loan Banks -- have been scrutinizing how they account for derivatives after Freddie Mac's $5 billion restatement last summer and the public disagreement Fannie Mae has had with its federal regulator in recent months.

The SEC stepped into that controversy Wednesday night, when it announced that it disagreed with Fannie Mae's method of accounting for derivatives and essentially agreed with the regulator, the Office of Federal Housing Enterprise Oversight.

OFHEO and the SEC say Fannie Mae will have to restate prior earnings, reducing them as much as $9 billion for the periods going back to 2001.

Mike Ciota, a spokesman for the Federal Home Loan Banks Office of Finance, which issues the debt securities of the 12 banks and prepares a combined financial statement for them, said he doesn't know whether the banks have individually reviewed their accounting policies for derivatives. He said his office only assembles the information the banks provide and doesn't vouch for that information.

However, a lobbyist for the banks said that each one has carefully reviewed its accounting practices in anticipation of having to register with the SEC next summer. The reviews resulted in revisions of less than $20 million, too little to require a restatement.

However, the Federal Home Loan Bank of Chicago announced this week that, as the result of a separate review required by its federal regulator, it will restate its earnings going back to 2001, increasing them by $75 million.

The financial industry opposed the accounting rule at issue, known as FASB 133, when it took effect in 2001, saying it would result in wide swings in reported earnings, giving a misleading picture of a firm's underlying economic health. Fannie Mae, Freddie Mac and others have sought to dampen that volatility by using a special exemption in the rule that, under certain conditions, permits a company to exclude losses or gains in a derivative's value from earnings.

In the ruling this week, the SEC said Fannie Mae's decision about when to use the exception was too subjective and misled investors.

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