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The Trial and Tribulations of Risk Intermediation Folly

Surging crude prices, along with unsettled trading in global commodity, currency, and debt markets, weighed on international equities this week. Here at home, the Dow declined 2% and the S&P500 was down 1.6%. The Transports dropped almost 2%, while the Utilities dipped 1%. The Morgan Stanley Cyclical index lost 1%, while earnings worries were behind a 3% drop in the Morgan Stanley Consumer index. The broader market was generally resilient, with the small cap Russell 2000 down 1% and the S&P400 Mid-cap index losing only 0.6%. The NASDAQ100 declined 2%, and the Morgan Stanley High Tech index dipped 1%. The Semiconductors were down 1.5%. The Street.com Internet index dropped 3%, and the NASDAQ Telecom index declined 1.6%. The volatile Biotechs gave back 2% of recent gains. With an earnings disappointment from Morgan Stanley and revelations of serious accounting issues at Fannie Mae, the financial stocks were on the defensive. For the week, the Broker/Dealers and Banks were down 2%. With bullion up almost $2.20, the HUI gold index gained 5%.

The Treasury market "squeeze" continued at the long end, while rates backed-up at the short end. For the week, 2-year Treasury yields were up 10 basis points at 2.58%, while 10 year Treasury yields dropped 8 basis points to 4.03%. In an extraordinary move that surely caused grief for some sophisticated speculators, the 10 year to 2 year spread collapsed 18 basis points to 145, the narrowest margin in about three years. For the week, five-year Treasury yields were 1 basis point lower to 3.32%. Long-bond yields ended the week at 4.80%, down 11 basis points on the week. Benchmark Fannie Mae MBS yields notably underperformed, with yields declining only 3 basis points. The spread (to 10-year Treasuries) on Fannie's 4 3/8% 2013 note jumped 4.5 to 32.5, while the spread on Freddie's 4 ½ 2013 note rose 3.5 to 29. The 10-year dollar swap spread was volatile intraweek, ending down 1.5 to 42. Corporate bonds were mixed but generally resilient. The implied yield on 3-month December Eurodollars jumped 8.5 basis points to 2.30%.

At $22 billion, it was another booming week of corporate debt issuance ($43 billion in two weeks!), with financial companies accounting for the vast majority of investment grade borrowings. Investment grade issuers included Wells Fargo $3.5 billion, Goldman Sachs $2.15 billion, Enterprise Products $2 billion, JPMorgan $1.5 billion, Lubrizol $1.15 billion, KFW $1 billion, Xerox $750 million, Meridian Funding (special-purpose vehicle) $650 million, Nationwide Life $300 million, XTO Energy $350 million, Union Electric $300 million, Sunoco $250 million, and AGL Capital $250 million.

Junk bond fund inflows slowed to a respectable $101 million for the week (from AMG), with five-week inflows an impressive $1.02 billion. Issuers included Echostar $1 billion, Crystal Holdings $850 million, Jostens $500 million, Chiquita Brands $250 million, Intrawest $225 million, Frontier Oil $150 million, US LEC $150 million, Riddell Bell $140 million, and Coleman Cable $120 million.

Foreign dollar debt issuers included Mexican United States $1.5 billion, Rentenbank $1 billion, and Development Bank of Singapore $750 million.

Japanese 10-year JGB yields dipped 9 basis points to 1.41%, a six-month low. Emerging bond markets were volatile and mixed, with yields generally collapsing early in the week only to reverse higher into the week's end. Brazilian benchmark bond yields sank another 13 basis points to 8.66%. Mexican govt. yields ended the week at 5.30%, up 5 basis points. Russian 10-year Eurobond yields were up 6 basis points to 6.26%.

Freddie Mac posted 30-year fixed mortgage rates declined 5 basis points this week to 5.70% (down 13 bps in two weeks) and about 30 basis points lower than one year earlier. Fifteen-year fixed mortgage rates dipped 3 basis points to 5.10%. One-year adjustable-rate mortgages could be had at 4.00%, also down 3 basis points for the week. The Mortgage Bankers Association Purchase application index rose slightly last week. Purchase applications were up almost 14% year-over-year, with dollar volume up 22%. Refi applications increased 4% to the highest level since the first week of May. The average Purchase mortgage was for $217,900, while the average ARM jumped to $303,000. ARMs accounted for 33.1% of total applications last week.

Broad money supply declined (M3) $4.9 billion (week of September 13). Year-to-date (37 weeks), broad money is up $453.8 billion, or 7.2% annualized. For the week, Currency added $400 million. Demand & Checkable Deposits declined $5.8 billion. Savings Deposits rose $9.7 billion. Saving Deposits have expanded $297.1 billion so far this year (13.2% annualized). Small Denominated Deposits dipped $0.5 billion. Retail Money Fund deposits added $1.0 billion, and Institutional Money Fund deposits rose $4.4 billion. Large Denominated Deposits sank $21.2 billion (up 22.3% annualized y-t-d). Repurchase Agreements gained $4.8 billion, and Eurodollar deposits added $1.3 billion.

Bank Credit added $2.5 billion for the week of September 15th to $6.693 Trillion. Bank Credit has expanded $418.4 billion during the first 37 weeks of the year, or 9.4% annualized. Securities holdings declined $5.6 billion, while Loans & Leases expanded $8.1 billion. Commercial & Industrial loans gained $2.0 billion, while Real Estate loans added $2.2 billion. Real Estate loans are up $222.7 billion y-t-d, or 14.0% annualized. Consumer loans were about unchanged for the week, while Securities loans dipped $400 million. Other loans increased $3.9 billion. Elsewhere, Total Commercial Paper declined $12.9 billion (down $33.4 billion in three weeks) to $1.329 Trillion. Financial CP dipped $4.8 billion to $1.205 Trillion, expanding at a 5.2% rate thus far this year. Non-financial CP dropped $9.1 billion (up 21% annualized y-t-d) to $124.3 billion. Year-to-date, Total CP is up $60.5 billion, or 6.5% annualized.

The ABS boom runs unabated with $22 billion issued this week (from JPMorgan). Year-to-date issuance increased to $456.9 billion, 43% ahead of comparable 2003. 2004 home equity ABS issuance of $282.7 billion is running 82% ahead of last year's record pace.

Fed Foreign "Custody" Holdings of Treasury, Agency Debt declined $1.2 billion to $1.290 Trillion. Year-to-date, Custody Holdings are up $223.5 billion, or 29% annualized. Federal Reserve Credit declined $1.0 last week to $767.5 billion, with y-t-d gains of $20.9 billion (3.8% annualized).

September 22 - Dow Jones: "Leading dealers estimate the global credit derivatives market was worth $3.5 trillion at the end of last year and will reach $8.4 trillion by the end of 2006, according to the British Bankers Association... They said the market is expected to grow to $5.02 trillion this year... London remains the center for credit derivatives trading, with the market there estimated to account for $1.58 trillion at the end of last year, according to the BBA. That local market is expected to rise to $2.23 trillion this year and $3.56 trillion by 2006."

Currency Watch:

The "commodity currencies" were especially strong this week, with the Australian dollar up 2.3%, South African rand up 2%, Canadian dollar 1.75%, and Norwegian krone 1.5%. The Columbian peso declined almost 2%. The dollar index dipped about 0.5% in continued unimpressive trading action.

Commodities Watch:

September 22 - Bloomberg (Hector Forster): "Crude-oil imports by Japan, the world's largest consumer of crude oil after the U.S. and China, rose 9.1 percent in August, the Ministry of Finance said."

For the week, the CRB index added 1.2% (y-t-d gains of 8.8%). October crude surged $3.29 to a record closing price of $48.88. The Goldman Sachs Commodities index jumped 5.2% this week to a new record high. Y-t-d gains increased to an impressive 26.5% and the GSCI has now doubled from February 2002 lows. Heating oil also traded to an all-time high, with gold at a one-month high and copper at a 5-month high.

China Watch:

September 21 - AP: " China 's crude oil imports jumped 37.4 percent in August to 70 million barrels... The increase, equivalent to an average of 2.21 million barrels a day, brought the country's crude imports for the first eight months of this year to nearly 600 million barrels - a 39.2 percent jump from the same period last year, the General Administration of Customs said."

September 23 - Bloomberg (Wing-Gar Cheng): "China paid 64 percent more to buy crude oil from overseas in the first eight months of this year as oil prices increased, customs statistics showed. China 's oil import costs for January to August rose to $20.45 billion compared with a year earlier..."

Asia Inflation Watch:

September 22 - UPI: " Asia's economic growth is likely to hit 7 percent this year, the fastest expansion since the Asian financial crisis, the Asian Development Bank said Wednesday. Strong growth in exports and a pickup in consumption and investment are expected to boost aggregate growth in developing Asia. In a report, the bank forecasts this high growth path will likely continue in 2005, though moderating to 6.2 percent."

September 23 - Bloomberg (Kyunghee Park): "Mitsui O.S.K. Lines Ltd., Neptune Orient Lines Ltd. and other shipping companies estimate costs on Asia-U.S. trade routes will rise by at least 10 percent next year because of congestion at ports in the U.S. The shipping companies and their customers are facing transit delays of eight to nine days because of overcrowding at U.S. ports, which may take more than a year to be resolved, a shipping group representing 14 companies said..."

September 22 - Bloomberg (Lily Nonomiya): "Japanese exports rose to a record in August on demand from China and the U.S., helping ease concern that a recovery in the world's second-largest economy is faltering. Exports climbed 2.3 percent, seasonally adjusted, from July, the first gain in three months... Imports rose 1 percent. The trade surplus unexpectedly widened to...$9.52 billion."

September 23 - Bloomberg (Koh Chin Ling): "Taiwan's export orders rose more than a quarter for a seventh straight month as electronics makers sold more components to Chinese factories and U.S. customers bought more flat-panel displays, computer chips and cell phones. Orders -- indicative of shipments in one to three months -- increased 26 percent from a year earlier to $18.1 billion after climbing 28 percent to a record $18.5 billion in July... Orders from the U.S...jumped 32 percent to $5.4 billion."

September 21 - Bloomberg (Seyoon Kim): "South Korean exports rose 28 percent from a year earlier to $12.9 billion in the first twenty days of this month, the Ministry of Commerce, Industry and Energy said... Imports rose 38 percent to $12.9 billion..."

September 22 - Bloomberg (Koh Chin Ling): "Taiwan's unemployment rate fell to a three-year low in August as companies added workers to increase sales. The seasonally adjusted jobless rate was 4.4 percent, compared with 4.5 percent in July..."

September 22 - Bloomberg (Anuchit Nguyen): "Thailand's exports rose 28 percent last month from a year earlier to $8.29 billion on higher sales of automobiles, rubber, rice and other products, the Commerce Ministry said. Imports rose 35 percent to $8.5 billion in August from a year earlier..."

September 23 - Bloomberg (Kartik Goyal): "India's exports may rise 21 percent to a record $75 billion in the year to March 31, 2005, Kamal Nath, minister for Commerce and Industry, said."

September 23 - Bloomberg (Jason Folkmanis): "Vietnamese inflation accelerated for an 11th month in September to its highest in almost nine years as prices of food and pharmaceuticals surged. The consumer-price index rose 10.1 percent from a year earlier, up from a gain of 9.9 percent in August and the biggest increase since December 1995..."

Global Reflation Watch:

September 21 - Bloomberg (Lindsay Whipp): "Japanese land prices declined for the 13th consecutive year as a recovery in the world's second-largest economy failed to boost the real estate sector. The average price of land fell 5.2 percent in the year ended June 30, less than the 5.6 percent drop in the previous year..."

September 22 - Bloomberg (Masahiro Hidaka and Lily Nonomiya): "Deflationary pressures are easing, said Kazumasa Iwata, one of the Bank of Japan's two deputy governors. 'It appears that both globally and in the domestic economy there is disinflation,' Iwata said... 'The basic trend of prices gradually rising and nominal wages rising, which will lead to reflation, is still intact.'"

September 22 - Bloomberg (Francois de Beaupuy): "The Bank of France said a surge in home costs and increase in households' indebtedness pose 'significant risks' if housing prices turn lower. Real estate prices in 2003 were 30 percent higher than at the previous 1991 peak in real terms, the bank said. In Paris, where prices declined by almost a third in the mid-1990s from their 1991 peak, real estate is now 13 percent costlier than 12 years ago in nominal terms."

September 23 - Bloomberg (Inti Landauro and Thomas Black): "Mexico set a monthly record for exports in August as rising U.S. demand for consumer goods prompted companies such as Black & Decker Corp. to boost production in their plants in the country. Exports rose almost 28 percent from a year earlier to $17 billion after rising 8.8 percent in July..."

September 22 - Bloomberg (Michael Smith and Cecilia Tornaghi): "Brazilian President Luiz Inacio Lula da Silva said the country created the most jobs since 1992 in August as an economic expansion led companies to hire more people. About 230,000 jobs were created in August..."

September 21 - Bloomberg (James Cordahi): "Saudi Arabia, the world's largest oil producer, will generate more than $100 billion in oil sales in 2004 for the first year because of higher international prices and more output, a Saudi bank economist said. The price of Saudi crude will be about 20 percent higher than last year, or $32.50 a barrel compared with $27 a barrel, Brad Bourland, chief economist at Samba Financial Group..."

U.S. Bubble Economy Watch:

September 21 - The Wall Street Journal (Ray A. Smith): " While economists have said the U.S. recession ended in late 2001, a fiscal recession continues in America's cities, according to the latest annual survey by the National League of Cities. The survey of finance directors from 288 cities found that 63% said their cities were less able to meet financial needs during their fiscal 2004 than in the previous year. Looking ahead, 61% said their cities will be less able to meet financial needs in 2005 than in 2004."

Total August Inbound Containers into the ports of Long Beach and Los Angeles were up 9% y-o-y to 614,342 (down from July's 643,401). Outbound Containers declined to 166,032, the lowest level since last September and up only 2% from one year ago. A total of 367,918 left the ports empty, up 16% from a year earlier.

August Durable Goods Orders dipped 0.5% from July to $195.4 billion. This was up 11.7% from August 2003. Ex-transports, August Durable Goods Orders increased 2.3% for the month and were up 13.2% from last August.

Mortgage Finance Bubble Watch:

September 23 - Dow Jones (Daniel Rosenberg and Howard Packowitz): "Chicago Board of Trade 10-year Treasury note futures have set open-interest records for five straight sessions, and traders and analysts say the mortgage industry can take at least partial credit. CBOT reported open interest for 10-year Treasury note futures totaled 1,571,091 contracts after Wednesday's session... With the Treasurys market climbing and mortgage rates going down, there's been an increased interest in refinancing. That means real-estate Mortgage lenders, made up of firms such as Countrywide Financial and Wells Fargo, must use the markets to hedge their positions. 'The mortgage guys need to hedge' said one CBOT trader... 'They've been forced to buy 10-years (Treasurys), either futures or options.'"

August Housing Starts were reported at a stronger-than-expected 2.0 million annualized pace. This equaled March, with Starts not stronger since December. Housing Starts were up 9% y-o-y and up 44% from August 1997. Housing Completions were up 12.6% y-o-y and up 48% from August 1997. August Building Permits, however, were somewhat weaker-than-expected at a 1.952 million annualized pace. Permits were actually down slightly from a year ago. Year-to-date, Single-family Housing Starts are running 12.8% ahead of comparable 2003 (the strongest year since 1978), led by the 17.6% gain in the West.

August Existing Home Sales were resilient, although somewhat weaker-than-expected at a 6.54 million annual pace. Transactions were down from June's record 6.92 million pace, but were up 2% from a year earlier. Year-to-date sales are running 9% above last year's record pace. And with average (mean) Prices up 7.7% y-o-y, annualized Calculated Transaction Value (CTV) was up 10.2% y-o-y to $1.578 Trillion. CTV was up 44% over two years (prices up 17%, volume up 23%), 49% over three years (prices up 25%, volume up 19%), and 101% over six years (prices up 49%, volume up 35%).

As I am writing, Florida is bracing for Jeanne, the fourth hurricane in about a month. I will be surprised if this hurricane season does pierce the Florida real estate Bubble.

Fannie Mae posted a respectable August, with the company's Book of Business expanding $8.3 billion, or 4.4% annualized, to $2.264 Trillion. Year-to-date, Fannie's Book of Business has increased $65.7 billion, or 4.5% annualized (Retained Portfolio down 0.5%, with MBS up 8%). The company's Retained Portfolio expanded at a 3.6% annualized rate during the month to $895.4 billion. From Fannie's monthly release: "Total residential mortgage debt outstanding (MDO) grew at a compound annual rate of 12.4 percent during the second quarter of 2004. This was the 9th consecutive quarter during which total residential MDO grew by at least 10 percent."

Fannie Watch:

Much has and will continue to be written regarding the serious issues raised following the Office of Federal Housing Enterprise Oversight's (OFHEO) one-year audit of Fannie Mae. The GSEs, particularly Fannie, Freddie and the FHLB, have for too long been encouraged to grow large and powerful - financing the "American Dream" and ongoing prosperity. At the same time, historic financial innovation has been nurtured with extraordinarily low interest rates, Fed assurances of abundant marketplace liquidity, regulatory forbearance, and the expedient disregard for the marketplace's abuse of the GSE's implicit government guarantees.

During the nineties, the GSEs and mortgage finance were recognized as the key to economic expansion and, with it, political success and power. Then, as the nineties boom tottered toward bust, mortgage finance evolved into the Fed's primary mechanism to forestall systemic debt crisis. Players including the hedge funds, the banks, Wall Street, and the GSEs have taken full advantage.

The financial sector ballooned, as the quantity of mortgage Credit instruments mushroomed. Low "pegged" short-term rates and a perpetually steep yield curve afforded handsome profits to anyone borrowing short and lending long. In addition, a thriving interest-rate derivatives marketplace provided a highly liquid market for inexpensive "insurance" for players to hedge leveraged positions against a potential rise in interest rates. And with their unlimited access to borrowings, it became only a matter of how much the GSEs desired to earn from their expanding leveraged portfolios (and derivative positions).

There should be no surprise that such a profligate environment - with a truly historic opportunity to easily accumulate financial wealth - incited gross excess and chicanery. For years, corporate America pushed the envelope in both risk-taking and accounting for earnings. And while accounting improprieties became a major issue over the past few years, booming profits from the Greenspan Fed's interest rate collapse basically insulated the financial sector from earnings and accounting woes, hence scrutiny.

For the GSEs and U.S. financial sector, the Fed created the best of times. But, less discernable, it has also nurtured the worst of times for Fannie and Freddie. On the one hand, ballooning Credit and a glut of liquidity creation were a boon inspiring astonishing asset and earnings growth. Yet the resulting interest rate volatility and speculative excess (Monetary Disorder) has led to a most challenging operating environment. Bouts of collapsing interest-rates have incited historic refi booms, interrupted occasionally by rate spikes and near dislocation in the interest-rate hedging markets. The derivatives market dynamics hedgers - instituting trading positions to hedge exposure based on market direction - were occasionally whipsawed and always exacerbated market volatility. As the King of Dynamic Hedging, the GSEs were forced at times to aggressively hedge their massive and ballooning portfolios against collapsing rates only to abruptly reverse course and prepare for rising rates. And they had to go through this drill at least a few times. Meanwhile, the nature of their financing and hedging operations became only more complex each passing year, as well as much, much larger in scope.

Contemporary finance is an amazing phenomenon. More specifically, providing unlimited quantities of low-cost 30-year fixed rate mortgages - financed mainly through short-term securities market-based borrowing by highly leveraged institutions - is the most powerful (and free-wheeling) financing mechanism the world has ever known. But the bottom line is that it also the greatest risk intermediation experiment in history. And the thinly capitalized GSEs - aggressively borrowing short in the securities market while lending for long-term mortgages in an environment characterized by extraordinary financial and economic uncertainty - are in the midst of Risk Intermediation Folly the likes of which no one could have imagined.

The Comptroller of the Currency this afternoon released its Second Quarter 2004 OCC Bank Derivatives Report. For the quarter, the total notional amount of Interest Rate derivatives increased $4.4 Trillion, or 27% annualized, to $70.6 Trillion. In just two years, Interest Rate derivatives have surged 65%. By derivative type, Interest Rate Swaps are up 31% in one year to $49.7 Trillion. By institution, JPMorgan derivative positions increased 29% in 12 months to $42.1 Trillion, followed by Bank of America up 21% to $16.8 Trillion, and Citigroup up 47% to $16.2 Trillion.

The GSEs - as the world's biggest risk intermediaries - are by far the largest buyers of derivatives. And I would expect that OFHEO's applaudable tough stance with Fannie this week will prove only the opening battle in what will be a very long and bewildering war over derivative accounting. There is a great deal at stake for Fannie, Wall Street, and the entire U.S. financial sector. With this in mind, I believe it is worth our time to educate ourselves on SFAS 133 and some of the important issues today impacting Fannie Mae. I thought OFHEO did a very nice job in their "Report of Findings to Date - Special Examination of Fannie Mae." Once again, "hats off" to Director of OFHEO Armando Falcon (having been given a "new lease on life," he's making the most of it!). Below are, hopefully, helpful extractions.


"OFHEO's (Office of Federal Housing Enterprise Oversight) on-going special examination has placed a specific focus on Fannie Mae's application of Statement of Financial Accounting Standards No. 133 Accounting for Derivative Instruments and hedging Activities ("SFAS 133"). SFAS 133, which was issued in 1998 and became effective in 2001, presented Fannie Mae with the potential for significant volatility in earnings and several operational challenges. For the Enterprise to avoid much of the potential earnings volatility caused by marking derivatives to fair value under SFAS 133, it elected to adopt hedge accounting under the new standard. However, qualifying for hedge accounting under SFAS 133 required changes to significant administrative, documentation, and system requirements for most entities. For an entity with a large and dynamic hedging program, like Fannie Mae, hedge accounting posed even greater challenges. Fannie Mae devised a hedge accounting approach in which the vast majority of its derivatives were treated as "perfectly effective" hedges with the objectives of minimizing earnings volatility and simplifying operations. OFHEO has determined that Fannie Mae has misapplied [generally accepted accounting principles] (specifically, the hedge accounting requirements of SFAS 133) in pursuit of these objectives. The misapplications of GAAP are not limited occurrences, but appear to be pervasive and reinforced by management whose objective is to reduce earnings volatility at significant cost to employee and management integrity. The matters discussed herein raise serious doubts as to the validity of previously reported financial results, as well as adequacy of regulatory capital, management supervision, and overall safety and soundness of the Enterprise."


"SFAS 133, as emended and interpreted, provides the primary guidance under GAAP for companies' accounting and reporting for derivatives... SFAS 133 requires that all freestanding and certain embedded derivatives be carried on the balance sheet at fair value. Changes in a derivative's fair value are included in earnings, unless the derivative is designated and qualifies for hedge accounting. Hedge accounting provides a means for matching of the earnings effect of a derivative and the related designated hedged transaction, thereby mitigating the impact of marking-to-market the derivative under SFAS 133.

Hedge accounting is elective. However, to qualify, certain stringent criteria must be satisfied. These requirements were outlined in a recent "SEC" speech by John James, Professional Accounting Fellow from the Office of the Chief Accountant at the SEC. Below is an extract from the speech which emphasizes the strict criteria necessary to receive hedge accounting.

"Many have complained that Statement 133 is not a principles-based standard and that its rules are too complex to follow. However, the principle in Statement 133 is fairly straightforward in that derivatives should be recorded on the balance sheet at fair value with changes in fair value reported in earnings. The complexity is mostly associated with achieving hedge accounting, which is optional under Statement 133. Thus, in order to achieve hedge accounting, the Board concluded that entities would be required to meet certain requirements at the inception of the hedging relationship and on an ongoing basis. These requirements include: contemporaneous designation and documentation of the hedging relationship, the entity's risk management objective and strategy for undertaking the hedge including identification of the hedging instrument, the hedged item, and the nature of the risk being hedged and how effectiveness will be assessed and measured. Additionally, Statement 133 requires an entity to perform a hedge effectiveness assessment at both the inception of the hedge and on an ongoing basis as support for the assertion that the hedging relationship is expected to be (or was) highly effective in achieving offsetting changes in fair value or cash flows attributable to the hedged risk during the designated hedging period..."

Implementation of SFAS 133 at Fannie Mae

"Prior to SFAS 133, Fannie Mae followed synthetic instrument accounting for debt instruments whereby cash flows were synthetically altered through the use of derivatives. As Fannie Mae was not a "mark-to-market" entity, the new accounting for derivatives under SFAS 133 would significantly affect the volatility of its financial results if hedge accounting were not applied. Some entities, such as broker-dealers and investment companies, account for most of or all of their assets and liabilities at fair value, with changes therein flowing through earnings (referred to as "mark-to-market" accounting). When such entities use derivatives to manage risk, they often achieve a natural offset in earnings due to the mark-to-market of both the derivatives and the asset/liabilities that give rise to the risk. Fannie Mae, as well as most banks and finance companies, apply a modified historical cost approach to accounting for most financial assets and liabilities. Thus, the introduction of fair value accounting for derivatives under SFAS 133 had the potential to create significant earnings volatility unless hedge accounting was used to allow an offset of the earnings effect of marking the derivatives to market.

Fannie Mae faced significant challenges in qualifying for hedge accounting. Due to its extensive documentation and effectiveness calculation requirements, hedge accounting under SFAS 133 was most easily adopted by entities with simple, passive hedging approaches in which hedges are established and allowed to run their course. However Fannie Mae's hedging approach was neither simple nor passive. The complex nature of funding its massive mortgage portfolio and managing the associated interest rate risk necessitated an active, dynamic, hedging approach to respond to changing market conditions and portfolio re-balancing requirements. Such an environment adds significant complexity to the administrative and systems requirements to support hedge accounting. Furthermore, Fannie Mae's use of option-based derivative products further complicated the application of hedge accounting, due to additional complexities associated with such instruments."

Determination to Maintain the Pre-SFAS 133 Accounting

"Despite the challenges noted above, Fannie Mae had a strong desire to retain the status quo of accrual/synthetic instrument accounting. Fannie Mae's net interest margin reflects the spread between the income earned on its assets (interest income) and its cost of funding (interest expense). Synthetic instrument accounting provided relatively smoother accounting earnings and greater predictability of reported financial results, including Earnings Per Share ("EPS"). Fannie Mae's derivative accounting policy makes several references to derivative transactions in which the intended result is for the accounting to continue to mimic synthetic instrument accounting even after the adoption of SFAS 133."

Minimizing Earnings Volatility a Primary Objective

"Fannie Mae documents relating to its SFAS 133 implementation discuss minimizing earnings volatility and maintaining the simplicity of the Enterprise's operations as the primary objectives when Fannie Mae undertook the implementation of the standard. Earnings volatility would naturally arise from those derivatives that did not quality for hedge accounting and from any hedge ineffectiveness resulting from hedging relationships that qualified for hedge accounting. OFHEO acknowledges that minimizing earnings volatility and simplifying operations in connection with the adoption of SFAS 133 are not prohibited and that many companies likely had similar objectives... However, as discussed further below, these goals have influenced the development of misapplications of hedge accounting. These improper approaches included not assessing hedge effectiveness, not measuring hedge ineffectiveness when required, and applying hedge accounting to hedging relationships that do not qualify for such treatment."

Derivatives Accounting Policies & Procedures

"Fannie Mae's accounting policies for derivatives post SFAS 133 are contained in the Derivatives Accounting Guidelines ("DAG"). The DAG represents Fannie Mae's effort to detail the potential derivative transactions that the Enterprise may enter into, the accounting to be followed for such transactions, and the impact the accounting has on earnings. The DAG serves as the foundation for Fannie Mae's derivative accounting. Interviews with Fannie Mae personnel indicate that these guidelines also formed the basis for system development efforts so support SFAS 133.

The DAG has the appearance of a comprehensive set of accounting policies. However, a close review of the guidelines revealed numerous instances of departures from hedge accounting requirements under SFAS 133. Jonathan Boyles, Senior Vice President - Financial Standards & Corporate Tax, is the head of accounting policy formulation at Fannie Mae, and had primary responsibility for the DAG's development. Mr. Boyles has referred to some of these matters as "known departures from GAAP". Other members of Fannie Mae management refer to these matters as "practical applications" of GAAP. These departures, or practical applications, had the effect of allowing Fannie Mae to apply hedge accounting and the assumption of perfect effectiveness to numerous transactions in situations where such treatment was not appropriate without the necessary documentation and analysis."

The Assumption of Perfect Effectiveness

"Consistent with Fannie Mae's desire to minimize volatility and maintain simplicity of operations, a great deal of emphasis was placed on treating hedges as perfectly effective, whereby it is assumed that no ineffectiveness exists in a hedging relationship, and no assessment or measurement of effectiveness is performed. In fact, Fannie Mae treats almost all of its hedging relationships as perfectly effective. SFAS 133 does allow the assumption of no ineffectiveness, but only in very limited circumstances. However, in many instances...Fannie Mae has disregarded the requirements of SFAS in its treatment of hedges as being perfectly effective. Accordingly, the Enterprise has not properly assessed and measured the effectiveness as required by the standard. At December 31, 2003, Fannie Mae had notional of $1.04 trillion in derivatives, of which a notional of only $43 million was not in hedging relationships... As noted above, there are specific requirements that must be met under SFAS 133 to treat hedges as perfectly effective. The complex nature of Fannie Mae's hedging approach makes meeting these requirements difficult... OFHEO believes that the disqualification of hedge accounting for such a large number of transactions would have a significant impact on Fannie Mae's reported financial results, both prospectively and historically."

Disregard of FASB Decisions

"Like many entities, Fannie Mae engages in active efforts to influence the Financial Accounting Standards Board's ("FASB") rule making decisions, with a goal of advancing the accounting positions it views as most favorable... SFAS 133 was no exception...Fannie Mae played an active role in lobbying the FASB... In some instances, despite entreaties to the FASB by Fannie Mae for a desired derivative accounting treatment, the FASB rejected the requested treatment. 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."

From our review of documents, emails, testimony and initial interviews with Fannie Mae personnel, OFHEO has concluded that there has been an intentional effort by management to misapply the accounting rules as specified in the standard in order to minimize earnings volatility and simplify operations.

As of December 31, 2003, the balance in AOCI ("accumulated other comprehensive income" - where declines in derivative market values have been segregated to avoid impacting reported earnings/retained earnings) reflects $12.2 billion in deferred losses relating to cash flow hedges. Furthermore, carrying value adjustments of liabilities relating to fair value hedges amounted to $7.2 billion as of that date. The matters noted herein with respect to improper application of hedge accounting leads OFHEO to question the validity of the amounts reflected in AOCI... For hedges which do not quality for hedge accounting, fair value changes should be reflected in earnings in the period in which the value change occurred... Additionally, the possible reclassification of these amounts into retained earnings could have a substantial impact on Fannie Mae's compliance with regulatory capital requirements. In order to determine the actual impact of the matters discussed herein, a substantial investment of resources and management's commitment will be required."

And from Today's American Banker (Rob Blackwell): "The Office of Federal Housing Enterprise Oversight has taken several swings in the past few days at Fannie Mae's management, internal controls, and accounting, but it is too soon to tell whether they connected. On Wednesday the agency issued a 211-page report accusing Fannie of manipulating its earnings by misapplying accounting rules for amortization and derivatives hedging. Accounting experts were still scouring the document Thursday uncertain whether OFHEO had found evidence that generally accepted accounting principles had been violated or whether Fannie had merely made judgment calls that its regulator disagreed. There seemed little doubt that the policy impact of the report would be blunted, as highly technical and hard-to-read descriptions of Fannie's alleged accounting sins proved difficult to simplify or explain... Indeed, how serious Fannie's problems are may not be clear until the Securities and Exchange Commission weighs in, and that could be a long while ("that process could take three to five years to complete")"

Ironically, the Great Mortgage Finance Bubble has of late attracted myriad sources of liquidity (as is the nature of markets during "blow-offs"), to the point that the general mortgage market was this week content to brush off the systemic ramifications for the unfolding battle over Fannie's accounting and management practices. Yet it is becoming increasingly apparent that when the next period of "deleveraging" and systemic stress does develop, both Fannie and Freddie will be operating with considerably less flexibility and market power. This is a most-important development with respect to Financial Fragility. The prospect of - after an historic period of "blow-off" excess - the marketplace losing its coveted Buyers of First and Last Resort is a momentous and disconcerting development.

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