Far Bigger Than Enron, Is Fannie Mae Going Down?

Far Bigger Than Enron, Is Fannie Mae Going Down?
=====================================

And the bigger question is, will she take
us down with her?

But that is sensationalism, as GOP Senator Pusbucket
from the great state of ExxonCitiMcIBM would say.

Read chapter 28 in the saga, last half of
the article (below).

The impression one gets is that of a pyramid scheme
run by gamblers placing huge bets that the company
won't fail, and then using the proceeds of the
wagers to fund payouts to new "investors" (born
every minute). It's really more complicated
though.

There may have been days during the past year
when Fannie Mae was technically insolvent. It
may be insolvent now, though I suspect not. With
only 2% capitalization, and a trillion dollars
worth of derivative wagers on moves in interest
rates, if Fannie Mae traders took even one day off
and missed a move, KABOOM. With 50 to 1 leverage,
the tiniest mistake will make the Great Depression
of the 1930's look like a period of fantastic
wealth and prosperity -- for if FNM and brother
FRE go down, there will be Hell to pay. And with
bogus accounting systems...DESIGNED INTENTIONALLY
TO DECEIVE...who knows what the truth is, was
or will be?

Have a nice day. And a valium! It's all just a
matter of time (and remember: Enron didn't fold
in a day!)

P.S. Mr. Mao owns no stock in Fannie Mae (NYSE:FNM)
but recommends that readers, like himself, take sound
and prudent precautionary steps to insure against the
unthinkable. What that means to each individual is unknown.
It might mean buying some gold or some silver dollars, or
moving some $US to Euros, or even instituting regime change
in the United States (it appears that the people running this
country are lying thieves --- with nukes and a bazillion
paramilitary police, paid for with your tax dollars!.) Don't
bet ON financial Armageddon, but do ensure that you
have food and shelter when the inevitable happens!

* * *

http://64.29.208.119/creditbubblebulletin.asp

Credit Bubble Bulletin, by Doug Noland

The Trial and Tribulations of Risk Intermediation Folly
September 24, 2004

[....]

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.



Introduction:



“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.”



Background



“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.