Freddie Turmoil Points To Complex Auditing Issues

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When the folks in Norwalk, Conn., known as the Financial Accounting Standards Board, set new rules for market value accounting a decade ago the hue and cry by large financial entities was that the constant revaluing of investment securities, loans and other financial instruments would cause more harm than good by increasing the volatility of those institutions most heavily invested.

Among those joining in criticism when the FASB passed its long-debated rules were Fannie Mae and Freddie Mac, those government-created entities that had grown into among the largest and most sophisticated financial institutions in the world.

Among the issues raised during the FASB debates were, how do you value and revalue loans or investments held on an entity's books for an indeterminate length of time? More problematic at the time was the valuation of financial derivatives, then confined mostly to hedging, but much more commonly used today.

Limited Market Exacerbates Problem

The problem was and is especially acute when there is a negligible market or no market at all for these instruments. Who determines the value that should be recorded on an entity's financial statements?

These questions have risen to the forefront of public debate again in conjunction with last week's turmoil at Freddie Mac, the secondary mortgage giant that forced out its three top operating officers last week: Chairman and CEO Leland Brendsel, President David Glenn, and Executive Vice President Vaughn Clarke. The three left the company in the midst of a massive re-audit involving the last three years' financial statements.

What prompted the re-audit was the company's accounting for its huge hedging portfolio, which current accounting rules require is marked-to-market value every quarter.

But observers note that Freddie, Fannie Mae, and other similarly structured entities, including Sallie Mae, the secondary market giant for student loans, are plowing new ground when it comes to accounting for these huge hedging portfolios.

The results, much to the confirmation of the market value accounting critics a decade ago, have been great volatility in the financial statements of these entities, even as mortgage rates have been kept steady at low rates the past few years.

Some recent examples:

* In January, Fannie Mae reported that net earnings (profits) for its fourth quarter in 2002 fell by 52% from the previous year's period, and by 22% for the fiscal year, despite record business volume because of a massive $4.5-billion write-down in the market value of its purchased options, used to hedge interest rate risk.

* In July 2002 Freddie Mac reported a $115- million market loss on the value of its hedging portfolio for its fiscal second quarter, dragging down earnings in the midst of the greatest mortgage boom ever.

* In October 2002, Sallie Mae reported that market value losses on derivatives acquired to hedge its huge student loan portfolio pushed the company into the red for the fiscal third quarter to the tune of a $62-million loss, despite a profitable operating statement. Those losses would be erased by year- end.

Similarly complex entities, especially large financial institutions, have experienced the same kind of difficulties in their financial reporting.

There are two issued being exposed here.

The first is the lower interest rate environment against which these entities have acquired complex financial instruments, interest rate swaps, options and the like, to hedge against.

That is, insurance that when rates turn up they would be protected while holding low-yielding paper.

While these instruments are being acquired to hedge against an upturn in rates, their value has declined, in many cases, because rates have yet to rise.

The result has been a surprising volatility in their reported net earnings on a generally accepted accounting principles, or GAAP, basis despite the continuing rise of profits on an operational basis.

This is what the critics of market value accounting foresaw a decade ago during the debate before the accounting rules setters.

The concept of market value accounting is not a new one, as it has been debated for more than 60 years.

Of course, the nature of the markets was much different when the debate commenced. Proponents of the concept could not have foreseen the dawn of the computer age and its instantaneous effect on markets and the valuation of their underlying products.

Operating In Uncharted Terrority

The other issue being exposed is that these entities are so big and their loan operations are so complicated, between the loans they buy, then securitize, then buy and sell on the bond market, that there is no precedent for valuing their holdings. So they are operating in uncharted territory.

It's now been more than six months since Freddie Mac said it was submitting its financial statements all the way back to 2000 for a re-audit based on the accounting for its huge hedging portfolio.

A simple restatement of financials doesn't usually take this long.

But don't look for this issue to attract much attention as the Freddie Mac controversy goes forward.

It's one that will probably be confined to the accountants and other financial-types.

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