The Hindu Business Line : The Fannie-Freddie accounting jumble

It was Swami Vivekananda who said “Anything can be sacrificed for truth; but truth cannot be sacrificed for anything”. Two American mortgage financiers, Fannie May and Freddie Mac appear to have not followed this dictum in their accounting which has resulted in financial restatements, resignations and blame-games a la Enron-style.

Recently, Fannie Mae announced that it will sell an aggregate of $5 billion in two placements of preferred stock to qualified institutional buyers. This represents the largest capital placement ever undertaken by the mortgage-financing giant.

The lawsuit claims that Fannie Mae and its top executives purposely inflated the price of its publicly traded common stock to deceive investors about the financial state of the company. These deceptions may have cost shareholders billions of dollars. Consequently, the company has been the focus of a federal investigation by the Securities and Exchange Commission (SEC) which is examining the company’s accounting records. Many predict that the audit could knock out about $9 billion from Fannie Mae’s past profits. The recent controversy has forced the CEO and CFO to resign.

The sale of preferred stock has now become a key component of Fannie Mae’s capital restoration plan. The company is working on developing a capital plan with the Office of Federal Housing Enterprise Oversight (OFHEO), which has a mission to ensure financial safety and soundness of Fannie Mae. With the $5 billion preferred capital offering, Fannie Mae will not need to make any sales out of its portfolio.

Accounting issues

A number of accounting issues were brought to light during the investigation into these companies. The principal issue was the problem of capital adequacy of these financiers. The OFHEO and the SEC made bold public statements about the capital adequacy of these entities.

Company reports reveal that though the core capital of Fannie May was $38.3 billion — much more than the norm — as per US GAAP, capital assets minus liabilities amounted to $16 billion. The reason for the gargantuan difference was because Fannie May accounted for some securities as “available for sale” on which there were $32.4 billion of losses. In the complex world of hedging, a hedge is highly effective if the changes in fair value or cash flow of the hedged item and the hedging derivative offset each other.

Freddie Mac apparently changed this definition on its head by not recognising $3.9 billion of losses on cash flow hedges whose effectiveness were spread over a period of 26 years!

In addition, Freddie Mac also boosted its balance-sheet by recognising $19 billion of deferred tax assets despite violating the basic accounting doctrine that one should have sufficient profits in future years to offset these.

One is now not surprised that the Institute of Chartered Accountants of India (ICAI) pulled a stunner in March by asking companies to mark-to-market derivative transactions and recognise losses or adopt their accounting standard on the subject well before it become mandatory.

The IFRS scenario

Had both these companies adopted International Financial Reporting Standards (IFRS) — with its implicit faith in “fair value” — one expects that this situation may not have occurred. Having happened very close on the heels of Enron, it is surprising that this issue has taken so long to be reported public.

The more complex hedges, derivatives and other financial instruments get, one can only expect more accounting irregularities.

It appears some time away when we would not get news of accounting irregularities in the US.

India — toeing the line of IFRS — does not appear to have too many hedging complications save for the recent “exotic derivatives” controversy. Finding a Fannie or a Freddie in India appears as tough to find as a stock whose price is climbing even during these troubled times.

(The author is a Hyderabad-based chartered accountant.)

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