The difficulties created by FAS 133 are not unique to Fannie Mae. Bank regulators, for example, have decided not to include unrealized gains and losses recorded under FAS 133 through the accumulated other comprehensive income component of equity to determine capital adequacy, as such changes fail to reflect overall risk accurately. Bank regulators fully understand that financial statements produced under this standard are not a good measure of a corporation's financial position and risk profile. Securities Registration and Disclosure Fannie Mae has voluntarily registered its equity securities with the SEC under the Securities and Exchange Commission Act of 1934. As part of this process, the SEC reviewed our financial disclosures and critical accounting policies. Today, we file the same corporate disclosure documents with the SEC as any other publicly traded company. Although our decision to register with the SEC was a voluntary one, our registration with and regulation by the SEC is now binding and irrevocable. As Treasury Secretary John Snow noted in testimony given on July 9, 2003, "once you go [into SEC regulation] under '34, you don't go out." Additionally, Fannie Mae is fully bound by the relevant provisions of the Sarbanes-Oxley Act of 2002. Congressmen Chris Shays and Ed Markey have recently introduced legislation that would require Fannie Mae and Freddie Mac to register their debt securities and mortgage-backed securities under the Securities and Exchange Act of 1933. Because of the disruption it would cause to the housing market, this legislation is opposed by the Administration and the housing and housing finance industries. (A list of trade groups opposing Shays/Markey follows this release.) In response to a question posed by Congressman Chris Shays, also on July 9, 2003, Secretary Snow said, “there doesn't seem to be any difficulty with [Fannie Mae and Freddie Mac's securities] issuances. Virtually all of the key housing industry associations and non-profit organizations have previously expressed opposition to this legislation, including the following: National Association of Homebuilders Enterprise Foundation National Urban League League of United Latin American Citizens National Immigration Forum National Council of La Raza National Association of Hispanic Real Estate Professionals National Multi Housing Council National Association of Mortgage Brokers National Association of Local Housing Finance Agencies Council of State Community Development Agencies Freddie Mac, one of the two government-sponsored enterprises that dominate the secondary market for home mortgages, announced in January 2003 that its financial reports for the past three years would have to be restated. Reaction to the news was mild; the markets assumed that interpretations of complex accounting rules were at issue rather than fundamental economic problems at Freddie Mac. On June 9, 2003, without providing any new information about the nature of the accounting issues, Freddie dismissed its top three executives. This action raised the specter of an Enron-like financial scandal, and Freddie's stock price plunged by nearly 20%. On June 25, Freddie issued a press release with new details about the ongoing restatement. Freddie's expectation is that earnings for 2000 through 2002 will be revised upward by $1.5-$4.5 billion. The accounting corrections will involve reclassification and/or revaluation of certain securities and derivative financial instruments. The June 25th statement admitted that accounting controls had been weak and that certain accounting decisions and market transactions had been implemented to "smooth out," or reduce volatility in reported earnings. Regulatory agencies and federal prosecutors have begun investigations, and several committees in Congress have held or scheduled hearings. H.R. 2575 would restructure Freddie's regulator, while H.R. 2022 would end its exemption from certain securities disclosure requirements. This report will be updated as new information becomes available. Background Freddie Mac is a government-sponsored enterprise (GSE) that plays an important role in the secondary mortgage market. Like Fannie Mae,2 its rival GSE, Freddie buys mortgages from lenders and repackages them in the form of securities, which it may hold See: [www.freddienic.com/news/archives/corporate/2003/restatement_062503.html] 2 Freddie Mac was formally chartered as the Federal Home Loan Mortgage Corporation, and Fannie Mae as the Federal National Mortgage Association. Congressional Research Service❖ The Library of Congress CRS-2 or sell to public investors. Freddie finances its purchases of mortgage loans by selling bonds: either bonds backed by its own financial resources (called "straight debt”), or mortgage-backed securities, where interest and principal payments made by homeowners are passed through to holders of the bonds. As GSES, Fannie and Freddie are exempt from state and local taxes, from certain regulatory requirements, and have a line of credit with the U.S. Treasury. Their most significant advantage, however, is what is called the implicit guarantee – although the bonds they sell are not backed by the full faith and credit of the U.S. government, market participants behave as though they were. Because the markets do not believe that the Treasury would allow Fannie or Freddie to default, the GSEs are able to sell securities paying lower rates of interest than other financial institutions. Over 60% of all single family mortgage debt has been sold in the secondary market, or "securitized." As the leading players in this market, the housing GSEs represent an extraordinary concentration of financial risk. There is a strong public interest in ensuring that Freddie and Fannie remain financially strong; in 1992, Congress created the Office of Federal Housing Enterprise Oversight (OFHEO), a safety and soundness regulator dedicated exclusively to oversight of these two institutions. The savings and loan crisis of the 1980s illustrated the riskiness of the mortgage market. If interest rates rise, financial institutions may find that their cost of funds exceeds their income from long-term, fixed-rate mortgages. If rates fall, homeowners refinance their mortgages and reduce income streams to institutions, which must still pay off debt previously issued at higher interest rates.3 Protecting themselves from interest rate risk is critical to the GSES, and it appears that strategies to avoid, or "hedge," risk are partly responsible for Freddie's recent accounting problems. Freddie Mac's Accounting Problems Since 2000, interest rates have fallen dramatically - mortgage rates from over 8% to about 5.2%. The fall in rates had two major impacts on Freddie Mac's financial statements. Both Freddie's bond portfolio and the derivatives contracts Freddie had purchased to hedge the risk of falling interest rates' increased sharply in value. Under generally-accepted accounting principles (GAAP), these gains in asset value should have been reported as current income. However, Freddie chose accounting treatments for these asset gains that deferred recognition of income until later years. The restatement of earnings is based upon Freddie's and its new auditor's decision that these accounting policies were incorrect. 3 There is also the possibility of a sharp fall in housing prices. See CRS Report RL31918, U.S. Housing Prices: Is There a Bubble? by Marc Labonte. 4 * Bond prices rise when interest rates fall, because old bonds then pay higher interest relative to newly-issued bonds. 'Derivatives are financial instruments whose value is linked to changes in some price or variable, in this case interest rates. To hedge against falling rates, Freddie purchased interest rate swaps in which Freddie agreed to pay floating-rate interest to the swap dealer, while the swap dealer agreed to pay Freddie a fixed rate of interest. (The size of the payments is calculated by reference to a notional principal amount that does not actually change hands.) As rates fell, Freddie's floating rate obligation diminished, while it continued to receive the fixed payment. Traciges, CRS-3 Much of Freddie's bond portfolio was held in an accounting category called "held to maturity" (HTM). This meant that the bonds would not be sold, and that therefore dayto-day fluctuations in their market value were irrelevant; all that mattered was the amount of principal and interest payments, which was fixed and known in advance. These bonds were carried on Freddie's balance sheet at historical cost, which meant that increases in the bonds' market value (as interest rates fell after 2000) were essentially ignored, and did not appear as current earnings. However, during the 2000-2002 period, some of the bonds classified as HTM were sold. As a result, the restatement will reclassify the entire portfolio of bonds as "available for sale" (AFS), and changes in market value will be recognized. Gains in the bonds' value over the period will appear in the restated earnings as either current earnings or stockholders' equity." Derivatives accounting is governed by FAS 133 of the Financial Accounting Standards Board (FASB). Under FAS 133, the fair value of all financial derivatives must be calculated at the end of each accounting period ("marked-to-market”). Changes in fair value from the previous accounting period must be reported as current income, unless the derivatives are used for hedging. If a derivative is used to hedge an asset, the value of that asset - the hedged item - will move in the opposite direction to the derivative's value. Thus, a fall in the price of the hedged asset will be offset by a gain in the derivative (or vice versa). Under FAS 133, the firm can recognize as earnings both the change in the derivative's value and the offsetting change in the hedged item's. If the gains and losses are closely correlated, the net effect on reported earnings will be very small or zero. There is another form of hedge accounting under FAS 133, covering derivatives held to hedge a future transaction or cash flow. Since the hedged item in this case does not yet exist, it cannot be marked to market and used to offset gains in the derivative's fair value. However, FAS 133 allows the gain or loss in a derivative used to hedge a future event to be assigned to comprehensive income, a subcategory of stockholders' equity. When the future transaction or cash flow occurs, the derivative is marked to market and changes in fair value are recognized as current income, but presumably gains or losses in the derivative will be offset by the hedged item. Either form of hedge accounting has the effect of reducing the impact of changes in derivatives' fair value on current earnings and the bottom line. To qualify for this accounting treatment, however, FASB requires that there be a close relationship between changes in the value of the derivative and the hedged item. Derivatives that do not meet FASB's hedge test are considered speculative trading instruments, and changes in fair value from period to period must be recognized and reported as current earnings. Freddie Mac, like most U.S. corporations that use derivatives, states in its annual report that it does not use derivatives for speculative purposes. In its June 25th press release, however, Freddie concludes that “a majority of the corporation's derivatives in 2001 and 2002 will not qualify as accounting hedges. Gains and losses from the change in fair value of these derivatives will directly affect current period earnings as a result of 6 'Stockholders' equity is separate from current earnings; it represents the proprietary interests of the owners (stockholders) of a corporation, or the going-concern value of assets over liabilities. Sce CRS Report 98-52. Derivatives: A New Federal Accounting Standard. CRS-4 removing previously recorded gains and losses related to certain hedged items and recognizing gains and losses previously deferred in shareholders equity." Freddie's press release identifies other accounting changes and cautions that there may be others not yet identified. Based on current information, the accounting treatments of derivatives and bond portfolios appear to be the major factors in the restatement. In both cases, the drop in interest rates to 1950s levels produced unexpected windfall gains in the value of financial instruments. Freddie chose not to recognize these gains to avoid creating an impression of earnings volatility, knowing that these gains would be reversed if the trend in interest rates turned upwards. According to the June 25th statement, accounting policies were designed "with a view to their effect on earnings in the context of Freddie Mac's goal of achieving steady earnings growth." In other words, Freddie sought to "smooth out" reported earnings and reduce volatility by deferring earnings that should have been recognized under GAAP to future years. From all information now available, these accounting decisions, and the associated management and control issues, are what is behind the recent shake-up at Freddie Mac, and not any fundamental economic problem or financial weakness in the GSE's operations. Freddie Mac's Management and Regulatory Problems The June 25th press release noted several actions designed to remedy weaknesses in accounting and management controls. These include the expansion of senior accounting staff, creation of an operating risk oversight unit, and strengthening the review of accounting and other critical business operations. In conjunction with OFHEO, Freddie has embarked on a “comprehensive remediation program," to effect "broad changes in the finance function." Questions remain about why the situation unfolded as it did, particularly why the top management changes were made so dramatically and with so little public explanation. The sudden dismissals led many observers (and shareholders) to assume the worst: that a major scandal was in the offing. Information disclosed in the June 25th press release and in press accounts does not suggest that any major violations of securities or criminal laws have occurred. The "smoothing out" of reported earnings through questionable interpretations of GAAP is something that the Securities and Exchange Commission (SEC) normally regards as a violation of accounting rules. The SEC's view is that if a firm deals in volatile financial instruments, that volatility should be fully reflected on its accounting statements. However, smoothing out is not viewed with the same seriousness as fraudulently inflating reported earnings, as Enron, WorldCom, and others have allegedly done to conceal fundamental economic or financial problems. In 2002, the SEC settled charges against Microsoft that it had smoothed out earnings by creating "reserve The SEC's authority over Freddie is limited by the exemption from SEC regulation granted by Freddie's authorizing statute. In 2002, Freddie announced that it would voluntarily comply with SEC disclosure requirements (as did Fannie Mae), but full SEC reporting has been delayed by the re-audit process |