CONTENTS Page Linsmeier, Thomas J., Russell E. Palmer Endowed Professor and Chair- 33 Seidman, Leslie F., Member, Financial Accounting Standards Board Wallison, Peter J., Resident Fellow, American Enterprise Institute (III) FASB DERIVATIVE ACCOUNTING STANDARDS TUESDAY, JULY 22, 2003 HOUSE OF REPRESENTATIVES, SUBCOMMITTEE ON COMMERCE, TRADE, The subcommittee met, pursuant to notice, at 2 p.m., in room 2123, Rayburn House Office Building, Hon. Cliff Stearns (chairman) presiding. Members present: Representatives Stearns, Bass, Schakowsky, Markey, Davis, Stupak, Green, and Strickland. Staff present: David Cavicke, majority counsel; Ramsen Betfarhad, majority counsel; Jill Latham, legislative clerk; Jon Tripp, deputy communications director; and Consuela Washington, minority counsel. Mr. STEARNS. Good afternoon. The Subcommittee on Commerce, Trade, and Consumer Protection of the Energy and Commerce Committee, will come to order. I welcome all our members and witnesses to the subcommittee's hearings on the Financial Accounting Standards Board, or as we know FASB, Derivative Accounting Standards. In particular, I wish to thank Mr. Baumann, Freddie Mac's Chief Financial Officer, for testifying this afternoon. I fully appreciate the fact that Mr. Baumann is limited in his ability to be responsive to all questions as Freddie Mac's restatement process is ongoing and not yet complete, and that Freddie Mac's restatement is subject to a number of investigations, including one by the SEC. I also welcome all the other witnesses, too. The immediate trigger for this hearing was Freddie Mac announcing that it will restate its financial statements for the year 2002 to 2000, and that the restatement, to a great extent, was due to the misapplication of FAS 133, the 800-page FASB standard on accenting for derivative instruments and hedging activities. That misapplication, according to Freddie Mac's June 25 release, could increase retained earnings as of December 31, 2002, by between $1.5 to $4.5 billion. Although the restatement in and of itself is a significant event worthy of a serious inquiry, it is however not the focus of this hearing, but the focus of a hearing after the release of Mr. Dowdy's report, the counsel retained by Freddie Mac's Board. The purpose of this hearing is to explore the efficacy, helpful of course to the investors, of FASB's standard on accounting for derivative instruments in hedging activities. It is a standard providing (1) the investor with the transparency and disclosure to assess the economic impact of derivative contracts on a company. Does the derivative accounting and reporting standard enable the investor to compare financial statements of two similar companies based on their derivative positions? And essentially, my colleagues, the inquiry before the subcommittee is whether the standard is providing investors with meaningful and timely information about the impact of derivative instruments on a company's true economic condition? Derivative instruments entail both significant benefit and risk for companies that have come to rely on them for managing the operating and market risk. This is significant considering that the cumulative value of derivative contracts outstanding today is in excess of $127 trillion. Freddie Mac and its first cousin, Fannie Mae, together hold over $1.6 trillion worth of derivative instruments as hedges against interest great risk. These two government-sponsored enterprises are important case studies in the testing of the efficacy of accounting standards governing derivatives. They are important not only because of the sheer size of their derivative portfolio, but also because they play a key role in the vibrancy of our mortgage markets. The two combined either hold, trade, or guarantee over 50 percent of all conforming mortgages issued in this country and in securitizing mortgages provide greater liquidity to the mortgage markets. The basic rule of FAS 133 is clear. All derivative instruments must be measured and recorded on the books, both income statement and balance sheet, at fair value. With that, the elegant simplicity of the rule ends. Multiple hundreds of pages are then devoted to the justification and explanation of "creative construct," called "special hedge accounting." If a derivative instrument qualifies as a hedge, fluctuation in its fair value may be offset by changes in the fair value of the underlying hedge item, with a net effect on earnings being zero or nearly zero. Fannie Mae's financial 2002 statement is illustrative of the significance of special hedge accounting. In 2002, Fannie Mae reported $4.6 billion in earnings under GAAP accounting, yet, a review of its annual fair value balance sheet shows that Fannie Mae lost billions of dollars in shareholder equity, nearly wiping out its earnings for that year. In correctly applying FAS 133, Fannie Mae used a special hedge accounting rule to defer the billions of dollars in lost shareholder equity to the future. Freddie Mac, on the other hand, in misapplying the FAS 133 rule, is expected to restate its earnings for the past few years upward by as much as $4.5 billion. These are companies that are virtually in the same line of business encountering and applying FAS 133 with dramatically different results. Moreover, my colleagues, if two transactions such as two different hedging techniques bring about the same economic outcome, GAAP treatment of the two transactions should be similar, but in many cases are not. This similar treatment is the objective that FASB should strive for to achieve through its standards, and I am not sure why today the accounting results of a transaction should deviate substantially from the economic results of the same transaction and, if we are wrong, perhaps our witnesses will explain that to us. I understand that FAS 133, for example, is a stepping stone, an evolutionary step to a full fair value accounting for all derivative instruments. Such fair value accounting, in my view, will substantially reduce the difference between the accounting and economic results of the same transaction. There are many good reasons for the special hedge accounting rules. Nonetheless, as I have advocated in the past, I think financial accounting standards should be free from special exceptions if such exceptions help obfuscate the real economic conditions of a company in the company's public financial statement. And, last Congress, I, along with Chairman Tauzin, introduced a bill, H.R. 5058, seeking to establish general principles and objectives to be followed by FASB when establishing financial accounting reporting standards. I think FAS 133 and its application are an example of the need to have a more principle-based accounting system, free from special exceptions and undue complexity that, really, I don't think, serve investors well. So, I look very much to the testimony of our witnesses and, with that, I call upon our ranking member for an opening statement. Ms. SCHAKOWSKY. I want to thank Chairman Stearns for convening this important hearing today on FASB derivative accounting standards. Our subcommittee has an important responsibility to ensure that FASB's accounting rules provide clear and accurate information on the financial health of companies for workers, investors, and pension holders. To their credit, FASB has a long history of working diligently to create clear accounting standards. Changes and innovation in our financial markets and political pressure have made this a daunting challenge. The expanded use of derivatives in our financial markets provides a clear example of just how difficult this challenge can be. Derivatives, as we all know here, we are saying are trading instruments that are value-based on the price of another financial instrument like a bond or an exchange rate or an interest rate. Derivatives are popular in our financial markets because they enable companies and investors to diversify their portfolio and therefore reduce their exposure to risk. The total value of derivatives outstanding is estimated by one of today's panelists to be $127 trillion, up from $3 trillion in 1990. In response to this market innovation, FASB went forward and worked to establish accounting rules for derivatives. FASB began studying accounting for derivatives in September 1991. In 1996, after nearly 100 public meetings, unveiled a proposed standard that would require companies to account for derivatives in their quarterly statements based on their fair value. The sensible proposal was fiercely opposed by Federal Reserve Chairman Greenspan, Members of Congress, and nearly every major bank, securities firm, and insurance company. In response to the proposal, some Members of Congress went as far as to introduce legislation that would have abolished FASB. I should note that Democratic Ranking Member Dingell was one of the few members who defended FASB. However, in the end, the opponents of the new standard overwhelmed FASB and, as a result, FASB's final rule known as FAS 133 created complicated standards that included over 500 pages of exception. The standard allowed |