EVENTS

Date:	Monday, April 5, 2004
Time:	9:00 AM -- 10:30 AM
Location:	Wohlstetter Conference Center, Twelfth Floor, AEI 1150 Seventeenth Street, N.W., Washington, D.C. 20036

April 2004
Do We Understand Fannie Mae's Accounting?

An April 5 AEI conference addressed concerns regarding Fannie Mae's accounting, particularly in light of the company's recent 10-K annual report filing that showed losses on derivatives totaling approximately $7 billion.  John Barnett from the Center for Financial Research and Analysis presented a paper discussing Fannie Mae's accounting; and Mark Haefele of Sonic Capital and Albert Gavalis, a certified public account and financial analyst, responded.

John Barnett
Center for Financial Research and Analysis

Fannie Mae's regulatory core capital measure is inadequate to measure the underlying capital adequacy of the business due to reliance on the distorting effects of GAAP accounting for derivatives.  In the last three years, Fannie Mae did not earn as much in an economic sense as is reported on a GAAP accounting basis.   Fannie Mae has used GAAP accounting rules to smooth out economic losses it has suffered due to portfolio duration mismatches.  A simple example demonstrates this:  Assume Fannie Mae has $100 million in mortgages (asset) with a duration of five years and $100 million in debt (liability) with a duration of six years.  Fannie Mae has a twelve-month duration gap. If interest rates drop by 1 percent, the mortgage value will rise to $105 million while the value of the debt will rise to $106 million. In this example, Fannie Mae has a $1 million economic loss, which is not reflected in its earnings or its regulatory core capital. Fannie Mae can manipulate its current core capital measure through its choice of whether to repurchase debt or close derivative positions.  The fair value of Fannie's net assets lags behind core capital.  Fannie Mae's fair value of net assets was the only measure to pick up the portfolio losses the company suffered due to its wide duration gap. Fair value matters because it measures solvency, removes distorting effects of hedge accounting, and is the only way to immediately recognize portfolio losses. 

Mark Haefele
Sonic Capital

I agree with John Barnett's analysis.  He did an excellent job at reviewing the complex accounting details.  In my decade of financial experience I have yet to see anything, including Enron and WorldCom, on the scale of Fannie Mae.  Through accounting maneuvers and loopholes, Fannie Mae smoothed out its earnings to allow the interest-rate risk to remain hidden.  The interest-rate risk is off-loaded to the taxpayers.  There are many issues from earnings, capital regulation, and executive compensation that Fannie has distorted.  Their behavior is lousy but unfortunately legal. 

Albert Gavalis
Certified Public Accountant

There has been a manipulation of accounting practices. Fannie Mae is a both a mortgage-backed secondary lender and a derivatives participant.  The cash flows of Fannie Mae are also troublesome in that it is a derivatives participant, and that it can be both a long-term investor and also say it has short-term investments available for sale.  This is all perfectly legal under current financial accounting standards.   John's analysis might lead you to consider these procedures as "manipulation." Whether one views this as a secondary-mortgage market or a derivatives trader, the issues are so complex that it is difficult to make distinctions.   
 
AEI research assistant Jessica Browning prepared this summary.