Financial Accounting Standard 133 (FAS 133), which governs accounting for derivatives, was controversial from the outset and is perhaps even more so following the accounting scandals at Fannie Mae and Freddie Mac, the two giants of the mortgage market. American residential mortgage finance is particularly vulnerable to the vagaries of FAS 133 because mortgage finance requires extensive hedging to be done properly, making derivatives disclosure a key element of financial reporting. What’s more, the mortgage market is not only the largest credit market in the world, it is also intensely political, promoting as it does the “American Dream” of homeownership--and it is dominated by Fannie Mae and Freddie Mac with their special government-sponsored status and their $3.7 trillion presence in the market. FAS 133 is thus central to the hedging-intensive mortgage business in general and to Fannie Mae and Freddie Mac in particular--although no one would have predicted the role it played in bringing down the top managements of first Freddie and then Fannie.

The rules of FAS 133 and its copious official interpretations run to more than 800 pages, but different groups of accountants still cannot agree on how to apply them to actual situations--witness General Electric’s recent run-in with the SEC on FAS 133 disclosure. In addition to being enormously expensive to implement and maintain, the rules often cause accounting treatment to diverge markedly from economic reality. They make financial statements less clear, less transparent, less understandable, and less useful.

Testifying to the Congress against the adoption of FAS 133 in 1997, I predicted its negative consequences on the home mortgage market--although no one at that time could have imagined that these would include humiliating accounting embarrassments and organizational disruptions at the dominant sources of mortgage finance, as well as the ignominious end of a number of prestigious careers.

I pointed out that because FAS 133 involves marking some items to market but not others, with similar transactions treated varyingly as earnings, direct capital charges, or exempt from disclosure, normal hedges are often accounted for as if they represented speculation. I also observed that it was possible for the new rules to artificially inflate a financial institution’s capital.[1]

These developments pose a highly interesting question for corporate financial management: How should financial reporting cope with a bad accounting standard? If the Financial Accounting Standards Board has imposed a perverse rule, how should financial disclosure deal with it?

Enter FAS 133

From the time it was first proposed, financial experts have rejected not just the complexity but, more important, the fundamental concepts of FAS 133. Indeed, the experts who actually manage financial risks have made the following criticisms:

• FAS 133 marks to market for accounting purposes only one side of what are in fact two-sided positions. 
  
• It treats positions with identical net cash flows differently. 
  
• It requires the pretense that all hedging is “micro” hedging of specific items, while the reality is macro hedging of combined balance sheet risks. 
  
• It requires assigning hedges to specific assets or liabilities, while the real risk is the relationship between assets and liabilities. 
  
• It requires, as the result of a political compromise, direct debits and credits to the capital accounts, bypassing the profit-and-loss statement. 
  
• It can cause overstatement or understatement of capital. 
  
• It not only allows, but actually requires, deferral of certain realized cash losses. 
  
• It moves accounting even farther away from cash flows than before. 
  
• It diverts organizational effort from risk management to complicated bookkeeping exercises. 
  
• It makes documentation more important than the substance of the transaction. 
  
• It obscures financial performance. As a result of all of the above, FAS 133 creates a strong and perverse incentive not to hedge. In other words, it makes accounting risk a bigger problem than real risk and thus tends to increase real risk. An open survey I conducted recently in the electronic version of National Mortgage News had the following results:[2] 
  
• 86% said FAS 133 has made financial statements less clear 
  
• 89% said its costs are greater than its benefits 
  
• 97% said its rules are too complex 
  
• 63% think it should be withdrawn or replaced, while 31% say it could survive with major revisions, and only 6% say it should continue as is. Most interesting was the letter grade respondents gave FASB for its production of FAS 133. The average grade was D–, broken down as follows:
  
  A: 0%
  B: 0%
  C: 9%
  D: 41%
  E: 50%

Fannie and Freddie Meet FAS 133

Neither Fannie nor Freddie followed the derivatives accounting rules as imposed by FASB amidst continuing dispute and debate. While everyone agrees they should have, virtually everyone also agrees that the FAS 133 rules are extremely complex, convoluted, and difficult to apply. Without in any way making excuses for Fannie and Freddie, one can point out that the questionable design of FAS 133 is the ghost at the feast of accounting scandal. Let us ask again: How should financial disclosures deal with a bad official accounting standard, especially one central to your business?

No one is applauding Freddie’s accounting maneuvers, but it appears that one source of its problems was management’s conviction that FAS 133 so distorted the operating results that it made sense to structure shell transactions to adjust them. This was hardly a good idea, as truncated careers attest, but it is likely that the effects of FAS 133 on Freddie’s financial statements were--and remain--the result less of reality than of accounting artifacts.

If management believed that by their earnings management transactions they were actually providing a more accurate representation of the company’s performance, it is easier to understand their actions. Although the actions they took in response to their problem were clearly wrong, some measure of sympathy may be given a management faced with rules that seriously distort the operations of their principal business.

Consider the subsequent accounting history. Is the restated 47% after-tax return on equity reported by Freddie in its “corrected” 2002 financial statements believable? Does it make any sense at all? Freddie’s management, old and new, has consistently asserted that the company is economically well hedged. For example, Freddie’s Chairman and CEO recently testified to the Senate Banking Committee:

Our portfolio is very conservatively managed…Even in 2003-- a tumultuous year at Freddie Mac and the biggest refinancing year in history--our duration gap never deviated from a very narrow range, and averaged zero months for the year. Very few institutions in the world manage such a tight book…[3]

Virtually all Wall Street analysts and also the regulators agree that this is true. Then did a very tightly hedged commodity mortgage business really produce a 47% return on equity? I don’t think so, and neither does anyone else who knows anything about the subject.

Consider the subsequent year. Granting that Freddie’s mortgage book is in fact well hedged, what does the 30 percentage point drop from the restated 47% ROE for 2002 to the belatedly reported 17% ROE in 2003 mean? Either Freddie is not economically well hedged, or these numbers do not tell us anything.

Let’s look at 2004. Freddie reported $2.8 billion in net profit for the year, a dramatic drop from $4.8 billion in 2003 and a precipitous drop from 2002’s “corrected” $10.1 billion. If Freddie is economically well hedged, how could 2004’s net profit drop 41% from 2003 and a spectacular 72% from 2002? Again, either Freddie is not really well hedged or these numbers do not mean anything.

The most likely explanation is that FAS 133 caused an artificial and misleading one-sided recognition of gains on hedges, which had the effect of front-ending GAAP profits in 2002, making subsequent years look bad. This appears to be exactly what the old Freddie management correctly viewed as an accounting distortion.

With the imposition of FAS 133, are Freddie’s debt and equity holders better informed? The answer is that investors--and ordinary retail investors in particular--are more likely baffled. Freddie’s post-scandal accounting history shows that GAAP financial statements, following FAS 133 as well as it can be interpreted, are unlikely to enlighten them.

As for Fannie, its notorious $9 billion downward adjustment to aggregate earnings is largely the result of FAS 133--but is it real? That is open to doubt. Hedge accounting under FAS 133 appears to be viewed by the SEC as a matter of compliance, a benefit “earned” by doing the necessary paperwork, rather than as a matter of accurately presenting the substance of the financial structure. The SEC’s chief accountant is reported to have said to Fannie’s then-CEO, “Sir, hedge accounting is a privilege, not a right.”[4] Privilege? Right? What do these political terms have to do with financial measurement?

In other words, under FAS 133, if you have not provided sufficient documentation to obtain your accounting “privilege,” then you must present hedges as if they were speculations. This outcome is obviously wrong. As one mortgage market expert wrote, “What’s more meaningful to investors, financial statements that reflect the economics of transactions, or financial statements that pass some arduous test few people understand?”[5]

An unquestionably real problem for Fannie, meanwhile, is that it has deferred income statement recognition of about $8 billion of realized losses on terminated interest rate swaps. These are real losses: the cash is gone forever. But the corresponding debit entry is hung up in the capital accounts under FAS 133 as so-called “OCI” (other comprehensive income). Since OCI is excluded from the calculation of both profit and regulatory capital, both are overstated. Yet FAS 133 not only permits but requires this deferral.

It is a notable historical irony that such a hopelessly fl awed accounting rule became the “soft underbelly” of political vulnerability of Fannie and Freddie, which had long been viewed as unassailable founts of the American homeownership “dream.” But with accounting scandals, they suddenly found themselves with far less support on Capitol Hill than before:

On [Capitol] Hill everybody runs for cover if somebody’s accusing a company of some impropriety in terms of their accounting. All of a sudden they don’t have any friends any more.[6]

The disasters at Fannie and Freddie represent a highly interesting collision of two major government-sponsored efforts: leveraged mortgage finance, on one hand, and the elaboration of detailed, mandatory top-down accounting rules on the other. The force of government-sponsored accounting has prevailed over government-sponsored mortgage finance--an instructive outcome.

Accounting Choices

All businesses must necessarily address both economic and accounting effects (among many other things). A bad accounting rule that exacerbates the divergence between the two makes this double assignment challenging indeed. Under FAS 133, this is particularly and painfully true for managers of positions that need intensive hedging, such as mortgage portfolios.

For such managers, the tension between economics and accounting under FAS 133 leaves six possible choices. These are:

1. Publish only GAAP financial statements and confuse stockholders, creditors, and anybody else with no access to inside economic information. Not the ideal case. 
   
2. Reduce hedging and actual risk management in order to escape from the anomalies and vagaries, not to mention the overhead expenses, of FAS 133. A bad idea, but tempting.
   
3. Engage in dubious accounting-oriented transactions to adjust accounting results: the former Freddie approach. Another bad idea. 
   
4. The Sir Galahad approach, relying on purity of heart--do what is right economically and let the accounting chips fall where they may, with the success of the hedging strategy demonstrated in the long run. This approach may not last beyond the first quarter in which the GAAP financial statements show a loss resulting from hedging. A banking CEO I know actually tried this strategy for coping with FAS 133, with unhappy results. Whatever the company’s internal knowledge of its real economic position, published financial statements take on a reality of their own, and management may not survive while waiting for the long run. To paraphrase an old fi nancial market saying, “The accounting can stay irrational longer than you can stay employed.” 
   
5. Discover the domain in which economically correct hedging and the FAS 133 rules overlap, so that doing the right thing and having acceptable accounting results are consistent. This seems like the superior strategy. Unfortunately, because of the shortcomings of FAS 133, it results in seriously reducing the hedging alternatives available for risk management. As the portfolio or activity being managed grows larger, this approach becomes less and less attractive or practicable. 
   
6. Finally, publish two sets of financial statements, one the audited statements prepared in strict accordance with GAAP, and one the company thinks is the most accurate representation of the results. Further perspectives could also be added, if they provide additional insight and understanding.

The “two books” alternative is the best of those available because it provides the most information. The “two books” approach was adopted by the old management of Fannie, and it appeared to be very successful in convincing the markets that “core earnings” were more relevant than the reported results under FAS 133. But having won the conceptual battle, they threw their victory away by then failing to implement FAS 133 correctly. When they had convinced the markets to discount the FAS 133 accounting effects in any case, why did Fannie not follow the rules properly for its GAAP books? This is an exceptionally puzzling element of Fannie’s accounting and management disaster.

What Is Accounting Truth?

The FASB has labored mightily for more than three decades to produce a uniform system of detailed top-down rules for accounting. Yet Morgan Stanley’s accounting guru Trevor Harris recently told a Journal of Applied Corporate Finance roundtable that we need to “force people to become much more skeptical about GAAP income” and “no longer rely on GAAP income statements and balance sheets.”[7] FAS 133 demonstrates his point. I suggest that truth is most likely to be discovered through a variety of perspectives.

Pontius Pilate famously asked, “What is truth?” Were he with us today, the cynical Roman might ask in particular, “What is accounting truth?” A central axiom of GAAP is to impose a single perspective--a single set of rules for all businesses, all kinds of economic activity, and all contexts. Accounting standards struggle to establish rules for calculating net profit as a single definitive number. But no sophisticated investor believes in this for a second--nor does any sophisticated accountant. They all know that net profit is a number that has a range of plausible outcomes, subject to many estimates, conventions, and more or less reliable assumptions.

Accounting “truth” lies in multiple perspectives and approaches rather than in a single, official perspective. Like the “two books” approach to FAS 133, multiple perspectives will improve financial disclosure in general. Yet why is the idea that there are multiple ways to represent economic activity so threatening? Perhaps it is only the dogma of uniformity that makes it seem so to some people. As the editor of this journal has observed, “Where GAAP earnings do a poor job of representing the company’s long-run value,…[management should] commit to expanded disclosure and engage investors in a more strategic dialogue.”[8] Such a dialogue will involve multiple perspectives.

Consider an analogy. What is the true view of a statue? As we walk around it, we see something different from each angle. Expressed more theoretically, the object is the sum of all possible perspectives on it. Might this thought be carried into financial reporting? An interesting recognition of its applicability to accounting in a government context is found in the President’s fiscal 2006 Budget of the U.S., which makes several points that apply equally well to financial reporting in general:[9]

No single framework can encompass all of the factors that affect the financial condition of the Federal Government.

Its fiscal status is best evaluated using a broad range of complementary perspectives.

There is no single number that corresponds to a business’s bottom line.

A recent step forward in the acceptance of multiple perspectives involved recommendations from the European Union and consideration by the SEC of mutual recognition of international accounting standards and U.S. GAAP, providing companies disclose the differences in the standards.[10] If companies add to either set of financial statements their own views of the most accurate representation of their results, we will have advanced yet further.

Electronic computing, data storage and manipulation, and communication make practicable the expression of multiple perspectives in a way not possible in the past. I believe that the insistence on a single set of accounting rules and a single mandated perspective reflects in part the historical constraints of paper records and the aggregation of numbers from papers recording detailed data to papers with summary data. Perhaps the change in the technological basis of accounting records from paper ledgers to electronic databases should bring about changes in our ideas of what accounting standards mean.

Reflecting on the history of accounting standards over the last three decades, Walter Schuetze, a charter member of the FASB and a former chief accountant at the SEC (and quoted at the beginning of this article), concluded:

The Financial Accounting Standards Board…was going to write accounting standards that would bring forth financial statements based on concepts. What happened was that the FASB wrote a mountain of rules that produce financial statements that nobody understands.[11]

That FAS 133 is a bad rule which needs to be scrapped and completely redone is an important point. That the current combination of politics and accounting scandal has proved an explosive mix is an important lesson. But more fundamental and more important is to understand that no single accounting rule or set of rules will capture reality. Truth will be more adequately approached through multiple perspectives.

Companies should prepare their GAAP financial statements, precisely following all the relevant official standards, including FAS 133, as carefully as its requirements can be understood. They should also explain to investors, creditors, and counterparties how they actually conceptualize, measure, and manage the relevant risks--the risks of mortgage portfolios, for example. They should produce additional financial statements reflecting the non-GAAP perspectives needed to create accounting representations approximating the underlying economic truth as they believe it to be. They will doubtless change their minds about these matters from time to time and seek improvements. These changes too should be explained.

What is accounting truth? This is the best we can do.

Alex J. Pollock is a resident fellow at AEI.

1. Testimony of Alex J. Pollock, U.S. Senate Committee on Banking, Subcommittee on Securities (October 9, 1997).

2. Alex J. Pollock, “FAS 133 Gets a D-,” National Mortgage News (February 28, 2005).

3. Testimony of Richard F. Syron, U.S. Senate Committee on Banking (April 20, 2005).

4. “Fannie Regulator to Review Pay Pacts,” Wall Street Journal (December 23, 2004), p. A7.

5. David C. Stephens, private communication (December 22, 2004).

6. Report of the HUD Office of Investigation, Case # SID-04-0034-I (October 5, 2004), p. 9.

7. “Roundtable on Corporate Disclosure,” Journal of Applied Corporate Finance, Vol. 16, No. 4 (Fall 2004), p. 57.

8. Don Chew, “Roundtable on Corporate Disclosure” (cited in fn. 11), p. 39.

9. Analytical Perspectives, Budget of the U.S. Government, Fiscal Year 2006, “Stewardship,” p. 199.

10. “Another Step is Due in Uniting Accounting,” Wall Street Journal (April 28, 2005), p. C3.

11. Testimony of Walter P. Schuetze, U.S. Senate Committee on Banking (February 26, 2002).