Fannie Mae and Freddie Mac have hired thousands of consultants and are spending many hundreds of millions of dollars to produce financial statements that comply with FAS 133, the convoluted accounting standard for derivatives.

Doubtless their internal systems needed improvement. But the grand irony is that FAS 133 is such a bad rule, and so fundamentally flawed, that all the effort and enormous sums of money to comply produce distorted, misleading, and opaque financial statements.

Now it is the Federal Home Loan banks’ turn, under pressure from the Securities and Exchange Commission, to go to great lengths in similar FAS 133 projects.

At huge expense, they will produce re-stated financial statements that will befuddle, not enlighten, their readers. One after another FHLB has disclosed, as has Freddie Mac, that their hedges are highly effective economically, but not in accounting.

What kind of accounting rule produces this outcome?

As everyone in the mortgage business knows, the Byzantine complexity of FAS 133 means whatever the most recent group of accountants to get involved say it means--and what they say it means keeps changing.

It is apparent that a rule no one, including the public accounting firms, can get clear, is a bad rule. But it is a bureaucrat’s dream of how to create “gotcha’s” and of course, a bonanza for the accounting firms’ billings.

FAS 133 is the ghost at the feast for the consultants and accountants that accounting scandals are so richly providing.

From the time it was first proposed, financial experts have rejected not just the complexity but, much more importantly, 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 not only allows, but actually requires, deferral of certain realized cash losses.
  
• It diverts organizational effort from risk management to complicated bookkeeping exercises.

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.

All this is particularly disturbing because FAS 133 is also politically potent. As a HUD Office of Investigation report correctly pointed out last year: “On [Capitol] Hill everybody runs for cover if somebody’s accusing a company of some impropriety in terms of their accounting.”

Seldom or never has a rule adopted with the goal of clarifying a situation so failed in its purpose and spread confusion instead.

Considering what to do next with FAS 133, FASB and the SEC should take to heart a saying of John Maynard Keynes. When accused of changing his position, Mr. Keynes replied, “When I discover I have made a mistake, I change my mind. What do you do?”

In other words, don’t stick with a loser.

FAS 133 is so deeply flawed that it should be scrapped altogether and re-thought from scratch.

Alex J. Pollock is a resident fellow at AEI.