DERIVATIVES ACCOUNTING FOR THEIR USE AND ABUSE Randall

DERIVATIVES: ACCOUNTING FOR THEIR USE AND ABUSE Randall Dodd Director July 1, 2003

OUTLINE • • • Brief History of Fannie and Freddie Core business Basics of hedging: prices and flows Accounting for derivatives Description of balance sheet “Fair value” under GAAP and FAS 133: a stock method Core business: a flow method What Freddie Did Wrong What Fannie Did Wrong Myth-understandings

HISTORY • Fannie Mae established by Congress in 1938 as part of Reconstruction Finance Corporation which provided initial capital. • Purposes: – fresh capital to mortgage market – add liquidity to mortgage market – establish conventional mortgage contract (amortized 30 year loan) • Congress split off Ginnie Mae from Fannie in 1968 to securitize VA and FHA guaranteed mortgages, while Fannie was privatized. • Freddie Mac established in 1970 to securitize mortgages of thrift sector. Originally owned by FHLBB and later privatized.

CORE BUSINESS • Securitizing Mortgages into mortgage-backed-securities called MBS • Buy and Hold Mortgage Investment – buy mortgages from originators in order to add liquidity and fresh capital to market – finance mortgage purchases by issuing short, medium and long dated notes and bonds – manage interest rate risk inherent in buy and hold investment strategy • Risk Management – Credit risk on mortgages mitigated by high collateralization rate, high income requirement and limit on size of mortgage – Credit risk on derivatives mitigated by high collateralization rate and high credit rating of counterparty – Market risk mitigated with derivatives and repo transactions

HEDGING • Also known as Risk Management. • Same basic story as Joseph’s advice to the Pharaoh. • Use derivatives to hedge against the effects of a change in interest rates that determine the rates of return on investment in mortgages and the cost of borrowing to finance those investments. • Derivatives should generate a cash flow that is equal (in magnitude) but opposite (in direction) to the change in investment returns and borrowing costs.

The (Financial) World Is Variable Rather Than Constant Return

Variability Can Be Hedged Return

Hedging Needs To Be Reported Return t 1 t 2 How the firm looks depends in part on the state of the market at the time of the report.

GAAP and FAS 133 • FAS implemented January 1, 2001 • Uses “Fair Value” approach: fair present market value of instruments • Derivatives are reported in one of three ways: • fair value hedge: reported in “FV gain (loss)” • cash flow hedge : reported in AOCI* except for portion that unsuccessfully hedges flow, “basis loss” reported in “FV gain (loss)” • “no hedge” i. e. speculative HOW IT WORKS • The change in the fair value of derivatives is reported as a gain or loss that is reported in the income statement. * Accumulated and Other Comprehensive Income (change in fair value of available-forsale (AFS) securities

FINANCIAL REPORT INCOME STATEMENT • • Net interest income Fair Value of derivatives (purchased options expense) Other income Net income BALANCE SHEET • • Assets (mortgages) Liabilities (borrowings) Preferred stock Shareholder Equity

Stock vs Flow Approach • Flow approach measures the rate of change of revenues and costs over time. Steady growth in the net of revenues over costs will generate steady profit growth. • Stock approach measures how much something is worth at a specific point in time. – Applying to balance sheet shows that present or fair value of assets less the value of liabilities. The generates a measure of the net wealth of the enterprise. – Comparing stock measures of net wealth over time should measure earnings. • Advantages include the measure of net worth as indicator of credit risk for enterprise’s creditors • Problems: – changes in stock measure of net worth are more volatile than flows of net income – if hedge is applied to underlying first, and then present value is calculated, then the volatility of fair value and net worth are significantly less volatile

Formula (Black Scholes) for pricing option (call) -- price or premium is exponential function of price of underlying P = e-r(T-t) x (ST-X) g(ST) d. ST Where P is price, r is interest rate, S is price of underlying, X is strike, g() is density function, and t and T are start and end periods Formula for pricing bond -- price is exponential function of r

PROBLEMS WITH OPTIONS • Present value of flow hedge such as fixed-float swap will match, or come close to matching, present value of underlying if maturities and payment frequencies match. Consider the example of using fixed-float swap to hedge variable rate debt or asset. • Introduction of option breaks link between the maturity on hedge and underlying item. Options pricing also likely to be more exponential than that on security. • Introduction of options means that a change in the benchmark interest rate will likely change the present value (“Fair Value”) of hedge by more than that of the underlying even though the flows will be closely matched over time. The result is to make Fair Value reporting under GAAP more volatility than pre-FAS 133. • Introduction of hybrid instruments, also known as structured securities which combine derivatives will features of conventional securities, can change reporting. Consider the example of a callable bond. A 10 -year note callable in 5 -years is treated differently than a 5 -year note and a swaption exercisable in 5 years even though they provide the same economic function.

“CORE BUSINESS” APPROACH • The results were the same as GAAP until FAS 133 implemented • The total cost of purchased options (intrinsic and time value) was amortized in a straight-line fashion (constant proportion each period) over expected life of option and this was factored into net interest income. • Benefits from exercising derivatives and from the cash flows from interest rate swaps where factored into the interest expense on borrowings (liabilities) and thus factored into net interest. • To the extent that hedges were successful, the flow of interest revenue and interest expenses -- and the earnings on the net income from interest -- was more steady over time.

What Freddie Did Wrong • False reporting (understatement) of earnings • Causes: – incompetence – inadequate “management controls” of process – “numerous errors” in applying accounting principles • Restatement in wide range of $1 billion to $6. 9 billion before tax

What Fannie Did Wrong • Claims that there were large losses in 2002 and that accounting shenanigans were used to report smaller losses and stronger earnings. Particularly that there was a sharp decline in shareholder equity. • Fannie reported $6. 4 billion in CORE earnings but $4. 6 billion in GAAP earnings • Methods: – inadequate hedge against a fall in interest rates – manipulative reclassification of securities from HTM to AFS • Results are that GAAP reporting is growing increasingly divergent from CORE Business method • Fannie points to changes in method of pricing time value of purchased options

MYTH-UNDERSTANDINGS • Why Borrowing Costs Are So Low: 1) Bond issuances are schedule to meet market needs 2) Bonds are cleared through GSCC 3) Low credit risk (highly collateralized) business • Duration Gap: - Not really a good measure of interest rate risk - Does not account for liquidation of assets and liabilities - Does not account for callable debt and swaptions (only fixed rate swaps) • Too Big to Fail: - Many firms, especially the “critics” are too big to fail • Most large banks use massive amounts of derivatives - GSEs are largest hedgers, critics are largest dealers • Most large banks have weaker credit management of derivatives - GSEs have higher credit standard for derivatives • Some large banks are heavily invested in the subprime market - GSEs are not heavily invested in subprime market