Are Fannie and Freddie undercapitalized

1
Are Fannie and Freddie undercapitalized
MSF 2007 FINA 273

• Argyn Kuketayev
• About One Accident of History in Financial
  Accounting

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Contents

• GSEs
• Freddie Q3 Financials
• Bloomberg Article
• Accident of History FAS 130
• Unusually large AOCI
• Conclusion
• References
• Advanced Topics (optional)

The Bloomberg article claims that if it wasnt
for an accident of history Fannie Mae and
Freddie Mac would be undercapitalized under
current minimum capital requirements set by US
legislature. This presentation examines these
claims.
3
GSEs

• Fannie Mae and Freddie Mac private ownership
  government charter
• Federal Housing Enterprises Financial Safety and
  Soundness Act of 1992 US Congress
• OFHEO Office of Federal Housing Enterprise
  Oversight

4
FRE Q3 Balance Sheet
5
FRE Q3 Core Capital
6
Article

• Freddie Fannie Live Soft Core Capital
  Fantasy by Jonathan Weil Bloomberg.com Nov 28
  2007
• AOCI is not included into Core Capital by an
  accident of history
• GSEs have unusually large AOCI

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An accident of history

• From its 1992 inception through 2000 OFHEOs
  core-capital measure closely tracked GAAP
  shareholder equity. That changed in 2001 because
  new accounting rules required companies to show
  AOCI as a separate component of equity in a way
  Congresss 1992 statutory definition hadnt
  envisioned. So due to an accident of history
  AOCI isnt counted today. Jonathan Weil
• 12 USC 4502(4) - 1992
• CORE CAPITAL
• The par or stated value of outstanding common
  stock.
• The par or stated value of outstanding perpetual
  noncumulative preferred stock.
• Paid-in capital.
• Retained earnings.
• The core capital of an enterprise shall not
  include any amounts that the enterprise could be
  required to pay at the option of investors to
  retire capital instruments.

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Accident continued 1

• 12 USC 46 1992
• Minimum capital is a leverage ratio defined in
  statute that constitutes a base level of capital
  considered prudent to maintain safety and
  soundness. The statutory minimum capital level is
  defined as 2.5 of aggregate on-balance sheet
  assets and 0.45 of off-balance sheet
  obligations
• Currently both Enterprises maintain a 30 capital
  surplus over the statutory minimum capital
  requirement.

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Accident continued 2

• FAS 130 - 1997
• AOCI - 5th element of equity This Statement
  requires that an enterprise (b) display the
  accumulated balance of other comprehensive income
  separately from retained earnings and additional
  paid-in capital in the equity section of a
  statement of financial position.
• Paragraph 39 Prior to the issuance of this
  Statement the Board had not required that
  comprehensive income and its components be
  reported as part of a full set of financial
  statements. However several accounting standards
  required that certain items that qualify as
  components of comprehensive income bypass a
  statement of income and be reported in a balance
  within a separate component of equity in a
  statement of financial position.

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Unusually large AOCI

• Even with the surplus their capital
  requirements are much lower than for
  government-securities dealers or banks. While
  most bank regulators also exclude AOCI most
  banks dont have such large pent-up losses.
  Jonathan Weil
• As of Sep 30 2007 (millions)

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Conclusion

• An accident of history claim is credible.
  However AOCI concept was not unknown at the time
  of 12 USC 4502(4) regulation e.g. in FAS 109
  (Feb 1992).
• AOCI amount of Freddie Mac is very high compared
  to Wachovia.
• With AOCI included into Core Capital Freddie
  would be undercapitalized under 12 USC 46.
• Freddie Mac is undercapitalized

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References

• URL of the Bloomberg article http//www.bloomberg
  .com/apps/newspidemail_enrefercolumnist_weils
  idaS4lA98OsEzc
• Core Capital Definition 12 USC 4502(4) and
  Minimum Capital Requirements 12 USC 46 in Federal
  Housing Enterprises Financial Safety and
  Soundness Act of 1992 H.R. 6094
• Wachovia Form 10-Q November 09 2007
• Freddie Mac Financial Report for the Three Months
  and Nine Months Ended September 30 2007
• Freddie Mac Consolidated Financial Statements
  XLS Nov 20 2007
• FASB Statements 115 130 and 133 at
  http//www.fasb.org
• OFHEO Capital Requirements URL
  http//www.ofheo.gov/newsroom.aspxID389q10q2
  0

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Advanced Topics

• Available-for-sale FAS 115
• Cash Flow Hedging FAS 133

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FRE Q3 AOCI
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Article

• Freddie Fannie Live Soft Core Capital
  Fantasy by Jonathan Weil Bloomberg.com Nov 28
  2007
• Available-for-sale classification of securities
  allows to exclude huge losses from core capital
• Cash flow hedge accounting is unrealistic

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Available-for-sale

• Freddie had 8.8 billion of net losses in AOCI
  at Sept. 30. That included 4.3 billion of losses
  on so-called cash-flow hedges which are
  derivatives Freddie uses to protect against
  various risks. It also included 4.4 billion of
  losses on securities that Freddie classifies as
  available for sale those losses would count in
  earnings and core capital if Freddie classified
  them as trading securities instead. Jonathan
  Weil

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FAS 115

• FAS 115 1993
• Summary
• Debt securities that the enterprise has the
  positive intent and ability to hold to maturity
  are classified as held-to-maturity securities and
  reported at amortized cost.
• Debt and equity securities that are bought and
  held principally for the purpose of selling them
  in the near term are classified as trading
  securities and reported at fair value with
  unrealized gains and losses included in earnings.
• Debt and equity securities not classified as
  either held-to-maturity securities or trading
  securities are classified as available-for-sale
  securities and reported at fair value with
  unrealized gains and losses excluded from
  earnings and reported in a separate component of
  shareholders equity.
• Paragraph 13 Unrealized holding gains and losses
  for available-for-sale securities shall be
  excluded from earnings and reported as a net
  amount in a separate component of shareholders
  equity until realized.

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Cash flow hedges

• its hard to imagine how Freddie can know
  whether many of its cash-flow hedges are working
  now. It says it has used derivatives to hedge
  future cash-flow risks on forecasted debt
  issuances for -- get this -- as many as 26 years
  from now. About 70 percent of its AOCI losses
  from cash-flow hedges relate to forecasted
  transactions up to five years out.
• Making forecasts like these accurately would
  appear to require supernatural powers. If a hedge
  has lost money it will be 2033 in some instances
  before Freddie knows if the predicted transaction
  winds up producing any offsetting benefits -- if
  the transaction happens at all. Jonathan Weil

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FRE Q3 Statement

• NOTE 10. DERIVATIVES
• The total AOCI net of taxes related to cash
  flow hedge relationships was a loss of 4.3
  billion at September 30 2007 primarily
  composed of deferred net losses on closed cash
  flow hedges. Closed cash flow hedges involve
  derivatives that have been terminated or are no
  longer designated as cash flow hedges
• Over the next 12 months we estimate that
  approximately 896 million net of taxes of the
  4.3 billion of cash flow hedging losses in AOCI
  net of taxes at September 30 2007 will be
  reclassified into earnings. The maximum remaining
  length of time over which we have hedged the
  exposure related to the variability in future
  cash flows on forecasted transactions primarily
  forecasted debt issuances is 26 years. However
  over 70 and 90 of AOCI net of taxes relating
  to cash flow hedges at September 30 2007 will
  be reclassified to earnings over the next five
  and ten years respectively.

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FAS 133

• FAS 133 - 1998
• Summary
• If certain conditions are met a derivative may
  be specifically designated as (b) a hedge of the
  exposure to variable cash flows of a forecasted
  transaction
• For (a cash flow hedge) the effective portion
  of the derivatives gain or loss is initially
  reported as a component of AOCI and
  subsequently reclassified into earnings when the
  forecasted transaction affects earnings.