1 Are Fannie and Freddie undercapitalized MSF 2007 FINA 273
About One Accident of History in Financial Accounting
Freddie Q3 Financials
Accident of History FAS 130
Unusually large AOCI
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
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
7 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
The par or stated value of outstanding common stock.
The par or stated value of outstanding perpetual noncumulative preferred stock.
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.
8 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.
9 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.
10 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)
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
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
13 Advanced Topics
Available-for-sale FAS 115
Cash Flow Hedging FAS 133
14 FRE Q3 AOCI 15 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
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
17 FAS 115
FAS 115 1993
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.
18 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
19 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.
20 FAS 133
FAS 133 - 1998
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.
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