Freddie Mac's accounting books evoke shades of Enron

You have to wonder if a company is playing games when its earnings hinge on predictions that no mere mortal is capable of making. That's one of Enron's great lessons. And it's one that Freddie Mac investors might heed now.

Before it collapsed in 2001, Enron reported large profits by estimating the values of its future cash flows from energy contracts that extended 20 years or longer.

It then booked those amounts as current earnings. Even if Enron's executives had been acting in good faith, which they weren't, their forecasts weren't humanly possible.

Freddie's results depend on similar predictions, with a twist. The Mclean, Virginia-based company is using far-out forecasts of future cash flows to avoid recognising large losses in its net income and capital.

To believe Freddie's financial statements, you must believe that the government-sponsored mortgage financier can make prognostications about its cash flows and debt issuances as long as 26 years from now.

"It's preposterous to think that anyone can predict cash flows out that far,'' said Edward Ketz, an accounting professor at Pennsylvania State University. "When you start thinking 26 years out, it becomes doubtful that the cash flows would occur as predicted.''

Here's how the accounting works. Freddie's September 30 balance sheet shows $4.3 billion of pent-up losses on derivatives called cash-flow hedges. Companies use these side bets to guard against interest-rate fluctuations on, for example, variable-rate debt.

Changes in the hedges' values don't hit net income immediately. Instead, they go into a line in shareholder equity called accumulated other comprehensive income, or AOCI. From there, they are released gradually into net income as payments come due.

Doesn't Count
These losses also don't count in the primary gauge the government uses to measure Freddie's capital, the financial cushion that helps any company absorb losses. Had Freddie counted them in net income, it would have fallen $3.7 billion short of its minimum capital requirement at the end of the third quarter.

Freddie said that it has closed out almost all its cash-flow hedge positions and this means the losses are now fixed. About 70 per cent of its AOCI will be released into earnings over the next five years, it added.