Blaming it on accounting

World Money

As our financial markets grapple with the introduction of interest rate futures and currency options, the participants should look at a case from the US that has been reported extensively in the financial media.

It pertains to the Federal Home Loan Mortgage Corporation ("Freddie Mac"). Freddie Mac and its sister company, Fannie Mae, both government sponsored entities, are the backbone of the $ 7 trillion housing finance market in the US. Though privately owned, both the companies are treated as quasi-sovereign and are able to raise funds at a marginal premium to US treasuries.

Their main business is to coordinate between primary lenders like commercial banks and housing finance companies and the ultimate saver or investor. This is done by buying housing loans from primary lenders, and then either keeping the assets on their own books or packaging them as securities and selling to investors.

Their balance sheets together amount to as much as a fifth of the total housing finance market. The bonds created out of packaged loans are also guaranteed by them.

Freddie Mac's debt equity ratio is as high as 25:1, but the quasi-government character, as perceived by the financial markets, leads to its easy acceptance as the guarantor to bonds "" or as the counterparty to derivative contracts.

In many ways, the two companies face one of the most complex asset liability management problems from the angle of interest rate risk. The reason is that, in a falling interest rate scenario, a homebuyer is free to prepay an existing mortgage loan, by borrowing money at a lower rate.

To the extent such loans are carried on the books, and not packaged and sold to investors, this leads to a great deal of volatility in the maturity of the asset portfolio, making companies employ complex strategies to keep the interest rate risk within acceptable limits.

Freddie Mac prides itself of aiming at a duration gap of more than a month, by using investments in treasury securities, as also derivative contracts like interest rate futures, options, swaps and so on.

The size of the derivatives book of the two companies taken together is as high as $ 1.6 trillion (notional principal). Clearly, a default by either has the potential to reverberate into a systemic risk for the huge interest rate derivatives market in the US.

Early this year financial markets were jolted by an announcement by Freddie Mac that it may have to restate its profits for the previous three years because of some problems with the accounting of derivatives, brought to notice by a new auditor.

To be sure, the restatement was likely to result in an upward revision of the profits rather than the other way round as has become all too common.

Nevertheless, the news came as a shock "" after all, if accounting errors can lead to upward revisions, the situation could as well be the other way round! Further bad news came early last month when Freddie Mac sacked a top executive and forced two others to resign.

Gradually, the details of what went wrong are emerging. The applicable US accounting standard for derivative contracts is AS 133. (Its International Accounting Standards counterpart is in the last stage of being finalised.

In India, at the moment, there is no accounting standard for derivatives. Given derivatives' popularity in the equity market, the introduction of various commodity futures, interest futures and currency options, there is obviously a need for this gap to be filled, and also for transparent tax regulations).

Though AS 133 is very detailed, as is the custom for such regulations in the US, it still gives some flexibility to companies like Freddie Mac on the accounting treatment of mark-to-market profits and losses, that too with the blessings of the previous auditor (Arthur Anderson once again!).

Apparently, the management of Freddie Mac used this flexibility to reduce the volatility of reported profits. In a way, this would be tantamount to creating a secret reserve in good years, to be drawn upon when times are bad.

In reality, given the prepayment freedom to house loan borrowers, earnings in the kind of business Freddie Mac was doing, are inevitably volatile.

A couple of weeks back, Freddie Mac reported on the restatement progress. Some extracts "The expected cumulative increase to retained earnings will likely be driven by gains on certain derivatives and mortgage securities that will be marked to fair value during periods in which interest rates were declining."

Again, "historically, a significant portion of Freddie Mac's mortgage securities was classified as held to maturity (HTM) and, accordingly, reported at cost adjusted for amortisation of premiums and discounts....

The restatement will shift all securities previously classified for accounting purposes as HTM to the available for sale or trading classifications", and that "a majority of the corporation's derivatives in 2001 and 2002 will not qualify as accounting hedges."

Again, it has acknowledged "the lack of sufficient accounting expertise and internal control and management weaknesses." Anybody still thinks that accounting is simple?

Email: avrco@vsnl.com