The Fannie Mae Derivatives Reporting Debacle A Case Study in FAS 133 Pitfalls

1. Return to Risk LimitedWebsite atwww.RiskLimited.com The Fannie Mae Derivatives Reporting DebacleA Case Study in FAS 133 Pitfalls December 2004

2. Overview • Background on Fannie Mae • What Happened? • Magnitude of the Disaster • FAS 133 Rules & Revisions • Major Pitfalls • Shortcut Method • Observations & Conclusions

3. Who Is Fannie Mae? • Fannie Mae Is The Giant Housing-Finance Company • A private, shareholder-owned company whose stock is traded on the New York Stock Exchange • Not a government entity now

4. Who Is Fannie Mae? • Created by Congress in 1938 operating under Federal control • Privatized by legislation enacted in 1968 and became fully private in 1970 • Operates under a federal charter, called the Federal National Mortgage Association Charter Act • Mission is to increase liquidity in the residential mortgage finance market and promote access to mortgage credit • Second largest U.S. corporation, in terms of assets • Since 1968, provided 63 million homeowners with more than $6.3 trillion in housing finance

5. What Was Fannie Mae’s Derivatives Reporting Debacle? • It Is Alleged That Fannie Mae Incorrectly Reported The Financial Results On Their Derivative Instruments Used For Interest Rate Hedging • Incorrect FAS 133 Application • Alleged Abuse Of Accounting ‘Shortcut’ Method • The Magnitude Of Earnings Affect Is Staggering

6. What Was Fannie Mae’s Derivatives Reporting Debacle? • 12/15/04 findings by SEC’s chief accountant that Fannie Mae should correct its earnings for the past several years • Such a restatement would wipe out $9 billion in earnings; 38 percent of FM’s profit since FAS 133 went into effect • Bigger than the restatement that lead to the Enron collapse • FM’s regulator, the Office of Federal Housing Enterprise Oversight, in a September 2004 report accused the company of pervasive accounting violations

7. Outcome of Fannie Mae’s Derivatives Reporting Debacle • At the urging of the regulator and due to the response after the Congressional hearing on FM’s 133 problem, the CEO and CFO of Fannie Mae have been forced to resign • It appears likely that Fannie Mae will have to comply with the SEC findings and restate all prior years earnings since they began FAS 133 reporting

8. FAS 133 Overview • FAS 133 passed by FASB in June 1998 • Effective for fiscal years beginning after 6/99 • Controversial rule. Considered since the early 1990’s • Exposure draft provisions differed from final Statement, but considerable opposition

9. Evolution of the Rules • FAS 133 Rules Have Not Remained Static • Continual Evolution With Adoption By The Financial Accounting Standards Board of... • FAS 138 and FAS 149 • Various Derivatives Implementation Group (DIG) Rules • Various Emerging Issues Task Force (EITF) Rules

10. Evolution of the Rules • FAS 149 • Address apparent conflicts between certain DIG Issues and the technical definition of a derivative • Clarify “smaller initial net investment” • Application of ‘Shortcut’ Method • Potential changes to DIG Issue C15 • Effective for transactions after June 30, 2003

11. Evolution of the Rules • EITF 98-10 & EITF 02-03 • EITF 98-10, “Accounting for Contracts Involved in Energy Trading and Risk Management Activities” • First discussed May 1998 • Intended to give guidance on Gross vs. Net Presentation in Income Statement • EITF 02-03, “Issues Involved in Accounting for Derivative Contracts Held for Trading Purposes and Contracts Involved in Energy Trading and Risk Management Activities” • First discussed June 2002 • Rescinds EITF 98-10 • Net Presentation of Trading Activity • 10/02 consensus effective • New contracts and inventory purchases after 10/25/02 • Old contracts periods beginning after 12/15/02

12. Evolution of the Rules • DIG Issue C20 – “Scope Exceptions:  Interpretation of Clearly and Closely Related in Contracts That Qualify for the Normal Purchases and Normal Sales Exception” • EITF reconsidered issue and released tentative guidance • Certain new circumstances where use of CPI index would result in transaction qualifying for scope exception • Percentage change in index must be within 80 – 120 percentage of the percentage change in the fair value of the electricity being sold under the contract

13. The Shortcut Method • The Provision That Has Gotten Fannie Mae Into Trouble • What Is It? And When Can It Be Used? • Very Narrowly Applied • Under Certain Stringent Conditions, Can Simply Assume That Hedges Remain Perfectly Effective • Avoids The Extensive Documentation & Quarterly Testing, And Still Excludes Gains Or Losses From Earnings • Zero-Value Initially For The Derivative When Designated As A Hedge • Issue For Re-application Or Restructuring Of Hedges

14. The Shortcut Method • Fannie Mae's auditor, KPMG LLP, flagged FM's use of the Shortcut Method as a “Difference” and point of concern • But FM estimated that the accounting effect of using the Shortcut instead of the traditional long-haul method would be "minor" and "immaterial” • Impact on FM earnings appears now to be within the range of the potential $9 billion restatement demanded by the SEC

15. Observations from the Fannie Mae Debacle • Obtaining Hedge Accounting Was Fannie Mae’s Objective • Which Would Likely Have Reflected Economic Reality • At Least Portions Of Transaction Portfolio Could Likely Have Qualified For Hedge Accounting, If Full Long-Haul Rules Had Been Carefully Followed

16. Observations from the Fannie Mae Debacle • Fannie Mae Apparently Was Motivated Partly By The Objective Of Avoiding The Infrastructure Cost Of FAS 133 Compliance Through Full Requirements Of Hedge Rules • Creation of Systems, Documentation, Quarterly Effectiveness Testing • Illustrates The Complexity And Effort Required For Ongoing FAS 133 Compliance • Challenge For Both Big And Small Organizations

17. Conclusions from the Fannie Mae Debacle • Rules Are Rules - FAS 133 Included • In The Post-Enron World, Caution Is In Order When It Comes To Financial Reporting & Disclosure • Especially, For Derivatives • Economic Reality Argument Doesn’t Change Accounting Requirements Or Application

18. Conclusions from the Fannie Mae Debacle • FAS 133 Rules Have Continually Evolved • Subsequent Issue Of FAS 138 & FAS 149 • DIG & EITF • Complex Set Of Rules • However, FM Doesn’t Seem To Now Argue That They Did Not Understand the 133 Rules • Just Decided Not To Apply Them Since A ‘Gray Zone’ • According To CEO In Congressional Testimony, The Disputed Rules Involve Complex Decisions About Which Experts Often Disagree

19. Conclusions from the Fannie Mae Debacle • FM Debacle Has Prompted Review & Vetting Of FAS 133 Application At Many Companies • Documentation For Designated Hedges • Quarterly Hedge Effectiveness Testing • Risk Control Systems • Evolution Of The 133 Rules Creates Both Opportunities And Risks