Derivatives too complex for accounting?

Fannie buys mortgages. Some it repackages and sells, others it holds in its portfolio. Since borrowers can refinance and repay their mortgages early if interest rates drop, the income stream from a mortgage portfolio is hard to predict. You can think of numerous variables that might affect the refinancing rate: interest rates, level of consumer debt, employment rates, etc. Fannie wanted smooth, predictable earnings - investors would demand a risk premium for shares in a company whose earnings are volatile. CEO Franklin Raines and company smoothed earnings using derivatives to hedge the fluctuations in value of their portfolio. Or did they? Well, we don't know. And the SEC claims it won't know for a year or more as auditors go carefully over the books at Fannie. "Books" here really means software models with some intricate mathematics and questionable assumptions about stochastic interest rate fluctuations, prepayment rates, etc., etc.

At the moment we are in the dark as to whether the $8B charge Fannie will take over its incorrect use of hedge acounting reflects real losses by the company, or just lack of compliance with FAS 133. From the discussion below, taken from today's WSJ, even Raines himself (Harvard College, Rhodes Scholar, Harvard Law, former head of OMB, $40M or so in total compensation in recent years) didn't know what was going on. Who can you trust these days except a quant with a PhD?

According to people who attended the meeting, SEC officials described their findings about Fannie's accounting, which reinforced the views expressed previously by Ofheo. The biggest issue was Fannie's use of so-called hedge accounting for its derivatives, which allowed the company to spread out losses or gains over long periods. The SEC and Ofheo found that Fannie hadn't taken the steps needed to qualify for hedge accounting.

During the meeting, Mr. Raines took issue with the accounting rule for derivatives, known as FAS 133, at the center of the controversy.

"Many companies can and do comply with the rules," Donald Nicolaisen, the SEC's chief accountant, shot back, according to two participants. "Sir, hedge accounting is a privilege, not a right," he continued. "[It] is applied only under strict circumstances, and you did not comply."

Mr. Raines seemed shocked, participants say. He then asked how far off Fannie's books had been in relation to FAS 133. In response, according to one participant, Mr. Nicolaisen held up a sheet of paper and told Mr. Raines that if it represented the four corners of the rule, "you were not even on the page."