MSF 2007 FINA 273 Are Fannie and Freddie undercapitalized? Argyn Kuketayev About One Accident of History in Financial Accounting Contents GSE’s The Bloomberg article claims that if it wasn’t for Freddie Q3 Financials “an accident of history”, Bloomberg Article Fannie Mae and Freddie Accident of History? FAS 130 Mac would be undercapitalized under Unusually large AOCI? current minimum capital Conclusion requirements set by US References legislature. Advanced Topics (optional) This presentation examines these claims. GSE’s • 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 FRE Q3 Balance Sheet FREDDIE MAC CONSOLIDATED BALANCE SHEETS September 30, December 2007 31, (unaudited) 2006 (in millions, except share-related Assets Total assets $ 792,873 $ 813,081 Liabilities and stockholders' equity Total liabilities 766,772 784,264 Stockholders' equity Preferred stock, at redemption value 8,109 6,109 Common stock, $0.21 par value, 726,000,000 shares authorized, 725,863,886 shares issued and 646,064,612 shares and 661,254,178 shares outstanding, respectively 152 152 Additional paid-in capital 961 962 Retained earnings 29,607 32,177 Accumulated other comprehensive income (loss), or AOCI, net of taxes, related to: Total AOCI, net of taxes (8,823) (7,869) Treasury stock, at cost, 79,799,274 shares and 64,609,708 shares, respectively (4,186) (3,230) Total stockholders' equity 25,820 28,301 Total liabilities and stockholders' equity $ 792,873 $ 813,081 FRE Q3 Core Capital Freddie Mac’s Total Equity $25,820 (millions) Statutory Minimum capital $26,190 (millions) requirement (given by OFHEO) Minimum capital requirement $34,047 (millions) plus 30% OFHEO add-on Freddie Mac’s Core capital Total Equity – AOCI = $25,820 - $(8,823) = $34,643 !!! Article “Freddie, Fannie Live Soft `Core Capital' Fantasy” by Jonathan Weil, Bloomberg.com, Nov 28 2007 1. AOCI is not included into Core Capital by “an accident of history” 2. GSE’s have unusually large AOCI An accident of history? “From its 1992 inception through 2000, OFHEO's 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 Congress's 1992 statutory definition hadn't envisioned. So, due to an accident of history, AOCI isn't counted today”. Jonathan Weil 12 USC 4502(4) - 1992 CORE CAPITAL: 1. The par or stated value of outstanding common stock. 2. The par or stated value of outstanding perpetual, noncumulative preferred stock. 3. Paid-in capital. 4. Retained earnings. 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. 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. 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”. 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 don't have such large pent-up losses”. Jonathan Weil As of Sep 30, 2007 (millions): Wachovia Corp & Freddie Mac Subsidiaries Total Assets $754,168 $792,873 Total Liabilities $680,733 $766,772 Minority interest $3,295 $281 Stockholder’s Equity AOCI $(2,750) $(8,823) Total Stockholder’s Equity $70,140 $25,820 Conclusion • “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 References • URL of the Bloomberg article: http://www.bloomberg.com/apps/news?pid=email_en&refer=colu mnist_weil&sid=aS4lA98OsEzc • 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.aspx?ID=389&q1=0&q2=0 Advanced Topics Available-for-sale, FAS 115 Cash Flow Hedging, FAS 133 FRE Q3 AOCI FREDDIE MAC CONSOLIDATED BALANCE SHEETS September 30, 2007 December (unaudited) 31, 2006 (in millions, except share-related amounts) Accumulated other comprehensive income (loss), or AOCI, net of taxes, related to: Available-for-sale securities (4,434) (2,749) Cash flow hedge relationships (4,309) (5,033) Defined benefit plans (80) (87) Total AOCI, net of taxes (8,823) (7,869) Total stockholders' equity 25,820 28,301 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 Available-for-sale “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 FAS 115 FAS 115 – 1993 Summary: • 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. Cash flow hedges “…it's 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 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.” FAS 133 FAS 133 - 1998 Summary: “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 derivative's gain or loss is initially reported as a component of [AOCI] … and subsequently reclassified into earnings when the forecasted transaction affects earnings”.