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Are Fannie and Freddie undercapitalized

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					              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”.

				
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