Transparency, Government-Sponsored Enterprises and Financial Derivatives 

By Greg Kaza  

The states, in the 1990s, were innovative laboratories for market-based conservatives and libertarians.

In December 1994, Orange County, California lost $1.6 billion and was forced into bankruptcy when interest-rate sensitive financial derivatives collapsed after a series of Federal Open Market Committee rate hikes.  The derivatives included structured notes issued by government-sponsored enterprises (GSEs) like Federal National Mortgage Association (Fannie Mae).  Taxpayers demanded a policy response, and Michigan lawmakers responded by mandating transparency for government units.  The law, signed by Republican Gov. John Engler (1991-2003) requires government units using derivatives to disclose them in reports subject to the Michigan Freedom of Information Act.  It permits derivatives’ legitimate use to hedge but creates a disincentive against the bad behavior that forced Orange County into bankruptcy.

Sunshine (transparency) is a powerful disinfectant, and should be advanced in Washington. I noted in a 2004 article for Pensions, a London-based academic journal (http://www.palgrave-journals.com/pm/index.html) that Michigan’s action was unique among the 50 states. It can serve as a model for other market advocates.

Why do derivatives matter in the ongoing crisis that has exposed cracks in the U.S. credit structure? The misuse of derivatives by GSEs including Fannie Mae contributed to an epic housing bubble that has collapsed, leaving failed financial institutions in its wake.  Fannie Mae, the second largest borrower next to the U.S. government itself is at the heart of a financial debacle where profits have been privatized and losses socialized by American taxpayers. Market advocates should stand with taxpayers and shareholders, not Washington GSE’s like Fannie Mae.

Markets work best when there is an umpire and transparency. The umpires (regulatory authorities) have been calling strikes on Fannie Mae’s suspect use of derivatives for years.  Consider the following:

● The Office of Federal Housing Enterprise Oversight criticized Fannie’s accounting under Statement No. 133 ("Accounting for Derivative Instruments and Hedging Activities") in September 2004. The OFHEO report, released in 2006, found “an arrogant and unethical corporate culture where Fannie Mae employees manipulated accounting and earnings to trigger bonuses for senior executives from 1998 to 2004.” 

● OFHEO found Fannie Mae implemented No. 133 “in a manner that placed minimizing earnings volatility and maintaining simplicity of operations above compliance with GAAP.”  OFHEO found Fannie Mae “did not assess and record hedge ineffectiveness,” and “applied hedge accounting to hedging relationships that did not qualify.”  Fannie Mae treated “many hedge relationships as perfectly effective when they were not, improperly ignored ineffectiveness in hedge relationships, and failed to perform assessment tests.” Fannie Mae applied the “short-cut” method or the “matched terms” method “for a broad range of hedge relationships where those methods were inappropriate.

●  The Securities and Exchange Commission ordered Fannie Mae to restate its earnings (Dec. 15, 2004), noting its accounting practices “did not comply in material respects” with Statement No. 133. No. 133 requires certain derivatives to be carried on the balance sheet at fair value. The SEC noted:

“Fannie Mae internally developed its own unique methodology to assess whether hedge accounting was appropriate. Fannie Mae's methodology, however, did not qualify for hedge accounting because of deficiencies in its application of Statement No. 133. Among other things, Fannie Mae's methodology of assessing, measuring and documenting hedge ineffectiveness was inadequate and was not supported by the Statement.”

Congress should pay heed to the umpire’s call. Market advocates must insist that any new financial architecture provide for increased transparency of derivatives used by GSEs. They should note economist Joseph A. Schumpeter’s observations about the evolutionary role of financial architecture in market economies. The financial architecture underlying an advanced market economy like the U.S. must be built on a rock solid foundation, not a GSE’s shifting political sands.

Greg Kaza is executive director of the Arkansas Policy Foundation and author of the 1996 Michigan transparency act.

October 8, 2008