CONGRESS OF THE UNITED STATES

CONGRESSIONAL BUDGET OFFICE

A

PAPER

JUNE 2006

Measuring the

Capital Positions of

Fannie Mae and

Freddie Mac

CBO
Pub. No. 2711
The Congress of the United States O Congressional Budget Office

CBO

Measuring the Capital Positions of

Fannie Mae and Freddie Mac

June 2006

A

PAPER

Preface

This Congressional Budget Office (CBO) paper, prepared at the request of the Chairman 

of the Senate Committee on Banking, Housing, and Urban Affairs, examines the implications 

for Fannie Mae’s and Freddie Mac’s capital of a recent proposal by the Financial Accounting 

Standards Board (FASB). The proposal would allow firms to account for most financial assets 

and liabilities on a current market (or “fair value”) basis. In keeping with CBO’s mandate to 

provide objective, impartial analysis, the report makes no recommendations.

David Torregrosa of CBO’s Macroeconomic Analysis Division conducted the analysis under 

the direction of Marvin Phaup. Eric Wang, formerly of CBO, also made contributions. 

Andrew Gisselquist assisted with the preparation of the figures, and Linda Lewis Harris 

assisted with the preparation of the tables. 

Douglas Hamilton, Mark Hadley, Arlene Holen, Wendy Kiska, Kim Kowalewski, Angelo 

Mascaro, Damien Moore, Robert Murphy, Benjamin Page, Robert Shackleton Jr., and 

G. Thomas Woodward, all of CBO, provided valuable insights. Useful suggestions were also 

made by Douglas Holtz-Eakin of the Council on Foreign Relations; Deborah Lucas of Northwestern University and a consultant to CBO; Wanda DeLeo, Patrick Lawler, Tom Lutton, 

Robert S. Seiler Jr., and Valerie Smith of the Office of Federal Housing Enterprise Oversight; 

Michael Gibson and Wayne Passmore of the Federal Reserve Board; W. Scott Frame and Larry 

Wall of the Federal Reserve Bank of Atlanta; Ron Feldman of the Federal Reserve Bank of 

Minneapolis; Wendolyn Comes of the Federal Accounting Standards Advisory Board; Jack 

Reidhill of the Federal Deposit Insurance Corporation (FDIC); Michael Fratantoni of the 

Mortgage Bankers Association; and Robert Wilkins of FASB. In addition, staff members of 

Fannie Mae and Freddie Mac provided information and assistance, as did Jeffrey Mahoney 

of FASB and Ross Waldrop of the FDIC. (The assistance of external reviewers implies no responsibility for the final product, which rests solely with CBO.) 

Christine Bogusz edited the paper, and Loretta Lettner proofread it. Maureen Costantino 

prepared the report for publication and designed the cover, and Lenny Skutnik printed copies 

of the paper.

Robert Dennis

Assistant Director, 

Macroeconomic Analysis

June 2006

Contents

Summary vii

Introduction 1

The Role of Capital in Federally Insured Institutions 2

Alternative Measures of Capital 2

Current GAAP-Based Capital 3

Regulatory Capital 4

Fair Value Capital 5

Market Value of Stock 7

Advantages and Disadvantages of Alternative 

Measures of Capital 8

The Effects of the Fair Value Option on Current Accounting Standards 9

How Current Accounting Standards for Fixed-Income Securities 

Would Be Affected by the Fair Value Option Proposal 9

How Current Accounting Standards for Hedges Would Be 

Affected by the Fair Value Option Proposal 10

Implications of the Fair Value Option for the GSEs’ Capital Regulation 11

Implications for Fannie Mae and Freddie Mac 11

Implications for Improved Regulation of Safety and Soundness 13

Appendix A: Capital Requirements for Fannie Mae and Freddie Mac 17

Appendix B: Qualifying for Hedge Accounting Treatment Under 

FAS 133 21
VI MEASURING THE CAPITAL POSITIONS OF FANNIE MAE AND FREDDIE MAC

Tables

S-1. Alternative Accounting Measures of Fannie Mae’s and 

Freddie Mac’s Capital Ratios viii

1. Freddie Mac’s Simplified GAAP-Based Balance Sheet, 

as of December 31, 2005 3

2. Comparing Accounting Treatments Under Different 

Measures of Capital 4

A-1. Regulatory Capital Requirements for Fannie Mae and 

Freddie Mac, as of December 31, 2005 18

Figures

1. Fannie Mae’s and Freddie Mac’s Capital Positions 5

2. Fannie Mae’s and Freddie Mac’s Ratios of Capital to Assets 6

3. Fannie Mae’s and Freddie Mac’s Net Income 7

Boxes

1. Tailoring Fair Value Estimates of Derivatives 12

2. Possible New Disclosures for the GSEs’ Fair Value 

Estimates of Derivatives 12

3. Estimating Fair Values for Liabilities 14

A-1. OFHEO’s Powers of Resolution 19
Summary

Recently, the Financial Accounting Standards 

Board (FASB) proposed giving firms a broadly applicable 

option to account for most of their financial assets and liabilities on a fair value basis—that is, using either current 

market prices or estimates of prices that would be paid 

were there market transactions. That proposal could affect measures of capital for financial firms, including 

those whose debt is explicitly or implicitly guaranteed by 

the federal government, such as insured banks and government-sponsored enterprises (GSEs). Because taxpayers 

are potentially at risk for losses in GSEs that exceed capital, the federal government specifies minimum and riskbased levels of capital for those institutions. Improving 

measures of capital could increase the effectiveness of 

such regulations in protecting taxpayers.

Capital is the net worth of a firm, measured for accounting purposes as the difference between estimates of what 

the firm owns (its assets) and what it owes (its liabilities). 

Capital represents the ability of a firm to absorb losses 

and pay off creditors without external assistance and is 

thus an important measure of a firm’s soundness.

Two of the largest financial firms in the United States are 

Fannie Mae and Freddie Mac, GSEs for mortgage finance, and both would be affected by changing the rules 

for capital reporting. Both Fannie Mae and Freddie Mac 

invest heavily in mortgage-backed securities (MBSs) and 

use various derivatives as hedges to limit their exposure to 

changes in interest rates. FASB’s proposal would affect 

the accounting for such hedges. Although Fannie Mae’s 

and Freddie Mac’s levels of capital are regulated by the 

Office of Federal Housing Enterprise Oversight 

(OFHEO), the capital measures OFHEO uses are based 

on audited financial statements and thus would be affected by FASB’s proposal. 

The principal accounting measure of capital is defined by 

generally accepted accounting principles (GAAP). That 

measure appears on balance sheets prepared using accounting standards established by FASB. The current 

GAAP-based measure of capital that the housing GSEs 

must report on their balance sheets is based on a mix of 

valuation measures for assets and liabilities. Some measures are reported at fair value, and other measures are 

reported at historical cost. The GAAP-based measure of 

capital is also the starting point for developing a measure 

of regulatory capital, which OFHEO monitors for compliance with federal capital requirements. Summary 

Table 1 shows the current GAAP-based, regulatory, and 

fair value measures of capital for Fannie Mae and Freddie 

Mac.

FASB’s proposed accounting change is based on the rationale that fair values for firms’ financial assets and liabilities provide more accurate and timely information than 

measures based on historical cost. In addition, the proposed change would simplify the accounting standards. 

Simplifying the accounting for hedges would be particularly useful to firms that hold derivative positions, such as 

Fannie Mae and Freddie Mac. Finally, the proposed fair 

value option could improve the accuracy and timeliness 

of reported capital compared with current accounting 

measures, especially for Fannie Mae and Freddie Mac. 

FASB’s proposed fair value option does not require that 

firms use estimated market values for all of their financial 

assets and liabilities. One reason is that fair values would 

be difficult for many firms to estimate, especially firms 

whose financial assets are not traded in active markets. 

The proposed rule would permit firms to select those 

balance-sheet items to be reported at fair value, and different firms might choose to apply fair value to different 

assets and liabilities. However, allowing the enterprises to 

implement fair value measures selectively could diminish 

the timeliness and accuracy of capital measures.
VIII MEASURING THE CAPITAL POSITIONS OF FANNIE MAE AND FREDDIE MAC

Summary Table 1.

Alternative Accounting Measures of Fannie Mae’s and Freddie Mac’s

Capital Ratios

(Percentage of assets)

Source: Congressional Budget Office based on data from the Office of Federal Housing Enterprise Oversight, Fannie Mae, and Freddie Mac.

Notes: n.a.= not available; GAAP = generally accepted accounting principles. 

Fannie Mae will restate its results for the January 2002 through June 2004 period. It has not issued financial statements since the second quarter of 2004. 

Freddie Mac’s 2005 data have not been audited.

Fair value capital is expressed as a percentage of fair value assets. Other capital measures are expressed as a percentage of GAAPbased assets.

If FASB’s fair value option is adopted, OFHEO may wish 

to consider requiring Fannie Mae and Freddie Mac to use 

fair value measures for all of their financial assets and liabilities for certain regulatory reporting purposes. That requirement would not be burdensome for Fannie Mae and 

Freddie Mac because virtually all of their assets and liabilities are traded in active markets. Fannie Mae and Freddie 

Mac have also disclosed fair value balance sheets since 

1992. However, if policymakers decide that OFHEO 

should use that fair value capital measure as the measure 

of regulatory capital for meeting minimum capital standards or for triggering prompt corrective actions, then the 

Congress may need to consider revising the statute that 

defines regulatory capital.

Increases or decreases in a firm’s stock market capitalization can also provide an early signal of financial change, 

which may provide additional information to OFHEO 

about the financial health of the enterprises. For that reason, OFHEO may wish to consider using changes in 

market capitalization as an early warning of GSEs’ 

financial distress. 

2000 2001 2002 2003 2004 2005

Regulatory capital 3.08 3.15 3.16 3.41 n.a. n.a.

Fair value capital 3.02 2.78 2.41 3.09 n.a. n.a.

GAAP-based capital 3.09 2.26 1.84 2.22 n.a. n.a.

Regulatory capital 3.52 3.15 3.85 4.11 4.40 4.46

Fair value capital 3.42 2.84 3.02 3.39 3.87 3.82

GAAP-based capital 3.75 3.06 4.16 3.92 3.95 3.37

Fannie Mae

Freddie Mac
Measuring the Capital Positions of

Fannie Mae and Freddie Mac

Introduction

The Federal National Mortgage Association (Fannie 

Mae) and the Federal Home Loan Mortgage Corporation 

(Freddie Mac) are government-sponsored enterprises 

(GSEs) whose primary purpose is to facilitate the flow of 

funds from bond markets to retail lenders for home mortgages. The enterprises are private financial institutions. 

They have special market status, however, because their 

charters are perceived to imply a federal guarantee of their 

debt.1

Although there is no explicit government guarantee, investors presume that the GSEs’ obligations are protected 

from the risk of default because, in a number of ways, 

Fannie Mae and Freddie Mac are treated differently from 

private entities under federal law. The enterprises’ securities are exempt from registration requirements under the 

Securities Act of 1933 and are eligible for unlimited investment by most federally insured banks and thrift institutions. In addition, the GSEs’ earnings are exempt from 

state and local income taxes. The federal government is a 

potential source of external assistance to the enterprises—

each enterprise has a $2.25 billion line of credit at the 

U.S. Treasury. Moreover, there is a precedent for federal 

aid to GSEs, such as that provided to the Farm Credit 

System, a GSE, following the farming financial crisis of 

the mid-1980s. Furthermore, investors may take into account the policy objective of containing systemic risk—

that is, the risk that the failure of a GSE might adversely 

affect the stability of the financial system and the economy.2

Because of investors’ perceptions of an implied guarantee, 

the GSEs are able to issue debt at interest rates only 

slightly above the rates for Treasury securities and in practically unlimited amounts. The GSEs use their borrowed 

funds to buy mortgages from lenders. Those mortgages 

are then either held for investment or converted into 

mortgage-backed securities (MBSs), which are sold to investors with a guarantee of timely interest and principal 

payment from the enterprises.3

 Those activities expose 

the enterprises—and, hence, taxpayers, through the implied federal guarantee—to potential risk. (When the 

government assumes credit risk, that risk is borne by tax1. See Congressional Budget Office, Federal Subsidies and the Housing GSEs (May 2001), Effects of Repealing Fannie Mae’s and Freddie 

Mac’s SEC Exemptions (May 2003), and the statement of Douglas 

Holtz-Eakin, Director, Congressional Budget Office, Aligning the 

Costs and Benefits of the Housing Government-Sponsored Enterprises, 

before the Senate Committee on Banking, Housing, and Urban 

Affairs (April 21, 2005); W. Scott Frame and Lawrence J. White, 

“Fussing and Fuming over Fannie and Freddie: How Much 

Smoke, How Much Fire?” Journal of Economic Perspectives, vol. 19, 

no. 2 (Spring 2005), pp. 159-184; and Andreas Lehnert, Wayne 

Passmore, and Shane Sherlund, GSEs, Mortgage Rates, and Secondary Market Activities, Finance and Economics Discussion Series 

No. 2005-7 (Board of Governors of the Federal Reserve System, 

January 2005), available at www.federalreserve.gov/pubs/feds/

2005/200507/200507pap.pdf. 

2. For an analysis of the enterprises’ systemic risk, see Office of Federal Housing Enterprise Oversight, Systemic Risk: Fannie Mae, 

Freddie Mac, and the Role of OFHEO (February 2003), available at 

www.ofheo.gov/media/archive/docs/reports/sysrisk.pdf. Also see 

Robert A. Eisenbeis, W. Scott Frame, and Larry D. Wall, An Analysis of the Systemic Risks Posed by Fannie Mae and Freddie Mac and 

an Evaluation of the Policy Options for Reducing Those Risks, Working Paper 2006-2 (Federal Reserve Bank of Atlanta, April 2006); 

and Gary H. Stern and Ron J. Feldman, Too Big to Fail: The Hazards of Bank Bailouts (Washington, D.C.: Brookings Institution, 

2004). 

3. Mortgage-backed securities are created when mortgages are packaged, or “pooled,” and sold as securities. The pooled mortgages 

are generally of the same type (fixed rate or adjustable rate), have 

fairly similar interest rates, and have the same term to maturity 

(for example, 15 years, 20 years, or 30 years). 
2 MEASURING THE CAPITAL POSITIONS OF FANNIE MAE AND FREDDIE MAC

payers or beneficiaries of federal programs.)4 Some of the 

financial rewards of the implied guarantee flow through 

to borrowers in the form of lower mortgage rates, but 

shareholders and other stakeholders of the GSEs also

benefit. 

Capital—the difference between the value of a firm’s assets and the value of its liabilities—indicates the ability of 

a firm to survive losses and pay off its creditors without 

external assistance. Because taxpayers are potentially at 

risk for losses that exceed the GSEs’ capital, the Office of 

Federal Housing Enterprise Oversight (OFHEO) requires that the enterprises meet specified capital standards 

(see Appendix A). Compliance with the standards is 

gauged by the firms’ level of regulatory capital, the measurement of which is based on generally accepted accounting principles (GAAP), with some modifications 

imposed by OFHEO. 

A recent proposal from the Financial Accounting Standards Board (FASB) could improve measures of capital 

and, thus, the measurement of taxpayers’ current exposure to risk. That proposal would give firms increased opportunities to report assets and liabilities at fair values 

rather than historical values. According to the working 

draft of the proposed rule, “Fair value is the estimated 

price that would be received for an asset or paid to transfer a liability in a current transaction between marketplace participants.”5 If implemented, that new standard 

could affect the level of capital reported by all firms, including Fannie Mae and Freddie Mac.

The Role of Capital in Federally 

Insured Institutions

Capital is an approximate measure of the net worth of a 

firm, or the value of assets remaining after debts and 

other liabilities have been paid. It is important to creditors, shareholder-owners, and potentially to taxpayers.6

Shareholders are the source of equity capital. They provide the initial funds to organize a company and acquire 

the assets needed for start-up. Over time, retained earnings and new equity issues provide the bulk of equity 

capital, while creditors contribute funding through the 

purchase of a company’s bonds and other liabilities.

The ratio of a firm’s capital to its outstanding assets is important to creditors because capital affects their exposure 

to credit risk and, consequently, that ratio affects the rate 

of interest a firm must pay on its debt. Specifically, as 

capital per dollar of assets increases, the credit risk to 

bondholders and the required rate of interest on bonds 

and other debt decreases, although other risk-based factors also affect the required rate of interest on bonds. 

For shareholders, the capital of a firm is an indicator of 

the value of their stake in the enterprise. High ratios of 

capital to assets may be disadvantageous to equity investors because such high ratios may indicate that the company has not used all of its opportunities to borrow to 

acquire income-earning assets. If the return on assets is 

greater than the rate paid on debt, shareholders’ income 

increases with leverage (that is, the ratio of borrowing to 

equity). But very high leverage, combined with even relatively modest volatility in asset values, can expose owners 

to the possibility of sharp declines in the value of their entire investment in a firm.

When the federal government guarantees some or all of 

the liabilities of a firm, capital and unguaranteed liabilities provide a buffer between the firm’s potential losses 

and taxpayers’ exposure to risk. Government regulators 

thus are usually authorized to impose on insured financial 

institutions minimum and risk-based requirements for 

the level of capital they must hold. Ideally, the reported 

measure of capital as defined by those requirements 

should be as close to the actual, current economic value as 

is possible.

Alternative Measures of Capital 

Capital is measured in several different ways. One key 

difference among measures is in their use of historical values (the prices paid for assets when acquired or the prices

4. In essence, taxpayers are equityholders in the government’s financial activities. See Congressional Budget Office, Estimating the 

Value of Subsidies for Federal Loans and Loan Guarantees (August 

2004), p. 4. 

5. That definition is subject to revision. All of FASB’s definitions of 

fair value clearly exclude valuations based on fire sales. See Financial Accounting Standards Board, “Statement of Financial 

Accounting Standards No. 15X: Fair Value Measurements” (working draft, October 21, 2005), paragraph 5, p. 2. 

6. For additional analysis of the role of capital, see Edward J. Kane, 

“Three Paradigms for the Role of Capitalization Requirements in 

Insured Financial Institutions,” Journal of Banking and Finance, 

vol. 19, no. 3-4 (June 1995), pp. 431-459.
MEASURING THE CAPITAL POSITIONS OF FANNIE MAE AND FREDDIE MAC 3

Table 1.

Freddie Mac’s Simplified GAAP-Based 

Balance Sheet, as of December 31, 

2005

(Billions of dollars, unaudited)

Source: Congressional Budget Office based on data from Freddie 

Mac.

Note: GAAP = generally accepted accounting principles. Numbers 

may not add up to totals because of rounding.

a. Freddie Mac is temporarily barred from using the held-tomaturity classification.

received for debt when issued) rather than the current 

actual or estimated market values. Alternative measures 

may also differ in their treatment of unrealized gains and 

losses and in the assets and liabilities they include. Those 

differences have become more noteworthy with the implementation of FASB’s accounting standard for derivatives in 2001. 

For Fannie Mae and Freddie Mac, three accounting measures of capital are relevant to an assessment of FASB’s 

proposed fair value option: the current GAAP-based measure of capital, regulatory capital, and fair value capital. 

All three measures aim to report the accumulated net position of a firm on the basis of transactions that have occurred by the reporting date. 

In addition to those measures, the market value of outstanding equity shares provides a continuous measure of 

investors’ views of the current value of a firm and of its 

future performance. Although market participants are influenced by reported accounting information, the market 

value of a firm is also affected by factors not included in a 

firm’s general-purpose financial statements, including the 

value of any government guarantee of the firm’s liabilities, 

the value of the firm as an ongoing entity, and the expected results of anticipated future transactions.

The appropriate level and measure of capital depends on 

the purpose of the measure. This report explicitly views 

capital and assessments of its adequacy from the perspective of taxpayers who are potentially liable for repaying 

the debts of the GSEs conditional on the firms’ insolvency. From that perspective, capital is the buffer between 

a firm’s losses and costs to taxpayers that protects against 

unanticipated shocks to the financial position of the 

GSE. For that purpose, fair value capital defined as the 

difference between a firm’s assets and liabilities, with both 

valued at observed or estimated market prices, is an accurate and timely measure of the margin of safety. Fair value 

capital is superior for this purpose to other capital measures that are based on a mix of market values, estimated 

market values, and historical values. For other purposes, 

measures of capital other than fair value may be superior, 

but an assessment of those measures for their intended 

purposes is beyond the scope of this report. 

Current GAAP-Based Capital

The GAAP-based measure of capital (stockholders’ 

equity) reported on a firm’s balance sheet is the residual 

remaining after deducting balance-sheet liabilities from 

balance-sheet assets. (See Table 1 for a simplified GAAP61.4

0

638.5

8.9

0.6 ____

648.0

709.4

67.8

Derivative assets 7.1

21.9

Total assets 806.2

748.8

0.6

28.7 ____

778.1

subsidiaries 0.9

4.6

31.6

1.1

Accumulated other comprehensive income

-2.5

-6.3

___

-8.8

-1.3

27.2

Total liabilities and 

stockholders' equity 806.2

Assets

Retained portfolio

Mortgage loans

Mortgage-related securities

Held to maturitya

Available for sale

Trading

Other

Subtotal

Total retained portfolio

Cash and investments

Other

Liabilities and Stockholders' Equity

Liabilities

Debt securities

Retained earnings

Derivative liabilities

Other

Total liabilities

Minority interests in consolidated 

Other

Available-for-sale securities

Cash flow hedge relationships

Stockholders' equity

Preferred stock

Subtotal

Treasury stock

Total stockholders' equity (GAAP 

measure of capital)
4 MEASURING THE CAPITAL POSITIONS OF FANNIE MAE AND FREDDIE MAC

Table 2.

Comparing Accounting Treatments Under Different Measures of Capital

Source: Congressional Budget Office.

a. Fair values are permissible only if those hedges are “highly effective.”

based balance sheet for Freddie Mac.) Under current 

standards, GAAP-based valuations of assets and liabilities 

are based on a mix of historical cost and fair values (see 

Table 2). Historical values are used because GAAP is 

largely transactions-based. That is, the accounting system 

records and uses the prices at which transactions were 

conducted. That method has the advantage of using information that is verifiable. But historical measures of the 

value of assets and liabilities may not be reliable indications of current value, which is the relevant measure for 

investors, creditors, and regulators. Another feature of 

GAAP is that some unrealized gains and losses from 

changes in the market value of assets or liabilities are reported in income and capital, but others are not recognized until they are realized. 

GAAP-based balance sheets do not include all potential 

claims and obligations of a reporting firm. For example, 

obligations that may arise in the future from credit guarantees issued by a firm are not liabilities. Rather, they are 

regarded as contingent claims and reported in notes to 

the financial statements. That treatment is significant for 

Fannie Mae and Freddie Mac, which have more than $2 

trillion in guaranteed mortgage-backed securities outstanding. Those securities are contingent claims.7

Regulatory Capital

Regulatory capital is defined in specific laws and regulations. (See Appendix A for regulatory capital requirements for Fannie Mae and Freddie Mac.) Regulatory 

capital may differ from the GAAP-based measure of 

stockholders’ equity. For Fannie Mae and Freddie Mac, 

regulatory capital excludes some gains and losses from 

changes in market prices on assets that have not yet been 

realized by the sale of those assets.8 Thus, the enterprises’ 

regulatory capital currently relies less on fair value measures than GAAP-based capital does. 

Regulatory capital for Fannie Mae has exceeded GAAPbased capital since 2001 because the firm’s GAAP-based

GAAP-Based Regulatory Fair Value

Held to maturity Historical cost Historical cost Fair value

Available for sale Fair value Historical cost Fair value

Trading Fair value Fair value Fair value

Historical cost Historical cost Fair value

Fair value Fair value Fair value

Fair valuea Fair valuea Fair value

Fair valuea Historical cost Fair value

Measure of Capital

Balance Sheet Entry

Cash Flow Hedges

Mortgage-Backed Securities

Debt Obligations

Derivatives

Fair Value Hedges

7. Even though the volume of outstanding guarantee commitments 

does not directly affect the GSEs’ reported liabilities and capital, 

the minimum capital regulations require Fannie Mae and Freddie 

Mac to hold 45 cents of additional capital for each $100 of outstanding guarantee commitments.

8. Specifically, regulatory capital excludes a component of GAAP 

equity known as “accumulated other comprehensive income” 

(AOCI). That component of equity capital accounts for unrealized gains and losses on MBSs that are classified as “available for 

sale” and cash flow hedges (both discussed in the main text of the 

paper) that are reported first on the balance sheet and then flow 

through to the income statement in later periods. The AOCI balance can be positive (net gains) or negative (net losses). However, 

regulatory capital includes some unrealized gains and losses on 

derivatives and securities classified as “trading.”
MEASURING THE CAPITAL POSITIONS OF FANNIE MAE AND FREDDIE MAC 5

Figure 1.

Fannie Mae’s and Freddie Mac’s

Capital Positions

(Billions of dollars)

Source: Congressional Budget Office based on data from Fannie 

Mae, Freddie Mac, and the Office of Federal Housing 

Enterprise Oversight.

Note: Fannie Mae is restating its income and capital for the 2002–

June 2004 period and has not yet issued financial statements for subsequent periods. Freddie Mac’s 2005 data have 

not been audited. GAAP = generally accepted accounting 

principles.

capital, on balance, has recognized more unrealized losses 

than gains (see the top panels of Figures 1 and 2). However, Fannie Mae’s upcoming restatement of income and 

capital could change that pattern.9

 For Freddie Mac, 

regulatory capital has been greater than GAAP-based capital in four of the past six years (see the bottom panels of 

Figures 1 and 2).10

Fair Value Capital

FASB requires firms to disclose where practical the fair 

value of their financial assets and liabilities. Fannie Mae 

and Freddie Mac have gone further than most firms have 

done by disclosing fair value balance sheets since 1992.11

In principle, fair value accounting attempts to measure all 

financial assets and liabilities at actual or estimated market values, thus providing a more current value of capital

1993 1995 1997 1999 2001 2003

0

10

20

30

40

Regulatory Capital

GAAP-Based Capital

Fair Value Capital

Fannie Mae

1993 1995 1997 1999 2001 2003 2005

0

10

20

30

40

Regulatory Capital

GAAP-Based Capital

Fair Value Capital

Freddie Mac

9. Fannie Mae is restating its results for the January 2002-June 2004 

period. In addition, the firm has stated that its previously audited 

financial statements issued for 2001 are unreliable but are not 

being restated. Both income and capital will be affected by the 

restatements, which must be completed before Fannie Mae can 

resume issuing its quarterly and annual statements on a current 

basis. Fannie Mae currently expects to recognize net cumulative 

after-tax losses of $10.8 billion as of December 31, 2004. (That 

estimate is subject to change as a result of its continuing accounting review.) No restatement is expected prior to the second half of 

2006. See Fannie Mae, “Form 12b-25 Notification of Late Filing 

with the Securities and Exchange Commission” (March 13, 

2006), p. 8-14, available at www.fanniemae.com/media/pdf/news 

releases/W18441_1621_E2.pdf. Since that report was issued, 

Fannie Mae has uncovered additional accounting errors, but it has 

not updated its estimated loss. See Fannie Mae, “Form 12b-25 

Notification of Late Filing with the Securities and Exchange 

Commission” (May 9, 2006), p. 7-8, available at www.fannie 

mae.com/media/pdf/newsreleases/W20890_2156_C_sub.pdf. 

10. Freddie Mac has completed its restatement for 2000 through 

2002. In that restatement, income was increased by a net cumulative amount of $4.4 billion for 2000, 2001, and 2002, and $0.6 

billion for periods prior to 2000. Regulatory capital increased by 

$1.8 billion in 2000, $0.8 billion in 2001, and $5.2 billion in 

2002. GAAP-based capital was also up, by $6.7 billion in 2002. 

See Freddie Mac, “Freddie Mac Announces Restatement Results” 

(press release, McLean, Va., November 21, 2003); available at 

www.freddiemac.com/news/archives/investors/2003/

restatement_112103.html. 

11. Financial Accounting Standards Board, “Statement of Financial 

Accounting Standards No. 107: Disclosures About Fair Value of 

Financial Instruments” (Norwalk, Conn.: Financial Accounting 

Standards Board, December 1991).
6 MEASURING THE CAPITAL POSITIONS OF FANNIE MAE AND FREDDIE MAC

Figure 2.

Fannie Mae’s and Freddie Mac’s

Ratios of Capital to Assets

(Percent)

Source: Congressional Budget Office based on data from Fannie 

Mae and Freddie Mac.

Notes: Fannie Mae is restating its income and capital for the 2002–

June 2004 period and has not yet issued financial statements for subsequent periods. Freddie Mac’s 2005 data have 

not been audited. GAAP = generally accepted accounting 

principles. Regulatory capital is defined by the Office of Federal Housing Enterprise Oversight, and its ratio is expressed 

as a percentage of GAAP-based assets. The fair value capital 

ratio is expressed as a percentage of the fair value measure 

of assets. GAAP-based capital is expressed as a percentage 

of GAAP-based assets.

than is provided by historical values.12 Doubts about 

the quality of fair value measures center mainly on their 

reliability, because managers have some discretion in estimating fair values when price quotes from markets are 

unavailable.

One of the GSE bills before the Congress would require 

that the enterprises release fair value statements quarterly.13 Although Freddie Mac and Fannie Mae issue 

those statements in their annual reports as notes to their 

financial statements, only Freddie Mac issues them quarterly. Recent releases have been delayed, however, because 

of the enterprises’ continuing accounting problems.14

Fair value capital can be above or below GAAP-based 

capital depending on the net effects of measuring both assets and liabilities at estimated market values. Differences 

between fair value and GAAP-based capital can be persistent and significant. In recent years, fair value capital has 

been below regulatory capital (see Figure 1). Moreover, 

Freddie Mac’s fair value capital declined slightly in 2005, 

but its regulatory capital increased. Sources of volatility in 

fair value measures of capital include changes in interest

1993 1995 1997 1999 2001 2003

0

1

2

3

4

5

6

7

8

Regulatory

Capital Ratio

GAAP-Based

Capital Ratio

Fair Value

Capital Ratio

Fannie Mae

1993 1995 1997 1999 2001 2003 2005

0

1

2

3

4

5

6

7

8

Regulatory

Capital Ratio GAAP-Based

Capital Ratio

Fair Value

Capital Ratio

Freddie Mac

12. The fair value balance sheet reports the capitalized value of 

expected MBS guarantee fees (minus expected credit losses) on 

mortgage-backed securities. The value of those fees will change 

when interest rates and expected mortgage prepayment rates 

change. In contrast, the guarantee asset (and credit obligation) 

recognized on the GAAP-based balance sheet represents the 

present value of the guarantee fees that are expected at inception 

of the guarantee. On the GAAP-based balance sheet, the asset is 

recorded as the fee income is received. 

13. S. 190, the Federal Housing Enterprise Regulatory Reform Act of 

2005, as approved by the Committee on Banking, Housing, and 

Urban Affairs (July 28, 2005). 

14. Freddie Mac revised its income for the first half of 2005. That 

revision delayed the release of the year-end statement for 2005 

and disclosures of updated fair value balance sheets. See Freddie 

Mac, “Freddie Mac to Revise Reported Net Income for First and 

Second Quarters of 2005” (press release, McLean, Va., November 

8, 2005), available at www.freddiemac.com/news/archives/

investors/2005/20051108_earnings.html. For Freddie Mac’s 

unaudited financial results for 2005, see Freddie Mac, “Freddie 

Mac Reports 2005 Financial Results” (press release, McLean, Va., 

May 30, 2006), available at www.freddiemac.com/news/archives/

investors/2006/2005er.html. Fannie Mae expects to complete its 

financial restatement by the end of 2006. See the statement of 

Daniel H. Mudd, president and chief executive officer, Fannie 

Mae, before the Senate Committee on Banking, Housing and 

Urban Affairs, June 15, 2006. 
MEASURING THE CAPITAL POSITIONS OF FANNIE MAE AND FREDDIE MAC 7

Figure 3.

Fannie Mae’s and Freddie Mac’s

Net Income

(Billions of dollars)

Source: Congressional Budget Office based on data from Fannie 

Mae and Freddie Mac.

Note: Fannie Mae is restating its income and capital for the 

2002–June 2004 period and has not yet issued financial 

statements for subsequent periods. Freddie Mac’s 2005 

data have not been audited. The fair value net income represents the change in the fair value of net assets adjusted 

for capital financing activities, including the payment of 

dividends and the issuance or repurchase of stock. 

GAAP = generally accepted accounting principles.

rates and mortgage-to-debt spreads, and changes in the 

fair value of guarantee fees on MBSs.15

Estimates of fair value income can be imputed from the 

change in fair value net position in consecutive statements after adjusting for capital financing transactions, 

such as payments of dividends and purchases or sales of 

stock. The fair value income measure is a more consistent 

and perhaps more relevant measure of income than current GAAP for many firms, particularly financial institutions. Fannie Mae’s fair value income for recent years 

shows more volatility than its reported GAAP-based income, which is being restated; Freddie Mac’s fair value income shows less volatility than its GAAP-based income 

(see Figure 3).16

Market Value of Stock

In addition to the accounting measures, the equity markets provide a continuous estimate of the net value of a 

publicly traded firm (market capital, which is the number 

of shares of stock outstanding multiplied by the current 

price). Market capital is a comprehensive estimate of the 

market’s perception of the net worth of a firm, including 

off-balance-sheet assets and liabilities, intangible assets, 

and expected future earnings and earnings growth. 

Changes in the market values of assets and liabilities are 

incorporated in market capitalization as soon as information becomes available. Because market capitalization is a 

more forward-looking measure, it will not equal fair value 

capital. 

In the case of Fannie Mae and Freddie Mac, market capitalization also includes the value of the implied federal 

guarantee.17 The implied guarantee raises the value of the 

GSEs’ MBS guarantees and, thus, the guarantee fees that 

the GSEs are able to charge. In addition, the implied fed1993 1995 1997 1999 2001 2003

0

2

4

6

8

10

12

GAAP-Based

Net Income

Fair Value

Net Income

Fannie Mae

1993 1995 1997 1999 2001 2003 2005

-2

0

2

4

6

8

10

12

GAAP-Based

Net Income

Fair Value

Net Income

Freddie Mac

15. For a discussion of these and other factors affecting fair value 

capital, see Freddie Mac, “Information Supplement” (release, 

McLean, Va., May 30, 2006), pp. 23-27, available at www. 

freddiemac.com/investors/infostat/pdf/supplement_053006.pdf.

16. For a similar comparison for commercial banks, see Leslie D. 

Hodder, Patrick E. Hopkins, and James M. Wahlen, “RiskRelevance of Fair Value Income Measures for Commercial Banks,” 

Accounting Review (April 2006), available at http://papers.ssrn. 

com/paper.taf?abstract_id=810925. 

17. See W. Scott Frame and Lawrence J. White, “Charter Value, RiskTaking Incentives, and Emerging Competition for Fannie Mae 

and Freddie Mac,” Journal of Money, Credit, and Banking (forthcoming). 
8 MEASURING THE CAPITAL POSITIONS OF FANNIE MAE AND FREDDIE MAC

eral guarantee raises the value of the GSEs’ debt and thus 

generates a wider spread between the rate GSEs pay on 

their debt and the rates they earn on their assets. The capitalized value of the expected interest rate spread between 

assets and liabilities multiplied by the projected portfolio 

volume contributes to the market value of the firms along 

with anticipated net returns on guarantees of MBSs. 

Advantages and Disadvantages of Alternative

Measures of Capital

Of the various accounting measures of the GSEs’ capital, 

fair value capital, based on the observed or estimated current market values of assets and liabilities, is potentially 

the most useful for monitoring the magnitude of the financial cushion that protects creditors and taxpayers. 

One advantage of fair value capital relative to currently 

defined GAAP and regulatory capital is that it reflects 

more accurately in net worth any changes in asset and liability values since assets were acquired or liabilities incurred. 

The regulatory measure of capital for Fannie Mae and 

Freddie Mac—which excludes some unrealized gains and 

losses—is less up to date than the currently defined 

GAAP-based measure, and the reporting firm can manage it by timing the realization of gains (or losses) on its 

holdings of MBSs. For example, selling some securities 

that have appreciated in value since acquisition while 

continuing to hold securities that have depreciated in 

value will increase a firm’s regulatory capital, even though 

the timing of the realization of such gains and losses may 

be irrelevant to the financial condition of the firm.

Market value is the most volatile measure of a firm’s capital. Increases or decreases in that value can provide an 

early signal of financial change.18 Because market value is 

so strongly affected by market expectations, however, 

there is considerable noise in that measure of capital. In 

addition, the market value of a GSE includes the value of 

the implicit guarantee of debt, which increases with financial distress but provides no safety cushion between 

GSEs’ losses and claims on taxpayers.19 The increasing 

value of the implied guarantee as a GSE nears insolvency 

could offset declines in the economic value of its portfolio. A GSE thus could have a larger market value than 

the market value of its financial assets less debt, as was 

the case when Fannie Mae was insolvent on a mark-tomarket basis in the early 1980s.20 Partly for those reasons, regulators have traditionally focused on accounting 

measures rather than market values to determine the net 

worth of the GSEs. 

18. For example, equity valuations responded to a spike in Fannie 

Mae’s duration gap, which greatly exceeded its target range, in 

September 2002. (The duration gap measures the difference in the 

sensitivity of portfolio assets and liabilities to changes in interest 

rates. The enterprises disclose that information on a monthly 

basis.) See Deborah Lucas and Robert L. McDonald, “An 

Options-Based Approach to Evaluating the Risk of Fannie Mae 

and Freddie Mac,” Journal of Monetary Economics, vol. 53, no. 1 

(January 2006), pp. 155-176. Also see Andreas Lehnert and 

Wayne Passmore, “Comment on: ‘An Options-Based Approach to 

Evaluating the Risk of Fannie Mae and Freddie Mac,’ ” Journal of 

Monetary Economics, vol. 53, no. 1 (January 2006), pp. 177-182. 

For background information on the options-based approach, see 

Peter Crosbie and Jeff Bohn, “Modeling Default Risk” (white 

paper, Moody’s KMV Company, December 18, 2003), available 

at www.moodyskmv.com/research/whitepaper/ModelingDefault 

Risk.pdf.

19. One analyst estimates that roughly 40 percent to 80 percent of the 

GSEs’ market value is from subsidies provided by their charters. 

See Wayne Passmore, “The GSE Implicit Subsidy and the Value of 

Government Ambiguity,” Real Estate Economics, vol. 33, no. 3 

(September 2005), pp. 465-486. 

20. Congressional Budget Office, Controlling the Risks of GovernmentSponsored Enterprises (April 1991), p. 129. That report used estimates from the Department of Housing and Urban Development.
MEASURING THE CAPITAL POSITIONS OF FANNIE MAE AND FREDDIE MAC 9

The Effects of the Fair Value Option on 

Current Accounting Standards

On January 25, 2006, FASB issued a proposal, “The Fair 

Value Option for Financial Assets and Financial Liabilities.”21 The rule change that FASB proposes would give 

all firms the option to account for most of their financial 

assets and liabilities on a fair value basis.22 Under the proposal, changes in fair value would be recognized in earnings and capital each quarter, which is not consistently required under current accounting standards. For Fannie 

Mae and Freddie Mac, the proposed change could—depending upon the enterprises’ use of the option—increase 

the use of fair values in their financial reports.23

FASB offered several justifications for its proposal.24

First, fair values for financial assets and liabilities provide 

more relevant and timely information than historical 

measures. Second, the proposal would simplify the existing accounting for hedged assets and liabilities, which is 

highly complex and has contributed to the restatement of 

earnings by many financial firms, including Fannie Mae 

and Freddie Mac. Allowing firms to use fair values provides flexibility and avoids imposing fair values on financial assets and liabilities that may be hard to value accurately. Third, the proposal would reduce volatility in 

income and capital that occurs under current GAAP with 

its mix of measures and that may not be representative of 

the economics of the activities. For example, not all economic hedges will qualify for special hedge accounting 

under current GAAP. 

How Current Accounting Standards for FixedIncome Securities Would Be Affected by the Fair 

Value Option Proposal

Financial Accounting Standard 115 (FAS 115), which 

governs the valuation of fixed-income securities held as 

assets, permits three ways of valuing otherwise identical 

mortgage-backed securities on the basis of management’s 

intent to hold or sell those securities (see Table 2).25 

B MBSs categorized as “held to maturity” (an indication 

of intention) are recorded on the balance sheet at historical cost rather than at current fair value. Earnings 

and capital are unaffected by changes in those securities’ fair value.26

B MBSs categorized as “trading” are carried at fair value, 

and changes in their valuation are reflected in income 

and capital as they occur.27

B MBSs categorized as “available for sale,” which are 

typically those the GSEs intend to hold for an unspecified period, are recorded at fair value on the balance 

sheet. Unrealized (by sale) gains and losses in their fair 

21. Financial Accounting Standards Board, Proposed Statement of 

Financial Accounting Standards, “The Fair Value Option for 

Financial Assets and Financial Liabilities Including an Amendment of FASB Statement No. 115” (exposure draft, No. 1250-

001, January 25, 2006), available at www.fasb.org. Both Fannie 

Mae and Freddie Mac submitted comment letters to FASB that 

support the concept of a fair value option with some suggested 

changes to the proposal. Those letters are available at 

www.fasb.org/ocl/1250-001/39110.pdf and www.fasb.org/ocl/

1250-001/39195.pdf. 

22. The International Accounting Standards Board has a similar standard in place.

23. The proposed fair value option is not as stringent as the current 

required disclosures under FAS 107, which requires all financial 

assets and liabilities to be disclosed at fair value where practical in 

the notes to a firm’s financial statements. However, FAS 107 does 

not apply to GAAP-based balance sheets. 

24. Financial Accounting Standards Board, “The Fair Value Option 

for Financial Assets and Financial Liabilities Including an Amendment of FASB Statement No. 115,” pp. 7-8. 

25. Financial Accounting Standards Board, “Statement of Financial 

Accounting Standards No. 115: Accounting for Certain Investments in Debt and Equity Securities” (Norwalk, Conn.: Financial 

Accounting Standards Board, May 1993). 

26. More specifically, securities that are held to maturity are carried at 

amortized cost—that is, the cost is adjusted over time for the 

amortization of premiums or discounts paid. 

Fannie Mae and Freddie Mac have temporarily lost use of the 

“held to maturity” classification because of violations of FAS 115. 

See Baker Botts, LLP, Report to the Board of Directors of the Federal 

Home Loan Mortgage Corporation: Internal Investigation of Certain 

Accounting Matters, December 10, 2002-July 21, 2003 (July 22, 

2003), pp. 35-41; Office of Federal Housing Enterprise Oversight, Report of the Special Examination of Freddie Mac (December 

2003), pp. 27-29; Fannie Mae, “Form 12b-25 Notification of 

Late Filing with the Securities and Exchange Commission” 

(November 10, 2005), p. 6, available at www.fanniemae.com/

media/pdf/newsreleases/f12b25111005.pdf; and Paul, Weiss, Rifkind, Wharton, & Garrison, LLP, and Huron Consulting Group, 

A Report to the Special Review Committee of the Board of Directors of 

Fannie Mae: Executive Summary (February 23, 2006), p. 13, available at http://download.fanniemae.com/execsum.pdf.

27. This category is available for all MBSs regardless of whether management intends to sell them in the near term.
10 MEASURING THE CAPITAL POSITIONS OF FANNIE MAE AND FREDDIE MAC

value are not reported on the income statement but 

are instead reported as a component of stockholders’ 

equity (accumulated other comprehensive income) on 

the balance sheet (for an example, see Table 1). 

FASB’s fair value option would not eliminate the three 

classifications nor require that all financial assets be valued at fair market; it only provides an increased opportunity to do so and thus to value assets more uniformly. If 

FASB adopts the fair value option, firms will still be able 

to use the three classifications and apply different valuations to similar assets. 

How Current Accounting Standards for Hedges 

Would Be Affected by the Fair Value Option Proposal

Many firms, including Fannie Mae and Freddie Mac, use 

financial derivatives to hedge risks (see Appendix B). In 

2001, FASB decided that fair value is the relevant measure for derivatives and it imposed FAS 133, which requires that firms report derivatives on a fair value basis on 

their GAAP-based balance sheet.28 The hedge provisions 

in FAS 133 are designed to match the timing of the income effects of the changes in the fair value of the derivative and the hedged position. However, firms can report 

their hedged debt positions (as distinct from the derivatives) on a fair value basis only if they meet certain requirements. If the position being hedged cannot be reported at fair value, the change in the fair value of the derivative will not be offset by any change in the historical 

value of the hedged position. In that case, the use of 

hedges will increase the volatility of the firm’s reported income and capital, even though the intent and result may 

be to reduce risk.

Under FAS 133, the hedged item may be reported at fair 

value only if the transaction qualifies as a “highly effective” hedge. Specifically, the effectiveness test requires 

that the offsetting changes in the value of the derivative 

and the changes in the fair value of the hedged item be in 

the range of 80 percent to 125 percent at the inception of 

the hedge. Periodic testing of the hedge’s actual effectiveness is also required. 

If, for example, the fair value of an interest rate derivative 

rose by $1 million while the fair value of a debt position 

being hedged fell by $1.3 million because of a change in 

interest rates, that hedge would fail to meet the effectiveness test.29 (The value of the debt fell by more than 125 

percent of the change in the value of the derivative.) The 

derivative would still be reported at fair value (plus $1 

million), but the debt issue would have to be reported at 

its historical cost (no change in value). Fannie Mae and 

Freddie Mac have both experienced difficulties meeting 

the requirement that hedges be “highly effective.”

The fair value option would give firms the benefits of 

hedge accounting without imposing the effectiveness test. 

Instead, the fair value option would allow both sides of 

the hedge to be reported at fair value without regard to 

the size of the offsetting effects.30

FAS 133 imposed another complication for hedge accounting. It requires firms to hedge individual assets or liabilities one by one, even though the relevant risk is the 

volatility of the entire portfolio. The GSEs seek to manage their interest rate risk, which can arise from a mismatch in terms to maturity between their mortgage portfolios (assets) and bonds (liabilities) that finance those 

assets or the prepayment options on their mortgage port28. For derivatives, fair value is the replacement value and is determined by discounting projected cash flows to their present value. 

Before FAS 133, swaps and other derivatives that did not require 

upfront payment were off-balance-sheet items that firms disclosed 

in the notes to their financial statements. See Financial Accounting Standards Board, “Accounting for Derivative Instruments and 

Hedging Activities: FASB Statement No. 133 as Amended and 

Interpreted—Incorporating FASB Statements Nos. 137 and 138 

and Certain Statement No. 133 Implementation Issues as of 

December 10, 2001" (Norwalk, Conn.: Financial Accounting 

Standards Board, 2001). 

29. The effectiveness test excludes changes in fair value that are not 

attributable to the risk being hedged. For example, if an entity was 

hedging interest rate risk, changes in the fair value of the security 

from changes in credit risk or exchange rate risk would be 

excluded from the measurement. Moreover, changes in fair value 

from risks that were not being hedged might not be recognized on 

the income or balance sheet until realized. 

30. If firms used the fair value option rather than existing hedge 

accounting treatment under FAS 133, then the entire change in 

the fair value of the hedged position would be reported in their 

income and capital, not just the change attributable to the risk 

being hedged. Use of the fair value option, therefore, could result 

in more volatility in firms’ reported income and capital, although 

that volatility would be more reflective of the economic variability 

of earnings and capital. It would be a firm’s choice to use the fair 

value option. 
MEASURING THE CAPITAL POSITIONS OF FANNIE MAE AND FREDDIE MAC 11

folio that are not matched by bond call options.31 Unexpected changes in interest rates can lead to changes in the 

market value of the firm’s equity unless the portfolio is 

hedged. Under FAS 133, a GSE can take hedge positions 

that reduce the risk of its portfolio and then identify an 

asset or liability that is most correlated with the hedge. 

But the requirement to match an asset or a liability with a 

derivative raises the cost of hedging and may limit the 

type of hedges that can be used. FASB’s fair value option 

eliminates the need for linkages between the derivative 

and the hedged position and expands the types of hedges 

that can be used. Thus, the fair value option may lower 

the firms’ cost of hedging. 

Implications of the Fair Value Option 

for the GSEs’ Capital Regulation

FASB’s fair value option is consistent with the federal objective of maintaining the financial safety and soundness 

of the GSEs and would simplify some of the more complex features of current accounting procedures for Fannie 

Mae and Freddie Mac.32 The proposal could also increase 

the accuracy and timeliness of Fannie Mae’s and Freddie 

Mac’s reported capital while providing an opportunity to 

improve OFHEO’s capital regulation of the enterprises.33

To achieve the maximum benefit from adoption of the 

standard, however, OFHEO may need to supplement it 

with a requirement that Fannie Mae and Freddie Mac apply it to all of their financial assets and liabilities for certain regulatory reporting purposes. Because the definition 

of regulatory capital is specified in statute, if policymakers decide that OFHEO should use a measure that incorporates fair value, the Congress may wish to alter the

statute.

Implications for Fannie Mae and Freddie Mac

Adoption of FASB’s fair value option would pose few 

problems for the enterprises, because nearly all of their assets and liabilities are financial and most trade on organized exchanges. For example, almost 90 percent of Freddie Mac’s assets (its mortgage-backed securities, cash, and 

other investments) and more than 95 percent of its liabilities (its debt issues) trade in liquid markets.34 Thus, fair 

values for the debts and securities can be taken from 

quoted market transactions. Estimates for other holdings, 

such as mortgages, can be based on comparable transactions in the market. 

The fair value balance sheets that the enterprises disclose 

include the net present value of expected guarantee fees 

for their existing book of business as an asset and the estimated amounts of guarantee losses as a liability.35 Those 

positions, which represent most of the GSEs’ credit risk, 

may be more difficult to value because the enterprises do 

not buy credit protection and the guarantees are not 

traded.36

Furthermore, fair value estimates of the enterprises’ derivatives—a combined $1.5 trillion notional value at the

31. Dwight Jaffee, “The Interest Rate Risk of Fannie Mae and Freddie 

Mac,” Journal of Financial Services Research, vol. 24, no. 1 (2003), 

pp. 5-29.

32. Before the fair value option was introduced, some analysts had 

advocated using fair value measures for regulatory purposes. For 

example, see Dwight Jaffee, “On Fannie Mae Accounting” (presentation at the American Enterprise Institute, October 28, 

2004). For a discussion of how fair value capital can improve 

prompt corrective actions by OFHEO, see W. Scott Frame and 

Lawrence J. White, “Regulating Housing GSEs: Thoughts on 

Institutional Structure and Authorities,” Economic Review (Federal 

Reserve Bank of Atlanta, second quarter of 2004), pp. 87-102. 

Also see John Barnett, “Accounting Concerns at Fannie Mae” 

(presentation at the American Enterprise Institute, April 5, 2004). 

33. For example, Freddie Mac’s restatement of its income had relatively little effect on its fair value balance sheet. That restatement 

raised its reported fair value net assets from $17.7 billion to $18.3 

billion in 2001. In contrast, the value of its GAAP-based capital 

increased by $4.3 billion in 2001with the restatement. See Freddie 

Mac, “Restatement Results,” Appendix III (November 21, 2003), 

p. 8, available at www.freddiemac.com/investors/restatement/pdf/

appendix3_112103.pdf. 

34. Measuring the enterprises’ holdings of mortgage revenue bonds on 

a fair value basis could pose some difficulties. Those bonds are 

generally issued by state or local housing authorities and the proceeds are used to fund mortgage loans to individuals. Mortgage 

revenue bonds are highly customized transactions, which once 

sold at issuance rarely trade in the secondary market. Thus, current market prices may not be available. OFHEO reports that the 

enterprises held just over $30 billion of mortgage revenue bonds 

in 2004, but those holdings represent only a small share of their 

retained portfolios.

35. In contrast, the GAAP-based balance sheet reports the present 

value of the guarantee fees expected at inception as an asset. The 

fair value computation does not capture the value of new business 

that would probably replace the prepayments as they occurred. 

For those and other reasons, the fair value of net assets is not the 

market’s valuation of the enterprise as an ongoing concern. 

36. For an explanation of how market inputs can make valuation of 

the guarantee assets and liabilities more transparent, see Freddie 

Mac, “Information Supplement,” pp. 26-28.
12 MEASURING THE CAPITAL POSITIONS OF FANNIE MAE AND FREDDIE MAC

Box 1.

Tailoring Fair Value Estimates of Derivatives

Box 2.

Possible New Disclosures for the GSEs’ Fair Value Estimates of 

Derivatives

The Office of Federal Housing Enterprise Oversight’s 

investigation of Freddie Mac’s accounting procedures 

reveals how a firm can reduce the volatility of its 

earnings by selecting the best interpretation for recognizing its income and expenses from among alternative accounting treatments. The enterprise’s estimates 

of the fair value of its swaptions provide one example.1 (A swaption allows, but does not require, a firm 

to trade a stream of payments at a fixed interest rate 

for payments at a variable rate on the same notional 

amount of principal over a certain period.)

Where quoted prices for financial instruments are not 

available, Financial Accounting Standard 107, “Disclosures About Fair Value of Financial Instruments,” 

sets up a hierarchy of valuation methods. To value 

swaptions, which are not traded on exchanges, generally accepted accounting principles (GAAP) require 

firms to use standard financial models, with the key 

inputs based on market transactions. Market estimates of volatility, a key input to the pricing of swaptions, were available from vendors and were routinely 

used by Freddie Mac for most estimates.

Investigations concluded that in one instance, however, Freddie Mac violated the requirements of the accounting standard by substituting its own assumptions of historical volatility for the market’s current 

reading of volatility for the swaptions. The enterprise 

did so to reach a predetermined result—namely, to 

offset a $730 million gain from the transition to Financial Accounting Standard 133, according to the 

investigations. That manipulation affected the enterprise’s GAAP-based and fair value balance sheets. 

Freddie Mac has taken several steps that are intended 

to improve internal controls over the valuation of its 

financial instruments.2

1. See Office of Federal Housing Enterprise Oversight, Report of 

the Special Examination of Freddie Mac (December 2003), p. 

32; and Baker Botts, LLP, Report to the Board of Directors of 

the Federal Home Loan Mortgage Corporation: Internal Investigation of Certain Accounting Matters, December 10, 2002- July 

21, 2003 (July 22, 2003), pp. 43-47.

2. See Freddie Mac, 2004 Annual Report, pp. 22-29 and 97-98, 

available at www.freddiemac.com/investors/ar/pdf/2004 

annualrpt.pdf.

If the Financial Accounting Standards Board’s fair 

value option is adopted, the Office of Federal Housing Enterprise Oversight (OFHEO) could enhance 

the option’s usefulness by requiring Fannie Mae and 

Freddie Mac to disclose how they estimate the fair 

value of derivatives. Although the disclosures would 

not prevent the government-sponsored enterprises 

(GSEs) from “managing” their earnings and capital, 

they would make it easier for investors and regulators 

to detect any violations, thereby improving the enterprises’ safety and soundness. 

OFHEO also could require the GSEs to separate 

their derivatives whose values are based on models 

from those whose values can be taken from quotes in 

liquid markets and from dealers. If the estimates from 

the models changed because of adjustments to the 

model or its assumptions, then the GSEs could be required to disclose what the fair value estimates would 

have been using the previous model or assumptions. 

When appropriate, regulators also could require that 

the enterprises justify any changes that they make to 

their models, and they could verify that the new 

model better estimates fair value. 
MEASURING THE CAPITAL POSITIONS OF FANNIE MAE AND FREDDIE MAC 13

end of 2004—generally cannot be taken directly from organized market exchanges and instead must be estimated. 

Given that latitude, managers may be able to identify 

only a range of likely values and may have incentives to 

assign “preferred” values to those items that would 

smooth reported earnings and capital.37 According to 

OFHEO, both Fannie Mae and Freddie Mac had numerous accounting violations largely because management 

wished to report smooth earnings’ growth to investors.38

(See Box 1 for an example of how Freddie Mac tailored 

its fair value estimates for certain derivatives under 

GAAP.) OFHEO could take some steps to guard against 

that potential, however (see Box 2).

Relative to current GAAP-based balance sheets, fair value 

balance sheets for the enterprises have advantages as an 

indicator of financial safety and soundness.39 The major 

risk that the enterprises face is interest rate risk, and fair 

value balance sheets reflect changes in value from interest 

rate fluctuations more quickly and evenly than any alternative method of accounting. Fair value accounting is 

also consistent in using estimated market values for both 

sides of the balance sheet. Consequently, there is no need 

for special hedge accounting provisions or designations 

based on management’s intent. Although reporting liabilities at fair value could mislead investors in some firms, 

that drawback is not likely to apply to Fannie Mae and 

Freddie Mac as long as the implied federal guarantee remains (see Box 3).

Implications for Improved Regulation of Safety and 

Soundness

For the purpose of improving the safety and soundness of 

the GSEs, FASB’s proposed standard leaves some gaps 

that could be supplemented by additional changes in statute and OFHEO’s regulations. The standard permits 

firms to choose whether to report fair value on a contractby-contract basis, meaning that fair values could be used 

for some holdings but not for others, even when those 

holdings were similar securities.40 For example, Fannie 

Mae and Freddie Mac could choose to account for some 

MBSs on a fair value basis and others on a historical cost 

basis. Alternatively, the firms might hedge 60 percent of 

their portfolio and still report the unhedged portion at 

historical cost, which would diminish the timeliness and 

accuracy of the measure of capital and allow the firms to 

use the standard to manage their reported earnings and 

capital. If the Congress decides that the fair value capital 

measure should be used as the measure of regulatory capital for meeting minimum capital standards or for trigger37. Misuse and abuse of fair value estimates of energy and other 

commodity-trading contracts, derivatives, and other investments 

played a major role in Enron’s accounting scandals. For a critique 

of fair value accounting, see George Benston and others, Following 

the Money: The Enron Failure and the State of Corporate Disclosure 

(Washington, D.C.: Brookings Institution Press, 2003); and 

George J. Benston, “Fair-Value Accounting: A Cautionary

Tale From Enron,” Journal of Accounting and Public Policy

(forthcoming). 

38. Office of Federal Housing Enterprise Oversight, Report of the Special Examination of Fannie Mae (May 2006), Report of Findings to 

Date: Special Examination of Fannie Mae (September 17, 2004), 

and Report of the Special Examination of Freddie Mac (December 

2003). 

39. Joerg-Markus Hitz, The Decision Usefulness of Fair Value Accounting—A Theoretical Perspective, Working Paper No. 05/2005 

(Cologne, Germany: University of Cologne, Cologne Working 

Papers on Banking, Corporate Finance, Accounting, and Taxation, July 2005), available at www.wiso.uni-koeln.de/working

papers/bcfat/2005/04-2005-cologne-wp.pdf. Also see Securities 

and Exchange Commission, Division of Corporate Finance, 

Office of Economic Analysis, Office of the Chief Accountant, 

“Report and Recommendations Pursuant to Section 401c of the 

Sarbanes-Oxley Act of 2002 on Arrangements with Off-Balance 

Sheet Implications, Special Purpose Entities, and Transparency of 

Filings by Issuers” (staff report, 2005), pp. 110-115.

40. Once the accounting decision has been made for a specified contract at initial election, however, it is irrevocable. The rationale for 

making the decision irrevocable is that changing the election after 

initial recognition would result in losses or gains in earnings after 

those losses and gains had occurred. See Financial Accounting 

Standards Board, “The Fair Value Option for Financial Assets and 

Financial Liabilities Including an Amendment of FASB Statement 

No. 115,” paragraph A8, p. 10. 
14 MEASURING THE CAPITAL POSITIONS OF FANNIE MAE AND FREDDIE MAC

Box 3.

Estimating Fair Values for Liabilities

One possible objection to the Financial Accounting 

Standards Board’s (FASB’s) fair value option is the 

counterintuitive effects that credit impairments can 

have on a firm’s balance sheet and income statement.1

Under fair value accounting, if a firm’s creditworthiness declines, the fair value of its debt obligations will 

also fall. (Investors demand higher yields on impaired 

debt.) The decline in the value of outstanding debt 

would boost the firm’s net income in the current period—just as a rise in the value of assets raises income, so will a fall in the value of liabilities—which 

could conceal losses in operating income and make 

comparisons across firms less meaningful. 

One implication of using fair values to estimate liabilities is that a firm’s balance sheet could not report 

negative net worth, because the fair value of its debts 

would approach zero if the firm had no chance of repaying those debts. (Instead, the firm would report 

capital of zero.) However, that reporting would correctly reflect the fact that shareholders can lose no 

more than the capital they have invested in the firm. 

(That is why a firm’s market capitalization cannot 

drop below zero.) 

Under the fair value option, changes in a firm’s creditworthiness would be reflected in the fair values of its 

liabilities so that the estimates reflect the value that 

would be observed in a market exchange. However, 

the fair value proposal also would require firms to disclose the difference between the fair value carrying 

amount and the principal amount the firm is contractually required to pay, as well as the reasons for 

the fair value changes in their debts and how those 

changes affected reported earnings. Thus, users of financial statements, including regulators, would have 

the relevant information about the relationship between current values and required cash payments.2

Reflecting creditworthiness in fair value measures for 

liabilities may not be particularly relevant for the 

measure of Fannie Mae’s and Freddie Mac’s capital. 

As long as investors perceive an implied federal guarantee on the enterprises’ debt, there can be no significant impairment. However, the Office of Federal 

Housing Enterprise Oversight would need to consider this measurement issue for regulatory capital 

purposes.3

1. One FASB board member argued that most users of financial 

statements would not expect deterioration of a firm’s own 

creditworthiness (and the resulting revaluation of its debt 

securities) to affect its operating performance. See Financial 

Accounting Standards Board, Proposed Statement of Financial Accounting Standards, “The Fair Value Option for 

Financial Assets and Financial Liabilities Including an 

Amendment of FASB Statement No. 115 (exposure draft, 

No. 1250-001, January 25, 2006), paragraph A 26, p. 15.

2. Ibid., paragraphs A9-A14, pp. 10-12. 

3. The Basel Committee on Banking Supervision concluded 

that national supervisors should exclude those gains and 

losses from regulatory capital. See Basel Committee on Banking Supervision, “Supervisory Guidance on the Use of the 

Fair Value Option for Financial Instruments by Banks” 

(Basel, Switzerland: Bank for International Settlements, June 

2006), available at www.bis.org/publ/bcbs127.pdf.
MEASURING THE CAPITAL POSITIONS OF FANNIE MAE AND FREDDIE MAC 15

ing prompt corrective actions, then the Congress may 

need to consider revising the definition of regulatory capital to require consistent application of the standard to all 

of the GSEs’ financial assets and liabilities.41 Alternatively, it could give OFHEO the discretion to make such 

changes. The information provided by those fair value 

measures would not replace OFHEO’s stress tests, which 

determine risk-based capital.

OFHEO could take additional steps to make fair value 

measures for Fannie Mae and Freddie Mac more reliable 

and comparable for purposes of safety and soundness. 

First, to make the enterprises’ balance sheets more comparable, it could provide guidance on measuring fair values for derivatives and guarantee fees and examine the enterprises for compliance. Second, to improve the 

timeliness of capital reporting, OFHEO could require 

that fair value statements be released more frequently 

during periods of economic stress, when losses might escalate. Third, OFHEO could require greater disclosures 

about the factors contributing to period-to-period 

changes in the firms’ reported capital.

41. FASB’s proposal would allow firms to select the fair value option 

for existing financial assets and liabilities, rather than just newly 

recognized balance-sheet items. One implication is that firms 

could select the fair value option for their securities that were 

available for sale and held to maturity. FASB decided that the 

reclassification of those securities would result in a cumulativeeffect adjustment of retained earnings, and the amount should be 

separately disclosed. Ibid., paragraph A20, p. 13.

APPENDIX

A

Capital Requirements for

Fannie Mae and Freddie Mac

By law, Fannie Mae and Freddie Mac must meet 

the higher of two regulatory capital requirements: minimum and “risk based.” The minimum capital requirement is 2.5 percent of their assets, which largely consist of 

mortgage-backed securities (MBSs) and whole mortgage 

loans, plus 0.45 percent of their off-balance-sheet obligations, which consist primarily of credit guarantees on the 

MBSs sold to investors. The Office of Federal Housing 

Enterprise Oversight (OFHEO), the federal regulator 

of the firms’ safety and soundness, also requires both 

government-sponsored enterprises (GSEs) to hold an additional 30 percent capital surplus (above their minimum 

levels of capital) to protect against the uncertainty that 

currently surrounds their operating performance. That 

provision temporarily raises the firms’ capital requirements to 3.25 percent of assets and 0.585 percent of the 

MBSs guaranteed by the GSEs but held by investors. 

The risk-based capital standards are intended to ensure 

that Fannie Mae and Freddie Mac can survive a sustained 

period of economic distress. The Federal Housing Enterprises Financial Safety and Soundness Act of 1992 specifies that the risk-based capital requirement be calculated 

to withstand two hypothetical stress tests. Both tests 

cover a period of 10 years. In one test, interest rates rise 

by 75 percent over a 12-month period and then remain at 

that level for the remaining nine years. In the other test, 

rates fall by 50 percent. In each test, the rate change is 

generally capped at 600 basis points (6 percentage 

points). Both tests have a credit risk component: real 

estate prices fall throughout the country by 11 percent 

during the first five years of the stress period and then recover to their initial level during the last five years.1

 Fannie Mae and Freddie Mac must hold capital sufficient to 

survive the worst of those stress tests plus an extra 30 percent of capital to cover operational risk.2

 Under the law, 

the enterprises are required to hold capital equal to the 

minimum requirement or the risk-based requirement, 

whichever is larger.

The risk-based capital requirement has been significantly 

lower than the 2.5 percent of assets plus 0.45 percent of 

off-balance-sheet obligations for both Fannie Mae and 

Freddie Mac since the risk-based standard was adopted in 

2002. For example, as of December 31, 2005, Freddie 

Mac’s risk-based capital requirement was $11.3 billion, 

while its minimum capital requirement was $25 billion 

(see Table A-1).3 As a result, the risk-based standard has 

had no effect on increasing the capital requirements of 

the two firms.

1. OFHEO determined that rate of decline on the basis of the provision in law requiring a rate observed in an area containing 5 percent of the population with the highest rates of default and credit 

losses for the GSEs during a period of at least two years. 

2. The requirement of 30 percent additional capital for operational 

risk is a permanent feature of the risk-based standard and thus will 

not be removed once the uncertainty surrounding the GSEs’ 

accounting ends.

3. Office of Federal Housing Enterprise Oversight, “OFHEO 

Announces Fourth Quarter 2005 Minimum and Risk-Based Capital Classification for Fannie Mae and Freddie Mac” (press release, 

Washington, D.C., March 31, 2006), available at www.ofheo.gov/

media/pdf/capclass33106.pdf. 
18 MEASURING THE CAPITAL POSITIONS OF FANNIE MAE AND FREDDIE MAC

Table A-1.

Regulatory Capital Requirements for 

Fannie Mae and Freddie Mac, as of 

December 31, 2005

(Billions of dollars)

Source: Congressional Budget Office based on data from the 

Office of Federal Housing Enterprise Oversight.

Notes: Fannie Mae submits estimated financial information because 

its accounting practices remain under review by OFHEO.

The results are subject to revision during its restatement 

process.

Freddie Mac’s capital position is also based on the firm’s 

best estimates of its financial position, as represented by its 

management. The results have not been audited.

In this table, regulatory capital refers to core capital, which 

is defined as common stock, perpetual noncumulative 

preferred stock, paid-in capital, and retained earnings.

Both enterprises currently meet the capital standards 

because their regulatory capital exceeds both the minimum 

amount with a 30 percent surplus (required by OFHEO to 

cover management and operations risk) and the risk-based 

level.

Many analysts are skeptical of the robustness of the riskbased capital standard, and several proposals before the 

Congress would allow OFHEO to raise the minimum required level of capital.4,5 The types of shocks included in 

the stress tests are narrow in scope, and the tests assume 

that Fannie Mae and Freddie Mac stop conducting new 

business at the outset of the stress period.6 The assumption of no new business is consistent with the stress tests’ 

objective of assessing the GSEs’ ability to survive on the 

basis of what they have done prior to the onset of the 

stress period rather than what they might do in the future. However, their responses to financial stress will 

play a significant role in the probability and severity of 

failure.7

Capital’s role as a buffer against taxpayers’ losses makes 

declining capital a natural trigger for regulatory intervention.8 The housing GSEs are subject to specified structured intervention by regulators to avoid insolvency if 

capital falls below required amounts. OFHEO uses four 

classifications of capital adequacy: adequately capitalized; 

undercapitalized (the minimum level of capital is met but 

the risk-based level is not); significantly undercapitalized 

(fails to meet both minimum and risk-based levels but 

meets the “critical capital level” of 1.25 percent of on-balance-sheet assets and 0.25 percent of off-balance-sheet 

obligations); and critically undercapitalized (no requirements are met).9 The aggressiveness of the regulatory intervention increases as capital adequacy falls through 

those classifications. If capital falls below the required 

minimum, OFHEO can require prompt corrective action, which includes limitations on the growth of the 

4. Analysts recognize that risk-based capital tests can be manipulated, or “arbitraged,” by the financial institutions in a number of 

ways that may not be observable. See W. Scott Frame and 

Lawrence J. White, Emerging Competition and Risk-Taking Incentives at Fannie Mae and Freddie Mac, Working Paper No. 2004-4 

(Federal Reserve Bank of Atlanta, February 2004), available at 

www.frbatlanta.org/filelegacydocs/wp0404.pdf.

5. Two bills before the Congress, S. 190 (the Federal Housing Enterprise Regulatory Reform Act of 2005) and H.R. 1461 (the Federal 

Housing Finance Reform Act of 2005), would give OFHEO the 

authority to raise the capital standards, although the bills differ 

considerably in many of their provisions. See Mark Jickling, Government-Sponsored Enterprises (GSEs): Regulatory Reform Legislation, CRS Report for Congress RL32795 (Congressional Research 

Service, updated October 27, 2005). 

Requirement Fannie Mae Freddie Mac

Minimum Capital 28.46 24.99

Minimum and 30 Percent Surplus 37.00 32.49

Risk-Based Capital 12.64 11.28

Actual Capital 38.14 36.33

6. For an analysis of how the risk-based capital test might be 

strengthened, see Dwight Jaffee, “The Interest Rate Risk of Fannie 

Mae and Freddie Mac,” Journal of Financial Services Research, vol. 

24, no. 1 (August 2003), pp. 5-29; and Dwight M. Jaffee and 

Gerd M. Welke, “The Risk-Based Capital Test for Fannie Mae 

and Freddie Mac” (December 10, 2003, version of a paper prepared for the Allied Social Science Association meeting, San 

Diego, Calif., January 2004), available at http://faculty.haas.

berkeley.edu/jaffee/Papers/JWGSEPaper04.pdf.

7. See Congressional Budget Office, The New-Business Assumption in 

the Risk-Based Capital Rule for Fannie Mae and Freddie Mac (Letter 

to Paul S. Sarbanes, Chairman, Senate Committee on Banking, 

Housing, and Urban Affairs, January 3, 2003). Other analysts 

argue that the new-business assumption would be speculative and 

could determine whether the enterprises passed or failed the riskbased capital requirement; see General Accounting Office, 

OFHEO’s Risk-Based Capital Stress Test: Incorporating New Business 

Is Not Advisable, GAO-02-521 (June 2002). 

8. See George J. Benston and George C. Kaufman, “FDICIA After 

Five Years,” Journal of Economic Perspectives, vol. 11, no. 3 (Summer 1997), pp. 139-158. 

9. W. Scott Frame and Lawrence J. White, “Regulating Housing 

GSEs: Thoughts on Institutional Structure and Authorities,” Economic Review, vol. 89, no. 2 (Federal Reserve Bank of Atlanta, second quarter of 2004), pp. 87-102. 
APPENDIX A CAPITAL REQUIREMENTS FOR FANNIE MAE AND FREDDIE MAC 19

GSEs’ assets, restrictions on their payment of dividends, 

and required adoption of plans to restore capital. If capital falls below a critical level—about one-half of the minimum amount—OFHEO must classify the enterprise as 

critically undercapitalized and may place the firm into 

conservatorship before it becomes insolvent. In that case, 

a conservator runs the institution as a going concern and 

attempts to strengthen or restore solvency. (The effectiveness of regulatory intervention may also depend on

OFHEO’s power to resolve an insolvency; see Appendix 

Box 1.) 

Appendix Box 1.

OFHEO’s Powers of Resolution

In ensuring the safety and soundness of the government-sponsored enterprises (GSEs), the Office of 

Federal Housing Enterprise Oversight (OFHEO) can 

use its powers of conservatorship, if necessary, to take 

control of an insolvent firm and attempt to operate it 

on a financially sound basis. Other regulators of 

safety and soundness have a more powerful tool at 

their disposal—receivership.1 Bank regulators, for example, can appoint a receiver to oversee a failed institution. A receiver has the power to reorganize a bank 

or liquidate it and pay off creditors on the basis of the 

priority of their claims under law. With only conservatorship powers, OFHEO lacks the authority to liquidate an enterprise and thus lacks the option of allowing the GSEs’ debt holders to incur a loss. That 

constraint strengthens the perception of an implied 

federal guarantee. Several proposals before the Congress that would change how the GSEs are regulated 

would give OFHEO the power to appoint a receiver.2

1. See Richard Scott Carnell, “Handling the Failure of a Government-Sponsored Enterprise,” Washington Law Review, vol. 

80 (2005), pp. 565-642; statement of Richard S. Carnell, 

Fordham University School of Law, Improving the Regulation 

of Fannie Mae, Freddie Mac, and the Federal Home Loan 

Banks, before the Senate Committee on Banking, Housing, 

and Urban Affairs (February 10, 2004); and Robert A. Eisenbeis, W. Scott Frame, and Larry D. Wall, Resolving Large 

Financial Intermediaries: Banks Versus Housing Enterprises, 

Working Paper No. 2004-23a (Federal Reserve Bank of 

Atlanta, October 2004), also available in Journal of Financial 

Stability, vol. 1, no. 3 (April 2005), pp. 386-425. 

2. Two bills before the Congress, S. 190 (the Federal Housing 

Enterprise Regulatory Reform Act of 2005) and H.R. 1461 

(the Federal Housing Finance Reform Act of 2005), address 

that concern and others. The bills’ receivership provisions 

differ. See Mark Jickling, Government-Sponsored Enterprises 

(GSEs): Regulatory Reform Legislation, CRS Report for Congress RL32795 (Congressional Research Service, updated 

October 27, 2005).

APPENDIX

B

Qualifying for Hedge Accounting Treatment

Under FAS 133

One of the rationales behind the Financial Accounting Standards Board’s (FASB’s) fair value option is 

to offer firms the benefits of hedge accounting without 

the complex accounting required by Financial Accounting Standard (FAS) 133. In general, Fannie Mae and 

Freddie Mac, as well as other large financial institutions, 

seek to hedge their balance sheets rather than particular 

transactions, but FAS 133 does not allow portfolio hedging to receive hedge accounting treatment. 

If certain requirements, which are fairly stringent, are 

met, however, FAS 133’s special hedge accounting does 

allow both the hedge and the changes in fair value of the 

hedged position attributable to the hedged risk to be reported at fair value.1 Any derivative designated as a hedge 

must be linked for accounting purposes to a specific asset 

or liability (or a portfolio of similar assets or liabilities) on 

the balance sheet (that is, the hedged item) with contemporaneous documentation of the hedged relationship, 

meaning identification of the hedged item, the hedging 

instrument, and the nature of the hedge. The hedge must 

also be “highly effective.” Thus, the economics of a hedging relationship may not be reflected in its accounting, 

which may result in excess volatility in firms’ reported income and capital measures. 

Use of Derivatives and Hedges by 

Government-Sponsored Enterprises

If Fannie Mae and Freddie Mac hedged their balance 

sheets perfectly, a change in interest rates would have the 

same effect on their assets and their liabilities, so their net 

worth would be unaffected. Although the enterprises do 

not fully hedge their portfolios against interest rate risk 

(because doing so would be expensive and would reduce 

opportunities for profits), they do try to lock in the 

spreads between the yields on their portfolio holdings and 

their debt issues for small changes, but not necessarily 

large changes, in interest rates. (Fannie Mae and Freddie 

Mac also leave most of their credit risk unhedged.) 

Hedging is complicated by prepayment risk on the enterprises’ mortgage holdings. When interest rates fall, the 

market value of fixed-rate securities rises. However, borrowers are more likely to prepay their mortgages when 

rates fall, so the enterprises may realize no market gains 

and instead must reinvest the proceeds at the lower rates. 

Predicting prepayment rates is difficult because borrowers 

do not always maximize their potential gains.

Fannie Mae and Freddie Mac use a range of derivative instruments—including options, swaptions, and interest 

rate caps—to help hedge their portfolios. Derivatives are 

financial instruments whose promised payoffs are derived 

from the value of something else.2 Options are the right, 

but not the obligation, for the holder to buy, borrow, or 

sell a financial instrument at a stated price in the future. 

1. Firms generally do not hedge all of their risks. For example, the 

hedged risk could be “the risk of changes in the overall fair value 

of the entire hedged item; the risk of change in its fair value attributable to changes in the designated benchmark interest rate; the 

risk of changes in its fair value attributable to changes in the 

related foreign currency risk; or the risk of changes in its fair value 

attributable to both changes in the spread over the benchmark 

interest rate with respect to the hedged item’s credit sector at 

inception of the hedge (referred to as credit risk).” See Financial 

Accounting Standards Board, “Statement of Financial Accounting 

Standards No. 133: Accounting for Derivative Instruments and 

Hedging Activities” (Norwalk, Conn.: Financial Accounting Standards Board, June 1998), paragraph 21.

2. Under its definition of derivatives, FASB also includes a firm’s 

commitments to purchase mortgage loans and purchase or sell 

mortgage-backed securities. For a general analysis of companies’ 

use of derivatives, see Rene M. Stulz, Should We Fear Derivatives? 

Working Paper No. 10574 (Cambridge, Mass.: National Bureau 

of Economic Research, June 2004). 
22 MEASURING THE CAPITAL POSITIONS OF FANNIE MAE AND FREDDIE MAC

For example, the enterprises might use interest rate options to control the cost of future borrowing. Swaptions 

are the option to trade a stream of fixed-rate interest payments for variable-rate payments on the same notional 

amount of principal. The enterprises use interest rate caps 

to limit their exposure to rising interest rates on variabledebt instruments. 

Derivatives can also be used to effectively turn short-term 

debt into long-term debt and noncallable debt into callable debt. Callable debt gives the enterprise the right to 

redeem the issue at a specific price after a specified date. 

(Because the call option is embedded in the security, the 

accounting for callable debt is not changed by FAS 133. 

Callable debt is generally reported on a historical cost basis.) The enterprises use callable debt as a refinancing tool 

to offset mortgage prepayments. 

Fair Value Hedges

Under generally accepted accounting principles (GAAP), 

derivatives are always reported at fair value. Fair value 

hedge accounting under FAS 133 allows the enterprises 

to also report the position being hedged at fair value on 

their income statement, so both sides of the hedge are valued in the same way. For example, if a GSE used a payfixed, receive-floating interest rate swap to hedge a fixedrate mortgage, a rise in interest rates would lower the fair 

value of the mortgage but raise the fair value of the swap.3

If the hedge was perfect, income and thus capital would 

be unaffected by changes resulting from interest rate

fluctuations. 

Cash Flow Hedges

Cash flow hedges smooth income.4 A cash flow exposure 

under FAS 133 is the risk that a change in price will cause 

a change in expected future cash flows. For example, Fannie Mae and Freddie Mac use interest rate swaps to transform short-term debt into long-term debt. (That transformation can allow the enterprises to reduce their 

funding costs.) Changes in the fair value of derivatives 

classified as cash flow hedges are initially reported on the 

balance sheet but not on the income statement because 

the change in value has not been realized; however, 

changes in their value flow into the income statement 

over the life of the hedged transactions to match the timing of the cash flows on the hedged position. If a cash 

flow hedge was perfect, fair value changes would be offsetting, so that income would be stabilized over the life of 

the hedge.5 Without special accounting treatment, the 

gains and losses on the derivatives would be reported earlier in earnings than the gains and losses on the hedged 

transactions, which are realized over time. 

Testing for Effectiveness

FAS 133’s hedge accounting treatment is available only 

for “highly effective” hedges. Effectiveness measures the 

extent to which changes in the fair value of a derivative 

are matched with changes in the fair value or cash flow of 

a hedged item. The enterprises must test the hedged relationship for effectiveness at the inception of the hedge 

and on an ongoing basis at least every quarter, unless the 

relationship meets the requirements of the short-cut 

method or the critical terms of the hedging instrument 

and hedged item match such that there will be no question of ineffectiveness in the hedge relationship. FASB 

did not specify how strong the statistical correlation between the measures needs to be in order to count as 

“highly effective.” According to the Securities and Exchange Commission, the dollar offset ratio between the 

hedge instrument and the hedged item should range from 

80 percent to 125 percent to qualify for hedge accounting 

treatment.6 The ineffective portion, or the unmatched 

amount of the change, must be recorded in earnings. To 

meet those and other criteria, the enterprises must main- 3. A pay-fixed, receive-floating swap means that the GSE has agreed 

to pay a predetermined fixed rate of interest on a set notional 

amount and receive a floating rate of interest tied to a specific 

index that resets periodically. For example, the GSE and a counterparty—often a money center bank—might agree to swap payments on $10 billion (the notional amount). The GSE also faces 

risk that the counterparty might default on the swap. 

4. Financial Accounting Standards Board, “Accounting for Derivative Instruments and Hedging Activities: FASB Statement No. 

133 as Amended and Interpreted—Incorporating FASB Statements Nos. 137 and 138 and Certain Statement No. 133 Implementation Issues as of December 10, 2001” (Norwalk, Conn.: 

Financial Accounting Standards Board, 2001), p. 187, paragraph 

371. 

5. Cash flow hedges do not smooth GAAP-based capital. The fair 

value change in the derivative reported in equity capital generally 

will not match the cash flow changes of the hedged position in a 

given period. Regulators, however, exclude the unrealized changes 

in the fair value of derivatives qualifying as cash flow hedges when 

measuring capital for the purposes of determining a firm’s safety 

and soundness. 

6. Office of Federal Housing Enterprise Oversight, Report of Findings 

to Date: Special Examination of Fannie Mae (September 17, 2004), 

p. 102. 
APPENDIX B QUALIFYING FOR HEDGE ACCOUNTING TREATMENT UNDER FAS 133 23

tain extensive documentation and perform numerous calculations. 

The lack of testing for effectiveness by the GSEs has resulted in the enterprises’ loss of hedge accounting treatment for most of their derivatives. Fannie Mae asserted 

that its hedge relationships were perfectly effective due 

to the matching of critical terms, although investigations 

determined that in certain instances not all of the critical 

terms matched. In those instances, Fannie Mae should 

have reported the ineffective portion in its earnings or 

abandoned the hedge accounting option.7

Asserting effectiveness is particularly problematic in the 

case of derivatives being redesignated into new hedging 

relationships. Redesignations of hedges typically occur 

when firms rebalance their portfolios following interest 

rate changes. But when the existing derivatives are redesignated, they generally fail to meet an explicit requirement of FAS 133—the derivative must have a fair value 

of zero when the new hedging relationship is established.8

From a risk-management perspective, the GSEs are concerned about how well-hedged their entire book of business is, but FAS 133 requires linking derivatives to a particular security. An internal investigation of Freddie Mac’s 

accounting practices by the law firm Baker Botts concluded that “management believed that FAS 133 should 

be ‘transacted around’ because it did not reflect the economic fundamentals of the company’s business.”9 The 

enterprise’s basic objection was that the standard required 

marking the derivatives to fair market value but did not 

allow the debt that was being hedged to be reported at 

fair value except under restrictive conditions. In 2004, 

Freddie Mac discontinued all of its cash flow hedge accounting relationships and a significant portion of its fair 

value hedge accounting relationships because they failed 

to meet the effectiveness tests.10 By allowing portfolio 

hedging and dropping the effectiveness test, FASB’s fair 

value proposal would be particularly advantageous to the 

enterprises and other financial institutions. 

7. See Paul, Weiss, Rifkind, Wharton, & Garrison, LLP, and Huron 

Consulting Group, A Report to the Special Review Committee of the 

Board of Directors of Fannie Mae (February 23, 2006), pp. 8-10, 

p. 102, and pp. 118-128, available at http://download.fanniemae. 

com/report.pdf. Also see Office of Federal Housing Enterprise 

Oversight, Report of the Special Examination of Fannie Mae (May 

2006), available at www.ofheo.gov/media/pdf/FNMSPECIAL 

EXAM.pdf.

8. That requirement is in paragraph 65 of FAS 133. See Office of 

Federal Housing Enterprise Oversight, Report of Findings to Date: 

Special Examination of Fannie Mae (September 17, 2004), p. 90. 

9. Baker Botts, LLP, Report to the Board of Directors of the Federal 

Home Loan Mortgage Corporation: Internal Investigation of Certain 

Accounting Matters, December 10, 2002-July 21, 2003 (July 22, 

2003), p. 34. 

10. Freddie Mac, Annual Report (2004), pp. 30-31 and 199-201.