Report of Findings to Date 

Special Examination of Fannie Mae

Office of Compliance 

Office of Federal Housing Enterprise Oversight

September 17, 2004 
OFFICE OF FEDERAL HOUSING ENTERPRISE OVERSIGHT

1700 G STREET, NW, WASHINGTON, DC 20552 (202) 414-3800 

Office of Compliance

MEMORANDUM

TO: Armando Falcon, Jr., Director

FROM: Christopher H. Dickerson, Chief Compliance Examiner

SUBJECT: Fannie Mae Special Examination 

DATE: September 17, 2004 

Attached are the findings to-date of the special examination of Fannie Mae. The matters

detailed in this report are significant and warrant your immediate attention. 

This report is the result of a collective effort by the Office of Compliance, the Office of

the Chief Accountant, and other OFHEO staff, as well as technical support provided by

accountants from Deloitte & Touche, LLP. During our examination, we have reviewed more 

than 200,000 documents and e-mails, and have interviewed and taken sworn testimony from 

numerous current and former Fannie Mae employees. 

Our examination is continuing and we will keep you apprised of our findings. 

 

Special Examination of Fannie Mae 

Privileged & Confidential 

Disclosure and/or Duplication Prohibited
Report of Findings to Date 

Special Examination of Fannie Mae

Office of Compliance 

Office of Federal Housing Enterprise Oversight

September 17, 2004 
Table of Contents

 

INTRODUCTION AND EXECUTIVE SUMMARY ............................................................................ i

ACCOUNTING FOR PURCHASE DISCOUNT AND PREMIUM AND OTHER DEFERRED PRICE 

ADJUSTMENTS UNDER SFAS 91................................................................................................ 1

REQUIREMENTS OF SFAS 91 .............................................................................................................. 2

POLICY AND INFRASTRUCTURE DEVELOPMENT.......................................................................................... 7

Events of 1998 and 1999 .......................................................................................................... 7

Fourth Quarter of 1998 ...........................................................................................................................7

Bonuses Awarded in 1998 .....................................................................................................................10

Recognition of 1998 “Catch-up” in 1999 .................................................................................................12

Formulation and Adoption of Accounting Policy......................................................................... 13

Formulation of Accounting Policy ...........................................................................................................13

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Policy Adopted to Recognize Expense or Income Over Multiple Reporting Periods .....................................15

Policy to Defer Income and Expense Up To Certain Thresholds ................................................................17

Policy To Permit Discretionary Adjustments Within The Targe Catch-Up Range........................................27

Managing the Catch-Up .......................................................................................................... 29

Managing Within The Current Quarter’s Catch Up Range.........................................................................29

Modeling And Managing The Forecasted Catch-Up ..................................................................................32

Development of Systems and Modeling Capability ..................................................................... 40

HISTORICAL ANALYSIS OF ACCOUNTING FOR DEFERRED PRICE AMORTIZATION ............................................... 42

Management of Catch Up Results ............................................................................................ 45

Management Discretion Applied in the Selection of Market Rate Assumptions............................. 49

Capitalization and Amortization of Reconciliation Differences...................................................... 53

Inconsisten and Incorrectly Applied Accounting Practices to Determine the Catch-Up.................. 58

INTERNAL CONTROLS OVER THE AMORTIZATION PROCESS ......................................................................... 65

Segregation o Duties and Key Person Dependencies................................................................. 66

Modeling Undertaken to Produce Desired Resul s...................................................................... 67

Underlying Data Issues........................................................................................................... 68

Factor Anomalies ................................................................................................................... 69

How Factor Anomalies Could Represent Departures from GAAP ...............................................................71

The Office of Auditing Amortization Investigation...................................................................... 73

HEDGE ACCOUNTING UNDER SFAS 133.................................................................................. 82

INTRODUCTION ............................................................................................................................. 82

BACKGROUND ............................................................................................................................... 82

Implementation of SFAS 133 at Fannie Mae ............................................................................. 83

Determination to maintain the pre-SFAS 133 accounting............................................................ 84

Minimizing Earnings Vola ility a Primary Objective ..................................................................... 84

Derivatives Accounting Policies & Procedures............................................................................ 85

The Assumption of Perfect Effectiveness .................................................................................. 86

Environmen for Formula ion of Derivatives Accounting Policy at Fannie Mae............................... 87

SUMMARY OF KEY SSUES IDENTIFIED ................................................................................................. 90

ISSUE 1: DERIVATIVE RE-DESIGNATIONS ............................................................................................. 94

ISSUE 2: ACCOUNTING FOR OFFSETTING DERIVATIVES........................................................................... 104

ISSUE 3: APPLICATION OF SHORTCUT AND MATCHED TERMS METHODS ...................................................... 112

ISSUE 4: INTEREST RATE CAPS ....................................................................................................... 129

ISSUE 5: HEDGE ACCOUNTING DOCUMENTATION ISSUES ........................................................................ 136

ACCOUNTING OVERSIGHT .................................................................................................... 146

ACCOUNTING POLICY DEVELOPMENT ................................................................................................. 147

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ACCOUNTING POLICY REVIEW ......................................................................................................... 152

SEGREGATION OF DUTIES .............................................................................................................. 155

Chief Financial Officer (CFO) ................................................................................................. 156

Senior Vice President – Financial Reporting and Planning......................................................... 158

Director of Financial Reporting .............................................................................................. 159

SVP of Operations Risk (Head of Internal Audit)...................................................................... 160

KEY PERSON DEPENDENCY ............................................................................................................. 162

The Financial Standards Group.............................................................................................. 162

Controller ............................................................................................................................ 164

Vice President for Financial Accounting .................................................................................. 166

CONCLUSION.............................................................................................................................. 168

APPENDIX I ........................................................................................................................... 170

ESTIMATION METHODS USED FOR MODELING THE CATCH-UP .................................................................. 170

A. Background ....................................................................................................................................170

B. Development of Amortization Estimation Methods.............................................................................172

C. Use of Multiple Rate Paths...............................................................................................................175

D. The Application of Estimation Methods in 1999 and 2000..................................................................178

E. Conclusion......................................................................................................................................184

APPENDIX II ......................................................................................................................... 185

SUMMARY OF SFAS 133, ACCOUNTING FOR DERIVATIVES AND HEDGING ACTIVITIES ..................................... 185

APPENDIX III........................................................................................................................ 187

EXAMPLE OF A TERM-OUT TRANSACTION ............................................................................................ 187

APPENDIX IV......................................................................................................................... 192

EXAMPLE OF AN OFFSETTING SWAP .................................................................................................. 192

APPENDIX V .......................................................................................................................... 195

EXAMPLE OF A CANCELABLE SWAP .................................................................................................... 195

Special Examination of Fannie Mae 

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INTRODUCTION AND EXECUTIVE SUMMARY 

We are currently conducting a Special Examination of Fannie Mae’s accounting policies, internal

controls, and financial reporting processes. Although the examination is still in process, our 

findings to-date are serious and warrant a report at this juncture. This report details the Special 

Examination’s concerns on the framework and conditions of Fannie Mae’s accounting policies 

and internal controls, with a particular focus on two critical accounting areas: deferred price

adjustments, and derivatives and hedging activities. 

We have determined that Fannie Mae, in developing policies and practices in these critical 

areas, has misapplied Generally Accepted Accounting Procedures (“GAAP”), specifically

Accounting for Nonrefundable Fees and Cos s Associated with Originating or Acquiring Loans 

and Initial Direct Costs of Leases (“SFAS 91”) and Accoun ing for Derivative Instruments and 

Hedging Activities (“SFAS 133”). The misapplications of GAAP are not limited occurrences, but

are pervasive and are reinforced by management. The matters detailed in this report are 

serious and raise concerns regarding the validity of previously reported financial 

results, the adequacy of regulatory capital, the quality of management supervision,

and the overall safety and soundness of the Enterprise.

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The problems relating to these accounting areas differ in their specifics, but they have emerged 

from a culture and environment that made these problems possible. Characteristics of this 

culture include: 

• management’s desire to portray Fannie Mae as a consistent generator of stable and 

growing earnings; 

• a dysfunctional and ineffective process for developing accounting policies; 

• an operating environment that tolerated weak or non-existent internal controls; 

• key person dependencies and poor segregation of duties; 

• incomplete and ineffective reviews by the Office of Auditing;

• an inordinate concentration of responsibility vested with the Chief Financial Officer; and 

• an executive compensation structure that rewarded management for meeting goals tied 

to earnings-per-share, a metric subject to manipulation by management.

The tenor of earnings management is deeply ingrained at Fannie Mae and has given rise to 

accounting policies and practices that emphasize effects on earnings volatility, rather than 

faithfulness to GAAP. A key message by Fannie Mae to the investor community is 

management’s ability to generate stable and growing earnings. This is evidenced by Fannie 

Mae’s annual financial reports, with their recurring graphs of steadily increasing earnings 

against a backdrop of volatile interest rates. Less well known, but detailed in this report, is the 

fact that the desire by management to minimize earnings volatility was a central organizing 

principle in the development of key accounting policies. 

Management also emphasized the stable earnings imperative in its communications to the 

Fannie Mae Board of Directors. In July 2003, even as the accounting problems of Freddie Mac 

were publicly emerging, Fannie Mae’s Chief Financial Officer, Tim Howard, made a presentation

to the Board that emphasized a “stable pattern of earnings” as a requirement for Fannie Mae if

it were to be perceived as a low-risk Enterprise. Mr. Howard included in this presentation a 

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graph showing that the earnings of Fannie Mae were smoother than those of Freddie Mac and 

almost all other companies in the S&P 500. 

Sound risk management practices can reduce the economic effects of volatile cash flows. 

However, management should not reduce earnings volatility through accounting policies and 

practices that do not comport with GAAP. 

The key findings of our examination relating to SFAS 91, SFAS 133, accounting policy 

development, and internal controls are summarized below.

Accounting for Purchase Discount and Premium and Other Deferred Price 

Adjustments (SFAS 91) 

OFHEO has concluded that the accounting used by Fannie Mae for amortizing 

purchase premiums and discounts on securities and loans as well as amortizing 

other deferred charges is not in accordance with GAAP. This is particularly significant, in 

that management, in the MD&A section of their Form 10-K, details their underlying application 

of amortization as it relates to SFAS 91, and also explains that the accounting estimates 

associated with deferred price adjustments are “critical accounting estimates.” 

However, despite the importance of premium and discount amortization to the financial 

statements of Fannie Mae, and despite the requirement of SFAS 91 to formulate best estimates

in good faith, management intentionally developed accounting policies and selected and applied 

accounting methods to inappropriately reduce earnings volatility and to provide themselves with 

inordinate flexibility in determining the amount of income and expense recognized in any 

accounting period. In this regard, the amortization policies that management developed and

the methods they applied created a “cookie jar” reserve. In addition, OFHEO found that 

management: 

• deliberately developed and adopted accounting policies to spread estimated income or 

expense that exceeded predetermined thresholds over multiple reporting periods; 

• established a materiality threshold for estimated income and expense, within which 

management could avoid making adjustments that would otherwise be required under 

SFAS 91; 

• made discretionary adjustments to the financial statements, for the sole purpose of 

minimizing volatility and achieving desired financial results; 

• forecasted and managed the future unrecognized income associated with misapplied 

GAAP; 

• capitalized reconciliation differences as ‘phantom’ assets or liabilities and amortized 

them at the same speeds as 30-year fixed-rate mortgages; 

• developed estimation methods that were inconsistently applied to retrospective and 

prospective amortization required by SFAS 91 for current and future periods; 

• developed and implemented processes to generate multiple estimates of amortization 

with varying assumptions in order to select estimates that provided optimal accounting 

results; 

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• failed to properly investigate an employee’s concerns regarding illogical or anomalous

amortization results, along with that employee’s further allegation of an intent to

misstate reported income; 
• tolerated significant weaknesses in internal controls surrounding the amortization

process; and 

• inappropriately deferred $200 million of estimated amortization expense in 1998, which 

had significant effects on executive compensation. 

This report provides details on the thresholds established by management for recognizing – or 

not recognizing – amortization income or expense. Although management often refers to the 

amounts within these thresholds as “the functional equivalent of zero”, our report details why, 

in fact, the ranges of these thresholds are quite large relative to the amounts of amortization 

normally recognized, how the ranges greatly facilitate the smoothing of income, and why these 

thresholds fail the test of GAAP compliance. 

This report chronicles the events that led to the development of Fannie Mae’s current 

amortization policies and practices. It describes how management, after experiencing

unexpected increases in amortization expense in 1998, developed policies and practices to 

cushion the income statement against future surprises. In various memoranda, management 

openly expressed as an objective of its amortization policies and practices a desire to minimize 

earnings volatility. For example, a March 1999 memorandum from an employee in the 

Controller’s Department described the benefits of a particular brand of software for modeling 

amortization, noting that the software allowed a user to “manipulate factors to produce an 

array of recognition streams”, which “strengthens the earnings management that is necessary 

when dealing with a volatile book of business.” 

This statement is a clear acknowledgement that a balance sheet comprised of fixed-rate 

mortgages produces volatility. However, in testimony that is highlighted in this report, 

management sought to portray their amortization policies and practices as attempts to dampen 

“artificial volatility” that arises from the estimation process. Chief Financial Officer Tim Howard, 

who was the chief architect of Fannie Mae’s amortization policy, attempted to justify the use of 

a discretionary threshold for recording amortization by asserting that a single point-estimate 

resulted in “spurious precision.” In fact, said Controller Leanne Spencer, management’s 

freedom to book a number within this range was useful to investors, because doing so helped 

eliminate “jerky moves.” 

Management asserts that the “artificial volatility” they seek to dampen arises from assumption 

risk. Because key assumptions, such as mortgage prepayment speeds, can change dramatically 

from period to period, estimates of amortization can likewise change dramatically. However, 

changes in prepayment assumptions are driven by actual changes in the economic 

environment, particularly changes in interest rates, which gives rise to volatility. GAAP 

requires this volatility to be recognized and reported.

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In arguing against the use of a single point-estimate for amortization, management has also 

asserted that estimates of prepayments may vary widely at any particular point in time. For 

example, one can survey Wall Street dealers and observe a wide range of prepayment

estimates, any of which could be justified for estimating amortization. In fact, management

sometimes obtains many prepayment estimates from market sources and, for particular asset 

categories, selects a speed within the range of estimates to develop amortization factors. 

Management asserts that any prepayment estimate within the range can be justified, but in fact 

the flexibility to select any prepayment speed within a range simply enhances the ability of 
management to hit an earnings number. Because these estimates of amortization are also used

in management’s analysis of net interest income sensitivity, this practice has unfavorable safety 

and soundness implications that go beyond financial reporting. 

The Special Examination also found that the process for estimating amortization was 

characterized by significant control weaknesses. Many of these control weaknesses are

centered on the amortization system and the process for modeling amortization factors. These 

control weaknesses undermine the process of amortization to such an extent that 

the accuracy of premium and discount amortization is questionable. These control 

weaknesses include: 

• inadequate segregation of duties and key person dependencies; 

• modeling multiple runs to produce desired results; 

• underlying data issues, including illogical or anomalous amortization factors; and 

• a lack of written procedures, supporting documentation, and poor or non-existent 

audit trails. 

This report also details an investigation performed by the Office of Auditing into allegations of 

amortization accounting irregularities raised by Roger Barnes, a former employee in the 

Controller’s Department who left Fannie Mae in November 2003, and whose cooperation was 

important to our examination. The Special Examination found that Mr. Barnes’s allegations 

were substantive, and that the Office of Auditing failed to adequately investigate the problems

surrounding the amortization process that he raised. 

The consequences of the misapplications of GAAP and control breakdowns 

surrounding accounting for amortization are potentially large. The management of 

Fannie Mae, by recording incorrect and incomplete amounts of premium and discount

amortization, has misstated interest income over many reporting periods, as well as balance 

sheet accounts for unamortized premiums and discounts. Also, because amortization estimates 

ultimately flow to individual securities, gains or losses recorded on the sale or transfer of

securities in previous periods are also questionable. Fannie Mae will need to devote 

considerable resources to determine the full magnitude of these errors. 

Accounting for Derivative Instruments and Hedging Activities (SFAS 133) 

Fannie Mae adopted SFAS 133, Accounting for Derivative Ins rumen s and Hedging Activities, 

on January 1, 2001. The standard requires that all freestanding and certain embedded 

derivatives be carried on the balance sheet at fair value. Changes in the fair value of a 

derivative are included in earnings, which gives rise to earnings volatility. However, the hedge 

accounting provisions of SFAS 133 provide methods for offsetting the earnings effect of a

derivative with a designated hedge transaction, if the combination meets specific criteria. 

Hedge accounting is optional. To qualify, entities must maintain extensive documentation 

and, in many instances, perform rigorous calculations. These stringent criteria presented 

significant challenges to Fannie Mae, which has a large and dynamic hedging program. 

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Fannie Mae had a strong desire to retain the status quo of accrual/synthetic instrument 

accounting in effect before SFAS 133, because synthetic instrument accounting provided 

smoother accounting earnings and greater predictability of reported financial results. To this 
end, Fannie Mae implemented SFAS 133 in a manner that placed minimizing 

earnings volatility and maintaining simplicity of operations above compliance with 

GAAP. These goals, to an inordinate degree, influenced the development of Fannie Mae’s 

approach to hedge accounting. 

Indeed, in a March 2003 memorandum that took a retrospective look at Fannie Mae’s SFAS 133

implementation, Jonathan Boyles, Senior Vice President for Financial Standards, wrote that the 

implementation of this standard was driven by management’s desire to minimize earnings 

volatility, leverage off existing systems, and make the non-GAAP measure of “operating 

earnings” simple and easy to understand. Mr. Boyles wrote that these goals “were intertwined

in many of the decisions we made during the implementation process.” He went on to write 

that these decisions “were often the joint decisions of management including the CFO.” He

further noted that “in hindsight these decisions may not have been the best decisions given 

what we know now.” 

These drivers did, in fact, result in major problems for Fannie Mae’s accounting for derivatives.

In fact, OFHEO has found that in many cases Fannie Mae does not assess and record

hedge ineffectiveness as required by SFAS 133, and applies hedge accounting to 

hedging relationships that do not qualify. 

Fannie Mae’s hedge accounting regime assumes that the vast majority of its hedging

relationships are “perfectly effective”; this greatly simplifies operations, because SFAS 133 

requires no effectiveness assessment or measurement of ineffectiveness for such relationships.

However, SFAS 133 prescribes specific rules for assuming perfect effectiveness; hedges that do

not meet these criteria require an assessment of effectiveness to qualify for hedge accounting

and a measurement of ineffectiveness for qualifying hedge relationships. OFHEO’s analysis 

indicates that Fannie Mae has many hedging relationships that do not qualify as 

perfectly effective, yet have been treated as such. Because Fannie Mae has not 

performed a proper assessment of hedge effectiveness for such hedges, these hedge 

relationships do not qualify for hedge accounting treatment. Thus, the fair value changes 

for derivatives in these relationships should be recorded in earnings. 

Even if a hedge relationship qualifies for hedge accounting, “ineffectiveness” may exist. 

Ineffectiveness represents the extent to which changes in the fair value of a derivative are not

perfectly matched with the changes in fair value or cash flows of the hedged item. The 

ineffective portion of changes in the derivative’s fair value must be recorded in earnings. 

OFHEO has identified numerous instances in which Fannie Mae has improperly ignored 

this ineffectiveness in hedge relationships or has failed to perform assessment tests.

For example, Fannie Mae often re-designates derivatives to different hedged items during the 

life of the derivative. OFHEO found that Fannie Mae incorrectly assumes that such derivatives 

are perfectly effective upon re-designation, even though the derivatives do not have a fair value 

of zero at the time of re-designation. This is required in order to assume perfect effectiveness 

or to receive matched terms accounting. 

Further, Fannie Mae has applied the “short-cut” method, or the “matched terms” 

method, for a broad range of hedge relationships where these methods are 

inappropriate. The Enterprise has also applied its own definitions of “matched terms” in 

certain instances. Examples detailed in this report include: 

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• receive-fixed swaptions hedging the fair value of non-callable debt; 

• callable swaps hedging discount notes, which are incorrectly treated as perfectly 

effective without regard to the option value existing in the derivative but not the 

hedged item; 

• swaps arising from the exercise of a swaption, which are treated as perfectly effective 

despite their non-zero fair value at inception; 

• the modification of the requirement for matching of reset dates (in order to assume

perfect effectiveness) between the hedged item and the swap in cash flow hedges to

permit up to a seven day reset date mismatch; 

• the modification of the requirement for matching of maturity dates (in order to assume 

perfect effectiveness) between the hedged item and the swap in fair value hedges to

permit up to a 90 day mismatch; and 

• the use of a “duration method” to assume perfect effectiveness in hedges of anticipated 

debt issuances. (In March 2004, Fannie Mae discontinued the use of duration matching 

as a method to assess the effectiveness of hedging anticipated debt issuances. The 

Enterprise admits that this methodology was a known departure from GAAP.)

When seeking to effectively terminate interest rate swaps, management often entered into 

offsetting swaps instead of buying back the existing swaps. However, the accounting for 

offsetting derivatives was inappropriate through the end of 2003, because Fannie Mae 

incorrectly treated the original swap and the offsetting swap as perfect cash flow 

hedges and recorded changes in their fair value in accumulated other 

comprehensive income (AOCI), instead of earnings. In the first quarter of 2004, Fannie 

Mae modified its accounting for these offsetting swaps prospectively. However, OFHEO 

believes that these offsetting swaps were not valid hedging relationships under SFAS 133 in 

past periods and should not have received hedge accounting after the execution of the second 

swap. 

OFHEO identified a number of problems with Fannie Mae’s hedge documentation. In

several examples OFHEO reviewed, the documentation was ambiguous as to the nature of the 

hedging relationship or did not clearly identify the hedged risk, hedged item, or its probability of 

occurrence. In addition, OFHEO found instances where there was no contemporaneous hedge 

documentation, as well as instances where staff created hedge designations retroactively. 

Under SFAS 133, the lack of contemporaneous hedge designation documentation precludes a 

company from qualifying for hedge accounting. This lack of documentation and the 

ability to create such documentation retroactively is not only a SFAS 133 violation, 

but is evidence of a poor control framework and is a significant safety and 

soundness problem. 

This report also provides details on an error made by Fannie Mae in accounting for changes in

the time value and the intrinsic value components of purchased interest rate caps. The 

Enterprise discovered the error, corrected its methodology, and applied the new methodology 

only prospectively to new interest rate caps. The analysis and discussion in this report show 

that Fannie Mae has incorrectly accounted for and reported this error in its financial 

statements. Further analysis is necessary to make a precise determination of the complete 

financial statement impact on all periods affected. 

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For derivatives not qualifying for hedge accounting, fair value changes should be reflected in 

earnings in the period in which the value change occurred. As of December 31, 2003, the 

balance in “Accumulated Other Comprehensive Income” (AOCI) included approximately $12.2

billion in deferred losses relating to cash flow hedges. Furthermore, carrying value adjustments 

of liabilities relating to fair value hedges amounted to $7.2 billion as of that date. Fannie Mae’s 

improper application of hedge accounting leads us to question the validity of the amount

reflected in AOCI, as well as amounts reflected as carrying value adjustments, at any point in

time after the adoption of SFAS 133. The possible reclassification of such amounts into 

retained earnings could have a significant effect on Fannie Mae’s regulatory capital. 

Accounting Oversight 

As part of the Special Examination, we assessed various controls and processes surrounding 

Fannie Mae’s accounting and financial reporting. These include processes for developing, 

approving, maintaining, and implementing accounting policies, as well as the segregation of 

duties and key person dependencies. In particular, we concentrated examination efforts on 

evaluating the roles and responsibilities of the Chief Financial Officer, executives in the 

Controller’s Department, and controls that support the integrity of the financial reporting 

process. 

The failure by management to properly implement critical accounting policies is due 

in part to the lack of a sound framework for developing these policies. Fannie Mae 

often relies on a few individuals to make key decisions on critical accounting policies and 

practices. This report documents how management failed to establish an internal control 

system to ensure that accounting policies are appropriately developed and reviewed. 

A prime example of this failure is the process for developing the key document relating to SFAS 

91 accounting. OFHEO found that Fannie Mae’s Purchase Premium and Discount Amortization

Policy was developed without input from the Financial Standards, which is the group in the 

Controller’s Department normally responsible for setting accounting policy. Indeed, the head of 

that group, Jonathan Boyles, testified that key provisions of that document do not comply with 

GAAP. 

Our report documents that Fannie Mae’s external auditor, KPMG, is often viewed within the

Enterprise as the final arbiter of compliance with GAAP. However, it is ultimately the 

responsibility of management to determine sound accounting policies for the Enterprise – the 

burden of management can not be shifted to the external auditor. OFHEO views this reliance 

on the external auditor to determine the propriety of accounting policy as an indication of

inadequate technical expertise within the Controller’s Department. OFHEO found that the 

accounting policy review process does not provide reasonable assurance that the accounting 

policies adopted by the Enterprise are in compliance with GAAP. 

The control weaknesses that we identified in Fannie Mae’s accounting policy 

development process have contributed to accounting policies that do not comply 

with GAAP. Additionally, the Special Examination found that a lack of formal procedures for 

accounting policy development has resulted in incomplete disclosure of critical accounting 

policies by the Chief Financial Officer to the Audit Committee of the Board of Directors. 

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A cornerstone of sound corporate oversight is the control structure itself. It is management’s 

responsibility to ensure that Fannie Mae operates in a safe and sound manner and has proper 

segregation of duties, an adequate level of controls to support its key business processes, and 

clear and appropriate accounting policies. In addition, it is the responsibility of management to 

ensure that personnel in key control functions are competent and qualified to execute their

responsibilities. In this regard, OFHEO found that a combination of heavy workloads, weak 

technical skills, and a weak review environment contributed to the development of key person 

dependencies and inadequate segregation of duties. 

The Special Examination found that the Chief Financial Officer, Tim Howard, failed 

to provide adequate oversight to key control and reporting functions within Fannie 

Mae. Mr. Howard oversees the Controller’s Department, which does not possess the skills 

required to ensure that Fannie Mae has appropriate accounting policies, the resources to 

appropriately implement such policies, nor an effective system of internal controls. In addition, 

the Chief Financial Officer significantly influences the evaluation of the head of the Office of 

Auditing, and makes compensation recommendations for him. This decreases the 

independence and effectiveness of the internal audit function and is inappropriate. 

With respect to key person dependencies, we found that the Chief Financial Officer also serves 

as the Chief Risk Officer of Fannie Mae, and is directly responsible for overseeing the

Enterprise’s Treasury and Portfolio Management functions, in addition to the Controller’s 

Department. The combination of these responsibilities does not provide the 

independence necessary for an effective Chief Risk Officer function. We further found 

that Mr. Howard was instrumental in setting financial targets as Vice Chairman, and had the 

authority to meet these targets as Chief Financial Officer.

Additionally, we found inherent conflicts in the roles assigned to key managers and executives. 

For example, Janet Pennewell, Senior Vice President for Financial Reporting and Planning, has 

the ability to affect the amounts of reported net income in order to achieve results that her 

group forecasted. In the critical area of purchase premium and discount amortization, the 

Special Examination found that one director, Jeff Juliane, has responsibility for modeling, 

reporting, and accounting. 

 

Fannie Mae’s dysfunctional accounting policy development, key person dependencies, and poor 

segregation of duties were major contributors to the accounting failures and the safety and 

soundness problems detailed in this report. 

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ACCOUNTING FOR PURCHASE DISCOUNT AND PREMIUM AND OTHER DEFERRED 

PRICE ADJUSTMENTS UNDER SFAS 91 

OFHEO has concluded that Fannie Mae’s accounting for the amortization of purchase premiums 

and discounts on securities and loans as well as the amortization of other deferred charges was 

not in accordance with Generally Accepted Accounting Principles (“GAAP”). 

Specifically, the Enterprise’s method of recording adjustments for the difference between the 

cumulative life-to-date amortization (which was based upon the previous estimated lives) and 

what that amortization should be (based upon current estimated lives of the underlying 

mortgage assets) does not comply with the requirements of Statement of Financial Accounting 

Standards Number 91, Accounting for Nonrefundable Fees and Costs Associated with 

Originating or Acquiring Loans and Initial Direct Costs of Leases (SFAS 91). The Enterprise’s 

determination of prospective amortization also does not comply with GAAP. 

 

SFAS 91 is highlighted as a critical accounting policy in the Enterprise’s 2003 Form 10K filed 

with the Securities and Exchange Commission. The MD&A section of the Form 10K details 

Fannie Mae’s underlying application of amortization as it relates to SFAS 91, and also explains 

that the accounting estimates associated with amortization of deferred price adjustments are 

“critical accounting estimates.” 

Despite its importance to the Enterprise’s financial statements and despite the requirement to

formulate best estimates in good faith, Fannie Mae intentionally developed accounting policies,

and selected and applied accounting methods, to inappropriately reduce earnings volatility and 

provide management with the flexibility to determine the amount of income and expense 

recognized in any accounting period. In this regard, Fannie Mae developed policies and 

methods to create a “cookie jar” reserve. More specifically, management of the Enterprise: 

• Failed to apply the accounting treatment required by SFAS 91 to REMIC1

 securities held 

in its portfolio until 1998, even though SFAS 91 became effective in 1988. 

• Inappropriately deferred $200 million of estimated expense in 1998, and established and 

executed a plan to record this expense in subsequent fiscal years. Furthermore, the 

deferral of such amount enabled management of the Enterprise to receive 100% of their 

annual bonus compensation. Without such deferral, no bonus would have been paid 

out.

• Undertook a concerted effort to develop and adopt accounting policies that would 

enable the Enterprise to spread income or expense over multiple reporting periods.

• Applied a materiality threshold to estimated income and expense, within which the 

Enterprise could avoid making adjustments that would otherwise be required under 

SFAS 91. 

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1

1

 Real Estate Mortgage Investment Conduit, as defined by Barron’s Dictionary of Finance and Investment 

Terms 2003, is a pass through vehicle created under the Tax Reform Act of 1986 to issue multi-class 

mortgage backed securities. 
• Made discretionary adjustments to the financial statements, for the sole purpose of 

minimizing volatility and achieving desired financial results. 

• Forecasted and managed unrecognized income and expense to measure and maintain a 

“cookie jar” reserve. 

• Recorded reconciliation differences and other errors as ‘phantom assets and liabilities’. 

These phantom assets and liabilities were then amortized in accordance with a 30-year 

conventional mortgage proxy life. 

• Developed estimation methods that were inconsistently applied to retrospective and 

prospective amortization. 

• Applied discretion to the selection of market rate assumptions in order to achieve 

desired accounting results. 

• Developed and effected capabilities to iteratively generate and evaluate estimates under 

varying assumptions, in order to obtain desired outcomes. 

• Incorrectly and inconsistently applied adjustments to the estimate of amortization. 

• Failed to properly investigate an employee’s concerns regarding illogical or anomalous

amortization results, and allegations of an intent to misstate reported income.

• Tolerated significant weaknesses in internal controls that undermined control objectives, 

maintained inadequate segregation of duties, and impeded the review and oversight of 

accounting processes and results. 

Requirements of SFAS 91 

SFAS 912 was issued to establish consistent accounting for nonrefundable fees and costs 

associated with lending activities. The scope of SFAS 91 includes premiums, discounts, and 

other deferred purchase and guarantee fee price adjustments (collectively “deferred price 

adjustments”), and requires that they be recognized as an adjustment to income using the 

effective yield method. This method requires that a company estimate a constant effective 

yield for (e.g., loans and mortgage-backed securities (MBS)) each time a company reports its 

financial results. 

The accounting standard requires that purchases of loans and MBS be recorded at the net 

purchase price, taking into account premiums, discounts and other deferred purchase and 

 

Special Examination of Fannie Mae 

Privileged & Confidential 

Disclosure and/or Duplication Prohibited 

2

2

 Statement of Financial Accounting Standards No. 91 Accounting for Nonrefundable Fees and Costs 

Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases, effective December 

1988. 
guarantee fee price adjustments.

3

 These price adjustments are recognized as an adjustment of

yield over the life of the loan or security. In determining an estimate of the appropriate 

adjustment of yield, a company would need to consider the anticipated rate of prepayment for 

the associated loans and securities to the extent they are subject to prepayment.

4

 

In addition, if a difference arises between the prepayments anticipated and the actual 

prepayments experienced, the effective yield must also reflect the actual payments to date, and

a new estimate of anticipated future payments needs to be made. The difference between the 

revised estimate of amortization and the actual recorded amortization is required to be booked 

as an adjustment to interest income immediately. SFAS 91 also requires disclosure of 

anticipated prepayments and significant assumptions underlying the prepayment estimates. 

The key phrase in the guidance for SFAS 91 is the term “constant effective yield.” This means,

for instance, assuming no changes in the estimated life of an instrument, that the effective yield 

on an investment would be the same for each reporting period in the life of the instrument. The 

guidance on this process is also provided by SFAS 91 as follows: 

Except as stated in the following sentence, the calculation of the constant

effective yield necessary to apply the interest method shall use the payment 

terms required by the loan contract, and prepayments of principal shall not be 

anticipated to shorten the loan term. If the enterprise5

 holds a large number of 

similar loans for which prepayments are probable and the timing and amount of 

prepayments can be reasonably estimated, the enterprise may6

 consider 

estimates of future principal prepayments in the calculation of the constant 

effective yield necessary to apply the interest method. If the enterprise 

anticipates prepayments in applying the interest method7

 and a difference arises 

between the prepayments anticipated and actual prepayments received, the 

enterprise shall recalculate the effective yield to reflect actual payments to date 

and anticipated future payments. The net investment in the loans shall be 

adjusted to the amount that would have existed had the new effective 

yield been applied since the acquisition of the loans. The investment in 

the loans shall be adjusted to the new balance with a corresponding 

charge or credit to interest income. [Emphasis added] Enterprises that 

 3 Guarantee fee price adjustments include “buy-ups” – negotiated up-front cash disbursements from the 

Enterprise to lenders in return for a higher Enterprise guarantee fee, and “buy-downs” – up-front cash 

receipts from lenders in return for a lower Enterprise guarantee fee.

4

 A mortgage is typically subject to prepayment. Most of the loans and securities held by Fannie Mae are 

mortgage related and therefore are subject to prepayment. 

5

 In this context enterprise is used generically and does not refer specifically to Fannie Mae.

6

 Alternatively, if an enterprise chooses not to use estimates of prepayments, the amortization period 

could be the contract period (e.g., loan term). However, if the contract period is used, large spikes in 

amortization could occur if the amortization period is shortened due to prepayment. For instance, if a loan 

prepaid early, all of the unamortized amounts would have to be immediately recognized in the income

statement. 

Because mortgages and mortgage-backed securities generally can be prepaid at any time, using the 

contract period could lead to significant fluctuations in amortization (for instance if rates fall precipitously 

and prepayments speed up due to refinancing) which makes this an unpopular option. 

Special Examination of Fannie Mae 

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Disclosure and/or Duplication Prohibited 

3

7

 “Interest Method” is terminology that also refers to the method for determining a constant effective yield. 
anticipate prepayments shall disclose that policy and the significant assumptions 

underlying the prepayment estimates.8

Thus, as time passes, new estimates of the estimated life of an instrument can be developed,

and the amount of amortization needs to be changed both re rospec ively (that is what is 

meant by the guidance above which states in part, “adjusted to the amount that would

t t

 have 

existed had the new effective yield been applied since the acquisition of the loans”) and 

prospectively (by changing the rate of amortization going forward). 

The accounting guidance on how to estimate prepayments for purposes of calculating interest

amortization is provided in question 52 in the Q&A on SFAS 919

: 

Q--If a lender meets the requirements of paragraph 19 for considering principal 

prepayments in calculating constant effective yield, what factors should be

considered in estimating those principal prepayments? 

A--The lender should consider historical prepayment data in making its estimate

of future prepayments. Also, the lender should consider external information,

including existing and forecasted interest rates and economic conditions and 

published mortality and prepayment tables for similar loans. If periodic changes 

in estimates occur or actual prepayments are different from estimated

prepayments, an adjustment will be necessary. 

In a large mortgage portfolio, the accounting for amortization could lead to significant volatility 

for two reasons: 

• SFAS 91 requires that adjustments should be recorded into income when the estimated 

amortization period changes. This is significant because the amount of such adjustment 

is a cumulative life-to-date amount. 

• The estimated life of a mortgage loan or mortgage-backed security fluctuates constantly 

due to changes in interest rates, changes in forecasts of prepayments and other factors. 

In subsequent sections of this report we will demonstrate how Fannie Mae 

established an amortization policy that would allow the Enterprise to avoid current 

period volatility, and would further provide management with the latitude to shift 

income and minimize the potential for prospective volatility. 

A hypothetical example of the application of SFAS 91 was provided to the Audit Committee of 

the Board of Fannie Mae on November 17, 2003 by Ms. Leanne Spencer, SVP Controller.10 The 

 8

 SFAS 91, Application of the Interest Method and Other Amortization Matters, paragraph 19. 

9

 “A Guide to Implementation of Statement 91 on Accounting for Nonrefundable Fees and Costs 

Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases: Questions and 

Answers”, published by the FASB 10 Fannie Mae Audit Committee Update, Critical Accounting Policy, Deferred Price Adjustments, by 

Leanne Spencer, November 17, 2003, FMSE 015610-015623 

Special Examination of Fannie Mae 

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4

It should be noted that, pursuant to SFAS 91, prepayment can only be forecasted for a pool of loans. A 

single security has been used for this illustration as an example only. 
example is based upon a $100,000 loan that is purchased at a 2% discount. The discount of 

$2,000 would be recorded as additional interest income over the estimated life of the loan with

an offsetting increase to the recorded amount of the loan. 

Table 1 of the example below shows how the constant effective yield method of amortization

would translate into amortization of the discount over the originally estimated life of the loan. 

Table 2 of the example is based on an assumption that at the end of the fifth year the 

estimated life of the instrument is shortened from 10 years to 7 years. This table shows what 

the amortization would have been if the estimated life of the instrument had originally been 

estimated to be 7 years. The difference between the two “Inception to-date” amounts of 

amortization at the end of the fifth year is the amount of income to be recognized ($1,587-

$1,400 = $187). In addition, the future amortization periods in table 2 show that there are only 

two more years of amortization to be recorded, and that the amounts to be recorded (in years 6 

and 7) have been adjusted accordingly. 

Table 1 Table 2

Original

Est. Life

Discount

Amortizati

on

Effective

Yield

Adjusted

Est. Life

Adjusted

Discount

Effective

Yield

1 $333 6.4618% 1 $373 6.5030%

2 $308 6.4618% 2 $347 6.5030%

3 $282 6.4618% 3 $319 6.5030%

4 $254 6.4618% 4 $290 6.5030%

5 $224 $ 1,400 6.4618% 5 $258 $1,587 6.5030% $187

6 $192 6.4618% 6 $225 6.5030%

7 $158 6.4618% 7 $189 6.5030%

8 $122 6.4618%

9 $84 6.4618%

10 $43 6.4618%

Inception

to-date

Inception

to-date

Inception todate

adjustment

Presentation to Fannie Mae Audit Committee: Critical Accounting Policy, Deferred Price Adjustments, by Leanne Spencer dated November 17, 2003, 

FMSE 015610-015623 

The $187 in this example is calculated as the difference between the cumulative life-to-date 

amount of interest amortization of $1,400 (what was already recorded based upon a previous 

estimated life of 10 years) and what the amortization should be: $1,587 (based upon the new 

estimated life of 7 years). 

As mentioned previously, SFAS 91 requires that the amount of amortization income or expense 

for prior periods caused by a change in the set of assumptions be recorded into income 

immediately (in this example $187 needs to be recorded at the end of year 5). 

We have used the information in the tables above to chart the effect that this would have on 

the discount amortization: 

Special Examination of Fannie Mae 

Privileged & Confidential 

Disclosure and/or Duplication Prohibited 

5
Accounting Example - Level Yield with Catch-Up

$0

$50

$100

$150

$200

$250

$300

$350

$400

$450

1 2 3 4 5 6 7 8 9 10

Years

Discount Amortization

Original Estimated Life Adjusted Estimated Life

As the graph above shows, the recording of the $187 of retrospective amortization in the year 

that the estimated life is shortened from 10 years to 7 (in this case year 5) significantly 

increases the volatility of the amount of amortization. OFHEO has concluded that this is exactly 

the type of volatility that Fannie Mae was trying to avoid in designing their amortization policy.11 

 11 OFHEO Interview, Ms. Janet Pennewell, VP Financial Reporting & Planning, June 15, 2004, pp. 16-18 

Q: What is arbitrary volatility in earnings? 

A: Arbitrary volatility, in our view, was introduced when--I can give you an example of what would cause, 

in our view, arbitrary volatility. If your constant effective yield was dramatically different between one 

quarter and the next quarter because of an arbitrary decision you had or view--changing your view of 

long-term interest rates that caused a dramatic change in the constant effective yield that you were 

reporting, you could therefore be in a position where you might be booking 300 million of income in one 

quarter and 200 million of expense in the next quarter, introduced merely by what your assumption about 

future interest rates was. And to us that was arbitrary volatility because it really just literally because of 

your view, your expectation of interest rates and the way that you were modeling your premium and 

discount constant effective yield, you would introduce something into your financial statements that, 

again, wasn't very reflective of how you really expect that mortgage to perform over its entire expected 

life, and was not very representative of the fundamental financial performance of the company. 

OFHEO Interview, Mr. Tim Howard, EVP Chief Financial Officer, August 5, 2004, pp. 120-121 

Q: Do you have a specific understanding of the individual that approved this policy for the company? 

A: Well, again, it would have been Jonathan Boyles who would have been our subject matter expert. 

Leanne technically approved it as the Controller, and I concurred. KPMG also reviewed this and opined 

that it was GAAP. 

Q: So, specifically, this policy was recommended by Jonathan Boyles? 

Special Examination of Fannie Mae 

Privileged & Confidential 

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6

A: I’m not sure who recommended it. I was involved in the development of the policy. There was a lengthy

process where we looked at many different ways to deal with the fact that estimating the life of a 
Policy and Infrastructure Development 

Events of 1998 and 1999 

Fourth Quarter of 1998

The genesis for many of Fannie Mae’s philosophies, policies and methods began at a time of 

financial stress for the American economy. In the third quarter of 1998, the Russian Financial 

Crisis (among other things) caused dramatically lower interest rates. The resulting interest rate 

environment increased the propensity of consumers to prepay their existing home mortgages 

and refinance them at more favorable rates. 

The following chart illustrates the dramatic shift in rates during 1998: 

Yield on 10-Year Treasury Note - 1998

4.0

4.5

5.0

5.5

6.0

Dec-97

Jan-98

Feb-98Mar-98

Apr-98

May-98

Jun-98

Jul-98

Aug-98Sep-98

Oct-98

N

ov-98

Dec-98

Yield (%)

Federal Reserve US H15 T Note Treasury Constant Maturity 10 Year Source: Bloomberg

The manifestation of faster prepayments adversely impacted the Enterprise. The impact of

changing rates of prepayments on deferred price adjustments is a function of cumulative life to

date amortization itself, and whether prepayment rates are increasing or decreasing, and 

whether aggregate premiums are greater or lesser than aggregate discounts with respect to the

associated loans and securities.

12 Since prepayments were increasings, Fannie Mae’s 

amortization models showed that an estimated expense of approximately $400 million had been 

incurred. This estimated expense was the adjustment necessary to recognize the impact of

 

mortgage has inherent uncertainties, and we wanted to come up with a policy that was consistent with 

GAAP, that minimized the potential for introducing unnecessary volatility based on what, to me, would 

have been arbitrary assumptions that would change substantially over time and therefore not be reflective 

of the economic substance of the transactions being accounted for. 

Special Examination of Fannie Mae 

Privileged & Confidential 

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7

12 Faster prepayments generally result in losses for a portfolio where aggregate premiums exceed 

aggregate discounts, and gains where aggregate discounts exceed aggregate premiums. Slower 

prepayments have the opposite affect. 
changing prepayments on deferred price adjustments, consistent with the constant effective 

yield calculation required under GAAP. Rather than recognizing the full amount of this 

estimated adjustment to income, Enterprise management decided to defer 

recognizing approximately one half (or $200 million) of the estimated expense.13

The $200 million was known within the Enterprise as the “catch-up”. In both previous and 

subsequent reporting periods, differences between amounts estimated versus the amount 

previously recorded, were consistently referred to within the Enterprise as the catch-up. OFHEO 

has further concluded that Fannie Mae’s methods for determining the catch-up were also 

inconsistent with the requirements of SFAS 91.

As described throughout this report, OFHEO has concluded that there a variety of reasons why 

the “catch-up” calculation would not produce results similar to those required by the 

retrospective adjustment required by SFAS 91. However, the term “catch-up” is used 

throughout this report in order to provided context and factual information related to the 

preliminary results of our examination. 

In their testimony, management explained that the deferral of this expense was necessitated by

limitations in models and insufficient infrastructure that caused the estimate of expense to be

overstated. However, the Enterprise has not provided OFHEO with any credible analysis14

which supports the recording of only half of the calculated catch-up amount. In fact, 

information received during the examination directly contradicts the explanations which

management provided. Both Ms. Leanne Spencer, Controller, and Mr. Tim Howard, Chief 

Financial Officer indicated that one of the reasons for not recording the additional $200 million 

of amortization expense related to the fact that not all REMIC securities could be modeled

individually.

15 In contrast, records provided to OFHEO indicate that, upon increasing the 

 13 OFHEO Interview, Ms. Leanne Spencer, June 22, 2004, pp. 34-36 

Q: What was the potential impact of the 200 million difference on earnings? 

A: I would like to give you some background on 1998 – 

Q: Sure. 

A: [...] By the end of the year--by the end of the year, as we moved to the end of the year, we took an

adjustment of over $200 million into our financial--into our financial statements. We had a remaining 

balance of approximately 200 million which our auditors were very comfortable with. We were very 

comfortable with. [...] 14 Memorandum from Mr. Jeff Juliane to Ms. Leanne Spencer, Subject: Income Risks from Amortization 

Issues, dated July 14, 1999, FMSE-SP 003103. 

15 OFHEO Interview, Mr. Tim Howard, August 5, 2004, pp. 211-212 

Q: You mentioned the inadequacy in the system or your ability to deal with the REMIC at the time. What’s

the relevance of that to the determination of the catch-up adjustment in ’98? 

A: We believed that the REMIC book – that the expense that needed to be booked to reflect expected 

amortization in the REMIC book was overstated based on the inadequacies of the system. We were in 

the process of undertaking a project to do loan level detail, or at least security class level detail of the 

REMIC book. And as we completed that, our basic instinct on the nature of that book turned out to be 

correct. And once we reflected that in actuals later on – don’t know if it was ’99; I think it was – that also 

proved out to be true. So that part was factually verified. The rest was situational.

OFHEO Interview, Ms. Leanne Spencer, June 22, 2004, pp. 34-37 

Q: What was the potential impact of the 200 million difference on earnings? 

A: I would like to give you some background on 1998 – 

Q: Sure. 

Special Examination of Fannie Mae 

Privileged & Confidential 

Disclosure and/or Duplication Prohibited 

8

A: In 1998, particularly as relates to the second half of the year, interest rates were extremely volatile. 

You had global economic meltdown occurring, Russian financial crisis, so you had a very precipitous drop 
percentage of REMIC securities which could be modeled, the amount of the catch-up expense 

amount actually increased.

16

Lastly, in performing their audit of the Enterprise’s 1998 financial statements, Fannie Mae’s 

independent auditor, KPMG, identified the $200 million deferred expense (the unrecorded 

amount) as an audit difference.17 

Despite their insistence that the estimate of loss was overstated, Fannie Mae 

management nevertheless developed a strategy to record planned monthly on-top 

adjustments18 to the financial statements to recognize the estimated $200 million 

deferred expense in the subsequent fiscal years 1999 and 2000.19

 

in interest rates that occurred with a significant – significant effect on business was that you had a 

significant amount of prepayment occurring. So, this is what you had going on in the world. We found 

ourselves in a company at that point in time where our balances on our balance sheet as it relates to the 

portfolio, rates have been fairly stable. You moved into a big period of rate move, and we had a model at 

that point in time that had been developed, predated my involvement in the Controller’s Department, but it 

was an early generation model that had been built to implement FAS 91, and it had limitations now for 

this period of time in terms of how the business had grown, how – how the business had grown, volatility 

in rates, the limitations that would even allow you to put good robust assumptions into it. So, it’s the kind

of second piece that we were dealing. And then there is a third piece relevant to this that we were dealing 

with as a company, in that we had some asset classes that had been had been allowed to be purchased 

for the portfolio, gone through all the pertinent reviews in terms of allowing the portfolio to begin to 

purchase REMIC to hold as an investment – as an investment class. We had good controls on the front 

end in terms of who could evaluate them and price them appropriately. We didn’t have sufficient – we 

didn’t have a sufficient infrastructure on the back end and in the model to be able to do a pristine FAS 91-

type level yield calculation on this asset class, although it was something that we were working toward. 

So, there was a set of factors that were occurring in 1998. [...] 16 Fannie Mae PDA Catch-Up, FMSE-SP 000471. Note 2 to the analysis indicates that the amount of the 

catch-up expense on REMICS increased in June of 1999 by approximately $60 million from the prior 

month. Note 2 reads “Increased percent of REMIC book modeled.” Such increase in the percent of the 

REMIC book modeled was corroborated by the testimony of Jeff Juliane on August, 31, 2004. 

OFHEO Interview, Mr. Jeff Juliane, August 31, 2004, pp. 245-246 

Q: Now there’s a Footnote 2 that relates to June of 1999 for the REMIC portfolio that indicates increased 

percent of REMIC book modeled. What does that refer to? 

A: With [sic. What] that means is that prior to that, there were issues with getting cash flows passed back 

from Intex to the model, so that we were only modeling about 74 percent of all REMIC securities. And 

then when we – I think we increased it to approximately 90 percent at that point in time. 

Q: And this increased the amount of negative catch-up? 

A: Correct. 

17 OFHEO Interview, Ms. Leanne Spencer, SVP Controller, June 22, 2004, pp. 33-34 

Q: Do you recall the nature of the premium discount amortization audit difference identified by KPMG? 

A: Yes. 

Q: Do you recall the amount? 

A: Yes. 

Q: And what was the amount? 

A: Approximately 200 million. 18 “On-top adjustments” represent adjustments made directly to the general ledger during the financial 

statements close process.

Special Examination of Fannie Mae 

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9

19 OFHEO Interview, Ms. Janet Pennewell, VP Financial Reporting & Planning, June 15, 2004, pp 149-

150 
Beyond the $200 million deferred estimated expense itself, the explanations provided by 

management, as well as documents provided to OFHEO, raise other issues. First, if one 

accepted the Enterprise’s rationale of estimation inaccuracy that existed at the end of the fourth

quarter of 1998, then what about previous quarters? Information obtained by OFHEO shows 

that catch-up amounts were calculated as far back as 1995.

20 Furthermore, the catch-up 

exceeded $100 million as early as December 1996, and further exceeded $150 million for each 

of the three quarters prior to the fourth quarter in 1998.21 Consistent with managements 

explanation, the incremental effect to the catch-up does indeed appear to arise in the fourth

quarter 1998; however, it seems to arise because that time period is the first time period in 

which any calculation of catch-up for REMIC’s was performed.22 This information as well as 

other documentation23 seems to indicate that the calculation of constant effective 

yield for REMIC securities had not previously been performed at all, even though 

SFAS 91 became effective in 1988.

The second issue raised is one concerning the nature of the catch-up itself. This issue will be 

further examined in subsequent sections of this report. 

Bonuses Awarded in 1998

 

Fannie Mae compensation for executive officers involves several key components: 1) basic 

compensation, which includes base salary and other annual compensation; 2) Annual Incentive 

Plan (AIP) awards (“bonuses”), which link the size of the bonus pool to meeting annual

earnings per share (EPS) goals; and 3) long-term incentive awards, which typically award 

substantial amounts of “performance shares” to executives if EPS and certain non-financial 

goals are met over a three-year period. 

The Fannie Mae proxy statement for 1998 disclosed salary and annual bonuses to certain senior 

executives as follows: 

Q: [...] you had testified that in December of 1998 that you had experienced losses due to the changes in 

the interest amortization, but at that point there was an approximately 200 million catch-up that was a 

negative catch-up, correct? 

A: That's my recollection, yes. 

Q: A negative catch-up would be a deferred expense, correct? 

A: Correct. 

Q: Now, you indicated that there had been discussions with KPMG and there was an objective to try to 

cut that in half. And was the objective to try to cut that in half in one year or over a two-year horizon, or do 

you recall any time— 

A: My recollection is over one year. 

Q: Okay. Now, was that achieved through systematic, planned on-tops, or was it offset against other 

changes in the catch-up? 

A: It was primarily--it was primarily achieved through a systematic, planned on-tops, but then in addition to

those planned on-tops, we re-evaluated our catch-up position each quarter to see if either the 

composition of the book premium discount or changes in interest rates would have altered our position. 

20 Analysis document titled “Fannie Mae PDA Catch-up”, dated October 6, 2000, FMSE-SP 002434. 

21 Id. 22 Id. 

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23 Memorandum from Mr. Jeff Juliane to Ms. Leanne Spencer, Subject: Income Risks from Amortization 

Issues, dated July 14, 1999, FMSE-SP 003103. 
1998 Salary and Bonus of Senior Fannie Mae Executives 

Officer Title Salary AIP Award/Bonus 

James A. Johnson Chairman and CEO $966,000 $1,932,000 

Franklin D. Raines Chairman and CEO 

Designate 

$526,154 $1,109,589

Lawrence M. Small President and COO $783,839 $1,108,259 

Jamie Gorelick Vice-Chairman $567,000 $779,625

J. Timothy Howard EVP and CFO $395,000 $493,750 

Robert J. Levin EVP, Housing and 

Comm. Develop. 

$395,000 $493,750

Source: Fannie Mae Notice of Annual Meeting of Stockholders, May 20, 1999 

1998 Earnings Per Share Targets 

Fannie Mae adopted EPS thresholds for annual bonuses in 1995 partly to bring that short-term, 

performance-based compensation measure into conformity with their long-term compensation 

plan, which was already EPS-based.24

For the year-ended 1998, the size of the annual bonus payout pool was linked to specific EPS 

targets, as follows: 25

Earnings Per Share (EPS) Range for 1998 AIP Corporate Goals 

$3.13 Minimum Payout 

$3.18 Target Payout 

$3.23 Maximum Payout 

For Fannie Mae to pay out the maximum amount in AIP awards in 1998 (approximately $27.1 

million), the Earnings Per Share would have to be $3.23. If EPS was below the $3.13 minimum 

payout threshold, no AIP payout would occur. Remarkably, the 1998 EPS number turned out to 

be $3.2309, a result that meant that Fannie Mae met the EPS maximum payout goal right down 

to the penny. 

Impact of 1998 Catch-up on Compensation

 

The annual EPS number is determined by dividing the net annual earnings by the average 

number of shares of common stock outstanding for the year. Accordingly, the 1998 $3.23 EPS 

was derived by dividing the net income available to common shareholders ($3.352 billion) by

the weighted average number of common shares outstanding (1,037 million).26 

Notably, had net income available to common shareholders been reduced by $125 million, the 

EPS for 1998 would have fallen to $3.1127--below the minimum payout threshold. As a result, 

24 FMSE 017772. 

25 Id.

26 These figures include dilutive potential common shares. Fannie Mae 1998 Annual Report, Financial 

and Statistical Summary, p. 51. 

Special Examination of Fannie Mae 

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11

27 $3.227 billion of earnings ÷ 1,037 million shares 
no bonuses would have been awarded. Alternatively, had net income been reduced even a 

relatively modest $50 million, the EPS would have been approximately $3.18.28 In that instance, 

the overall bonus pool would have been reduced by approximately $9 million to $18 million. 

This would have resulted in a corresponding reduction in bonuses awarded to individual 

executive officers. 

As it turns out, the unrecognized estimated $200 million negative catch-up was a pre-tax effect 

on net income. Adjusted for taxes at the 35% statutory federal corporate income tax rate,29

the after tax impact on net income – upon which calculations of EPS are made - was

approximately $130 million. The tax affected amount of deferred expense therefore, 

only slightly exceeded the $125 million difference between no bonus being awarded 

and the maximum amount being awarded. 

Recognition of 1998 “Catch-up” in 1999

In 1999, the Enterprise began to record the scheduled on-top adjustments to recognize the 

$200 million negative catch-up.30 The objective of the plan was to recognize amounts sufficient 

to ensure that the catch-up did not exceed negative $100 million at the end of fiscal year 

1999.31 Accordingly, the Enterprise determined to record monthly on-top adjustments to 

recognize estimated losses of $5 million and $2.9 million to Net Interest Income (“NII”) and 

deferred price adjustments (in internal documents Fannie Mae refers to these adjustments 

collectively as “GFee”, and this report adopts that convention) respectively.32 In addition to 

these planned on-tops however, the Enterprise also decided, during the course of the year, to

write-off an additional $95 million “against NII as a reserve against future interest rate 

changes.”

33 This additional $95 million write-off was also scheduled monthly, such that the 

planned aggregate monthly adjustment to NII and GFee ultimately grew to $16.5 million.34

Such amounts are described in a July 1999 analysis. The analysis shows the actual adjustments 

recorded to amortization as of June 1999 and the amount of forecasted adjustments through 

the remainder of the year. The analysis clearly shows that the Enterprise had developed a plan 

to systematically record the $16.5 million of adjustments per month. It should be noted that 

$16.5 million per month for twelve months totals to planned adjustments of $198 million. This 

amount of planned adjustments is almost identical to the amount of catch-up not recorded as of 

the end of 1998. 

 28 $3.302 billion of earnings ÷ 1,037 million shares 

29 Fannie Mae 1998 Annual Report, pp. 50-51, Notes to the Financial Statements, Note 6: Income Taxes. 

Further pursuant to this footnote, Fannie Mae is exempt from state and local income taxes. 

30 OFHEO Interview, Ms. Leanne Spencer, SVP Controller, June 22, 2004, pp. 55-56 

Q: Now, in 1999, did you make scheduled adjustments as a result of the 200 million that was determined 

at the end of 1998? 

A: Yes. 31 Fannie Mae Controller, Leanne Spencer, acknowledged the reason for this objective. OFHEO 

Interview, Ms. Leanne Spencer, June 22, 2004, p. 56. 

Q: Now, it is our understanding that, in fact, KPMG was desirous of reducing that 200 million to a hundred 

million at least by the end of ’99; is that consistent with your recollection? 

A: It’s consistent with my recollection.

32 Monthly Summary of Amortization Adjustments, July 14, 1999, FMSE-SP 003102 

33 Id.

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34 Id.
In addition, in the notes to the aforementioned analysis, the following explanation is provided 

for the planned on-tops:

Note- Per plan, a write-off of $95 million was to be taken to reduce our catchup 

[sic] in a systematic approach of $5 million a month for NII and $2.9 million a 

month for Gfee. Subsequent to plan, an additional $95 million was to be writtenoff [sic] against NII as a reserve against future interest rate changes.35

As the note above shows, not only was the $200 million amount of catch-up that was deferred 

being recorded into the income statement in a systematic manner, but a portion of it was 

specifically referred to as a “reserve against future interest rate changes.” This note is the 

earliest indication that the Enterprise specifically intended to manage the catch-up position as a 

buffer to sudden changes in interest rates and the resultant volatility of amortization amounts. 

The lesson the Enterprise learned in 1998 was clear: avoid having to record large 

amounts of unexpected catch-up expenses by actively managing the process of 

calculating amortization. 

But subsequent increases in interest rates overtook Fannie Mae’s plans. At the same time that

the Enterprise was recording the monthly on-top adjustments, a rise in interest rates was 

having a favorable economic impact on Fannie Mae’s catch-up position. OFHEO was not able to 

determine the exact amount of planned NII and GFee on-top adjustments that were actually 

recorded during the year 1999.36 However, through the combination of on-top adjustments 

that were recorded and the changing economic environment, the amount of unrecognized

catch-up had actually become a positive (deferred credit) amount of $84 million37 by the end of

1999. 

Formulation and Adoption of Accounting Policy

Formulation of Accounting Policy 

 

During 1999 Fannie Mae management also began a prolonged and concerted effort to

formulate a policy to manage the amortization of deferred price adjustments. Many of the 

policies considered, as well as those subsequently adopted, were inconsistent with 

GAAP, and were designed to provide earnings flexibility and minimize earnings

volatility. 

35 Id.

36 An analysis of the catch-up position prepared by the Enterprise would seem to indicate that the amount 

of recorded adjustments was $158.0 million ($136.3 million through on-top adjustments, and $21.7 million 

applied as amortization factor change adjustments). Fannie Mae PDA Catch-up, April 10, 2000, FMSESP 000505. 

37 OFHEO Interview, Ms. Leanne Spencer, SVP Controller, June 22, 2004, p. 53 

Q: And then you indicated at the end of 1999 they identified another audit difference that I believe was 

really the reversal of the $200 million effect, or was it something different? 

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A: No, I would describe that as different. I will kind of go back to time doesn't stand still, and as you do 

365 or how many business days you have during your start, you're starting with a balance, you're rolling 

forward, rates are changing, prepayments are changing, new business coming on--is coming on in a 

different mix. So, there is a variety of factors that affects your recalibration and your reestimation process. 

But by the end of the year, it was $84 million positive. 
The effort was directed and overseen by Chief Financial Officer Mr. Tim Howard. Policy analysis 

was performed for the most part by personnel within the controllers group, including active 

involvement by the Controller, Ms. Leanne Spencer. Mr. Tom Lawler, Senior Vice President 

Portfolio Management,38 was also part of the policy analysis team. Beginning in the first quarter 

of 1999 and continuing throughout 2000 numerous memoranda regarding SFAS 91 policy 

recommendations were developed. Many of these memoranda expressed – as an objective of 

policy formulation - the need to minimize the volatility of reported earnings. Certain of these 

memoranda acknowledged the flexibility provided by the policies and methods proposed.39

The specific recommended policy provisions within these memoranda varied as to 

their precise nature, and the empirical thresholds that would be applied. However, 

certain themes were consistently reflected within them, including policy 

recommendations that permitted the Enterprise: 

a. to not recognize estimated income or expense up to certain thresholds, 

and 

b. to defer the recognition of income or expense that exceeded 

recommended thresholds over a several year planning horizon 

Such accounting methods are neither supported by SFAS 91 nor Generally Accepted

Accounting Principles more broadly. However, provisions of this nature were 

ultimately adopted as policy by the Enterprise in December of 2000.40 

One memorandum, dated September 23, 1999, proposed that estimated income be treated 

differently than estimated expense. 41 In the case of estimated income, no adjustment to 

 38 Mr. Tom Lawler was Senior Vice President of Portfolio Management at the time the policy analysis 

team was functioning. In 2002, Mr. Tom Lawler was designated Senior Vice President of Corporate 

Financial Strategy. OFHEO Interview Mr. Tom Lawler, June 24, 2004, pp. 7-9. 39 Memorandum from Ms. Janet Pennewell, Vice President Financial Reporting, and Mr. Jeff Juliane, to 

Mr. Tim Howard, December 16, 1999, Subject: Catch-up Policy. FMSE 217559 -217561. 

One of several reasons provided for recommending a method of modeling the catch-up reads: “3) Due to 

system enhancements and increased analytics, we will be better positioned to forecast future catch-up

behavior. This should provide the flexibility to adhere to a much more stringent standard while minimizing 

material catch-up swings recently experienced. This policy acknowledges such changes and additionally 

maintains a cushion for income statement flexibility.” 

Attachment to email from Mr. Tim Howard, CFO, to Ms. Janet Pennewell, SVP Financial Reporting and 

Planning, November 25, 2000, Subject; Amortization. Pennewell 08182004 

A paragraph describing the proposed amortization strategy reads: “Today’s configuration would give us a 

fair amount of leeway under the policy I envision. We start out under our plus or minus $75 million range, 

so technically we wouldn’t have to do anything for at least the first year. However, if we wanted to ‘get a 

leg up’ on getting under the $75 million threshold three years out we could certainly justify getting started 

today. Our policy would allow us to do $40 or $50 million this year-or even more. (I wouldn’t recommend

it, but we would have the flexibility to do so).” 

40 Purchase Premium and Discount Amortization Policy, December 2000, FMSE 074523-074524

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41 Memorandum from Ms. Janet Pennewell, VP Financial Reporting & Planning, to Mr. Tim Howard, CFO, 

September 23, 1999, Subject: Policy on Purchase Premium/Discount Management, FMSE-SP 000106-

000107. 
income would be taken if current interest rates were more than one standard deviation above 

the 5 year historical average. Other memoranda dated May 4, 200042 and May 8, 200043

proposed that adjustments be determined by comparing the estimated catch-up to the 

calculated annual on-top adjustment. Both memoranda recommended that the estimate of

quarterly catch-up be given different treatment depending on whether the calculated estimate

was positive or negative.44 There is also no basis in SFAS 91, or in any promulgated accounting 

standard, that would support any of these accounting treatments recommended by

management. 

Policy Adopted to Recognize Expense or Income Over Multiple Reporting Periods

 

The first memorandum45 that proposed a recommended accounting policy on the catch-up 

position was dated March 2, 1999, and was from the Controller to the Chief Financial Officer. 

This memorandum recommended that adjustments only be required in the current year, if the

catch-up position exceeded +/-3.5% of projected annual revenue. Otherwise, management 

would implement a plan to bring the balance down to 2% of annual revenue by the end of the 

following year. Coincidentally, this threshold approximated the $200 million amount of 

estimated expense not recognized just two months prior.

46 The previously referred to 

memorandum47, dated September 23, 1999, alternatively recommended applying a similar $200 

million threshold, but characterized it instead as 1% of three year cumulative revenue.48

42 Memorandum from Mr. Jeff Juliane, Director Financial Accounting, to Distribution, May 4, 2000, 

Subject: Amortization/Catch-up Management Process, FMSE 217540. 

43 Draft Memorandum from Mr. Jeff Juliane to Distribution, May 8, 2000, Subject: Amortization/Catch-up 

Management Process, FMSE 217527. This draft memorandum was subsequently distributed as an 

attachment to a memorandum dated September 15, 2000 from Ms. Janet Pennewell to Mr. Tim Howard, 

Subject: Amortization Policy. In this distribution, the label “Draft” had been removed from the

memorandum. 

44 Memorandum from Mr. Jeff Juliane to Distribution, May 4, 2000, Subject: Amortization/Catch-up 

Management Process, FMSE 217540-217544, states that “In any interim year, if the mean catch-up is 

less than the calculated annual on-top, the amount of on-top applied in that year will equal the mean 

catch-up. If the mean catch-up is the opposite sign as compared to the calculated on-top, no adjustment 

will be made. 

Draft Memorandum from Mr. Jeff Juliane to Distribution, May 8, 2000 (with a handwritten note saying 

“draft for meeting with Tim on May”), FMSE 217527-217528, describes under “Catch-up Recognition” how 

the Enterprise plans to reach their “targeted catch-up”: “A. If the spot estimate exceeded 2.5% of pre-tax 

income, we would accelerate the on-tops to ensure that we were less than the 2.5% target within 1 year. 

B. If the spot estimate exceeded 5% of pre-tax income, an immediate on-top adjustment would be taken 

to bring us within the 5% limit. C. If the spot estimate for any interim year is less than the calculated 

annual on-top, the amount of on-top applied in that year will equal the spot estimate. D. If the spot 

estimate is the opposite sign as compared to the calculated on-top, no adjustment will be made.” OFHEO 

received this document in a final version labeled FMSE-SP 000019-000020. 

45 Memorandum from Ms. Leanne Spencer and Ms. Janet Pennewell to Mr. Tim Howard, Subject: Policy 

on Purchase Premium/Discount Management, March 2, 1999, FMSE-SP 000110-000111. 

46 Id., The actual recommendation stated; “If the Catch-up exceeds 3.5% of projected annual revenue 

(currently about $200 million) we will take a write-off during the current calendar year to bring it below that 

level, and will implement a plan to bring the balance down to 2% of projected revenue by the end of the 

following year.” 

47 Memorandum from Ms. Janet Pennewell to Mr. Tim Howard, September 23, 1999, Subject: Policy on 

Purchase Premium/Discount Management, FMSE-SP 000106-000109 

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48 Id.
Subsequent memoranda proposed even higher thresholds before an immediate adjustment to 

earnings would be required. The previously referred to memoranda49 dated May 4, 2000, May 

8, 2000, and September 15, 2000, recommended that immediate adjustments not be required 

until 5% of annual pre-tax income had been exceeded. 5% of annual pre-tax income was, at 

the time, approximately $300 million. This is an extremely large threshold considering that 

during the three years for which OFHEO has data, the quarterly combined deferred price 

amortization never exceeded $142 million (FMSE 184911, 184994, 185079, 184923, 185006, 

and 185092).

50 

Furthermore, in theory, if such a 5% threshold had been applied, quarterly changes in catch-up

of up to $600 million income statement impact (+/- $300 million) could go unrecorded in any 

given quarter. This too is also extremely large considering that the quarterly change in 

purchased premium/discount and guarantee fee amortization reported by the Enterprise in its 

financial statements never exceeded $135.8 million51 and $127.4 million52 respectively, in any of 

the quarterly periods for which OFHEO has such information.53

The subsequent memorandum that sought to recommend these higher thresholds also 

recommended that adjustments be made over a one year horizon of time to reduce the catchup to below a +/- 2.5% (approximately +/- $150 million) threshold. 

Ultimately, in December 2000, the Enterprise established a policy54 that had two provisions 

addressing the recognition of larger variances in catch-up over multiple reporting periods. 

These provisions are: 

 49 Memorandum from Mr. Jeff Juliane to Distribution, May 4, 2000, Subject: Amortization/Catch-up 

Management Process, FMSE 217540, and Draft Memorandum from Mr. Jeff Juliane to Distribution, May 

8, 2000, Subject: Amortization/Catch-up Management Process, FMSE 217527. This draft memorandum 

was subsequently distributed as an attachment to a memorandum dated September 15, 2000 from Ms. 

Janet Pennewell to Mr. Tim Howard, Subject: Amortization Policy. In this distribution the label “Draft” had 

been removed from the memorandum. 

50 Memoranda recommending accounting policy for deferred price amortization in 1999 and 2000 did not 

distinguish between purchased premium and discount amortization (which is recorded as a component of 

Net interest income) and guarantee fee amortization (which is recorded separately in the income 

statement as Guarantee fees). Various Fannie Mae analyses prepared in conjunction with these 

memoranda, as well as early policy drafts (FMSE 217499), indicate that these combined amortization 

amounts would be applied when measuring against the applicable recommended threshold. The policy 

subsequently adopted in December 2000 (FMSE 074523) also specified that these components would be 

combined. However, the policy also stated “Since the components of the total catch-up position are 

related to two different income statement line items, net interest income and Gfee, it is important to look 

at each component separately to determine whether an audit difference has occurred. For the quarterly 

periods for which OFHEO has the relevant information (Q1 2001 through Q1 2004), the highest separate 

amounts of quarterly purchased premium/discount amortization and guarantee fee amortization were 

approximately $(151) million (FMSE 186045,186115, and 186186) and $244 million (FMSE 186053, 

186123, and 186195) respectively. 

51 Change from Q4 2002 (FMSE 184911, 184994, and 185079) to Q1 2003 (FMSE 185164, 185244, and 

185319). 

52 Change from Q4 2003 (FMSE 185835, 185907, and 185980) to Q1 2004 (FMSE 186053, 186123, and 

186195). 

53 Q1 2001 through Q1 2004

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54 Purchase Premium and Discount Amortization Policy, December, 2000, FMSE 074523 
i. If our catch-up moves beyond one, but within two percent of combined portfolio 

net interest and guarantee fee income, we will book monthly “on-top” 

adjustments that bring us back to within the plus or minus one percent range 

within our three year planning period.55

ii. Should our catch-up ever exceed two percent of the combined portfolio and 

interest guarantee fee income, however, we will bring it back to within the one 

to two percent range within a six month period. After that time, we will continue 

our monthly “on-tops” to return the catch-up to the plus or minus one year 

range within the three year horizon.56

That policy adopted in December 2000, remains the Enterprise’s official policy today. In his 

testimony, Mr. Jonathan Boyles, Senior Vice President Financial Standards, acknowledged that 

these provisions were not consistent with GAAP.

57 Even though the estimated $200 million 

expense in 1998 was deferred and recognized in subsequent periods, Mr. Boyles and other

senior officers explained that neither of the above two provisions were ever used since this 

policy was adopted in December 2000. However, it should be noted that the accounting 

treatment of the estimated $200 million expense in 1998 is similar (if not identical) to the same

policies which Mr. Boyles stated would not be in accordance with GAAP. 

 

Information gathered thus far in this Special Examination has not identified any instances since 

December 2000 where either of these two provisions had been used. However, we have

identified other practices employed by the Enterprise whereby adjustments that should have

been recognized immediately, were instead deferred and recognized over multiple reporting 

periods. [See section Capitalization of Amortization of Reconciliation Differences for a discussion 

of the Enterprise’s treatment of “realignment” differences.]

Policy to Defer Income and Expense Up To Certain Thresholds

Management’s drive to formulate policy in 1999 and 2000 was fueled by management’s surprise 

at the magnitude of the $400 million estimated expense at the end of 1998, by a determination 

to avoid audit differences,58 and by the insistence of KPMG59 that a policy be developed. In 

 55 Id.

56 Id.

57 OFHEO Interview, Mr. Jonathan Boyles, August 24, 2004, pp. 12-13 (with respect to Exhibit 9A: 

Purchase Premium and Discount Amortization Policy, FMSE 074523-074524) 

Q: The first sentence of this paragraph states: If our catch-up moves beyond one within two percent of 

combined portfolio net interest in guaranty fee income, we will book monthly “on-top” adjustments that 

bring us back to within the plus or minus one percent range within our three-year planning period. Is that 

a provision that you recollect discussing with the outside auditors, KPMG? 

A: I don’t recall discussing that provision. 

Q: Is that a provision that you had approved at all? 

A: I don’t recall approving it. 

Q: Okay. In your opinion is that provision permitted under General Accepted Accounting Principles? 

A: No, I don’t believe that would be allowed. 

Q: Okay. In your opinion is that provision permitted under General Accepted Accounting Principles? 

A: No, I don’t believe that would be allowed. 

58 OFHEO Interview, Ms. Leanne Spencer, August 12, 2004, pp. 87-90

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Q: Now my question is what basis does the company – did the company have when they established this 

policy for believing that adding a de minimis [sic. minimus] amount onto the target range was appropriate 
addition to the policy provisions that would permit the Enterprise to recognize greater estimated 

income or expense over time, the Enterprise also recommended and ultimately adopted 

thresholds within which estimated income or expense would not be recognized at all. Indeed, 

such practice had already been an established part of the Enterprise’s financial reporting, even 

prior to the 4th quarter of 1998. During 1998, Mr. Jonathan Boyles was the individual within the 

Enterprise responsible for determining the amount of the catch up position. In his testimony 

Mr. Boyles could not recall the catch-up ever being booked to zero during this timeframe.60 In a 

memorandum dated November 25, 2000 from Mr. Tim Howard to Ms. Janet Pennewell, that

discusses the elements of proposed policy, Mr. Howard notes that KPMG was comfortable with 

 

for GAAP? Was there some accounting standard or some understood practice within industry that would 

have provided that basis?

A: Are you asking – I’m just trying to be clear here so I can give you exactly what you need. Are you 

asking me why we considered a de minimis [sic. minimus] amount on top of the plus or minus 1 percent? 

This discussion occurred between Fannie Mae and KPMG at the same time that we were in discussions 

around what did or didn’t constitute an audit difference. And what we were really trying to accomplish 

here with this document is to put things in writing and put things on paper so that we had an 

understanding and KPMG had an understanding of how we would operate in this framework. And so this 

was only put on here just for clarity and transparency. You probably know specifically – I can’t recall, 

about the same time was there not a new – I don’t know if it was an auditing standard or if it was an SEC 

standard, whereby all audit differences became a required part of conversations with the audit, you know, 

committee, or you know, this – you know where I’m going with this? 

Q: Uh-huh. 

A: And so what we were really trying to do, you know, I don’t really like audit differences. I prefer not to 

have them. If there is something that needs to be corrected, I just want to post it. 

Q: You wouldn’t be the first company to have that feeling. 

A: Pardon me? 

Q: You wouldn’t be the first company that had that feeling. 

A: But that’s how I feel. And so in a lot of putting this framework together, for our communication between 

Fannie Mae and KPMG to be very clear, and that we were going to operate within this policy, and I wasn't 

interested in having an audit difference. But since at the same time this new requirement in -- I can't 

remember what new requirement it was, but the new requirement around the discussion of audit 

differences, we were just trying to be clear about what constituted an audit difference. I never intended to 

have one. But we wanted to not wait for that. We wanted to be clear up front, and so just in terms of how 

you would operate within this policy and then tie that back to the other separate discussions we were 

having with them around – that I described to you, which this actually confirms what I was telling you 

earlier, pretax amount by 1 percent on adjustment [sic] that causes the net interest margin to move by a 

basis point, where it causes the fee rate to change by a tenth of a basis point. That's the earlier 

discussion that I was trying to describe to you. 59 OFHEO Interview, Mr. Jonathan Boyles, August 24, 2004, p. 78-79

Q: During 1998, what was the company’s policy for recording catch-up? 

A: I don’t recall there was a stated policy, and that was the issue that was raised with KPMG, They 

wanted a policy, and they wanted us to consistently apply a policy. And that was the genesis of the policy 

that we developed. 60 OFHEO Interview, Mr. Jonathan Boyles, August 24, 2004, p. 79 

Q: Do you recall whether or not the catch-up was booked to zero on a routine basis during that time? 

A: I don’t recall that it was ever booked to zero. 

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a $100 million threshold going back to the mid-90’s.61 During 1999 and 2000, the informal 

policy of the Enterprise was to stay within a $100 million threshold.62

The memorandum dated March 2, 1999 recommended that the range, within which the 

Enterprise did not need to recognize income or expense, be +/- 1% of projected revenue.63 

The policy adopted in December 2000, was consistent with this recommendation; however, the 

policy further established separate thresholds for purchase premium and discount amortization, 

and guarantee fee amortization. The threshold for purchase premium and discount

amortization was stated as +/- 1% of Portfolio Net interest income, while the threshold for 

guarantee fee amortization was stated as +/- 2% of related Gfee revenue. These thresholds 

were referred to as the target catch-up for both of these respective revenue items.64 As 

embodied in the December 2000 policy Enterprise management considered any point within the

respective target catch-up ranges as the “functional equivalent of zero.”65 

Superficially, these ranges within which estimated income or expense will not be recognized 

may seem immaterial. However, OFHEO has concluded that such target thresholds are 

inappropriate for many reasons: 

• SEC Staff Accounting Bulletin (SAB) No. 99 takes a dim view of defining any threshold of 

immateriality (no matter how small), and then purposely accounting for those 

transactions in a manner that does not conform to GAAP. 

• According to management, the threshold was established due to the uncertainty of 

forecasting interest rates and prepayments. However, the range that the Enterprise has 

employed is not expressed as a range around the amount of calculated catch-up, but

rather a more or less fixed threshold that is determined by reference to revenue 

amounts (e.g. NII) that include significant activity unrelated to amortization. 

 61 The attachment to an email from Mr. Tim Howard to Ms. Janet Pennewell, November 25, 2000, 

Subject: Amortization, states that “the second precedent is somewhat weaker but is KPMG’s own – they 

were comfortable with a $ 100 million PDA threshold in the mid-90s, when our book was half the size it is 

today.” Pennewell 08182004

62 OFHEO Interview, Leanne Spencer, SVP Controller, June 22, 2004, p. 61. 

Q: You said before there was roughly a hundred million dollar threshold. 

A: I said that previously in when we were talking about inherent limitations of the model, what the model 

could do and couldn’t do, that our auditors understood those limitations, and that it was an unwritten 

policy that was not documented, but it was an established practice we had in operating on our auditors 

that a plus or minus 100 million represented the acknowledgement of the imprecision that exists in this 

estimation process in connection with our model.

63 Memorandum from Ms. Leanne Spencer and Ms. Janet Pennewell to Mr. Tim Howard, Subject: Policy 

on Purchase Premium/Discount Management, March 2, 1999, FMSE-SP 000110-000111. 

64 Purchase Premium and Discount Amortization Policy, December 2000, FMSE 074523-074524. 65 OFHEO Interview, Ms. Janet Pennewell, June 15, 2004, pp.48-49

Q: So getting back to the plus or minus 1 percent threshold, which I understand you also called a target 

range, but if you are within that target range, policy doesn’t require you make an adjustment, and in fact 

you may leave the amounts as you have recorded them during and through the quarter, correct? 

A: That’s correct. 

Q: And you’ve also said that it’s the – that the nature of the range is that it’s the functional equivalent of 

zero? 

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A: Right. That’s a phrase that we used for it, because again, that’s our view as the level of precision in our 

estimate. 
• The Enterprise’s justification for such thresholds contradicts the basis for their election 

to change the amortization periods used from periods based upon contractual terms to

estimated periods, which incorporated forecasts of prepayments. 

• The thresholds are based upon annual income statement amounts, but are then applied 

in determining whether adjustments should be made to the quarterly financial

statements.

• The thresholds are so large relative to the amounts of deferred price adjustment

amortization that the retrospective adjustments required by SFAS 91 are unlikely to

occur. As such, the Enterprise has effectively ignored this requirement of the standard 

by spreading income and expense due to normal market fluctuations over future 

periods. 

• The Enterprise has provided no analysis which could separate what they have described 

as “artificial volatility”66 from the actual market volatility of a mortgage portfolio. 

• The range of the threshold is significantly larger than the amount of actual quarterly 

amortization and, in most cases, is almost as large as the amount of annual 

amortization. 

• The Enterprise applied a different threshold to net interest income (NII) and guarantee 

fees (Gfee) despite the fact that both NII and Gfee are exposed to interest rates and

prepayments in a similar manner. 

In their testimony, members of Fannie Mae management have contended that the target range 

thresholds were necessitated by the uncertainty and imprecision associated with estimating the 

amortization of deferred price adjustments pursuant to the calculation of constant effective 

yield that was required by SFAS 91. 

This line of reasoning on the part of management can be rejected on several grounds: 

a.

 

There is no basis of support either from a statistical standpoint or within Generally 

Accepted Accounting Principles for applying a range of uncertainty in this manner. 

The catch-up position for each respective source of revenue represents the 

66 OFHEO Interview, Mr. Tim Howard, August 5, 2004, pp. 187-188 (referring to Exhibit 8, Note for Janet 

Pennewell from Tim Howard, October 27, 1999, FMSE 217558). 

Q: [...] Then the next paragraph reads, “I then attempted to use our projected PDA sensitivities to ask 

‘where would we like our PDA to be’ in order to minimize the amount and frequency of PDA adjustments 

we would have to make as interest rates moved (as we know they will).” The question that I have for you 

is – well, actually, I have several questions. The first question is: Would you understand that FAS 91 

would actually attempt to capture the volatility that would arise in both retrospective and prospective 

changes to purchase premium/discount interest amortization that would result from changes in interest 

rate fluctuations and result in changes in prepayments? 

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A: Yes. And this is a shorthand that I think not really accurately worded formulation. The attempt was 

never to minimize economic sensitivity. This is always in the context of not having our assumptions drive 

artificial volatility, so that’s what we were talking about. 
difference between 1) an amortization amount that was recorded during the 

quarter based upon assumptions made at the beginning of that quarter, and 2) an 

amortization amount estimated at the end of the quarter that uses the latest 

available information on current interest rates and actual prepayments 

experienced.

67 Imprecision and uncertainty indeed exist when making estimates.

However, the Enterprise is using this uncertainty and imprecision to 

rationalize why it need not recognize changes to income that simply 

result from fluctuations in market rates that occur naturally over time. 

b.

 

The Enterprise’s treatment of estimation uncertainty was not consistently applied, 

even within the accounting framework for deferred price amortization itself. 

Determining a constant effective yield in accordance with SFAS 91 requires both a 

retrospective (historical) and prospective adjustment based on the revised 

estimated amortization period due to changing rates of prepayments. Fannie 

Mae’s objection to uncertainty seemed confined only to the immediate financial

statement impact of the estimate. In fact, estimation uncertainty did not prevent

Fannie Mae from adjusting the prospective amortization period of both 

discounts/premiums and guarantee fees in accordance with its revised estimate of 

prepayment speeds.

67 OFHEO Interview, Ms. Janet Pennewell, June 15, 2004, pp. 46-48.

Q: And only if the difference is 1 percent plus or minus do you make an adjustment. Otherwise you use 

what you've booked previously? 

A: That would be true, yes. 

Q: Now, why is what you booked previously a better estimate than the sensitivity analysis that you would 

perform at quarter end? 

A: Well, what we're really saying is that because we don't exactly know what prepayments are going to 

do in the future, that you cannot know what your--how much you should have booked in the past with 

precision, and that that range of plus or minus 1 percent is meant to recognize the fact that you don't 

know with precision what your prepayments are going to do, and so therefore, you don't know with 

precision exactly how much you should have booked inception to date. So to say that--within a range, to 

say that--because it's kind of all the same, that's as close as you can get. It's just to recognize the degree 

of imprecision in coming up with that estimate position, because it is an estimate until you know exactly 

what prepayments are going to be in the future. 

Q: I agree that it's subject to uncertainty, but when you're within the 1 percent threshold or when the 

difference is in the 1 percent threshold, why would what you booked previously be a better estimate than 

your latest modeling? 

A: It's not necessarily a better--as good of an estimate than to us it is within what we call—we actually the 

term functional equivalent of zero to say, yeah, that's what our estimate is. Our estimate is a number 

within this range. That's as close as we can estimate it. It's kind of like—I always kind of think of it as 

polling error, so if you see a poll that says, you know, John Kerry's behind by 9 points, however our 

polling error is plus or minus 4 percent, so it's really not as close as it sounds. You've got polling error 

here. There are just certain aspects that you don't know with precision, and therefore there is not a 

precise number. And you'd fool yourself if you treated it as if there was a precise point in time number. 

There isn't. 

Q: So because there is uncertainty, you in effect default to what you had previously booked as long as

you're within the threshold?

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A: Because what we previously booked, in the example that you give, where what we previously booked 

is within our range of what we think is exactly what we should have booked, that's as close as we can 

calculate the number. And we're saying what we did book was the correct amount to have recorded. 
Fannie Mae personnel fully understood the prospective nature of their policy in 

their own characterization of their method for managing the catch-up position. An 

undated and unsigned document68 provided by the Enterprise discusses a 

suggested defense to possible challenge by KPMG of the Enterprise’s proposed 

amortization policy. The document states: 

We have traditionally used a prospective approach because it 

reduces our income statement volatility; we don’t want to be 

placed in a position where we are booking a positive number 

one quarter and negative the next. 

A memorandum from Mr. Tom Lawler dated April 2000 further states: 

We currently employ what I would call a ‘modified prospective 

method’ in determining the premium or discount amortization to 

be booked to current income. By that I mean that we do not 

manage our ‘catch-up’ position to zero each quarter.....It is a

‘modified prospective method’, however, in that if our catch up 

moves beyond a certain threshold, we then periodically may 

take a one-time adjustment into income to lower the catch up

amount to a ‘manageable’ number.69

A prospective approach to adjusting income recognition on the amortization of 

deferred price adjustments is an explicit contravention of the requirements of 

SFAS No. 91. This accounting standard requires that the determination of 

constant effective yield be adjusted for the historical ‘inception to date what-if’ 

(retrospective) impact of changes in prepayment speeds each reporting period. 

c.

 

The Enterprise’s rationale for the catch-up threshold because of uncertainty70 in 

estimation calls into question their ability to elect to estimate prepayments 

(pursuant to the requirements of SFAS 91.) As mentioned previously in this 

report, FAS 91 requires that the amortization of deferred price adjustments be 

made over the contract life71 (e.g., 30 years for a 30 year MBS.) However, such 

accounting could cause significant volatility in certain market environments. For 

instance, a large drop in interest rates could lead to a wave of prepayments. 

68 Undated and unsigned document, Titled Proposed Amortization Policy, FMSE 217504 –217505. 

69 Undated and unsigned document, Titled Suggested Amortization Strategy, FMSE 217556-217557. 

This document has a handwritten note that indicates “from Tom April 00”. In his testimony Mr. Tim 

Howard provided information regarding the sender of the document; 

Q: Okay, I’d like to introduce into the record Exhibit 11. 

A: I can tell you just from the style that this would have been written to somebody from Tom Lawler. I 

don’t know if you knew that. It does say “from Tom”. 70 The Enterprise’s rationale of uncertainty includes not only the designation of the target catch-up range, 

but also the estimation methods to determine the catch-up. See Appendix I. 

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71 Except as stated in the following sentence, the calculation of the constant effective yield necessary to 

apply the interest method shall use the payment terms required by the loan contract [Emphasis 

added], and prepayments of principal shall not be anticipated to shorten the loan term. SFAS 91, p. 19. 
Under such conditions, previously unamortized amounts would be immediately

recorded into income. 

For large pools of similar loans, SFAS 91 provides an elective to companies that 

are seeking to avoid such volatility by including a forecast of prepayments in the 

determination of an estimated amortization period. The particular wording of this 

elective is as follows: 

If the enterprise holds a large number of similar loans 

for which prepayments are probable and the timing 

and amount of prepayments can be reasonably 

estimated [Emphasis added], the enterprise may consider 

estimates of future principal prepayments in the calculation of 

the constant effective yield necessary to apply the interest

method.72 

As such, the Enterprise’s justification of large target thresholds based on the 

uncertainty of estimating prepayments does not reconcile to the elective in SFAS

91 which requires that “prepayments can be reasonably estimated.

73” As such, 

OFHEO has concluded that the Enterprise’s adoption of a policy which 

establishes a threshold for recording adjustments to deferred price 

amortization is a violation of GAAP.

d.

 

Fannie Mae’s treatment of estimation uncertainty is not consistent with the 

Enterprise’s own treatment of other critical accounting estimates.74 In addition to 

the amortization of deferred price adjustments, the Enterprise’s Form 10K, filed

with the SEC, identifies three other critical accounting estimates:75

 

i. Determining the adequacy of the allowance for loan losses and

guarantee liability for MBS; 

ii. Estimating the time value of purchased options; and 

iii. Assessing other-than-temporary impairment. 

The Form 10K states that all of the critical accounting estimates “require significant

management judgment and assumptions about highly complex and uncertain 

matters.”76 Yet, none of these other accounting estimates are determined in 

accordance with methods analogous to the ‘target catch-up range’ that is applied 

to the amortization of deferred price adjustments. In their testimony to OFHEO, 

72 Id.

73 Id.

74 Fannie Mae Controller Ms. Leanne Spencer commenting on other critical accounting estimates. 

OFHEO Interview, Ms. Leanne Spencer, August 12, 2004, pp. 95-96. 

Q: I just wanted to continue discussion around the purchase premium discount amortization policy. I think 

you have testified previously that you do not apply a target range to other accounting estimates of the 

company; is that correct? 

A: I can’t recall an area where we do. 

75 Fannie Mae 2003 Annual Report, pp. 39-40. 

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76 Id., p. 40. 
officers of the Enterprise alternatively explained that the uncertainty associated 

with estimating deferred price amortization would give rise to “artificial” 77 or 

“spurious” volatility78 of reported financial results. Many readers of this 

summarized report will understand that estimation uncertainty in statistical 

parlance refers to how accura e an estimate may be. But accuracy, in this context,

is referring to an amount calculated at a point in time. Volatility, however, refers 

to the degree of change between an estimate made in one quarter, and the 

estimate made either the previous or following quarter. Therefore, uncertainty in 

accuracy and uncertainty in volatility are two different things. For example, a 

watch may be inaccurate because it is set 10 minutes ahead. However, that 

watch, all other things being equal, will still correctly mark the passage of three 

hours. While the Enterprise did prepare analysis that purported to demonstrate 

the extent of uncertainty associated with determining an estimate of deferred price 

amortization,

79 OFHEO is not aware of any analysis ever prepared that 

demonstrates the existence, nature, or magnitude of any ‘artificial’ or 

‘spurious volatility’ associated with estimating deferred price 

amortization. 80

t

 

Further undermining the argument of linkage between policy development and the 

manifestation of spurious volatility was the inability of Fannie Mae officers to explain why the 

target catch-up range for purchase premium/discount amortization (+/- 1%) was different from 

the target catch-up range for guarantee fee amortization (+/-2%).81 Furthermore, the 

77 OFHEO Interview, Ms. Janet Pennewell, June 15, 2004, p. 18. 

Q: So isn’t there actually some volatility in the business that you’re in? 

A: That’s true. There certainly is volatility in the business that we’re in, and certainly one would expect 

some volatility therefore in the premium and discount amortization that you’re reporting. And what I was 

focused on was, what I really want to be very clear on is, artificial volatility. In other words, dramatic 

changes on what you’re recording to income through FAS 91 because of what could be arbitrary changes 

in your assumption about interest rates. [...] 78 OFHEO Interview, Mr. Tom Lawler, June 24, 2004, pp. 127-128.

A: [...] what we have first on the core data and modeling, we have some core uncertainties about the 

accuracy of the results, and sometimes there is the arbitrary nature of the date of the sensitivities we do, 

and we felt that in looking at the results swings that, in our mind, were spurious in nature or related to--

unrelated to anything fundamental would be such that we would not want to, I believe the word they use 

here is book, although I don't do any booking. 79 Memorandum from Mr. Jeff Juliane to Mr. Tim Howard, June 21, 2000, Subject: Amortization Policy 

Runs. FMSE 217521- 217526. 

80 Fannie Mae officer Mr. Tom Lawler commenting on deferred price amortization. OFHEO Interview, Mr. 

Tom Lawler, June 24, 2004 p. 149. 

Q: How did the company conclude that the inaccuracy in the modeling translated into spurious volatility? 

A: How did we know for a fact that it created spurious volatility? 

Q: Yes. 

A: I don’t know that I could demonstrate for a fact that it created spurious volatility. It was based on 

analysis sensitivities and time where we saw that, that the conclusion was that we felt it did, it could 

create spurious volatility. 

Q: And did anyone at the time prepare an analysis or paper attempting to demonstrate that at the time? 

FANNIE MAE COUNSEL: What time are we talking about? 

Q: At the time you were formulating the policy at the 1 percent threshold. 

A: I don’t believe so. 

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81 OFHEO Interview, Jonathan Boyles, August 24, 2004, pp. 34-35. 
respective target catch-up ranges are each expressed in a curiously different manner. The +/- 

1% portfolio NII target catch-up range for purchased premium and discounts is expressed as

and determined on a tax equivalen basis, while the +/- 2% guarantee fee target catch-up

range is expressed on a basis not adjusted for taxes. Indeed, the income tax treatment of

these respective revenue amounts is in fact different. However, since both revenue amounts 

are reported in the financial statements before tax, modifying the threshold to reflect NII on a 

tax-equivalent basis would only be relevant to managing after tax net income or EPS. This 

convention would seem to have no relevance whatsoever to the issues of either estimation 

uncertainty or volatility of pre-tax reported financial results. 

t

 

Could the motivation for focusing on estimation uncertainty have been a means to justify the 

application of a materiality threshold? In their response to requests for information made by 

OFHEO, the Enterprise responded that the basis for justifying the magnitude of the target

catch-up range was an analysis prepared on June 21, 2000.82 However, a memorandum83

dated March 2, 1999 proposed a plus or minus 1% target catch-up well before the analysis 

dated June 21, 2000 was prepared. 

A memorandum84 dated April 2000 that Mr. Tim Howard testified was from Mr. Tom Lawler, 

explicitly refers to measures of materiality as the basis for determining the magnitude of target 

catch-up thresholds. A memorandum85 dated September 23, 1999, from Ms. Janet Pennewell, 

Vice President Financial Reporting,86 to Mr. Tim Howard devotes a section consisting of two 

paragraphs that discuss materiality. The first paragraph argues that it “may be appropriate to 

adjust the catch-up over time if the amount is not material,”87 and even suggests that “since 

catch-up relates to the entire period since the mortgages/fees were put on the books, one could 

Q: Do you have an understanding as to why the target catch-up for purchase discount and premium 

amortization is plus or minus one percent and why alternatively for guaranty fee income, it’s plus or minus 

two percent?

A: I don’t recall why there is a difference.

Q: Do you recall seeing any analysis that would have demonstrated that the estimation of guaranty fee 

income is subject to greater uncertainty than purchase premium discount amortization? 

A: I don’t recall an analysis. 

82 Memorandum from Mr. Jeff Juliane to Mr. Tim Howard, June 21, 2000, Subject: Amortization Policy 

Runs. FMSE 217521-217526. 

83 Memorandum from Ms. Leanne Spencer and Ms. Janet Pennewell to Mr. Tim Howard, Subject: Policy 

on Purchase Premium/Discount Management, March 2, 1999, FMSE-SP 000110-000111 

84 Unsigned document, Titled: Suggested Amortization Strategy, FMSE 217556-217557. This document 

has a handwritten note that indicates “from Tom April 00.” 

85 Memorandum from Ms. Janet Pennewell to Mr. Tim Howard, dated September 23, 1999, Subject: 

Policy on Purchase Premium/Discount Management, FMSE-SP 000106-000109. 86 Ms. Janet Pennewell was Vice President of Financial reporting at the time this memorandum was 

written. In May of 2003, Ms. Pennewell was promoted to Senior Vice President Financial Reporting and 

Planning. OFHEO Interview with Ms. Janet Pennewell, June 15, 2004. p. 8 

Q: So in 1999 you took on the responsibilities in Financial Reporting that you – describe what happened 

in 1999 again, if you would.

A: Sure. In 1999 I was promoted to Vice President, and before my promotion I was in charge of the 

business planning function, which resides within the Controller’s Department, and when I was promoted 

to Vice President in 1999, also took on responsibility for financial reporting and for financial accounting. 

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87 Memorandum from Ms. Janet Pennewell to Mr. Tim Howard, dated September 23, 1999, Subject: 

Policy on Purchase Premium/Discount Management, FMSE-SP 000106-000109.
argue that materiality should be judged in the context of multiple years of revenue.”88 The 

second paragraph however warns of SAB No. 99, which was released by the Securities and 

Exchange Commission just one month prior on August 13, 1999.89 Clearly, management was 

thinking in the context of materiality – as opposed to uncertainty – at the time that

memorandum was written. Lastly, as late as last year Fannie Mae’s Office of Auditing describes 

the catch-up threshold as “a materiality threshold that is used in determining when differences 

should be booked.”90

The Functional Equivalent of 16%

At this point, one might be forgiven for concluding that the thresholds ultimately adopted by the 

Enterprise were small in relation to the magnitude of the financial statement revenue amounts 

being reported. After all, management expressed the belief that the target catch-up was the 

functional equivalent of zero.

91 However, the thresholds either proposed or adopted were in

reference to annual revenue amounts.92 The effect on quarterly income was therefore much 

larger. 

First of all, each of the percentage thresholds needs to be appropriately scaled to understand 

the impact on quarterly reporting. If we assume, for purposes of simplification, that quarterly 

revenue is approximately 1/4th of annual revenue, the percentage thresholds scale up to a

quarterly effect of +/-4% and +/- 8% respectively. These percentages are the relevant 

threshold to understand the potential balance sheet effect on purchased premium/discounts 

and guarantee fees. To understand the potential impact on the volatility of reported earnings, 

the percentage thresholds need to be scaled further, in accordance with the full range of the

threshold, to properly consider the impact on quarterly income. Since volatility refers to the 

degree of change between financial measures, in theory, quarterly guarantee fee catch-up

could swing from +8% one quarter to -8% the next without any adjustment to income for the 

 88 Id. 

89 Id., FMSE-SP 000108. The full paragraph referred to reads: 

“However, on August 13, of this year [1999] the Securities and Exchange Commission released Staff 

Accounting Bulletin (SAB) No. 99, which specifically addresses the application of “materiality” thresholds 

to the preparation and audit of financial statements. This bulletin was released in response to the SEC’s 

concern about the tendency of companies, with the acquiescence of their auditors, to manage earnings 

by designating certain transactions or events below a certain percentage threshold as “immaterial” and 

the accounting for transactions and events in a manner that does not conform to GAAP. The bulletin 

states that the use of a percentage ceiling test alone to make materiality determinations is not acceptable. 

Although a quantitative test can be used as an initial assessment, all “facts and circumstances” must be 

evaluated to determine materiality - including whether a reasonable investor would find the amount to be 

material to the company’s ability to meet earnings expectations.” 90 Fannie Mae Office of Auditing Workpaper, July 7, 2003, Reviewed by Ms. Joyce Philip, Manager Office 

of Auditing, FMSE 118802-118803. 

91 OFHEO Interview, Mr. Tim Howard, August 5, 2004, p. 124. 

Q: And as long as it did not exceed the plus or minus 1 percent, then, in fact, no adjustment be required, 

correct? 

A: Yes, because we deemed any estimate within the plus or minus 1 percent to be what we called the 

functional equivalent of zero. 

92 OFHEO Interview, Mr. Jeff Juliane, June 8, 2004, p. 199. 

Q: On a quarterly basis, the cumulative catch-up amount is always evaluated in relation to one percent of 

projected annual net interest income? 

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A: Correct. 
retrospective impact of that swing. Therefore, the potential magnitude of avoided 

volatility becomes 8% and 16% of the respective quarterly revenue amounts. 

In 2003, the threshold for NII catch up was approximately +/-$110 million.93 The associated 

range of this threshold therefore was over $220 million. It was this threshold and range that 

were applied to quarterly financial reporting. The highest amount of quarterly Net interest 

income related to purchase premium and discount amortization, for the period in which OFHEO 

has such information (Q1 2001 through Q1 2004), was approximately $151 million. The largest 

magnitude of change in purchase premium and discount amortization between consecutive 

quarterly reporting periods was approximately $135.8 million. The analogous threshold and 

range for Guarantee Fees was approximately +/- $45 million and $90 million, respectively. 

In either case, when policy did not require that deferred price amortization adjustments be

made the effect was to shift the catch-up amount to future periods, and the default

amortization estimate in the current quarter would have been the estimate made at the 

beginning of the quarter. In quarters when the percent thresholds were exceeded and policy 

required that adjustments for estimated income or expense be made, the policy would have

only required that amortization be adjusted to the amount of the target catch-up threshold. For

example, if the target catch-up threshold was +/-$110 million, and the modeled catch-up 

estimate was $125 million, only a $15 million adjustment needed to be made under the policy. 

The key attributes of the policy were that: 1) quarterly thresholds were pegged to annual 

amounts, 2) the additional scaling of a plus and minus range insofar as quarterly changes were 

concerned, and 3) the operation of policy whereby the Enterprise only recognized estimated

adjustments that exceeded the range, allowed volatility to be avoided altogether - or at least 

significantly dampened – and future earnings surprises were rare. 

The application of the quarterly thresholds results in the failure to record amortization and 

misstates financial results. Such misstatements mask changes in earnings and other trends that

are important to investors. The SEC issued Staff Accounting Bulleting No. 99 to specifically 

prohibit such misstatements.94

Policy To Permit Discretionary Adjustments Within The Target Catch-Up Range

 

Yet another significant aspect of the Enterprise’s policy was the ability of management to make 

discretionary adjustments

95 to quarterly income as long as they were within the target catch-up 

93 OFHEO Interview, Mr. Tim Howard, August 5, 2004, p. 147. 

Q: And, in fact, I think, just to be more precise because I was using an approximation that the company 

has defined this 1-percent range as being as high as $ 110 million is my understanding. 

A: As of the date of that document, that was probably true, but net interest income has been elevated for 

the last couple of years. So I think that’s an outdated number. 

Q: And possibly understated; is that – 

A: Yes, it could be. 

94 SEC Staff Accounting Bulletin: No. 99 – Materiality, issued August 12, 1999. 

95 OFHEO Interview, Ms. Janet Pennewell, June 15, 2004, pp. 34-35 

Q: Sometimes when you’re under the 1 percent threshold, you may or may not make an adjustment? 

A: That’s correct. 

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Q: And that’s based on management discretion? 
range. While this was not explicitly stated in the policy, it arose as an extension of 

management’s assertion that the ‘functional equivalent of zero’ was anywhere within the range. 

Accordingly, in 2003, when the NII target catch-up position approximated +/- $110 million, 

management had the ability to make discretionary adjustments to income of up to $220 million 

that, in theory, could move the catch-up from one end of the range to the other and still be 

permissible under their policy. 

The following is a quote from testimony by Mr. Howard, CFO, regarding the latitude of 

recording adjustments to the catch-up position allowed in the amortization policy: 

Q: And then just to be clear, your terminology "deeper into the range" means 

that you could have booked an entry that would have made a positive catch-up a 

greater positive number, correct, in any given quarter? 

A: Right. If the calculated number was 120, and the minimum amount of the 

upper end of the range was 80, according to our policy, we needed to book the 

$40-million difference, but we were permitted to book--am I missing here? 

Q: No, keep going. I'm listening. 

A: We do the five scenarios, and each scenario we have an amount of catch-up

that has to be recorded as income or expense to produce the level of yield [sic]. 

In averaging the five scenarios, we get a single number. And let me just assert 

that that number is $120 million, and the question is how much of that $120 

million should be brought into income in the current quarter? Using our range--

and let's call it plus or minus 1 percent--I will assert that 1 percent of net interest

income, at this hypothetical time we're doing this, is $80 million. So that would 

mean that the smallest amount we could book as income was the difference 

between a $120- catch-up and the $80 million, top of the range. We could, by 

following the policy, conceivably book as much as $200 million of income, which 

would take us from the $120- all the way down to the negative $80-.96

Additionally, when asked about the ability to adjust earnings Mr. Tim Howard, Chief Financial 

Officer, provided the following testimony: 

Q: Okay. Now, were adjustments within the plus or minus 1-percent range ever

made to cause actual earnings to more closely align with forecasted earnings, as 

far as you know? 

A: Not to my recollection. 

Q: Do you believe that would be prohibited under your policy? 

A: Technically, no.

97

 

A: That’s based on management’s judgment in looking at our asymmetrical exposure to interest rates, 

yes.

Q: Is it ever based on anything else? 

A: There might be other factors that management might look at in making that judgment, such as the 

current composition of the book. Most of those other things we might look at come down to evaluating, 

again, that asymmetry of the impact if rates don’t move in line with how we forecasted them. 

96 OFHEO Interview, Mr. Tim Howard, August 5, 2004, pp. 139-141 

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97 OFHEO Interview, Mr. Tim Howard, August 5, 2004, p. 207 
Subsequent sections of this report will provide examples in which the Enterprise exercised 

latitude in making adjustments within the range of uncertainty permitted by the policy. If 

accounting standards permitted this practice (which they do not), similar latitude could be 

applied to other estimates such as loan loss allowances, pension obligations and estimates of 

fair value. If other companies used Fannie Mae’s logic in applying accounting 

principles, they could dictate the financial results they desired, and there would be 

no comparability of financial results between reporting entities even within the 

same industry.

Managing the Catch-Up 

Managing Within The Current Quarter’s Catch-Up Range

Another proposed mechanism to reduce earnings volatility was the intention to manage to a 

specific target level of catch-up. Targeting a specific level of catch-up was a means to minimize 

the probability that adjustments would be necessitated by exceeding either end of the plus or 

minus catch-up range. The idea essentially was to target a level of catch-up, such that the

probability – in future periods - of exceeding one end of the range be no greater than the 

probability of exceeding the other end of the range. In this manner, the Enterprise could 

navigate the catch-up within the threshold range such that future income volatility which might 

arise through recording adjustments which would exceed the target threshold would be 

avoided. This objective, as well as the means, was suggested by the Chief Financial Officer

himself to Ms. Janet Pennewell.

Here’s what I did in coming up with my proposed purchase premium and

discount rule. 

First, I looked at our projections three years from now, and calculated the 

‘expected’ amount of unamortized PDA.98 This is simply the average of the 

results from the ‘rates unchanged’ and ‘up and down 1 and 2 standard

deviations’ cases. Using the October projections, this ‘expected PDA amount’ in 

December ’02 was $160 million. 

I then attempted to use our projected PDA sensitivities to ask “where 

would we like our PDA to be” in order to minimize the amount and 

frequency of PDA adjustments we would have to make as interest rates 

moved (as we know they will). [Emphasis added] To answer that, I looked 

at the sensitivity of our PDA calculations to up and down 2 standard deviation 

moves in interest rates in each of the next four years. What I found when I did 

that is that, on average over this period, if interest rates went up by two 

standard deviations, our so-called ‘catchup’ credit would increase by a positive 

$80 million dollars (roughly). For a two standard deviation fall in interest rates, 

however, the catchup would drop by $250 million – actually turning into a 

negative. So to make our corporate sensitivity to these rate changes symmetric, 

I figured that as long as our PDA sensitivity looked like this we should aim for a 

PDA catchup position of a positive $85 million. (That way, if rates moved up by 2 

 

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98 PDA is the acronym for ‘premium/discount amortization’ 
standard deviations the catchup would rise by $80 million to a positive $165 

million; if rates fell by 2 standard deviations our catchup would decline by $250

million, to a negative $165 million. That’s symmetric.) 

My final step was to integrate the first and second paragraphs. That is, to say 

“given our current projected PDA sensitivity we want to be at $85 million; our 

probability-weighted expectation is that we will be at $160 million over the next 

three years, so to get where we want to be we should amortize the difference 

($75 million) evenly into income over the next three years (at $25 million per 

year).

I then added a couple of refinements to that. First, if the difference between

where we were and where wanted to be was large (and particularly if it were 

large and negative), we would want to get back to our target more quickly than

would be achieved by an even amortization over three years. So I would frontload the change – perhaps fifty percent in the first year, and 25 percent in the 

next two years. 

It also seemed to me that if we followed this procedure rigorously – i.e., we 

updated our PDA position and sensitivities, and our ‘where do we want to be 

calculation’ quarterly – we would find that the changes we would be making to 

our projected ‘on top PDA adjustments’ would be relatively small, spread out 

over a three year period. That would help with our goal of minimizing 

unnecessary net income volatility, while ensuring that we maintain an adequate 

amount of PDA amortization at all times. 99

 

In a later memorandum100 to Ms. Pennewell, dated November 25, 2000, Mr. Howard - on the 

eve of the adoption of the policy - further wrote:

In looking out three years, we should look not only at the base scenario (rates 

unchanged) and the weighted average of the five scenarios, but also at the two 

extremes. The reason is to see whether we get a sense of whether we may find

ourselves needing to move our catch-up quickly and in large amounts if rates 

move in a particular direction. This should affect where within the plus or minus 

$75 million range we aim for (i.e., if three years out the catch-up really 

plummets in the ‘down 120’ scenario, we should probably want to aim to be 

fairly high in the plus-or-minus $75 million range, as a cushion in case rates fall 

further). 

This memorandum clearly shows that the intention of the policy the Enterprise adopted was to 

allow for positive (income) adjustments to the catch-up and to mitigate negative (loss) 

adjustments. OFHEO has concluded that such a practice is the equivalent to establishing a 

 99 Memorandum from Mr. Tim Howard to Ms. Janet Pennewell, October 27, 1999, FMSE 217558 

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100 Memorandum titled “Notes on Purchase Premium and Discount Amortization,” attached to email from 

Mr. Timothy Howard to Ms. Janet Pennewell, November 25, 2000, Subject: Amortization. Howard 

08152004. 
reserve for amortization expenses. However, since the catch-up was never fully 

recorded, the policy of the Enterprise effectively created a “cookie jar” reserve. 

In his testimony regarding the October 27, 1999 memorandum, Mr. Howard went on to state 

that the concept of a “where we want to be” target “never went anywhere.”101 However, a 

memorandum dated April 12, 2001, describing the Q1 2001 Amortization results, indicates that 

the Enterprise determined to make additional on-top adjustments for NII and Gfee of $10

million and $8 million respectively, of which each had the effect of increasing the catch up, even 

though the modeled deferred price adjustment amortization was within the respective 

threshold. In her testimony regarding the information contained within the April 12, 2001 

memorandum, Ms. Leanne Spencer confirmed that it was management’s practice to make 

adjustments because of the Enterprise’s asymmetric exposure.102 Ms. Pennewell, when asked 

about the practice of making adjustments within the catch-up range, also confirmed that the 

asymmetric exposure of interest rates influenced where management wanted to be within that 

range, and further pointed out specifically where within the current policy this practice would be 

supported.

103

 101 Mr. Tim Howard commenting on the memorandum to Ms. Pennewell dated October 27, 1999, FMSE 

217558. OFHEO Interview, Mr. Timothy Howard, August 5, 2004, pp 197-198 

Q: Would you regard the quarterly analysis that’s done of catch-up as a “where we want to be 

calculation”?

A: No. The reason that’s in quotes, this is – the “where you want to be” is looking out towards the famous 

moving target. This is not a “fiddle the number” concept. And that’s why I put it in quotes. But, again, 

because this was sufficiently complex and hard to pin down, it never – the concept never went anywhere. 

102 Ms. Leanne Spencer commenting on a memorandum from Mr. Jeff Juliane and Mr. Rene LeRouzes to 

Distribution, dated April 12, 2001, Subject: Q1 2001 amortization update. FMSE-SP 000220-000223. 

OFHEO Interview, Ms. Leanne Spencer, June 22, 2004, p. 99. 

Q: Would it have been your practice to sometimes book such an amount in because of this asymmetric

exposure?

A: Yes.

Q: So, while you do not recollect specifically whether it was 10 million was booked or not, it could have 

been the case consistent with your practice. 

A: Yes.

Ms. Leanne Spencer further commented. OFHEO Interview, Ms. Leanne Spencer, June 22, 2004, p. 100 

Q: [...] and I assume you don’t have any specific recollection specifically whether 8 million was booked or 

not. 

A: I do not. 

Q: But by analogy looking [sic] such an amount would have been consistent with practice that you might 

have employed? 

A: Yes. 103 OFHEO Interview, Ms. Janet Pennewell, June 15, 2004, pp. 33-34.

Q: Now, if this threshold were to be exceeded and you were required under your policy to make an 

adjustment to the quarter’s interest amortization, you would only book the difference between the mean 

catch-up number and the threshold? 

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A: No. Our policy explicitly says that as long as we fall within that range, and the policy recognizes that 

we may use management judgment to recognize the fact that we typically have asymmetric exposure to 

interest rates. And so it’s recognized that management may- that that may influence management’s 

judgment in terms of where within that plus or minus 1 percent range we think is appropriate to be. 

Mortgages have a good deal of negative convexity, as I know you know, and therefore, depending on 

exactly the composition of our book, we won’t – our catch-up position won’t move symmetrically to, say, a 

plus or minus 100 basis point move in rates, and so where exactly within that policy range we thought it 

was appropriate to be, would typically be influenced by that asymmetry. 
This practice and the latitude within the policy that authorized it, meant that the Enterprise was 

no longer making adjustments to improve the accuracy of its reported financial results. 

Rather, the Enterprise was making preemptive adjustments for the sole purpose of 

managing prospective earnings. OFHEO is not aware of any basis in promulgated 

accounting standards that would support this accounting treatment. 

In his memorandum to Ms. Pennewell, Mr. Howard summed up the achievement of constructing 

the catch-up framework implemented by the Enterprise: 

There are variations on this theme, but you can see what I am trying to do. We

have a target range that we define as the ‘functional equivalent of zero’. We look 

at a three year horizon and multiple rate scenarios to try to avoid volatility in the 

monthly amortization numbers. And we give ourselves a (small) ‘safe zone’ 

before we force ourselves to make large changes in amortization to get quickly 

back to within our target range.104 

Modeling And Managing The Forecasted Catch-Up

The discussion of catch-up thus far has focused on the impact associated with the reporting of 

current period income. However, a full understanding of the accounting for deferred price 

adjustment amortization, and its impact on the Enterprise’s reported financial results, also has 

to consider the dimension of time and future reporting periods. For any given quarter, the 

quarterly catch-up amount is, by its very nature, simply unrecognized income or expense. The 

accounting policy adopted by the Enterprise specified the accounting to be applied to the catchup in the current quarter. However, the policy also states: 

“In managing the premium/discount catch-up position, it is important to project 

how that position can change over time. We believe that a three year time 

horizon is appropriate for that assessment.” 105

Since catch-up is unrecognized income or expense, a forecast of catch-up is, in effect, nothing 

more than a forecast of future unrecognized income or expense. It was in this regard that the 

Enterprise devoted considerable systems and human resources to supporting a well developed 

and robust capability to forecast the level of catch-up in future periods, in accordance with the 

several years planning horizon referred to in the policy. 

Each quarter, and often much more frequently, the Enterprise would perform analysis to 

determine both the current quarter’s catch-up as well as the forecast of catch-up for 

prospective periods. The forecasting of prospective period catch-up would further be 

 

OFHEO Interview, Ms. Janet Pennewell, June 15, 2004, p. 83. 

Q: Could you tell me in here where it refers to this policy around the negative convexity and booking 

within the target range that you referred to before? 

A: It’s on the second page, and specific – and I will tell you that the language that we look to in this policy 

is, “...we also need to be sensitive to the impact of extreme interest rate moves on our catch-up. This will 

affect where within our target range we should aim to be.”

104 Attachment to email from Mr. Tim Howard to Ms. Janet Pennewell, VP Financial Reporting & Planning, 

November 25, 2000, Subject: Amortization, Pennewell 08252004. 

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105 Purchase Premium and Discount Amortization Policy, FMSE 074524. 
performed pursuant to a variety of different assumptions, in order to determine, for example,

the impact of different interest rate assumptions on future period catch-up. 

During the period from 1999 through to 2004, the Enterprise performed many sensitivity 

analyses for forecasting purposes. Over this timeframe, the relationship between forecasted 

catch-up for near term periods, and forecasted catch-up for outer periods varied. In 2000, the 

forecasts performed show progressively higher levels of catch-up, where the cumulative 

amount, at the end of the planning horizon, is significantly higher than the current period catchup. For example, the table below presents a sensitivity analysis for the first quarter of 2000 

that provides an estimate of the catch-up for prospective periods through to 2004 - the end of 

the planning horizon. This forecast was contained within a memorandum dated April 5, 2000. 

The forecasted catch-up for each period represents a weighted average of the catch-up

calculated using prepayment estimates associated with each of five interest rate scenarios: Base 

Rate Path, +/- 60 basis points and +/- 120 basis points.

106 See Appendix I of this document for 

a more detailed description of the modeling methodology. 

Forecast 5-Apr-00

Period Analysis

Dec-00 $183.0

Dec-01 $222.0

Dec-02 $258.0

Dec-03 $292.2

Base rate path used 8.65%

Book used Jan-00

Reference FMSE-SP 000237

Another way to understand the catch-up is to view it graphically. The following is an illustration 

that uses the estimate of catch-up contained within the April 5th 2000 analysis. 

 

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106 Memorandum from Mr. Jeff Juliane to Ms. Leanne Spencer, dated April 5, 2000, Subject: Amortization

Sensitivities. FMSE-SP 000236–000238. 
Illustration

 

Current

Quarter

Dec 31 ‘00 Dec 31 ‘01 Dec 31 ‘02 Dec 31 ‘03

$146.1 mil

$292.2 mil $

Time

Catch-up

Current

Quarter

Dec 31 ‘00 Dec 31 ‘01 Dec 31 ‘02 Dec 31 ‘03

$146.1 mil

$292.2 mil $

Time

Catch-up

The catch-up represents the difference between the projection of deferred price adjustment 

amortization in accordance with a forecast using multiple up and down rate path scenarios 

versus the prospective amortization that would be taken in accordance with ‘in-use’ 

amortization factors applied prospectively. The level as well as shape of both the catch-up, and 

prospective amortization could however vary. This is due to the fact that such amortization 

could include the amortization of both premiums and discounts. All other things being equal, 

the amortization of premiums would result in projected expense and the amortization of 

discount would result in projected income. The projected amount of net interest income from

the amortization of both premiums and discounts would be a combination of the two. This net 

amount, therefore, is going to be impacted by whether there are more premiums or discounts 

associated with the underlying mortgage assets held by the Enterprise. Further complicating 

this is that at any given point in time, the mortgage assets held by the Enterprise have varying 

estimated lives. For example, a 15 year mortgage has a different estimated life than a 

conventional 30 year mortgage. 

For purposes of this discussion, the shape and level of expected amortization is not important. 

The illustration is meant to show the nature of the catch-up itself. In this example, the 

sensitivity analysis prepared on April 5, 2000, serves as an example of the catch-up calculation 

that would be made in the current quarter. The estimate of current quarterly catch-up would 

then be subject to comparison to the catch-up target threshold in effect in order to determine if

an adjustment to the cur ent quarter’s income is required. Alternatively, the estimate of the

subsequent year’s catch-up is, in this illustration, an estimate of the cumulative amount of 

future unrecorded income (catch-up) that would exist at each point forward if no other action is 

taken. 

r

Hypothetically, if the Enterprise were to record the entire amount of the current quarter’s catchup, the forecasted catch-up for subsequent periods would be similarly affected as well. 

Special Examination of Fannie Mae 

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Current

Quarter

Dec 31 ‘00 Dec 31 ‘01 Dec 31 ‘02 Dec 31 ‘03

$146.1 mil

$

Time

Catch-up (Before Adjustment)

Catch-up (After Adjustment)

Current

Quarter

Dec 31 ‘00 Dec 31 ‘01 Dec 31 ‘02 Dec 31 ‘03

$146.1 mil

$

Time

Catch-up (Before Adjustment)

Catch-up (After Adjustment)

Illustration 

 

OFHEO believes that the methods selected and infrastructure developed to support 

the estimation of prospective unrecognized income or expense, were in fact 

designed to facilitate a proactive management of earnings that extended well 

beyond the flexibility merely afforded by the Enterprise’s accounting for the current

quarter’s catch-up. This contention is supported both by a conceptual understanding of the 

catch-up and estimation methods used, as well as by the actual practices and accounting 

employed by the Enterprise that are documented both within this section, as well as other 

sections in this report. 

Relationship of Catch-up to Amortization

Outer periods that have a greater magnitude of either unrecognized income or unrecognized 

expense than the current or nearer term periods do, suggest a divergence between two 

estimates that conceptually should either be the same or at least be converging. 

SFAS 91 requires that a retrospective - “inception to date what-if” - adjustment be made to 

accumulated amortization and the corresponding income statement (amortization) account. 

This adjustment would be based on the latest estimate of the effective life of the mortgage

assets being amortized. SFAS 91 also requires that the mortgage assets be amortized 

prospectively over the new estimate of effective life. Presumptively, the estimated life of the 

deferred price adjustments would be the same for both the retrospective and prospective 

treatment. Why then, would forecasted unrecognized income or expense be growing in 

magnitude?

In making the adjustment required by SFAS 91, there should be no unrecorded income or 

expense other than the momentary difference that should then be immediately recorded, from 

applying the revised forecast of the new estimated lives of the mortgage assets that forms the 

basis of the retrospective adjustment. 

If hypothetically, a reporting entity were permitted to avoid making the retrospective 

adjustment under SFAS 91, the forecasted amount of unrecorded income or expense associated

with that treatment would then be either positive or negative but should still nevertheless, be 

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diminishing and converging to zero. The following graphic illustrates this effect in a 

circumstance where a positive (income) retrospective adjustment is not made. 

Current

Quarter

$

Time

Catch-up 

Current

Quarter

$

Time

Catch-up 

Illustration 

 

In the circumstance above, one would expect that the difference, between the amortization that

should have been recorded and the amortization that was recorded, should diminish. The rate 

at which the unrecorded amortization would diminish would be a function of the rate at which 

the portfolio of mortgage assets itself is diminishing due to mortgage loan prepayments. In a 

typical pool of mortgages, the rate at which mortgages prepay – and the portfolio diminishes – 

is faster earlier in the life of the pool, than at the end.

This expectation of diminishing differences however, was not always reflected in the forecasts 

of catch-up at the Enterprise. The graph below shows the forecast of guarantee fee107 catch-up 

for the first quarter of 2004.108 

 107 Fannie Mae started to separately track the catch-up associated with purchased premiums and 

discounts and guarantee fee separately, in accordance with the requirements of the December 2000 

purchased premium and discount amortization policy. Purchase Premium and Discount Amortization 

Policy, FMSE 074523-074524. 

108 The first quarter 2004 estimate of current quarter catch-up was further adjusted by the correction of an 

error related to the treatment of Dollar Rolls. The impact of this correction resulted in an adjustment to NII 

that reduced that catch-up by approximately $36 million. Accordingly, all prospective periods of

forecasted catch-up would have been similarly affected as well. OFHEO utilized the ‘before adjustment 

amounts’ since it did not have the ‘post adjustment’ analysis. 

Memorandum from Jeff Juliane and Rene LeRouzes, Subject: Q1 2004 Amortization Results, to File, 

dated April 27, 2004, FMSE-SP 000260-000265 and

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Memorandum from Mukul Gupta, Subject: Error in Amortization of Securities Used in Dollar Rolls, to 

Distribution, dated May 3, 2004, FMSE-SP 000266-000272. Distribution included among others Ms. 

Leanne Spencer, Mr. Jonathan Boyles, Ms. Janet Pennewell. 
GFEE 

Current 

Quarter

Q2 ‘04 Q3 ‘04 Q4 ‘04 Q1 ‘05

$

Time

+ 200 mil

+ 300 mil

+ 100 mil

$141.7

$176.7

$203.5

$220.8

$281.2

Current 

Quarter

Q2 ‘04 Q3 ‘04 Q4 ‘04 Q1 ‘05

$

Time

+ 200 mil

+ 300 mil

+ 100 mil

$141.7

$176.7

$203.5

$220.8

$281.2

 

This analysis shows the estimate of catch-up to be growing over subsequent prospective 

quarters. The next graph shows the forecast of NII catch-up for the same period: 

NII 

Current 

Quarter

Q2 ‘04 Q3 ‘04 Q4 ‘04 Q1 ‘05

$

Time

- 200 mil

-100 mil

+ 200 mil

+ 100 mil

$78.3

($78.0)

($152.9)

($194.8)

($217.8) Current 

Quarter

Q2 ‘04 Q3 ‘04 Q4 ‘04 Q1 ‘05

$

Time

- 200 mil

-100 mil

+ 200 mil

+ 100 mil

$78.3

($78.0)

($152.9)

($194.8)

($217.8)

In either case, the magnitude of forecasted unrecognized income and loss should be trending 

towards zero in subsequent periods. 

The selection of the catch-up forecast for the first quarter of 2004 was specifically made 

because according to the testimony of Fannie Mae management decided not to make any ‘in 

use’ factor changes at the end of that quarter. OFHEO does not find this decision to be 

appropriate. However, it serves a useful purpose since the Enterprise could not provide many 

Special Examination of Fannie Mae 

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instances where full catch-up forecasts were performed on both a before and after ‘in use’ 

factor change basis.109 

Appendix I provides an analysis of the estimation methods that Fannie Mae employed to

determine the catch-up. As noted in this appendix, the Enterprise uses a dif erent method for 

forecasting catch-up and estimating prepayment speeds for determining the SFAS 91

retrospective adjustment than it uses for determining prospective amortization. Pursuant to

the analysis provided in the appendix, OFHEO has concluded that Fannie Mae’s forecast of

catch-up and estimate of the SFAS 91 retrospective adjustment, based on their method of using

multiple rate paths and related assumptions, is incorrect. In addition, since the Enterprise’s own 

forecasts of catch-up do not consistently show a diminishing level of catch-up, OFHEO has

further concluded that the estimate of effective lives used for prospectively 

amortizing deferred price adjustments is also incorrect.

f

The Use of Catch-up to Promote Earnings Stability and

Shift Income or Expense between Periods 

In two previous sections, this report described 1) the latitude of the Enterprise – within the 

framework of policy – to recognize discretionary income or expense within the target threshold 

range, and 2) the view that the catch-up was to be managed in accordance with maintaining a 

target level of catch-up, such that the potential of exceeding the target range thresholds and 

the resultant earnings volatility, was minimized. 

The capability to forecast catch-up therefore was, among other things, the means to steer 

toward the desired target catch-up. Making discretionary adjustments within the target range 

served to propel the Enterprise toward this goal. A challenge however, would be the wake of 

earnings volatility that such navigation created. In this regard, course corrections using such 

discretionary adjustments would themselves potentially create an undesirable impact in the 

quarter in which they were made. 

A memorandum110 dated April 12, 2001 from Jeff Juliane and Rene LeRouzes indicates that

planned on-tops of $75 million of income related to NII, and $57 million of expense relating to 

GFEE will be taken prospectively via 2001 amortization factors. The memorandum further 

states that 1) an additional $10 million of on-tops will be booked for 2001 “to hedge our 

exposure if rates continue to decline,”111 and 2) “However, since we are disproportionately 

exposed to the Gfee catch-up in the down sensitivities (50 and 100 bps respectively), it was 

 109 OFHEO Interview, Mr. Jeff Juliane, August 31, 2004, p. 15. 

Q: Getting back to the instances you described before where the rate change was not processed, can you 

recall specifically what period that was?

A: The only period I can recall was Q1 – it was the April 2004 rate change. We did not process the April 

2004 rate change. 

Q: And that’s the April 2001 – 

A: Four. 

Q: April 2004, okay. 110 Memorandum from Mr. Jeff Juliane and Mr. Rene LeRouzes to Distribution dated April 12, 2001, 

Subject: Q1 2001 Amortization Update. Distribution included Mr. Tom Lawler, Mr. Peter Niculescu, Ms. 

Leanne Spencer and Ms. Janet Pennewell. FMSE-SP 002787–002790. 

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111 Id.
decided to layer on an additional $8 million of expense on-tops in 2001. This results in a total

on-top amount of $66 million of related expense for 2001.”112 

The practice of booking scheduled monthly on-tops was previous practice at Fannie Mae. 

OFHEO’s examination procedures did not extend to an exhaustive review of accounting records 

to determine all instances in which this occurred. However, in 1999 and 2000 OFHEO is aware 

of scheduled on-tops taken to reduce the $200 million deferred expense not taken in 1998. In 

addition, for purposes unrelated to this $200 million, scheduled monthly on-tops were made in 

2000 as well.

113

The memorandum dated April 12th 2001 however, is OFHEO’s first understanding that 

scheduled on-tops were now being made as factor change adjustments. Within the

amortization system itself, adjustments to current quarter and future period income could now 

be made. There are further instances of on-top adjustments being made through factor 

changes. 

More significantly, and as noted in subsequent sections of this report, there are numerous 

instances where the impact of other accounting events were capitalized as phantom assets or 

liabilities within the amortization system and subsequently amortized over a 30-year 

conventional mortgage proxy life. Typically, these items were reconciliation differences 

between various accounting sub-ledgers that had an income statement effect; however, other 

accounting events of a different nature were treated in similar fashion as well. Thus, earnings 

volatility could be managed and income shifted from one period to another. 

In fact, just two quarters prior to the commencement of the scheduled factor amortization 

adjustments of 2001, an unsigned note to Ms. Janet Pennewell stated the following: 

Lost $20 million in catch-up due to rate change and picked up $30 million in 

catch-up due to change in book (recognizing to [sic] little discount into income). 

Lost $78 million in catch up due to methodology change (short term CPR’s were 

changed from 3-months to 24-month) to slow down the recognition of discount 

into income in request to reducing the positive catch-up and transferring income 

into the outer years.114 

 

The use of the amortization process to effect changes to the Enterprise’s financial statements 

also supports OFHEO’s contention that Fannie Mae management selected estimation methods 

that understated the true level of the catch-up. Any items, on-tops or other accounting events 

that had an income statement impact would have had the earlier noted effect of reducing the 

estimate of prospective catch-up for all forecast horizons impacted. In this regard, having a 

 112 Id. 

113 Memorandum from Mr. Rene LeRouzes to Distribution, dated October 17, 2000, Subject: PDA/REMIC 

Results (August Book), the distribution list includes Ms. Janet Pennewell and Mr. Jeff Juliane. FMSE-SP 

000113-000116. This memorandum states: “With the Q3 update, our on-top adjustments for the 

remainder of 2000 and the forecast horizon was revised. Previously, we were booking approximately 

$8.0M monthly ($1.8 M Gfee, $6.0 M NII) for the balance of 2000. Revised for the Q3 update, and 

incorporated within the forecast, on-tops are approximately $2.0M monthly ($.7M GFee, $1.0M NII) for the 

remainder of the year.” 

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114 Undated document titled: “Notes for Janet – Explanation of results.” FMSE-SP 002590. 
large catch-up would be preferred. In theory, the catch-up could mechanically support the 

ratable recognition of stable earnings, or the shifting of income between periods, if it was in 

either a positive or negative position. However, it would be much better to have a

proportionally larger, rather than smaller, unrecognized income to cushion against earnings 

volatility – both market driven (i.e., changing prepayment estimates) and event driven 

(reconciliation errors). A larger rather than smaller catch-up could also serve as a reserve that 

could be drawn from or replenished as necessity might dictate. 

The use of the amortization system to effect adjustments to the financial statements also 

provided a means to contravene the internal controls that would otherwise be necessary when 

making adjustments to the general ledger. Accounting systems, as well as traditional related 

internal controls, serve to highlight such entries both on a current basis as well in accordance 

with maintaining a history or an audit trail of such adjustments that would facilitate inquiry and 

critical review. The amortization system on the other hand was not subject to these same 

internal controls. A diminished transaction trail, key person dependencies, as well as 

accounting effects obscured within sub-ledgers containing hundreds of thousands of

records, were all manifestations of the process of amortization at Fannie Mae. 

Subsequent sections of this report will detail matters concerning the weak control environment 

associated with the amortization process. We have concluded that Fannie Mae tolerated 

significant control weaknesses as a further means to obscure the management of the catch-up 

and any related income effects. 

 

Development of Systems and Modeling Capability

OFHEO has concluded that iterative modeling of the catch-up was performed for 

both the current quarter as well as prospective reporting periods for the purpose of 

generating results under varying assumptions in order to achieve a specific desired 

outcome. 

The active modeling and management of both current and forecasted catch-up required 

systems applications more robust than the Enterprise previously had. This section of the report

links methods for modeling and managing the catch-up that were previously described, to 

systems functionality specifically designed to support them and the earnings management 

intended. Subsequent sections of this report, as well as the included appendix titled 

“Estimation Methods Used for Modeling the Catch-up” will document examples of instances 

where either iterative modeling was performed or assumptions were selected specifically to 

achieve desired financial results. 

In 1998, the Enterprise anticipated this need and installed an application called “BancWare 

Convergence” (hereafter referred to as “BancWare”). This software was “purchased and 

installed as a tool to facilitate the scenario analysis of our purchase discount/premium and 

deferred/ prepaid fee position.”115 In a memorandum dated March 12, 1999, Mr. Jeff Juliane 

 

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115 Memorandum from Mr. Jeff Juliane to Distribution, dated March 12, 1999, Subject: BancWare 

Convergence – Next Steps, distribution included; Mr. Tom Lawler, Ms. Leanne Spencer, Ms. Mary 
described that the first phase of implementation began in the fall of 1998 and further advocated 

the elevated priority of functional development. In commenting on the capability now provided 

by BancWare, Mr. Juliane noted: “Phase I of the conversion to BancWare was completed

recently increasing our ‘what-if’ capabilities in analyzing purchase premium/discount and 

deferred/prepaid fees on the core book of business.”116 Commenting on upgrades in capability 

achieved in Phase I, Mr. Juliane further noted that “These upgrades created enhanced cash 

flows, which improved our catch-up forecasting ability.”117

In commenting on the need for a specific additional enhancement that would allow BancWare 

to produce modeling reports in dollars, and therefore bypass PDAMS118, Mr. Juliane states a

need for producing multiple scenarios quickly: “This enhancement would eliminate the need to 

run scenarios through PDAMS to produce useable reports. This greatly enhances our ability to 

produce multiple scenarios within short timeframes.” 119

Commenting on needs beyond speed, and providing a stated objective for certain desired 

capabilities, Mr. Juliane further wrote: 

BancWare amortizes premium and discount using an interest proxy method 

based on a proportionate amount of principal collected. This generates an

amortization amount that ensures that the purchase price is maintained 

throughout the life of the instrument. Consequently, the normal amortization 

factors BancWare produces assume that you record catch-up in the period when 

incurred. However, even though the normal factors assume that you 

will recognize catch-up in the period incurred, BancWare gives you the 

flexibility to manipulate the factors to produce an array of recognition 

streams.120 [Emphasis added] 

Mr. Juliane continues in the paragraph: 

With this manipulation you can ‘bleed’ the catch-up within a specified time period 

and affect both the subsidiary ledger as well as the general ledger equally. This 

strengthens the earnings management that is necessary when dealing with a 

volatile book of business.

121

Further in the memorandum, Mr. Juliane describes additional functionality that – if built - would 

provide further flexibility and control over the recognition of the catch-up: 

 

Lewers, Mr. Jonathan Boyles, with copy to Ms. Janet Pennewell and Mr. Rene LeRouzes, FMSE-SP 

000364–000367. 

116 Id.

117 Id.

118 Purchase Discount Amortization System. This was the system used at the time by the Enterprise to 

model catch-up. 119 Memorandum from Mr. Jeff Juliane to Distribution, dated March 12, 1999, Subject: BancWare 

Convergence – Next Steps, distribution included; Mr. Tom Lawler, Ms. Leanne Spencer, Ms. Mary 

Lewers, Mr. Jonathan Boyles, with cc to Ms. Janet Pennewell and Mr. Rene LeRouzes, FMSE-SP 

000364–000367. 

120 Id. 

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121 Id. 
It is recommended that we adopt the amortization method currently used within

BancWare. It applies Fas [sic] 91 more consistently than our PDAMS process 

and has the ability to generate factors that give us multiple recognition patterns 

that create maximum earnings flexibility. We will need to build a table within 

BancWare (or multiple tables) that will allow us to control the period over which 

catch-up is recognized.

122 

OFHEO believes that the catch-up convention itself is inconsistent with the requirements of

GAAP. It is clear however, that in addition to not recognizing amounts that should 

be recorded in the current period as they are estimated, the Enterprise intended to 

also manage the prospective periods over which the deferred amounts were 

managed, and devoted resources in order to systematically apply this inappropriate 

treatment. 

Additional sections of this report will demonstrate the circumstances under which this capability 

was used.

Historical Analysis of Accounting for Deferred Price Amortization

 

 

The previous discussion of OFHEO’s preliminary findings on accounting for deferred price 

amortization focused on the Enterprise’s accounting at the end of 1998 and years immediately 

subsequent, as well as the formulation of a policy that led to the adoption of the Enterprise’s 

policy in December 2000 that remains in effect currently. But what was the impact?

We have attempted to illustrate the effect that the Enterprise's policies and practices have had 

on the recorded amount of amortization. All of the information that these charts are based on

was provided by the Enterprise. While we have made adjustments to reflect the impact of

particular aspects of the Enterprise's policies and practices, in some cases this was difficult due 

to inconsistent information and inadequately described adjustments. It should be noted that 

while we have included adjustments to amortization for the periodic swings in the catch-up

level, we have concluded elsewhere in this report that the calculation of the catch-up level was 

not consistent with the requirements of SFAS 91. 

An overview of the effect is illustrated in the following charts which show how the 

implementation of the Enterprise’s amortization policy reduced income statement volatility: 

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122 Id. 
Chart 1: 

Amortization Income before and after on-top adjustments

-200.0

-100.0

0.0

100.0

200.0

300.0

Q1

2001

Q2

2001

Q3

2001

Q4

2001

Q1

2002

Q2

2002

Q3

2002

Q4

2002

Q1

2003

Q2

2003

Q3

2003

Q4

2003

Q1

2004

Amortization Inc/(Exp) after recording on top-adjustments

Amortization Inc/(Exp) before recording on-top adjustments

$

 

Chart 1 shows the effect the on-top adjustments had on the recorded amount of amortization

income or expense. 

Chart 2: 

Amortization Income if Mean Catch-up is recorded

-200.0

-100.0

0.0

100.0

200.0

300.0

Q1

2001

Q2

2001

Q3

2001

Q4

2001

Q1

2002

Q2

2002

Q3

2002

Q4

2002

Q1

2003

Q2

2003

Q3

2003

Q4

2003

Q1

2004

$

Amortization Inc/(Exp) after recording on top-adjustments

Amortization Inc/(Exp) if Mean Catch-Up is recorded

Chart 2 shows the effect of recording the mean amount of catch-up to $0 at each quarter-end. 

The base amount is calculated using a base rate path, which is the interest rate path the 

Enterprise deems to be the most likely forecasted rate. Such base rate path is then used to

generate a forecast of prepayments. The mean amount is a simple average using the base rate 

path and 4 shocks scenarios of up and down 50 bps and up and down 100 bps. As we have 

noted elsewhere in this report, we do not believe that the mean catch-up would be equivalent 

to the retrospective adjustment that is required by SFAS 91. However, this chart does show 

that the Enterprise's policy of applying the catch-up thresholds and not recording the mean 

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amount to $0 at each quarter end had the effect of significantly reducing the volatility of 

recorded amounts.

Chart 3: 

Amortization Income if Base Catch-Up is recorded

-200.0

-100.0

0.0

100.0

200.0

300.0

Q1

2001

Q2

2001

Q3

2001

Q4

2001

Q1

2002

Q2

2002

Q3

2002

Q4

2002

Q1

2003

Q2

2003

Q3

2003

Q4

2003

Q1

2004

$

Amortization Inc/(Exp) after recording on top-adjustments

Amortization Inc/(Exp) if Base Catch-Up is recorded

 

Chart 3 shows the effect of recording the base amount of catch-up to $0 at each quarter-end. 

This analysis clearly shows that, not only did the Enterprise’s policy provide more stable 

earnings but also the use of the mean of the five scenarios in the calculation of catch-up further

served to minimize the volatility of the catch-up position (as compared to the base amount of 

calculated catch-up) in certain periods. 

Chart 4:

Amortization Income if Base Catch-up is recorded and Realignments

are Recorded into Income

-200.0

-100.0

0.0

100.0

200.0

300.0

Q1

2001

Q2

2001

Q3

2001

Q4

2001

Q1

2002

Q2

2002

Q3

2002

Q4

2002

Q1

2003

Q2

2003

Q3

2003

Q4

2003

Q1

2004

$

Amortization Inc/(Exp) after recording on top-adjustments

Amortization Inc/(Exp) if Base Catch-Up is recorded before Realignments

Chart 4 shows both the effect of recording the base amount of catch-up to $0 at each quarterend as well as what the impact would have been if the reconciliation differences had been 

recorded (rather than capitalized and amortized over proxy lives) in the periods that they were 

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calculated. Although the true determination of what amounts should have been recorded in 

prior periods is a matter of ongoing examination, this chart adequately depicts the total impact 

of some of the Enterprise's policies and practices based upon the information we were provided. 

The remainder of this section provides further specific examples regarding the Enterprise’s 

application of its policies. These examples are intended to illustrate our findings. OFHEO is

still in the process of reviewing further information and analysis regarding the 

Enterprise’s accounting for deferred price adjustment amortization. Examples of the 

Enterprise’s accounting for deferred price adjustments include: 

a. On two occasions during 2003, a variety of means were employed to affect the amount 

of catch-up adjustment required during periods in which investment analysts’ 

expectations would otherwise not have been met. 

b. Numerous sensitivity runs of the catch-up were performed so that results under different 

assumptions could be evaluated. In the instances reviewed, assumptions were selected 

so that generated results would trigger adjustments to income in order to produce

desired financial results.

c. Management exercised discretion in accordance with the adopted policy in the selection 

of interest rate assumptions to ensure desired financial results were achieved. 

 

d. Inconsistent accounting practices were applied in the determination of the catch-up 

position. These inconsistently applied practices allowed management to avoid 

exceeding the thresholds for the catch-up position. 

e. Reconciliation differences between information maintained on sub-ledgers and 

information used by the catch-up modeling application were recorded as ‘phantom’ 

assets or liabilities and were amortized over subsequent years.123

Management of Catch-Up Results 

The Enterprise’s policies for accounting for amortization were purposefully designed and 

implemented in a manner that provided management with the discretion to adjust the amount

of recorded income or expense as long as such adjustments were made to reduce catch-up to 

the threshold amount as well as within the target catch-up ranges. This gave management the 

means to mitigate the volatility of income that is normally associated with a large mortgage 

portfolio, and further gave them the flexibility to achieve desired financial results. 

 123 Fannie Mae Audit Report, Office of Auditing, Amortization Audit, dated July 9, 2003, FMSE 023745-

023752 under the caption ‘Data Processes’ states: 

“Because of systems and process limitations, reconciliation differences exist between the amortization

account sub-ledgers (STATS and LASER), the G/L, and the amortization database (PDI). For this reason, 

the various systems need to be periodically realigned, resulting in adjustments to original unamortized 

accounts and accumulated amortization account balances. 

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These adjustments ranged from $700 thousand to $45 million during the period 11/2002 to 5/2003. 

Management’s practice has been to expense smaller differences, to book and amortize larger differences 

as new acquisitions, or incorporate the differences into the overall Catch-up balance.” 
In addition, the Enterprise engineered the catch-up results to generate a catch-up 

amount that exceeded the threshold, in order to trigger a specific amount of an ontop adjustment pursuant to the policy. 

 

EPS Analysis

$1.60

$1.65

$1.70

$1.75

$1.80

$1.85

$1.90

$1.95

$2.00

$2.05

Q4 2002 Q1 2003 Q2 2003 Q3 2003 Q4 2003 Q1 2004

EPS actual Analyst EPS (mean) EPS w/o on-top

During Q2 and Q4 of 2003, on-top adjustments were recorded that - after adjusting for the 

effect of income taxes - allowed the Enterprise to meet (or very closely meet) analysts’ 

estimates. Such adjustments made to the accounting for amortization - during the period since 

the Enterprise began filing public financial information - were contrary to SEC Staff Accounting 

Bulletin No. 99 (SAB 99). 

In June of 2003, the consensus EPS estimate for Fannie Mae was $1.867 per share and the low 

estimate was $1.81 per share.124 The actual EPS of Fannie Mae prior to recording the on-top 

adjustment would have been only $1.82 per share. After recording the on-top adjustment, the 

final EPS amount was $1.86 per share. 

The amount of the on-tops recorded for the June 2003 closing were $21.2 million for NII and 

$24.9 million for Gfee. The amount of the on-top required (per the Enterprise’s policy) as of 

June, 2003 was significantly affected by two different events. Both of the two events described

below had the effect of increasing the amount of income to be recorded without borrowing too 

much income from future periods: 

• First, the interest rate selected for the computation of the catch-up as of June 30 was 

specifically changed to incorporate interest rate drops that occurred (primarily during the 

 

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124 Source: Bloomberg 
month May).

125 OFHEO has concluded that the interest rate chosen by the Enterprise

for the June 2003 catch-up sensitivity was chosen, in part, because of the effect that 

such a change would have on the amount of income for the quarter as well as the 

forecasted amount of catch-up. Essentially, the rate was chosen to increase income, but 

in a measured fashion. See Section “Management Discretion Applied in the Selection of 

Market Assumptions” for more information on this matter. 

• Second, the Enterprise began to add certain capitalized reconciliation differences to the 

catch-up results (in addition to the impact of certain forecasted reconciliation differences 

which had been included in the catch-up analysis beginning in the prior quarter.) Again, 

the inclusion of a forecasted reconciliation difference in the catch-up results shows that 

management was thinking about current and future periods in determining the amounts 

to be recorded in the financial statements. OFHEO has concluded that the inclusion of 

such realignment differences in the catch-up sensitivity is not appropriate. See Section 

“Inconsistently Applied Accounting Practices to Determine the Catch-up” for more 

information on this matter. 

In December of 2003, the consensus EPS estimate for Fannie Mae was $1.75 per share.126 The 

actual EPS of Fannie Mae prior to recording the on-top adjustment would have been only $1.72 

per share. After recording the on-top adjustment, the final EPS amount was $1.76 per share. 

The December 2003 catch-up analysis was notable for the manner in which the catch-up 

amount was determined. In this circumstance, multiple catch-up sensitivities were run127 before

the final catch-up amount was determined. OFHEO has received draft sensitivity reports 

generated on January 5, January 6, and January 8, 2004. In addition, there was a final draft 

sensitivity report, which is undated, but which matches the amount of the final on-top 

adjustment which was recorded on January 10, 2004. 

In addition, there were two journal entries used to record the on-top adjustments. The first

journal entry, dated January 7, 2004 was for $50.1 million of income.128 The entry is supported

by a sensitivity analysis and bears a number of authorizing signatures including sign-offs by Mr. 

Juliane and Ms. Pennewell. The second entry, dated January 10, 2004 was for an additional 

$6.5 million.129 Such activity, on its face, may not raise much attention. But in retrospect, it 

seems suspect. The final catch-up threshold for the fourth quarter of 2003 was $110.2 million. 

If a sensitivity analysis was run on January 7th and an on-top had already been recorded, then 

why would another sensitivity analysis need to be run? Also, why would the result, a mere $6.5 

million then be recorded? The $6.5 million number seems especially small when you consider 

that, according to the definition provided by management, the “functional equivalent of zero”

130

was +/- $110.2 million? 

 125 The Fannie Mae 30-year coupon dropped from 4.908% on April 30, 2003 to 4.177% on June 12, 2003. 

The rate then rose to 4.648% on June 30, 2003. Source: Bloomberg. FMSE 194295-194296. 

126 Source: Bloomberg 127 For bates ranges see references in the table on the following page. 128 Journal Entry Dated 1/7/2004, FMSE 216777 

129 Journal Entry Dated 1/10/2004, FMSE 216778 

130 OFHEO Interview, Mr. Tim Howard, August 5, 2004, p. 151 

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Q: And do you think that, given the historical amount of the variability, that even an annual variability, that 

the $ 200- or potentially greater than $ 200-million target range that you apply is reasonable?
The results of the four sensitivities that we received are compared in the following table: 

Date Comments

January 5, 2004 $ 173.5 $ 109.5 $ 64.0 Marked "Not Final"

January 6, 2004 159.6 109.5 50.1 Agrees to on-top recorded on 1/7

January 8, 2004 133.6 110.2 23.4 Marked "Alternative"

January 10, 2004 166.8 110.2 56.6 Agrees to combined on-tops recorded on 1/7, 1/10

Bates numbers (in order by date above): FMSE-SP 002872, 002875, 002869, and 002502

NII Catch-Up

Mean

Catch-Up

Threshold Difference

As the table above shows, the NII catch-up was recalculated twice after the on-top journal 

entry was recorded on January 7, 2004. In addition, it should be noted that the NII revenue 

target was also slightly adjusted from $109.5 million to $110.2 million. The adjustment of the 

NII target had the effect of changing the catch-up threshold itself. 

As of the date of this report, we have received no specific evidence that such adjustments were 

made to intentionally match the analysts’ estimates. However, the existence of multiple 

sensitivity runs, the timing of their production and the small amounts of on-top journal entries 

recorded suggests that results were generated to achieve desired financial results.

A reason for the multiple runs however, is suggested by Mr. Juliane’s 2002 performance 

appraisal. That performance appraisal states: 

Under a section entitled “Objective 1” of Mr. Juliane’s 2002 year-end appraisal, the following 

statement appears (among others): “Assist management to reach results that fit within 

established guidelines.” Under the “Results Achieved” section of Objective 1, the following 

appraisal if provided: 

This was an extremely intense year as record low interest rates could have 

caused our catch-up position to fall outside of our corporate policy. The low 

interest rates resulted in a significant increase in the number of sensitivity runs 

performed to provide management with the best analysis possible when making 

decisions. In support of this need, Jeff and his staff completed several 

unscheduled sensitivity runs and responded to numerous requests for 

information.131 

Although this performance appraisal was for the prior year (2002) it supports OFHEO’s 

contention that the Enterprise processed multiple sensitivity runs in order to “reach results.” 

This strongly suggests that amortization expense was being actively and

inappropriately managed by the Enterprise. 

 

A: I wouldn’t relate it to the variability, economic variability, because what we were attempting to do was 

calculate a zone of estimation error, if you will, within which any number we produced we would view as 

the functional equivalent of zero – could not differentiate between whether $70 million is the right number 

or minus $50 million is the right number. That was the theory and intent behind the policy. 

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131 Employee Contribution Review Form for Mr. Jeffrey Juliane for the period January to December 2002. 

The appraisal was provided by Mr. Richard Stawarz and approved by Ms. Janet Pennewell and is dated

March 18, 2003. FMSE 220368-22073.
Management Discretion Applied in the Selection 

of Market Rate Assumptions 

Appendix I “Estimation Methods Used for Modeling the Catch-up” provides an analysis of 

estimation methods selected, and their impact on the catch-up. The appendix also provides an

analysis of assumptions selected in 1999 and 2000 by management that were used in the 

determination of the catch-up. OFHEO believes that the estimation methods selected, as well 

as market rate assumptions applied during this period, were consistent with an intent to avoid 

volatility and achieve desired financial results. OFHEO also believes there are other 

noteworthy instances in which management selected assumptions, in periods 

subsequent to 2000, in order to produce desired financial results as well. 

Noteworthy in particular is the calculation of the June 2003 amortization. First, in this period, 

rates had declined sharply during the quarter. This rate decline precipitated a significant

amount of discussion on how it should be addressed insofar as the modeling of the deferred

price amortization was concerned.132 

During testimony, management indicated that due to the timing of the rate setting meeting, it 

was common that the rate might be updated prior to quarter-end.133 Due to the steep decline

in rates, an analysis was performed to determine the most appropriate rate path to use for the 

June 2003 quarter-end sensitivity analysis. As a result of the analysis, management decided

that it would be best to use a “hybrid rate” in order to calculate the amortization for that 

quarter.134 The hybrid rate would be a combination of the current rate curve and the forward 

curve run as of April 30, 2003.135

 132 Memorandum prepared by Mr. Jeff Juliane, Re: Amortization, June 11, 2003, FMSE-SP 000166-

000167, in which he discusses 3 different interest rate scenarios and their expected impact on the Net 

Interest Income and Guarantee Fee catch-up position as of 6/30/03, 9/30/03, 12/31/03 and 12/31/04 

compared to the respective thresholds. 

133 OFHEO Interview, Mr. Jeff Juliane, June 8, 2004, p.34

A: In Q2 there was a significant rate move after the rate setting meeting that came out. So we had a 

subsequent meeting with the rate setters and we came up with an adjusted rate path that they felt was 

the more prudent rate path to deal with because rates had been so substantial.

134 OFHEO Interview, Mr. Jeff Juliane, June 8, 2004, p. 56 

A: We felt it prudent that we needed to adjust our interest rate forecast because taken into the effect that 

rate reduction and then management had discussions around whether we should use like the May 15 

floor or some other floor or what was an appropriate long-term rate associated with that historically low 

short-term perspective and they came up with this hybrid approach of getting back to the April 30 forward 

long-term perspective over a seven-month time horizon--6 month time horizon. 

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135 Memorandum prepared by Mr. Jeff Juliane, Re: Amortization, dated June 11, 2003, FMSE- SP 

000166-000167 states “Management elected to determine the impacts in considering the move down in 

rates as a “temporary shift” in the curve from the rates of April 30th. A third rate curve was modeled which 

we consider as a “hybrid” of the two runs. The “hybrid” rate path started at the May 28th current coupon 

rate, which was 50 basis points lower as compared to the April 30th forward rate, reverting back to the 

April 30th curve by the end of October. The curve was then consistent with the April 30th curve from that 

point forward.” 
The hybrid rate would consider the recent decline in rates, but at the same time assume a 

return to the April rate level over a short period of time. The net amount of the total catch-up

position at that point was a deferred income amount. The change to the hybrid rate had the 

effect of increasing the amount of deferred income and thereby increasing the amount available 

for income recognition in the future. 

The rate that was originally used for that quarter was previously determined at a meeting in 

April of that year. Subsequent to that meeting, rates suddenly dropped by approximately 50

basis points. The effect of the rate change on the catch-up level was analyzed in a 

memorandum dated June 11, 2003 from Mr. Jeff Juliane. The following table is an excerpt from 

that analysis: 

4/30/2003 Forward Curve Run

1% of NII 2% of Gfee

Revenue Target Revenue Target

6/30/2003 $190.2 $99.6 $77.6 $44.4

9/30/2003 $142.0 $99.6 $81.3 $44.4

12/31/2003 $112.8 $99.6 $83.2 $44.4

12/31/2004 $68.2 $108.5 $90.0 $47.7

Down 50 Run

1% of NII 2% of Gfee

Revenue Target Revenue Target

6/30/2003 $216.0 $99.6 $174.3 $44.4

9/30/2003 $138.7 $99.6 $192.5 $44.4

12/31/2003 $99.4 $99.6 $204.6 $44.4

12/31/2004 $8.6 $108.5 $231.2 $47.7

Hybrid run

1% of NII 2% of Gfee

Revenue Target Revenue Target

6/30/2003 $217.3 $99.6 $92.1 $44.4

9/30/2003 $158.0 $99.6 $100.2 $44.4

12/31/2003 $129.4 $99.6 $102.4 $44.4

12/31/2004 $92.6 $108.5 $106.7 $47.7

Date NII Catch-up Gfee Catch-up

Date NII Catch-up Gfee Catch-up

Date NII Catch-up Gfee Catch-up

Tables from memorandum dated June 11, 2003 from Jeff Juliane to Distribution. Subject: Amortization, FMSE –SP 000166-000167 

The first table labeled “4/30/2003 Forward Curve Run” shows the amount of catch-up position 

using the interest rates from the April forecast. 

The second table labeled “Down 50 Run” shows the amount of the catch-up position using the 

revised interest rate from a date in early June of 2003. 

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The third table labeled “Hybrid Run” shows the amount of the catch-up position using the 

revised interest rate from a date in early June combined with an assumption of a return to the 

April 30th rate level by the end of October 2003. 

It is important to note that in all these rate scenarios, management’s analysis 

included a pro ection of how it would affect future periods. This is consistent with 

emphasizing the forecasting and management of the catch-up over prospective 

periods. 

j

 

The different dates on the tables reflect the forecasted trend in the catch-up position based 

upon the forecasted interest rate and prepayment assumptions assuming no future change in 

market conditions. In all three scenarios, the amount of the deferred income for NII was 

forecasted to decline and the amount of the deferred income for Guarantee Fee was forecasted

to increase. 

A Bloomberg printout obtained from Enterprise management shows that the decrease in rates 

from April was a temporary decline, and that rates actually rose towards the end of June. The 

low point of rates for the quarter actually occurred on June 12, 2003, one day after the date of 

Mr. Juliane’s rate analysis.136 Coincidentally, this curve was the most advantageous rate curve 

possible. Had the analysis been re-run using the June 30 rate estimates, it is likely that the 

catch-up amounts would not have exceeded the respective thresholds and no income on-top 

adjustments would have been required or the amounts of the on-top adjustments would have 

certainly been lower.

Why the Hybrid Rate was Advantageous

The hybrid rate was attractive for two reasons: (1) the incorporation of the rate decline 

provided more income that could be recorded as compared to the income that could be

recorded using the April rate and (2) the hybrid rate provided less income than the “Down 50” 

scenario. This allowed management to record some income, but not so much that the catch-up 

position would become negative, if rates changed adversely in subsequent periods. To this 

extent, the hybrid rate presented a “Goldilocks” solution: it was not too high, not too low; it was 

just right. 

In addition, the Enterprise was in the process of correcting certain errors that had been 

discovered in the data used to calculate amortization. For instance, securities that were 

purchased at a premium were erroneously included in modeling groups with securities 

purchased at par or at a discount. The reason that including them together was incorrect is 

due to the fact that securities purchased at a premium do not respond to changes in interest 

rates in a similar manner as those purchased at a discount.137 The correction of these 

misclassifications was being done pursuant to a project known as “Security Master.” 

Beginning in the first quarter of 2003, the Enterprise began modeling the effects of the Security

Master project. This was important because the potential adjustments resulting from the 

project could have a significant effect on the amount of accumulated amortization. Specifically,

the changes were likely to result in large amounts of catch-up adjustments. As the modeling

 136 Bloomberg screen print, FMSE 194295-194296 

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137 SFAS 91, Q&A 51 
progressed, it became clear that the adjustments resulting from the Security Master project 

would result in a negative (expense) catch-up adjustment. This recognition was acknowledged 

by the inclusion of the projected expense as one of the reconciling items in the amortization 

results memorandum prepared for the quarter ended June 30, 2003.

138

Because the Security Master project was expected to result in a large expense adjustment, it

was monitored closely so that the final effect could be absorbed into the catch-up position when 

the project was completed without having an adverse effect on reported earnings. 

The projected expense resulting from Security Master is also a reason why the “Down 50” rate 

scenario was not advantageous as of June 30. If too much income was taken in June, then 

there might not be enough unrecorded income in the catch-up position to absorb the expense 

resulting from the corrections identified by the Security Master project in the following quarter 

when the project was expected to be completed. This is another example of how the catch-up 

framework was used as a “cookie-jar” to mitigate forecasted expenses. 

In her testimony Ms. Janet Pennewell described a point in the formulation of the policy in 1999 

where the concept of a mean reversion technique was considered.

139 Mean reversion is a 

concept whereby forecasts of long-term interest rates are assumed to always revert to a mean

interest rate level. Ms. Pennewell indicated that the Enterprise chose not to implement the 

mean reversion technique because they did not feel that such a technique was permissible. Ms. 

Pennewell further elaborated that it was her personal belief that such a technique (if employed

as a matter of policy) could lead to even greater volatility. For instance, if rates fell, the mean 

reversion technique could slow down the rate of change in the amortization speeds. However, 

if rates did not revert to the mean shortly thereafter or continued to fall a large amount of 

catch-up adjustment could result.140

Although the hybrid rate did not technically constitute a mean reversion technique, in fact, it 

had an analogous effect. The current rate path was only used for the next few months and 

expected to revert back to the April 30th rate curve within a 4 month period. The flexibility to 

apply discretionary judgment to selecting interest rate assumptions and modeling rate curves

provided much more favorable results than mandating certain rate scenarios by using the 

 138 Memorandum prepared by Mr. Jeff Juliane, Subject: Q2 Amortization Results, July 29, 2003, FMSE 

023763-023765. 

139 Memorandum prepared by Mr. Jeff Juliane, Subject: Amortization Policy Runs, to Mr. Tim Howard, 

June 21, 2000, FMSE-SP 000024-000025, in which he discusses various scenarios showing “sensitivity 

results using mean reversion to generate the prospective cashflows.” 

140 OFHEO Interview, Ms. Janet Pennewell, June 15, 2004, pp. 176-177. 

Q: [...] In this discussion of this alternative, the effect of assuming that rates will trend back down towards 

a historical average, that would have the effect of reducing earnings volatility, correct? 

FANNIE MAE LEGAL COUNSEL: Would or did? Because this was done – 

Q: Would. 

FANNIE MAE LEGAL COUNSEL: Hypothetically. 

Q: Hypothetically, it would. 

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A: I actually don’t think it would. The proponent of that particular view thought that it would help reduce 

the arbitrary earnings volatility that we’ve talked about before. In fact, I was of the view that, in fact, it 

would increase the potential, in certain circumstances, for additional volatility and, more importantly, I was 

concerned that if rates continued to, over a sustained period of time, continued to [sic] move away from 

historical means that you could very quickly develop a large catch-up, and that was never our objective. 
concept of mean reversion. As this circumstance shows, management had the latitude to

determine whatever interest rate assumptions it desired. 

Capitalization and Amortization of Reconciliation Differences 

Limitations in systems integration and application level controls undermined the integrity of 

information used to estimate amortization. This necessitated periodic reconciliations between 

information on transaction sub-ledgers (i.e. STATS, LASER) and the information on the 

amortization sub-ledger (iPDI). Differences from these reconciliations are known to Fannie Mae 

personnel as “realignments.” On some occasions, these differences were recorded as

adjustments in the period in which they became known. On other occasions, these differences 

were capitalized as phantom assets or liabilities and amortized over a period of time using the 

life of a proxy security.

141 Amounts capitalized in this manner were placed in a separate 

account in the PDI sub-ledger which was commonly referred to as the “deferred pool bucket” or 

the “bucket”. Management of the Enterprise refers to such reconciliation differences as 

realignments.142

This practice was well known within the Enterprise. In their July 9, 2003 audit report on 

Amortization, the Office of Auditing included the following statement (referring to reconciliation 

differences):

Management’s practice has been to expense smaller differences, to book and 

amortize larger differences as new acquisitions, or incorporate the differences 

into the overall catch-up balance.143

In addition, Ms. Joyce Philip provided the following background on the above observation: 

 

Q: Did audit inquire as to whether the alternative treatment of expensing smaller 

items and amortizing larger items was consistent under GAAP? 

A: We raised-we discussed this with Jonathan [Boyles] to determine whether any 

one of these treatments was appropriate. And Jonathan indicated that he had 

no concern with either one of the methods. But he did agree that there should

 141 OFHEO Interview, Mr. Jeff Juliane, June 8, 2004, pp. 137-138. 

Q: Is – what is the amortization characteristic of balances that are assigned to the bucket? 

A: We assign a conventional proxy for the amortization flow of those bucket acquisitions. 

Q: “Conventional” meaning 30-year fixed rate? 

A: Yes. 

Q: That would be true even though originally the amount assigned to this bucket may have come from a 

pooled mortgage that – pooled mortgages that was not 30-year fixed rate? 

A: That’s correct. I mean, the color of the elements of our asset is 30-year fixed range [sic: should be 

rate]. The specific answer to your question is you’re right. 142 OFHEO Interview, Mr. Jeff Juliane, June 8, 2004, pp. 82-83. 

Q: [...] So what is the deferred pool bucket comprised of? 

A: When we have--when we do--the deferred pool bucket is where we do realignments. We have a 

realignment policy that states that amounts above a certain threshold are put in the deferred pool bucket 

and given the proxy factors that amortize it over the life of that proxy collateral, and--but the amount is 

fully incorporated within the framework of the policy in times of catch-up. 

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143 Fannie Mae Office of Auditing Report, Amortization Audit, July 9, 2003, FMSE 023745-023752. 
be consistent direction or procedures as to how, going forward, realignment 

differences should be treated.

144

In his testimony, Mr. Boyles claimed no recollection of that discussion.145

There is no justification in GAAP for capitalizing and deferring differences resulting from 

reconciliation differences. Also, the effort involved in performing these reconciliations, and the 

magnitude of the differences, suggests that meaningful weaknesses in internal controls and 

system deficiencies had existed in previous years. 

The following is an illustration of how the practice of transferring differences into the bucket 

would work: For example, a security is purchased with a premium of $10, a purchase price of $ 

110 and $100 redemption value. Six months later the systems are realigned and the premium, 

which was originally recorded at $10, is adjusted to $5. As such, the amortization that has 

occurred to date is roughly twice as high as it should have been. Rather than recording an 

adjustment to income as they should have, Fannie Mae moved the difference to the bucket and 

amortized it using a proxy estimated life. 

According to information OFHEO received during the examination, the practice of capitalizing 

reconciliation differences dates back to 1991. The last significant LASER reconciliation 

difference added to the bucket was a deferred income of approximately $27.8 million in April of 

1998.146 Most of the older amounts in the bucket relate to LASER realignments and were for the

most part fully amortized as of June 2002. The total net composition of the bucket as of June 

2002 was a deferred credit balance of approximately $43 million.147

The first STATS realignment, however, was performed in August of 2002148 and the resulting 

difference was also recorded as a “new acquisition” into the bucket. This accounting practice 

was described in the Office of Auditing Amortization Audit Report, dated July 9, 2003, as one of 

their audit observations regarding processes that “should be improved to provide better 

documentation of analyses supporting G/L activities”149 as follows: 

Data Processes:

Because of systems and process limitations, reconciliation differences exist 

between the amortization account sub-ledgers (STATS and LASER), the G/L, and 

the amortization subledger (PDI). For this reason, the various systems need to 

be periodically realigned, resulting in adjustments to original unamortized 

accounts and accumulated amortization account balances. 

 144 OFHEO Interview, Ms. Joyce Philip, July 21, 2004, p. 91. 145 OFHEO Interview, Mr. Jonathan Boyles, August 24, 2004, pp. 97-98. 

Q: Okay. Have you ever rendered an opinion that it would be appropriate to capitalize and amortize 

reconciliation differences at any point? 

A: I don’t remember ever giving an opinion as relates to that. 

146 Subsidiary G/L Account by Acquisition Date, Month Ended: March 2002, FMSE 193570. 

147 Id.

148 Subsidiary G/L Account by Acquisition Date, Month Ended: September 2002, FMSE 193572, shows 

an addition to the STATS realignment product type in August of 2002 for approximately $46 million. 

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149 Subsidiary G/L Account by Acquisition Date, month ended: June 2002, FMSE 331640 
These adjustments ranged from $700 thousand to $45 million during the period 

11/2002 to 5/2003. Management’s practice has been to expense smaller

differences, to book and amortize larger differences as new acquisitions, or 

incorporate the differences into the overall catch-up balance.150

 

The following table shows significant STATS realignment amounts that were transferred into the 

bucket since 2002 and the total net balance of the bucket as of March 2004: 

August 2002 $ (15,102,606)

May 2003 $ (40,183,296)

August 2003 $ 63,951,446

February 2004 $ 105,915,406

Other (Net) $ (25,697,089)

Total $ 88,883,861

Composition of the Bucket as of March 2004

Deferred Debits (Credits)

 

Source: Subsidiary G/L Account by Acquisition Date: For Original Amount: Deferred Debits (Credits) Month 

Ended March 2004 (G/L Account 1201-01) FMSE 193584 

The amount shown on the schedule above for February of 2004 relates to a different error in 

the amortization process. OFHEO understands that the $105 million amount was subsequently 

revised to an amount of only $36.5 million.151 Management of the Enterprise informed OFHEO 

that the amount of this $36.5 million realignment was later reversed and recorded as an 

expense in the month of March.152 

The error related to a system problem in handling dollar roll transactions. In a dollar roll 

transaction, securities are lent out of the portfolio in secured financing arrangements. The error 

occurred when, upon return of the collateral, the original acquisition date of the security was 

overwritten with the date the security was returned to the portfolio. Such a date change 

caused issues with the accounting for amortization since the original acquisition date was 

needed to estimate the period of amortization. 

150 Id. 

151 Fannie Mae Reasonableness Test of Purchase Discount Income, for month ended March 31, 2004, 

FMSE-SP 003313. 

152 OFHEO Interview, Mr. Jeff Juliane, August 31, 2004, p. 181 

Q: If I understand this correctly, then at the end of that same corridor [sic quarter], Q104 [sic Q1 04], you 

were within the threshold for NII, but a debit was booked – 

A: For $36,515 [sic]. 

Q: Right. What did that amount relate to? 

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A: That related to the dollar-roll realignment that Financial Standards determined that was an error. We 

did a SAB 99 on it, and we booked it. We just happened to use that account booking. It wasn’t an on-top 

based on policy. That’s the account that we chose to recognize the expense related to this dollar-roll 

error. 
The final amount of the adjustment was determined by correcting the data in the STATS system 

and then determining the impact of the corrected information. Mr. Juliane specifically referred 

to the dollar-roll realignment as “non-standard.”

153

A formal SAB 99 analysis was prepared on the error including an evaluation of what effect the 

error had on prior periods, earnings per share, employee award calculations and other 

measures. This analysis was performed by the Financial Standards group at the request of Ms. 

Spencer.

154

It should be noted that the analysis completely ignores the Enterprise’s prior practice of 

capitalizing differences and amortizing them over proxy periods. While the memorandum 

recommends that the results of the analysis should be shared with management, 

any comparison to the Enterprise’s realignment policy is noticeably absent.155

The recording of this error as an expense is in direct contrast to the treatment of past

differences. In addition, it is not in conformity with the Enterprise’s policy for recording 

realignments into the bucket. Management of the Enterprise indicated that going forward all 

non-standard realignments will be evaluated by Financial Standards before they are recorded.156 

 153 OFHEO Interview, Mr. Jeff Juliane, August 31, 2004, pp. 181-182.

Q: What differentiated that dollar-roll error from, let’s say, a realignment? 

A: That would be a question for Financial Standards because we engaged them on this realignment, and I 

provided analysis to their group, and they did a determination, whether it was a change in estimate or an 

error. 

Q: When did that occur? 

A: End of March. You’ll see a Q1 memo for 2004, there’s an attachment of Nicole’s [sic. Mukul’s] analysis

of whether there was an error or not in the materiality relating to previous periods. 

Q: I thought that was for dollar rolls and not for realignments. 

A: No, it was a realignment due to the fact that we determined that we determine there was a dollar-roll 

error inside of STATS. So this was the processing of changing the original un-ams associated with the 

fact that there was a dollar-roll error, and that’s what Nicole’s [sic. Mukul’s] analysis is all about. 

Q: Does that mean that future realignments will no longer be capitalized into the bucket? 

A: No. Once again, when you see our SOX documentation, we have a formalized realignment policy that

says that standard realignment differences will be handled in the same fashion that they’re currently being 

handled. Nonstandard realignments will be run through Financial Standards to determine the proper 

handling of the accounting associated with that. 

154 OFHEO Interview, Mr. Jonathan Boyles, August 24, 2004, pp. 83-84. 

Q: Referring back to, I guess, audit difference related to dollar rolls, we saw an analysis that was done by 

someone who worked for you named Mukul Gupta? 

A: Yes.

Q: And he evaluated the error in context of many periods and many different things, basically a SAB 99 

analysis. Who directed him to perform that analysis?

A: I don’t recall who it was in particular, but either Janet or Leanne. My best guess would be Leanne. In 

one of my meetings with her, one of my regular meetings with her, described this issue and asked me to 

perform the analysis. And so I obtained the information from Janet Pennewell’s group and Mukul did the 

detailed analysis and reported up through me. 155 Memorandum dated May 3, 2004, from Mukul Gupta to Distribution, Re: Error in Amortization of 

Securities Used in Dollar Rolls, FMSE-SP 000268. 

156 OFHEO Interview, Mr. Jeff Juliane, August 31, 2004, p. 182. 

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A: [...] Once again, when you see our SOX documentation, we have a formalized realignment policy that

says that standard realignment differences will be handled in the same fashion that they’re currently being 
Our examination has not seen any evidence to indicate that the errors on dollar rolls are any 

different than other types of errors that have an effect on the accounting for amortization. 

OFHEO believes that the expense was taken for two reasons: (1) there was a large income ontop adjustment required for Guarantee fee amortization at the end of the first quarter of 2004 

which more than offset the amount of the expense resulting from the recording of the dollar roll 

error, and (2) changes in interest rates projected that the net interest income catch-up position 

would grow negative by the end of the year. If correct this conclusion would be consistent with 

the intent to maintain the catch-up amount in a deferred income position. 

Accounting for the Correction of an Error

The relevant accounting guidance for the treatment of the reconciliation differences can be 

found in Accounting Principles Board Opinion 20, Accounting Changes (APB 20). APB 20 

provides the following guidance about why matters such as the reconciliation differences should 

be considered errors: 

Reporting a correction of an error in previously issued financial statements

concerns factors similar to those relating to reporting an accounting change and 

is therefore discussed in the Opinion. Errors in financial statements result from

mathematical mistakes, mistakes in the application of accounting principles, or 

oversight or misuse of facts that existed at the time the financial statements 

were prepared. In contrast, a change in accounting estimate results from new 

information or subsequent developments and accordingly from better insight or 

improved judgment. Thus, an error is distinguishable from a change in 

estimate.

157

APB 20 also provides guidance on how corrections of errors should be recorded in the financial 

statements:

The Board concludes that correction of an error in the financial statements of a 

prior period discovered subsequent to their issuance (paragraph 13) should be

reported as a prior period adjustment.

158

Although the guidance above would indicate that the adjustment should be shown as a prior 

period adjustment, the SEC issued Staff Accounting Bulletin Topic 5F which provides the 

following additional guidance with respect to the correction of immaterial errors: 

If prior periods are not restated, the cumulative effect of the change should be

included in the sta ement o income for the period in which the change is made 

[Emphasis added] (not to be reported as a cumulative effect adjustment in the 

manner of APB Opinion 20). Even in cases where the total cumulative effect is 

t f

 

handled. Nonstandard realignments will be run through Financial Standards to determine the proper 

handling of the accounting associated with that. 

157 APB No. 20: Accounting Changes, Par 13. 

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158 Id., Par. 36 
not significant, the staff believes that the amount should be reflected in the

results of operations for the period in which the change is made.159

Based upon the guidance above, OFHEO has concluded that the practice of 

capitalizing and deferring these reconciliation differences is not permitted under 

GAAP. In addition, the Enterprise’s practice of treating reconciliation differences in one of 

three ways (expense, capitalize or include in catch-up position) demonstrates yet another 

manner in which inconsistent decisions were made by management that affected the recorded

amount of amortization.

Inconsistent and Incorrectly Applied Accounting Practices to Determine the 

Catch-Up 

OFHEO’s examination identified a number of instances whereby the catch-up results 

were changed by including adjustments that were incorrect or inconsistently 

applied.

During 2003, certain of the reconciliation differences started being included in the catch-up 

analysis for NII. However, not all reconciliations were included. The inclusion of reconciliation 

differences in the catch-up framework is inappropriate for a number of reasons: 

• According to management, the catch-up sensitivity analysis is necessary due to the 

range of uncertainty in estimating prepayments. However, the inclusion of such 

adjustments (which result from errors created by system limitations and other items) to 

the results of the catch-up sensitivity analysis is fundamentally inconsistent with this line 

of reasoning.

 

• Certain modeled future reconciliation amounts – modeled pursuant to only one interest 

rate scenario - were included as adjustments to different catch-up sensitivities. Even

management of the Enterprise pointed out to us that this would not make sense since 

the catch-up sensitivity is based upon the mean of five interest rate scenarios while the 

estimated impact of the future reconciliation amounts is based upon only one interest 

rate scenario.

160

• Management of the Enterprise used discretion to select which amounts to include as 

adjustments to the catch-up on a quarterly basis.

 159 SEC Staff Accounting Bulletin Topic 5F: Accounting Changes Not Retroactively Applied Due To 

Immateriality. 160 OFHEO Interview, Rene LeRouzes, July 16, 2004 p. 144 

Q: Three hundred and ninety-three million. So if you had run catch-up sensitivities as of that date, the 

393 million would have been the net impact that using an updated factor after-affecting the MBS reclass 

would have on catch-up? 

FANNIE MAE LEGAL COUNSEL: Q: Can you tell him what that number is? 

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A: That number – a sensitivity analysis of five rate environments, a base and two outliers up and down. 

This [the $393] is only reflective of one environment. So to confuse this with a sensitivity analysis would 

be apples and oranges, from my perspective. 
The catch-up calculation for the first quarter of 2003 was the first one to include the effects of 

reconciliation differences. The adjustment was actually made for the effect of a future 

realignment related to the Security Master Project. Alternatively, no adjustment was made for

past reconciliation differences. The following description of the Security Master project was

included in the Q2 2003 Amortization Results Memorandum: 

Security Master is an attribute level identification process that ensures consistent 

handling of collateral by assigning the FAS 91 type and associated general ledger 

accounts based on the actual security characteristics. These attributes are 

compared against rule-based tables within STATs [sic] to assign the appropriate 

set of accounts and FAS 91 designation. The rules are defined by the business 

users and maintained within STATs [sic].161

The result of the project would be that securities that had previously been included in

inappropriate modeling types would now be included in modeling groups based upon objective 

criteria. Prior to the implementation of Security Master, the process of identifying securities had

been done manually by the trade input area.

162 The two significant issues that were supposed 

to be resolved by Security Master were as follows: 1) certain securities purchased at a premium

had been included with securities purchased at par or at a discount. This was not appropriate 

because (as described in this report) prepayments on securities purchased at a premium were

not affected by changes in interest rates in a similar manner as securities purchased at a 

discount; and 2) certain REMIC tranches163 were inappropriately grouped together for modeling 

purposes as well (for example, premium and discount REMICs were commingled). 

The reason that Security Master was going to have a large effect on the financial statements 

was due to the fact that, after the securities would be transferred, catch-up would be recorded 

(comparing the new life-to-date calculation to the previously recorded amounts) and any errors

in the previous calculation would cause significant swings in the catch-up balance. 

 161 Memorandum prepared by Jeff Juliane, Subject: Q2 Amortization Results, dated July 29, 2003, to File, 

FMSE 023763-023765. 

162 OFHEO Interview, Mr. Rene LeRouzes, July 16, 2004, pp. 147-148.

Q: So this analysis that we just looked at, that was – that showed the dollar effect of the MBS reclass. 

Was there an analysis prepared to show any dollar impact of the REMIC remapping? 

A: Not that I worked on. No. 

Q: Do you know, in fact, whether or not the REMIC remapping did have a dollar effect on the catch-up or 

on the amortization? 

A: Yes, it had – it had an impact. But I don’t know what that was and, sitting here today, when that 

analysis was integrated with this one. If it was, in fact, done, but I would think it would have been. 

Q: Would it be possible for you to explain to us why that – what generated that impact? 

A: What impact? 

Q: The impact of the REMIC remapping? 

A: The REMIC remapping was a rule-based engine that provided instead of manually determined 

concepts at the cohort level, the rule-based engine for securities, specifically the MBS reclass and the 

REMIC project, made the actual process as best as it could be. So there was no manual tagging done at 

the trade level to determine FAS 91 types. It was an automated approach to provide increased data 

integrity. 

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163 Risk, maturity or other classes into which a multi-class security such as CMO or REMIC is split. 
An amount of $118 million was deducted from the amount of the NII catch-up position as of the 

first quarter of 2003. In addition, there were four sensitivity analyses run for the first quarter of 

2003164 which calculated a positive catch-up (income position) ranging from $175 million to 

$232 million. 

The impact of the Security Master was actually modeled twice (presumably for purposes of 

estimating the effect it would have on the catch-up). The first analysis was done using the 

existing (in-use) factors. That analysis showed that the Security Master Project would result in

an estimated $118 million expense amount.165 The second analysis was done using the 

updated (March 2003) factors and showed that the project would result in an estimated $393 

million amortization expense amount.166 

Management decided to rely on the analysis using the older rates. This was important for two 

reasons: 1) Had the analysis using the newer rates been used, the inclusion of the $393 million 

amount in the analysis of catch-up would have required management to record an on-top 

expense adjustment of roughly $62 million (using even the most advantageous catch-up based 

upon the 4 scenarios run).

167 In addition, that would have left the catch-up position in a

negative $99 million (deferred expense) position, the least advantageous position under the 

policy. 2) The catch-up position (based upon the final calculation) exceeded the threshold by 

approximately $78 million. By including the lower amount, no on-top adjustment was 

necessary because the catch-up was now within the range of +/- 1% of portfolio NII. 

Even though the adjustment for the Security Master project related to prior periods, it should be 

noted that an assessment of the impact of the project on prior reporting periods was never 

performed. However, in the first quarter of 2004, a comprehensive assessment was done for 

the amortization errors related to dollar rolls. This is interesting, especially due to the 

magnitude of the potential Security Master Project adjustment.168 In the instance of the dollar 

roll error, management concluded that the $36.5 million impact was immaterial. 

The final catch up calculation prepared for the quarter ended June 2003 showed a total catchup position of $220.5 million. However, the impact of Security Master had grown to be $155

million as of June 30, 2003. It is interesting to note, however that the amount of the impact 

had not been re-modeled (as would be necessary to appropriately reflect the updated rate

 164 The four sensitivity analyses referred to are labeled FMSE-SP 002926, FMSE-SP 002930, FMSE-SP 

002942 and FMSE-SP 002943. 

165 MBS Reclass Summary Update, FMSE-SP 000155-000156. 

166 Id.

167 $232-393=-161. With a catch-up threshold of approximately 99 million as of March 31, 2003, an ontop adjustment of approximately $62 million ($99-161) would have been required under the Enterprise’s

policy. 

168 OFHEO Interview, Mr. Jonathan Boyles, August 24, 2004, p. 86. 

Q: I'm just curious. Why prepare a SAB 99 analysis for this particular item and not, for instance, for the 

security master items? 

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A: Again, I'm not on the day-to-day, you know, feed on what's happening down in the purchase discount 

area. When I'm asked to perform it, I perform it. I'm not aware of other issues or other concerns that 

Leanne would have thought would have required a SAB 99. So, you know, what she will do will she'll ask 

me or, you know, here's something that we think we might have missed. You know let's evaluate it. And 

so she asked me to do it, and I would not have even known about the dollar roll if somebody didn't bring 

that to my attention and ask me to perform it. 
environment). Instead, an amount of $37 million was simply added to the original $118 

amount. The $37 million was the estimated impact that moving those securities (that had an 

estimated impact of $118) would have on the other securities that would still remain in their 

original modeling entities. Management of the Enterprise indicated that this amount had been 

more difficult to isolate and to model, and that is why this number was not determinable on the 

same date as the $118 million amount.169 It is not clear why the $118 amount was not 

updated, especially since there had been such a wide range of possible outcomes ($118-$393)

using the data from the first quarter.

The amortization catch-up results for the second quarter of 2003 were also adjusted to take 

into account certain reconciling items. The inclusion of reconciling items was identified as an 

observation in the internal audit report.170 That report noted that there were no standards 

specifying which reconciling items should be included.171 The reconciling amounts were related 

to certain realignments arising from the STATS system. However, reconciliation differences 

from the LASER system were ignored. Management of the Enterprise has not offered any 

credible explanation for why only certain items were included. 

The amounts included as reconciling items in the catch-up analysis performed for the second 

quarter of 2003 were deferred credits which totaled approximately $60 million increasing the 

mean catch-up position from $ 220.5 million to approximately $ 280.5 million.172 The actual net 

amount of deferred reconciliation differences as of that date was, however, $92.3 million. 

This raises the question of why only certain amounts of the realignments were included in the 

reconciliation. Although our examination has not found specific evidence that the inclusion of 

only certain realignments at June 30, 2003 was done intentionally to achieve a particular result, 

the inclusion of the reconciliation differences did have a direct impact on the amount of the on-

 169 OFHEO Interview, Mr. Jeff Juliane, August 31, 2004, pp. 104-105.

Q: Was that effect incorporated into the catch-up and the on-top, or was it included – was it treated similar 

to a realignment? 

A: It was completely encapsulated in the framework of the policy. There’s multiple stages of this thing. We 

did an analysis in Q1 to determine the 118 [million]. Then there’s an analysis that we – we enhanced that 

analysis because when you’re moving collateral out of a FAS 91 type and into a FAS 91 type, there’s 

going to be ancillary effect to the assets that remain in the old FAS 91 type because you’re altering the 

cash flows. So we went in and as we enhanced our estimate over time, we said that 118 was the initial 

estimate that we have from just moving collateral X – collateral out of conventional into conventional 

premium. 

We then said, okay, we didn’t have time at that point in time in Q1 to do an analysis, so, okay, what’s that 

going to do to the factor of the assets that are left behind in the conventional FAS 91 type, because 

theoretically you had just taken the higher-yielding assets, i.e., premium priced assets, out of 

conventional and moved them somewhere else. So you’re theoretically going to slow down or lengthen 

the duration of the remaining assets in conventional. So we did that analysis in Q2, and we came up with 

an estimate of, I believe, $37 million that was going to be the impact of the catch-up related to the 

conventional acquisitions. At that point in time, our total estimate was $155 million related to the entire 

Security Master impact relating to MBS re-class. [...] 170 Fannie Mae Audit Report, Office of Auditing, Amortization Audit, July 9, 2003, FMSE 023749 

171 Id., the audit report states “[...] procedures do not specify what level of documentation is required to 

support actions taken, or what level of management involvement is required. Examples include: - 

Changes to modeling methodology [...], - Adjustments to Catch-up Results [...].” 

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172 Memorandum prepared by Jeff Juliane, Subject: Q2 Amortization Results, July 29, 2003, to File, 

FMSE 023763-023765. 
top adjustment recorded in that period. Essentially, by including the projected effect of the 

STATS realignment, management of the Enterprise had allowed the amount of catch-up to grow 

so that the impact of the errors to be corrected by the Security Master project could be 

absorbed in the period the project was completed while still maintaining a positive catch-up 

position. This is further evidence that the catch-up framework was not a range of uncertainty 

in estimation but rather a reserve that management could rely upon and offset against other

adjustments. 

Later, in September 2003, the net amount of all realignments was included as a reconciling item 

in the catch-up analysis. 

The following table, taken from a draft of the Q3 Amortization Results Memorandum, shows the 

adjustments made to the modeled catch-up position for both the second and third quarters of 

2003: 

 Q2 Q3 Difference 

(Q3-Q2) 

Mean Catch-up position on 

preliminary sensitivity report $220.5 $298.1 $77.6 (a) 

All realignments $60.9 $82.8 $21.9 (b) 

Back out catch-up from PO 

sales $0 $(30.4) $(30.4) 

Modeling estimate of $1.3 

billion MBS reclass 

 $(155.0)

estimate

 $(132.0)

actual $23.0 

On-top recorded $(21.2) $(107.5) $(86.3) 

Ending Position $105.2 $111.0 $5.8 

(a) Difference due to higher rate environment. This caused the net premium book 

amortization speeds to slow relative to current in-use factors. This causes an 

increase in the overall income (over amortization of premium) position. 

(b) Included the impact of all net LASER realignments for the Q3 sensitivity runs. 

This caused an additional 21.9 million of positive catch-up to included [sic] into the 

analysis. 

Q3 Amortization Results Memorandum draf dated October 22, 2003; FMSE-SP 000377.173 t

 

There are a few things to note about the realignments included in the analysis above: 

• The catch-up threshold is, according to management, meant to serve as a measure of

the range of uncertainty in estimating prepayments. Conversely, the realignment

amounts relate primarily to known and quantified amounts that reflect the correction of

processing errors. 

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173 Although the memorandum dated October 22, 2003 is a draft, the amounts included in the table agree 

to a copy of the final memorandum dated as of the same date except that, in the final memorandum, the 

realignment amounts were included together with the mean catch-up amounts. See FMSE-SP 000576. 
• There are differences between the manner in which included amounts have been 

calculated. The mean catch-up position is calculated using the simple mean of five 

different interest rate scenarios. Alternatively, the estimated impact of the MBS reclass 

as of June 30 ($155 million expense) was estimated using only one interest rate path. 

Lastly, the recorded realignment amounts ($62.9 and $82.8 for June and September, 

respectively), the amounts related to PO sales in September ($30.4 million) and the 

amount of the MBS reclass are actual recorded amounts. This commingling of 

different reconciling items (with mixed bases of valuation) clearly shows that 

the catch-up framework devised by the Enterprise is a means for managing 

amortization expense and not, as management claims, a range of uncertainty 

in estimation. 

In addition, the balance of all realignments recorded to the bucket was $92.3 million and $20.9 

million (both deferred credits) as of June 30, 2003 and September 30, 2003, respectively. 

Based on OFHEO’s review neither of the amounts included in the table above agree to the 

balance of the bucket as of the respective dates.

The amount included in the table for realignments as of June 30, 2003 ($60.9 million) does not 

agree, because only certain realignment amounts were included, as previously discussed. 

The amount included in the table for realignments as of September 30, 2003 ($82.8 million) 

also does not agree. Information about how the $82.8 million amount was derived is not clear 

at this point in OFHEO’s examination. This amount appears to be included in error because the 

following month, only $19.4 million174 of deferred income from realignments was included in the 

analysis of the amortization results despite the fact that there were no realignments between

September and December of 2003. 

However, management of the Enterprise did inform OFHEO that an amount of $67 million, 

which was recorded into the bucket in August of 2003, directly corresponded to the originally 

estimated amount of the Security Master impact of $118 million.175 This means that the impact 

of Security Master had been included in the catch-up framework for three quarters, which

directly impacted the amount of amortization recorded. However, when the project was

completed and the impact was quantified, the amount was recorded as a new acquisition and 

amortized over a proxy (thirty year) life. This clearly shows that the inclusion of certain 

reconciling items had the effect of shifting large amounts of income from one period

to the next. Had the impact of Security Master not been included as an adjustment 

 174 Memorandum prepared by Mr. Rene LeRouzes, Subject: Q4 Plan Amortization Results, dated January 

30, 2003, FMSE-SP 000370. 

175 OFHEO Interview, Mr. Jeff Juliane, August 31, 2004, pp. 114-115.

Q: [...] Do you recall what the purpose of including these reconciling items was?

A: My recollection as we sit here today is that we were trying to encompass all the different arenas where 

STATS had been – where issues between STATS and iPDI were impacting the results. So at that point in 

time, we had two of them through realignments and one through Security Master. So we encompassed all 

those things to look at – to come up with what we thought at that point in time was our best estimate of 

our catch-up position. 

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to the catch-up results beginning in Q1 2003, the amortization results for the year 

would have looked very different. 

The following chart illustrates the difference between the amount of amortization recorded by 

the Enterprise during 2003 and the amount that would have been recorded if realignments had 

been recorded in income and if the catch-up (using the base rate forecast) had been recorded 

to $0 at each quarter end. 

2003 Amortization Income (Expense)

(150.0)

(100.0)

(50.0)

0.0

50.0

100.0

150.0

200.0

250.0

300.0

350.0

Q1 2003 Q2 2003 Q3 2003 Q4 2003

Dollars in Millions

Recorded amortization income/(expense)

Adjusted amortization income/(expense) to record base catch-up to $0 and record realignments into income

Management’s decisions on how to include realignments in the catch-up evolved as follows: 

Q1 2003: Include only the effect of the projected impact of the anticipated Security Master 

Realignment 

Q2 2003: Include Security Master and certain other STATS realignments

Q3 2003: Include all realignments 

Q3 2004: Continue to include all realignments 

As described previously, in the first quarter of 2004, the Enterprise performed another 

reconciliation and corrected a known error in the accounting for Dollar Rolls. In that case, 

management first decided to capitalize the amount and later decided to expense it. So in the 

span of one year, the Enterprise has employed four different practices with respect to

realignment differences. See section X for more discussion about the expensing of the Dollar 

Roll realignment. 

OFHEO also identified other adjustments to the modeled catch-up amount that were either not 

approved by management or the amortization policy did not provide guidance on how to handle 

these adjustments: 

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• For the 4th quarter of 2002 and the 1st quarter of 2003 the modeled catch up amount 

was adjusted for the impact of new acquisitions. In the 4th quarter of 2002 this 

adjustment brought the amount of the catch-up position within threshold and therefore 

made the recording of an adjustment to amortization income unnecessary. The 

adjustments for the impact of new acquisitions on the book of business were not 

approved by management. The inclusion of new acquisitions in the modeling process is

necessary because the book of business is generally on a two to three month lag;176

however, this process is not documented and was not applied consistently. 

• For the 3rd quarter of 2003 the catch up results for guarantee fees (as modeled by the 

system) were manually adjusted by $ 20 million. The adjustment was not disclosed on 

the catch-up sensitivity analysis report as a manual adjustment to the model results and 

therefore might not have been known and approved by management. Fannie Mae’s 

Office of Auditing was able to obtain some support for the adjustment; however, the 

amount was based on judgment and therefore “not very intuitive”.177

 Internal Controls over the Amortization Process 

 

During our examination, we noted a number of significant control weaknesses in the process of 

accounting for amortization. A majority of these internal control weaknesses are centered

around the AIMS system178 and the modeling process. Such findings have been made in spite 

of the fact that the Fannie Mae Office of Auditing (OA) completed an audit (which noted some

issues but only issued a “yellow”179 rating) of the amortization process as recently as July 2003 

and had, in addition, performed other procedures subsequent to that date.180 OFHEO believes 

176 OFHEO Interview, Mr. Jeff Juliane, June 8, 2004, pp. 99-100. 

Q: At some point, our understanding is that you began to incorporate – let me ask a question prior to that. 

The balances upon which the catch-up analysis is performed lagged by one quarter, so when – is that 

correct? 

A: That is correct. There is a – when a book is presented four [sic. for] our consumption; that is, between 

28 to 29 days after the months that is just closed so we always strive to stay on the same book as

portfolio, so there is a two- to three month lag between the book of business remodeling versus where 

we’re actually at from a calendar period. 177 Fannie Mae Office of Auditing SDI, Amortization Audit, 2003, FMSE 118808-118811. 

178 AIMS - Amortization Integration Modeling System. 179 The Office of Auditing “yellow” rating translates into a conclusion that “Controls need strengthening. 

Requires attention during the normal course of business.” 

180 OFHEO Interview, Ms. Joyce Philip, July 21, 2004, pp. 158-159 

Q: As a follow-up, I noted that Security Master was referred to in management’s corrective action. As a 

follow-up to this audit, would you do a post implementation review of the Security Master Project? 

A: We did do a post implementation review of Security Master. 

Q: And what was the date of that work, roughly? 

A: It would have been some time in the third of fourth quarter of ’03. 

Q: Would there have been an official audit report similar to the July 9th report? 

A: There would have been a memo issued. 

Q: And would there be work papers that support that memo? 

A: Yes.

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OFHEO Interview, Ms. Joyce Philip, July 21, 2004, p. 111 
that the presence of these significant control weaknesses themselves, undermined the process 

of amortization to such an extent that the material accuracy of deferred price adjustment 

amortization could not be reasonably assured. The significant control weaknesses include:

• Insufficient segregation of duties and key person dependencies 

• Modeling undertaken to produce desired results 

• Underlying data issues, including illogical or anomalous amortization factors 

• A lack of written procedures, supporting documentation and an insufficient audit trail.

Segregation of Duties and Key Person Dependencies 

In July 2003 Mr. Jeff Juliane was promoted and given responsibility over both the modeling and 

accounting for amortization. Immediately subsequent to his promotion, a concern was raised 

regarding the segregation of these functions in a meeting on August 8, 2003. The meeting 

related to an Office of Auditing investigation into an employee’s – Mr. Roger Barnes - concern 

over amortization factor anomalies, and Mr. Barnes’ further allegation that amortization factor 

change adjustments had been made to cause actual earnings to more closely align with planned 

earnings (See subsequent sections of this report for more information on the Amortization

Investigation). 

The following appears under the heading “3) Discussion of the internal controls over 

amortization activities” in the minutes to the August 8th meeting:

Sam [Mr. Rajappa, SVP Operations Risk, Office of Auditing] stated that a recent

reorganization, that organized iPDI subledger process (Roger Barnes’ team) 

under the AIMS modeling function (Jeff Juliane), weakens the segregation of

functions between the modeling and PDI data processing and general ledger

functions.

Despite the Office of Auditing report, and Mr. Rajappa’s concerns over the 

reorganization, that very same paragraph of the August 8th meeting minutes states: 

Janet Pennewell responded that the previous segregation of duties was largely

due to how the two systems and functions had been developed and evolved over 

time. She added that she did not see this segregation as a key control being

that determining how much income or expense should be recognized 

(accomplished by AIMS system) and processing to the G/L (accomplished by

PDI) would be uncommon [sic] across other accounting operations within the

Company.181

 

Q: Okay. Our understanding is that on August 8, 2003, a meeting was held to discuss his allegations. Is 

that consistent with your understanding? 

A: My understanding of the meeting of August 8th was to provide a status update to various parties within 

Fannie Mae of the results of the test work we had done up to that point in time. 

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181 Summarized Minutes of the Meeting (8/8/03), Unamortized Balances and Factor Analysis, FMSE-SP 

000080-000081. 
It is clear that members of the Controller’s staff had the ability to effectively ignore concerns 

about control weaknesses raised by the OA. OFHEO has not been provided with any 

information to indicate if the segregation issue raised by Mr. Rajappa has been addressed. 

OFHEO has determined that Mr. Juliane was already responsible for: a) all amortization 

modeling, b) determining changes to amortization prepayment assumptions, c) specifying 

functional requirements for the system that supported amortization modeling, d) performing the 

quarterly catch-up analysis, and e) making adjustments to earnings that were made directly to

the AIMS modeling system as factor adjustments. With the reorganization, Mr. Juliane was now 

responsible for the PDI data processing and general ledger function. The segregation of those 

functions previously served as an important check and control point in the amortization process. 

In fact, the factor anomaly concerns that were examined by the OA were observed through the 

PDI data processing and general ledger recording activities, and significantly, the allegation that

earnings were being adjusted to align with plan, were being directed at Mr. Juliane himself. An 

underdeveloped audit trail additionally impeded the capability of the Enterprise to effect any 

meaningful review or oversight of the processes and activities that now collectively fall under

his responsibility. 

 

Modeling Undertaken to Produce Desired Results 

The AIMS System -as designed by the Enterprise- has two primary functions: the calculation of 

the catch-up and the calculation of the amortization factors that are used to determine 

prospective amortization. The system has the functionality to model the amortization results 

using a variety of different scenarios. This provides management of the Enterprise with a

“menu” of available options for calculating the amount of catch-up. For instance, the AIMS

system has the functionality to model a variety of possible rate scenarios, prepayment speeds,

prospective catch-up adjustments and other modeling parameters. This allows the system user

to evaluate results generated under varying scenarios before determining which specific 

assumptions to use for quarterly reporting.

OFHEO has found that, on a number of occasions, multiple sensitivity runs were processed after

the quarterly closing. In particular, these occasions included periods after the yearly close. 

This is curious because the model-ready book is generally based on a book of business that is 

anywhere from one to three months old.182 As such, the catch-up sensitivity report could have 

been run well before the closing of the books at the end of these periods. It is furthermore not 

clear why performing multiple runs using different assumptions or parameters would otherwise 

be necessary at all. The Office of Auditing did not identify any systems performance issues that 

would have necessitated such multiple runs. Neither, did the Controllers Group, identify any 

 182 OFHEO Interview, Mr. Jeff Juliane, June 8, 2004, pp. 99-100. 

Q: At some point, our understanding is that you began to incorporate – let me ask a question prior to that. 

The balances upon which the catch-up analysis is performed lagged by one quarter, so when – is that 

correct? 

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A: That is correct. There is a – when a book is presented four [sic. for] our consumption; that is, between 

28 to 29 days after the month that is just closed so we always strive to stay on the same book as portfolio,

so there is a two- to three-month lag between the book of business remodeling versus where we’re 

actually at from a calendar period. 
performance issues in the controls self assessment questionnaire that all business units are 

required to complete. 

Underlying Data Issues 

There were also significant differences between the source systems (e.g. STATS, LASER) and 

the amortization system (iPDI), regarding the original balances to be amortized. These 

differences were primarily due to limitations in the timing and quality of the data which was fed 

from the transaction subledgers to the amortization system. As previously noted in this report, 

the reconciliation of those systems occasionally led to large differences which the Enterprise

capitalized as new acquisitions and amortized over a proxy life. In addition however, such 

realignments also led to manual adjustments made to the catch-up sensitivity analysis. These 

manual adjustments were sometimes inconsistently treated and were not always adequately 

documented or supported. Thus review or validation of them was difficult.

The Enterprise’s method for recording on-top adjustments within AIMS was also manually 

effected as well. AIMS system functionality supported the ability to selectively update factors 

for certain products without affecting others. This was one means to effect on-top adjustments 

(recorded as factor changes). Such adjustments were judgmentally allocated to particular 

modeling groups. This process of adjustment and allocation is inconsistent with maintaining the 

integrity of loan and security level information and, at a minimum, makes analysis and review of 

the amortization results more difficult (See following on Factor Anomalies). In her testimony 

Ms. Ann Eilers, Director Office of Auditing, described misclassifications caused by system feeds 

as one of her biggest concerns surrounding the amortization process.183

A manifestation of the extent of underlying data issues is illustrated by an adjustment to the 

catch-up results that was made in the third quarter of 2003. The analysis of amortization 

results noted an adjustment of approximately $30 million to the calculation of the catch-up 

amount to correct for improperly determined amortization for three principal-only (“PO”) 

mortgage securities that had just been sold, and upon which, incorrect gains on sale had also 

been determined. OFHEO is still evaluating this issue and its implications. However, in his 

testimony, Mr. Juliane acknowledged the inaccurate amortization, and further stated that a

review of the accuracy of the amortization of securities sold had never been previously 

performed. Aside from raising questions as to why such a review was performed at this 

particular time (the adjustment allowed the Enterprise to stay within the catch-up threshold), it 

also raises further concern about the extent or magnitude of similar errors on other 

securities.184

 183 OFHEO Interview, Ann Eilers, Director Office of Auditing, July 23, 2004, pp. 45-46. 

Q: What was your biggest concern personally about the control surrounding the amortization process? 

A: We had some system feeds that were creating misclassifications. We had some policies and 

procedures that weren’t documented, and we had some business area records that were not as well 

documented. 184 OFHEO Interview, Mr. Jeff Juliane, August 31, 2004, p. 103. 

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Q: You did an analysis on gain/loss?
Factor Anomalies 

The AIMS system produces results that are illogical or that represent mathematical anomalies. 

These illogical or anomalous conditions include negative amortization factors and amortization 

factors greater than one. In theory, a negative amortization factor would cause a premium or

discount to grow larger over time. A factor greater than one could potentially cause for

example, a premium to amortize beyond the original balance to become a discount. 

Management has asserted that such illogical and anomalous results derived from the 

aggregation of premiums and discounts as well as REMIC tranches with dissimilar 

characteristics, but that they did not translate into inaccurate financial statements. This 

explanation however implies, at a minimum, the presence of other potentially deeper issues 

regarding the aggregation of deferred price adjustments into incorrect modeling groups. In 

addition, it raises the question as to why edit checks and error reports on data processes did 

not prevent the illogical results and anomalies from occurring, or why the Enterprise was not 

able to sufficiently flag their existence or report their breadth. 

The improper aggregation of premiums and discounts and the illogical results and anomalies 

themselves posed other internal control concerns because such issues made it virtually 

impossible to correlate the amortization results to the actual performance of the underlying 

loans/securities. OFHEO believes that management would have been unable to effect such a 

review. In addition, the full extent to which illogical results and anomalies did, in fact, cause 

inaccurate financial reporting is a focus of OFHEO’s continuing examination. 

Our examination has concluded that these factor anomalies were caused primarily by a lack of 

clear delineation of responsibility by management of the Enterprise. A breakdown clearly 

occurred between the business unit owners of the source systems and the personnel in the 

Controller’s Department responsible for calculating amortization. Because neither party took 

responsibility for the quality of the data, amortization errors occurred. When questioned about 

responsibility for ensuring whether a loan or security was included in an appropriate modeling 

group, Mr. LeRouzes offered the following answer: “Well, it’s not me.”185 This was further 

validated by Mr. Juliane.186

 

A: No, no. I did an analysis quantifying the CUSIPs that we’re moving and passed it along. I mean, I – I 

don’t know if we – from an institutional perspective if we looked at that or not. I don’t know if STATS did 

an analysis or not. 

185 OFHEO Interview, Mr. Rene LeRouzes, July 16, 2004, p. 30. 

Q: I guess – okay, that’s fine. From a functional perspective, would you know which functional area would

be the owner of that process? 

A: Of signing off of ALEX?

Q: Making sure that securities are going into the right cohort? 

A: I really can’t speculate on what functional area there would be responsible for that. 

Q: Okay. But it’s clearly not – clearly not your area? 

FANNIE MAE LEGAL COUNSEL: Not him. Right. 

A: Well, it’s not me. 

186 OFHEO Interview, Mr. Juliane, June 8, 2004 p. 68. 

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Q: So, the business unit owner of the system would be responsible for setting the rules? 
Factor anomalies can occur in a variety of ways and for a variety of reasons. There are a few 

simple maxims that can be applied, however, to ensure that factor arrays are correct. 

Mathematically speaking, a graph of level-yield factor arrays should be curvilinear and 

downward sloping over time. Updates to factor arrays could shift the curve up or down, but the 

prospective array thereafter should assume a similar relationship. In addition, the sum of all 

factors in any given array should total to 1 (or 100% of the item to be amortized). Another 

example of a factor anomaly would be a negative factor (which technically should never occur 

except in the case of a retrospective adjustment.)

Ms. Mary Lewers, Vice President of Financial Accounting, was the supervisor of Mr. Barnes and 

the iPDI area (among other things) and, as such, was ultimately responsible for the amounts 

recorded to the general ledger. She provided the following example of how such anomalies 

could occur: 

Question: How can you get a correct answer with a negative amortization factor? 

Answer: My understanding is that in total, when you combine all of the related 

information that you get to the same answer. It's just the pieces have this

appearance to them that makes it difficult to analyze, but that fundamentally the 

amortization and the creation of factors is occurring at the REMIC level, which is 

the right level in terms of calculating the level yield. 

Her response reflects two recurring themes about factor anomalies that we have encountered in 

our examination: 1) Personnel in the Controller’s Department accepted the fact that factor 

anomalies existed and 2) Ms. Pennewell and Mr. Juliane continuously offered the same

explanations as to why factor anomalies could occur, while always managing to avoid the larger

question of whether such anomalies represented errors. 

The question of whether such anomalies represented errors did not get addressed until the 

concerns raised by Mr. Barnes precipitated the Office of Auditing Amortization Investigation. 

OFHEO has concluded that factor anomalies, in certain cases, do in fact represent 

errors and may also constitute departures from GAAP.

According to direct testimony received in our examination, there appears to be a critical control 

point between the AIMS and iPDI systems that would identify any factor anomalies.187 

 

A: They are responsible for insuring the light [sic, “right”] collateral on assets are getting put in the same 

FAS 91 types. 

187 OFHEO Interview, Mr. Roger Barnes, September 1, 2004, pp. 115-116. 

Q: Why would AIMS not calculate the right amount of the current month’s amortization if it had the factor 

with it generated and if it had received the balances from PDI? 

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A: The way AIMS was structured, and I am not the expert on AIMS, being on the periphery, they had the 

ability to include and exclude certain things. You could be including or excluding components that were 

part of AIMS. They could select, as they called it, a book of business to use for calculating the 

amortization. If they did not use the write-back [sic. right book] of business, they would be using a 

different month than what the production system had and not even realize until they finished the run and 

then had differences. These were the kinds of things that happened with great regularity even though 

they had the balances there, but because one could go in and make changes to what was and was not 
However, this control was not working effectively. Such a breakdown in controls is clearly 

evidenced by the size of the adjustment related to the Securities Master Project, and the

significant number of securities involved. This issue was known by personnel in the Controller’s 

Department for several years before the problem was resolved.188

Prior to the implementation of Security Master, the portfolio area was responsible for the

process of coding securities into modeling groups – information that ultimately found its way 

into the STATS system. This process was essentially a manual process and was not consistently 

applied by all relevant personnel.189 

How Factor Anomalies Could Represent Departures from GAAP

As previously described, securities are pooled into similar groups for purposes of modeling. 

SFAS 91 provides specific guidance on how to determine what constitutes “similar” for the 

purposes of grouping securities. 

Because the Enterprise is the largest holder of mortgage loans and mortgage-related securities, 

the process of grouping securities into similar groups is a data-intensive process. For example, 

 

included, certain components, there would be instances where the results would be different because I 

maintained a tightly controlled system where very few changes could be made, and their system was 

somewhat different where they in turn were inevitably massaging their write-back [sic. right book] of 

business, even though you are generating the factors, or some of the factors get passed in error in 

transition, or they could go through editing, and when the factors come to PDI, and they would show a list 

showing me their reports and I would reject them and pass them back to them saying there were 

problems. [...] 

188 OFHEO Interview, Mr. Jeff Juliane, August 31, 2004, pp. 106-107.

Q: You said earlier that the problem associated with the misclassified securities was something that you 

yourself became aware of when you started doing this job? 

A: Yes.

Q: Who did you report that to in management? 

A: We really had – we had a regularly convening FAS 91 kind of group, and that would have been Tom, 

myself, Leanne, Janet, and over time other people have come and gone, Bill Quinn, et cetera. At the point 

in time that you’re talking about with this conversation, I know there was a conversation with the group at 

that point in time that this dynamic was going on. 

189 OFHEO Interview, Mr. Jeff Juliane, August 31, 2004, pp. 98-99. 

Q: When did you first become aware that there was going to be a need to reclassify securities that had 

been erroneously categorized as discounts and reclassify them under premium FAS 91 – 

A: When did I first learn that we needed to do that? 

Q: Right. 

A: It would have been reasonably early on when I took over. When I looked at the inventory of the 

collateral, you realize that if in the conventional bucket we had premiums and discounts in there. It really 

became a question more of when could we do something about it because we didn’t have the 

infrastructure at that point in time to do anything about it. 

Q: Was it a matter of securities being miscoded as premiums? 

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A: The process to assign a FAS 91 type before Security Master, the way I understand it, was that the 

traders would enter a pool type code that would then be translated into a FAS 91 type. So these 

assignments of pool type code could theoretically be translated from one trader to another trader 

differently. So there wasn’t a way to ensure consistency of application of this information. Once Security 

Master came in place, we were able to do that by looking at relative sets of attributes and then assigning 

FAS 91 types at that point in time. 
the Enterprise’s MBS portfolio alone contains approximately 400,000 different security 

CUSIPs.190 

The criteria for determining whether securities can be pooled into a group are prescribed by

Question 51 to the Q&A on FAS 91 as follows: 

Q: What characteristics should be considered in determining whether the lender 

holds a large number of similar loans for purposes of estimating prepayments in

accordance with paragraph 19? 

A: The objective is to evaluate all characteristics that would affect the ability of 

the lender to estimate the behavior of a group of loans. The following are 

examples of some characteristics that should be considered when aggregating 

loans: 

• Loan type 

• Loan size 

• Nature and location of collateral 

• Coupon interest rate 

• Maturity 

• Period of origination 

• Prepayment history of the loans (if seasoned) 

• Level of net fees or costs 

• Prepayment penalties 

• Interest rate type (fixed or variable) 

• Expected prepayment performance in varying interest rate scenarios. 

The purpose of the guidance above is to distinguish between loans and/or securities that, based 

upon their characteristics, should be modeled together because they are likely to have similar 

estimated lives. Conversely, loans and/or securities that would not be expected to have similar 

estimated lives should not be modeled together. 

From an accounting control perspective, the pooling of securities with dissimilar characteristics 

would lead to anomalies in the factor array. This could be easily assessed by a comparison of

the performance of the underlying collateral to the amount of amortization recorded. As 

mentioned above, a number of factor anomalies existed which clearly indicated that the 

guidance in Q&A item 51 was not being followed appropriately. 

 190 OFHEO Interview, Mr. Sam Rajappa, June 17, 2004, pp. 96-97. 

Q: What specific parts of the accounting transaction did he not – the accounting for those transactions did 

he not understand? 

A: Okay. Again, I want to make sure – I’m not saying he didn’t understand. I’m just saying either he didn’t 

understand or he didn’t go there. For whatever reason, he didn’t go there. 

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The way we do the amortization, like we said, we have 400,000-plus securities. It’s not possible on each 

security or a CUSIP to determine what the factors should have been and what it was. So we grouped 

them into what we considered to be logical buckets of like securities, those with like characteristics. [...] 
The Office of Auditing Amortization Investigation 

Prior to the commencement of our examination, the Enterprise informed us that Mr. Barnes, a 

former manager in the Controller’s Department, had raised his concerns about several matters 

including the modeling of amortization factors, significant control deficiencies in the modeling 

systems, segregation of duties issues as well as other matters.191 

In August 2003 Fannie Mae’s OA performed an Amortization Investigation, which included a 

review of the controls over factor changes and a review of factor anomalies themselves. The 

timing of the investigation was made much more complicated due to the fact that the

Enterprise’s quarterly report on Form 10-Q was expected to be filed the following week.

192 In 

addition to completing the investigation, Mr. Rajappa also needed to inform the CFO and CEO of 

the investigation as part of the quarterly financial statement certification process, as well as 

update the Audit Committee of the Board. 

Although some of Mr. Barnes’ concerns were raised to the highest levels of the Enterprise, 

culminating in a presentation by Mr. Sam Rajappa on August 14, 2003 to the Audit Committee 

of the Board of the Directors, our examination has concluded that the Amortization

Investigation was flawed in a number of ways. 

Mr. Barnes raised concerns about the modeling process in an e-mail to Sam Rajappa.193 These 

concerns were related to three specific anomalies, which he had observed in the data passed to 

the iPDI system from the AIMS system: 1) factors in excess of 100%, 2) negative factors and 3) 

factor arrays that amortized almost the entire amount to be amortized in the first few 

months.

194 

A meeting was held on August 8, 2003, one week after Mr. Barnes expressed his concerns. This 

meeting was attended by a number of representatives from different internal groups as well as

the external auditors to discuss the concerns raised by Mr. Barnes. The OA performed a number 

of procedures to evaluate the issues raised by Mr. Barnes in preparation for this meeting. At 

this meeting. Mr. Rajappa stated that “...this process is in compliance with the company’s 

accounting policies that are in compliance with GAAP” and then asked if anyone at the meeting 

objected to that statement. There were no objections.195 Although we have interviewed a 

 191 Undated document titled ‘Unamortized Balances and Factor Analysis’, handwritten notes identify Mr. 

Roger Barnes as the source for this document. FMSE 023356. 

192 The audit notification memorandum is dated August 6, 2003 (FMSE 023289) and the 10-Q was 

officially filed on August 14, 2003 (http://www.fanniemae.com/ir/sec/index.jhtml?s=SEC+Filings). 

193 An email from Mr. Roger Barnes to Mr. Sam Rajappa, Subject: Request for Meeting, dated July 29, 

2003, states that “it is necessary that I schedule an important meeting with you regarding analysis and 

research I have been conducting for a number of weeks.” The email further states “it might be a good 

idea to invite select members of your staff (Ann Eilers, Paul Jackson, and/or Joyce Philip) who will have 

familiarity with the subject I must cover.” FMSE 024268 

194 “Unamortized Balances and Factor Analysis” Prepared by Mr. Roger Barnes and provided to the 

Office of Audit. FMSE 023356 

195 OFHEO Interview, Mr. Roger Barnes, September 1, 2004, p. 147-148. 

Q: Were you informed that they were concluded or that there was no problem?

A: I think they said it was not material and that it was in compliance with GAAP. 

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Q: But they never came back and provided you with any supporting documentation at all? 
number of witnesses on this particular conclusion, it is still not exactly clear how such a 

conclusion was reached, since many of the anomalies that Mr. Barnes had identified were

subsequently fixed through various projects including the Security Master Project, the 

enhancements to the Gfee modeling process and the REMIC re-mapping project.

196

However, one particular test performed by the OA was significant by virtue of the fact that it 

was performed at all. The OA performed specific procedures to test whether the transactions 

identified by Mr. Barnes were included in the catch-up analysis. As stated previously, OFHEO 

strongly disagrees with the Enterprise’s accounting (catch-up threshold) for estimation 

uncertainty. However, if one were to accept the Enterprise’s reasoning for establishing a catchup, would that acceptance further permit including adjustments resulting from data errors and 

other issues in the catch-up as well? Furthermore, the OA analysis in this regard was flawed for 

the simple reason that their procedures were insufficient to assess the breadth of the issues or

their quantitative impact on the catch-up analysis. Mr. Rajappa’s testimony on this matter

follows: 

Q: Now, was that correct or appropriate--was it appropriate under generally accepted 

accounting principles to assign REMICs to FAS 91 buckets regardless of their characteristics? 

A: I do not know the--I cannot opine on the generally accepted accounting principles, but 

that's the way it was done. 

Q: Were you aware that it resulted in large variance--were you aware that this practice of 

 assigning REMICs to FAS 91 types, regardless of the characteristics of the tranche, that it

resulted in large variances in modeling characteristics of the CUSIPs that reside in that type? 

 FANNIE MAE LEGAL COUNSEL: Are you reading from a particular part of the document? 

Q: Yes. 

 [Pause.] 

 A: Yes. 

 Q: Yet you had--yet the company concluded overall that its reported results were in 

accordance with generally accepted accounting principles, correct? 

 A: The company concluded--I concluded based on my audit that those specific 62 CUSIPs, 

give or take a few, and the 26 identified by Jeff, they were part of the beginning balance of

the catch-up analysis. 

Q: And that compensating control is what, in fact, made the financial statements correct? 

 

A: No, no one went in depth to try to explain, and that is what led to my comments of how can the review 

be done when at this point I raised questions and the items in [sic. internal] audit referred to were only 

one or two of the, so how can you have your review done? We had amortization of – it was occurring so 

rapidly that we were amortizing the income expense, the entire discount that should have been 10 to 15 

years, in as short as seven months. [...] 

196 OFHEO Interview, Mr. Jeff Juliane, June 8, 2003, pp. 125-126. 

Q: [...] My question is, is it your opinion that the amortization of the securities that he [Mr. Barnes] 

identified was corrected as a result of implementation of the project? 

A: I’ll answer that specifically. There was no correction needed in the securities he identified in his 

analysis. There was an enhancement done through Security Master to better group the assets so these 

kinds of anomalies from a myopic perspective would not show up any longer. 

Q: Do you still have REMIC as 91 categories or REMICs that produce negative factors? 

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A: A, yes, we do, and – but the occurrence of these are much – have been greatly reduced through 

Security Master.
FANNIE MAE LEGAL COUNSEL: Would you describe that as- OFHEO has characterized it as 

a "compensating control." You don't necessarily have to phrase it that way, but... 

 Q: Would you agree that including that effect in the catch-up is a compensating control? 

 A: I don't want to quibble on compensating or not, but it is a good control, having a

catch-up analysis that is approved by our external auditors and making sure that the catchup analysis starting point included this and all the other effects that we talked about that 

could change. As a starting point, I think that is a good--that gave me comfort.

197

The Office of Auditing’s attention was also brought to another matter related to a manual factor 

change submitted by the modeling group. This matter was raised at the August 8, 2003 

meeting to address the issues raised by Mr. Barnes.198 

The iPDI system, which at that point was the responsibility of Mr. Barnes, had the capability to 

manually change an individual factor that had previously been passed from AIMS. A manual 

change could be necessary if, for instance, it became too late in the closing process to effect

another complete pass of information from AIMS to iPDI. If a change was necessary, a 

message would be sent from the AIMS modeling team to the iPDI team to process the change. 

In addition, the AIMS team was responsible for validating the reason for the change. This is a 

segregation of duties that no longer exists today as a result of the changes to Mr. Juliane’s 

responsibilities. 

The manual factor change was processed “without full understanding by the iPDI group of the 

reason for the change”199 and despite the fact that “written documentation supporting the 

change request was not sufficient.”200 The minutes of the August 8, 2003 meeting clearly state 

Mr. Barnes’ concern: “Roger said that this transaction bothered him because it appeared that

the factor change was made to make iPDI “agree” with forecasted amortization expense.”201 

Mr. Barnes’ concerns were significant because, in his mind an intentional misstatement may 

have occurred, and by raising his concerns, he also brought attention to the potential

segregation of duties issue in the Controller’s Department. 

The CFO, Mr. Howard, clearly understood that Mr. Barnes had alleged an intentional

misstatement in the matter of the $6.5 million factor change. When OFHEO asked Mr. Howard 

whether Mr. Barnes had made such an allegation, Mr. Howard responded as follows: “Well, he 

alleged that was intentional misstatement.”202 Ms. Spencer, who reported directly to Mr. 

Howard and was ultimately responsible for the amortization area because it was part of the 

 197 OFHEO Interview, Mr. Sam Rajappa, June 17, 2004, pp. 99-101 198 Summarized Minutes of the Meeting (8/8/03), Unamortized Balances and Factor Analysis, FMSE-SP 

000081. The minutes state that “Roger [Barnes] said that this transaction bothered him because it 

appeared that the factor change was made to make iPDI “agree” with forecasted amortization expense.” 

199 Id., The meeting concluded the investigation by the Office of Auditing and was attended by members 

of the Controller’s Department, Financial Standards, Office of Auditing, Corporate Compliance and 

KPMG. 

200 Fannie Mae Office of Auditing, Amortization Investigation, August 2003, FMSE 023283 

201 Summarized Minutes of the Meeting (8/8/03), Unamortized Balances and Factor Analysis, FMSE-SP 

000081. 

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202 OFHEO Interview, Tim Howard, August 5, 2004, p. 99. 
Controller’s Department, did not understand Mr. Barnes’ allegation as intentional misstatement 

or fraud.

203

In addition, neither Mr. Rajappa, nor his staff (the very people who were responsible for 

conducting an independent investigation) understood his allegations as intentional

misstatement. 204 Such a lack of understanding is strange, especially since the summarized

minutes of the August 8, 2003 meeting (which included the statement made by Mr. Barnes that 

the factor change appeared to have been made to make actual results agree with forecasted 

results) were prepared by Mr. Paul Jackson, Director in the OA, and were reviewed by Mr. 

Rajappa.205

What made the manual factor change even more difficult to understand is the way in which it 

was processed. It seems, according to documentation reviewed by OFHEO, that the issue that 

gave rise to the need for the factor change occurred in one particular FAS 91 type but the 

factor adjustment actually occurred in a different FAS 91 type. 

The factor change actually occurred in the FAS 91 type RMC T802. RMC T802 is a special FAS 

91 type, which was created for a particular pool of securities related to a single transaction. The 

RMC T802 bucket was chosen because it would be easier to deal with later operationally when 

 203 OFHEO Interview, Leanne Spencer, August 12, 2004, pp. 52-53. 

Q: Okay. At any time in the past, did you ever have the opinion that the company's accounting was not in 

accordance with generally accepted accounting principles? 

A: No. 

Q: Are you aware of any company officer or employee ever expressing their belief that any of Fannie 

Mae's accounting policies or practices were inconsistent with GAAP? 

A: There was an employee in the controller's department in 2003 that raised some concerns to the level 

of the controller of some items that he felt warranted looking into and was unclear if they were appropriate 

and we investigated it. 

Q: And that was Roger Barnes? 

A: That's correct. 

Q: When he raised these issues, did he ever allege fraud or intention to misstate financial results? 

A: No. Not to me. 

Q: Okay. Did you ever develop an awareness that that was what he was alleging? 

A: No. I -- no. 

204 OFHEO Interview, Ms. Ann Eilers, July 23, 2004, p. 222 

Q: Now you testified earlier that you were present in the initial meeting that Roger Barnes had with Sam 

Rajappa where Mr. Barnes provided his concerns regarding premium discount amortization; correct? 

A: Yes.

Q: Now did Mr. Barnes make any allegations or statements regarding intentional misstatements? 

A: At that meeting? 

Q: Yes. 

A: Not that I recall. 

Q: Did he make any allegations or assertions regarding intentional misstatements at any other time that 

you are aware of? 

A: Not that I’m aware of. 

205 OFHEO Interview, Mr. Sam Rajappa, June 17, 2004, p. 86-87. 

Q: Did you prepare this document (FMSE-SP 000080-81)? 

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A: No, I reviewed it. I believe it was prepared by Mr. Paul Jackson. 
the factor change (which was made in iPDI) would need to be reflected in the data which feeds 

the AIMS system (from ALEX).206

OFHEO has prepared graphs to show the before and after effects of the factor change: 

 

In-Use Factor

0

0.005

0.01

0.015

0.02

0.025

0.03

Jun-02

Aug-02

Oct-02

Dec-02

Feb-03

Apr-03

Jun-03

Aug-03

Oct-03

Dec-03

Feb-04

Factor

In-Use Factor

The chart above is as of July 31, 2003 and, as such, shows the actual factors used prior to July

2003 and the projected factors for periods thereafter. The prospective factor array (after June 

30th) is –as would be expected- a curvilinear, downward sloping line. 

In-Use w ith Edit Factor

0

0.005

0.01

0.015

0.02

0.025

0.03

0.035

Jun-0 2

Aug -02

O ct-02

Dec-02

Feb-03Apr-03Jun-0 3

Aug -03

O ct-03

Dec-03

Feb-04

Factor

In-Use w ith Edit Factor

 

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206 “However, FAS 91 type RMC-T802 was selected for the factor change simply because it had only one 

underlying security (thus no changes would be required at the next discrete level – ALEX product type.)” 

KPMG 2003 workpapers “FAS 91 Amortization – Manual Adjustments”, KPMG 000904. 
The chart above shows the effect that the factor change has on the prospective array (after

June 30th). Because the factor array should correlate roughly to the forecasted cash flows (in 

this case on a security) the prospective factor array created by the factor change is clearly not

logical. 

The factor change was applied to two specific factors in the array for one amortization type for 

the periods of July and October 2003. This resulted in a transfer of amortization expense of 

approximately $ 6.5 million from future periods to the 3rd quarter of 2003. According to 

testimony provided by Mr. Juliane during OFHEO’s examination, the business purpose of the 

factor change adjustment was to roll forward the book of business used for modeling 

purposes.207 However, the rate change clearly seems to be counterintuitive based on the 

revised array of factors. The end result of the change (as the charts show) was to shift income

from the July 2003 period into future periods. 

Fannie Mae’s OA reviewed the documentation supporting the request for the factor change as 

part of the Amortization Investigation performed in August 2003 and concluded that the 

supporting documentation was in fact not sufficient to support the factor change made.

208

Based on the information the OA team received from the modeling group during their 

investigation the OA team was not able to come to a conclusion about whether the factor 

change causing the $ 6.5 million adjustment to amortization income was in fact a valid 

adjustment. The procedures performed by the OA team consisted of reviewing the supporting

documentation provided by the modeling group and, despite several requests, conclusive 

documentation was not provided by the modeling group. It was at precisely that point that the 

OA concluded its investigation. The lack of diligence on behalf of the OA in the matter 

of the manual factor change is inconsistent with their responsibility to exercise due 

professional care. 

The summarized minutes of the meeting on August 8, 2003 include the following conclusion 

from Mr. Rajappa: 

Sam [Mr. Rajappa] stated that in his opinion, the July factor change process 

showed a weakening of this control because the factor change request did not 

include sufficient written documentation to support the transaction and because 

a change was made without full understanding by the iPDI group of the reason 

for the change. Sam added that this required remediation in the form of written 

 207 OFHEO Interview, Mr. Jeff Juliane, June 8, 2004, pp. 117-118 

Q: Do you recall the $ 6.5 million factor change and what it related to? 

A: Yes.

Q: Can you describe it? 

A: [...] what we did is that we did a factor change. And in AIMS we had done an estimate on what that 

factor change was. There were new business books that we took into consideration. We basically rolled 

for our estimate and came up with an estimate that was. $6.5 million higher than what iPDI was booking. 

So, I vetted that conversation with my management team, and we decided that, based on my analysis, 

that we would increase the expense by $6.5 million through and a partial factor change. 

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208Summarized Minutes of the Meeting (8/8/03). Unamortized Balances and Factor Analysis, FMSE-SP 

000081 
procedures and better defined roles and responsibilities. Jonathan Boyles agreed 

with this statement.209

When asked during his testimony whether, in the instance of an assertion regarding intentional

misstatements, it would be the Enterprise’s policy to prove that entries made to the financial 

statements are in fact correct, Tim Howard, Chief Financial Officer, testified that it would be 

expected practice to verify the validity of these entries.210 However, Fannie Mae’s OA did not 

perform additional auditing procedures to determine if the request for a factor change was valid

or not. In fact management of Fannie Mae’s OA “had no basis to believe it was correct or 

wrong”211 and could “not rule out the possibility that entry could be incorrect.”212

Therefore the amortization investigation performed by Fannie Mae’s OA did not arrive at a 

conclusion on whether or not these factor changes are made to manage earnings rather than to

arrive at a best estimate for the amortization period of the underlying securities. 

Lack of Written Procedures and Supporting Documentation, and an Insufficient Audit Trail

In July 2003 Fannie Mae’s Office of Auditing issued its Audit Report

213 summarizing the results 

of their review of controls over Fannie Mae’s amortization of mortgage related price

adjustments. OFHEO believes that this report was flawed because it merely reflected a “yellow”

rating of “controls need strengthening requires attention during normal course of business,” 

rather than a “red” rating of “Controls need strengthening, request immediate attention.” 

OFHEO further believes that the characterization of findings within the report was either not 

clear, did not provide appropriate emphasis and inappropriately represented certain significant 

control weaknesses as documentation issues. Lastly, OFHEO determined that a number of

meaningful findings that were noted in the workpapers were inappropriately omitted from the 

report. 

However, irrespective of OFHEO’s evaluation of the July 2003 OA report itself, matters noted by 

OA auditors, in combination with OFHEO’s own analysis and findings suggest a pervasive 

lack of written procedures and documentation for most of the Enterprise’s 

amortization activities. 

OFHEO has concluded from its own examination procedures that: 

• Insufficient documentation existed for most procedures. 

 

 209 Summarized Minutes of the Meeting (8/8/03), Unamortized Balances and Factor Analysis, FMSE-SP 

000080-000081 

210 OFHEO Interview, Mr. Tim Howard, Chief Financial Officer, August 5, 2005, p. 58 

Q: In the instance of an assertion regarding intentional misstatement, would it be company policy to prove 

that any entries made to the financial statements were in fact correct? 

FANNIE MAE LEGAL COUNSEL: Are you talking specifically about the Barnes complaint or generally? 

Q: Generally. 

A: I don’t know that I would say company policy. It would certainly be expected practice to do so. 

211 OFHEO Interview, Mr. Sam Rajappa, June 17, 2004, p. 108 212 OFHEO Interview, Mr. Paul Jackson, August 17, 2004, pp. 152-153

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213 Fannie Mae Audit Report, Office of Auditing, Amortization Audit, July 9, 2003, FMSE 023745-023754. 
• Explanations regarding the basis for changes to methodology were not adequate or

appropriately documented. 

• Catch-up results were poorly documented, particularly for the periods prior to 2003. 

• Inconsistent accounting methods were applied without adequate supporting explanation. 

• Factor change adjustments were not sufficiently explained or documented. 

 

In addition, an observation contained within the July 9, 2003 report was that “policies over data 

processes and key modeling methodology and assumptions should be developed to provide 

better supportability.”214 Specifically, the audit report pointed out that “procedures do not

specify what level of documentation is required to support actions taken, or what level of 

management involvement is required.”215 Additional areas, not stated previously, cited for 

lacking appropriate documentation included among others: 

• Modeling performed outside the AIMS framework 

• Use of proxies instead of actual data

Other items not included in the audit report, but separately conveyed to business unit 

management further identified the need to develop guidelines to address documentation 

requirements related to:

 

• The use of proxies for FAS 91 types used to group types of securities with similar 

characteristics; 

• Manual factor adjustments to the amortization accounting sub-ledger and 

• Archiving the support for interest rate assumptions and the level of required 

management approval of these interest rate assumptions.

216

Lastly, the workpapers prepared by Fannie Mae’s Office of Auditing include comments about 

formalizing and documenting procedures to properly address the modeling process including

changes to the modeling methodology and to CPRs217 used in the modeling process.218 

In evaluating the catch-up process, Fannie Mae’s Office of Auditing identified several further 

areas with documentation weaknesses as described below: 

• Approval procedures documented in 2001, may not still apply and are not being followed 

currently. Specifically, Portfolio Management does not sign off on the Sensitivity 

Analysis prepared by the Controller’s Department 

 214 Id., FMSE 023749 

215 Id., FMSE 023749 

216 Email from Ms. Joyce Philip, Manager Office of Auditing, to Mr. Jeff Juliane and Mr. Paul Jackson, 

Director Office of Auditing, July 6, 2003, FMSE 118812 

217 CPR stands for Constant Prepayment Rate and is one of the critical components used in determining 

amortization factors. 

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218 Fannie Mae Office of Auditing SDI, Amortization Audit 2003, FMSE 117502-117503, states that “there 

are not documented procedures that address the CPR change process and specifically the 

documentation and approval process.” 
• Documented procedures do not address the incorporation of current month acquisitions 

activities into the quarterly catch up analysis and adjustment process. Adjusting the 

catch up analysis to include current period acquisitions was first incorporated in 

November 2002 for the September book of business.219

 

• The business analyst who runs the AIMS model was unable to provide support for the 

current acquisitions adjustments – this could only be provided by the manager –

potential Key Person Dependency. 

• There are no guidelines that identify what activities require management [approval or 

sign-off].”220

OFHEO believes that the lack of documented procedures and underdeveloped audit 

trail for the various processes and systems used to calculate deferred price 

adjustment amortization allowed personnel within the Enterprise to affect the 

management of earnings and volatility in a manner not easily observable or readily 

subject to sufficient review. 

 

Q: And you said that’s done manually, so what systems in particular is that information – 

219 Note that the process of determining the impact of current acquisitions on the catch-up analysis is

performed manually. 

OFHEO Interview, Mr. Jeff Juliane, August 31, 2004, pp. 60-61

A: Well, we don’t do it manually. It’s done through system interfaces between us and ALEX. There’s no 

manual processing involved at all in terms of rolling the book forward. We manually [sic. model] outside

the system, if we’re on a December book of business, look at the catch-up impact of January acquisitions 

and February acquisitions. That’s the manual process in terms of generating the sensitivity that I’m talking 

about. [...] 

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220 Fannie Mae Office of Auditing Workpaper, Amortization Audit 2003, FMSE 118804-118807 The 

workpapers prepared by Fannie Mae’s Office of Auditing cut off the text in the last bullet point. However, 

the related SDI prepared by the Office of Auditing titled “Catch Up Processes and Controls are not fully 

articulated, formalized, or documented” states that “the following areas need to be better defined” listing 

among others “when management approval/sign-off is required.” FMSE 118808
HEDGE ACCOUNTING UNDER SFAS 133 

Introduction 

OFHEO’s on-going special examination has placed a specific focus on Fannie Mae’s application 

of Statement of Financial Accounting Standards No. 133 Accounting for Derivative Instrumen s 

and Hedging Activities (“SFAS 133”). SFAS 133, which was issued in 1998 and became 

effective in 2001, presented Fannie Mae with the potential for significant volatility in earnings 

and several operational challenges. For the Enterprise to avoid much of the potential earnings

volatility caused by marking derivatives to fair value under SFAS 133, it elected to adopt hedge 

accounting under the new standard. However, qualifying for hedge accounting under SFAS 133

required changes to significant administrative, documentation, and system requirements for 

most entities. For an entity with a large and dynamic hedging program, like Fannie Mae, hedge 

accounting posed even greater challenges. Fannie Mae devised a hedge accounting approach 

in which the vast majority of its derivatives were treated as “perfectly effective”

221 hedges with 

the objectives of minimizing earnings volatility and simplifying operations. OFHEO has 

determined that Fannie Mae has misapplied GAAP (specifically, the hedge accounting

requirements of SFAS 133) in pursuit of these objectives. The misapplications of GAAP are not

limited occurrences, but appear to be pervasive and reinforced by management whose objective 

is to reduce earnings volatility at significant cost to employee and management integrity. The 

matters discussed herein raise serious doubts as to the validity of previously reported financial 

results, as well as adequacy of regulatory capital, management supervision, and overall safety 

and soundness of the Enterprise. 

t

 

Background 

SFAS 133,

222 as amended and interpreted, provides the primary guidance under GAAP for

companies’ accounting and reporting for derivatives. The accounting framework in SFAS 133

brought significant changes to prior accounting practice and effectively superseded concepts 

such as synthetic accounting.223 SFAS 133 requires that all freestanding and certain embedded 

derivatives be carried on the balance sheet at fair value. Changes in a derivative’s fair value are 

included in earnings, unless the derivative is designated and qualifies for hedge accounting. 

Hedge accounting provides a means for a matching of the earnings effect of a derivative and

the related designated hedged transaction, thereby mitigating the impact of marking-to-market 

the derivative under SFAS 133. 

221 See discussion of “perfectly effective” hedge relationships in; The Assumption of Perfect Effectiveness, 

herein. 

222 Appendix II provides a summary of the basic provisions of SFAS 133. 

223 Synthetic accounting was the accounting treatment followed by many entities, including Fannie Mae, 

prior to SFAS 133. Paragraph 349 of SFAS 133 defines synthetic instrument accounting as follows: 

“Synthetic instrument accounting, which evolved in practice, views two or more distinct financial 

instruments (generally a cash instrument and a derivative instrument) as having synthetically created 

another single cash instrument. The objective of synthetic instrument accounting is to present those 

multiple instruments in the financial statements as if they were the single instrument that the entity sought 

to create.” 

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Synthetic instrument accounting essentially allowed derivatives to be accounted for on an accrual basis 

together with the related hedged item, in order to “synthetically” replicate a fixed or floating rate 

instrument, as applicable. 
Hedge accounting is elective. However, to qualify, certain stringent criteria must be satisfied. 

These requirements were outlined in a recent Securities and Exchange Commission (“SEC”)

speech by John James, Professional Accounting Fellow from the Office of the Chief Accountant

at the SEC. Below is an extract from the speech which emphasizes the strict criteria necessary 

to receive hedge accounting: 

Many have complained that Statement 133 is not a principles-based 

standard and that its rules are too complex to follow. However, the 

principle in Statement 133 is fairly straightforward in that derivatives 

should be recorded on the balance sheet at fair value with changes in 

fair value reported in earnings. The complexity is mostly associated with 

achieving hedge accounting, which is optional under Statement 133.

Thus, in order to achieve hedge accounting, the Board concluded that

entities would be required to meet certain requirements at the inception 

of the hedging relationship and on an ongoing basis. These 

requirements include: contemporaneous designation and 

documentation of the hedging relationship, the entity's risk 

management objective and strategy for undertaking the hedge - 

including, identification of the hedging instrument, the hedged item, the 

nature of the risk being hedged and how effectiveness will be assessed 

and measured. Additionally, Statement 133 requires an entity to

perform a hedge effectiveness assessment at both the inception of the 

hedge and on an ongoing basis as support for the assertion that the 

hedging relationship is expected to be (or was) highly effective in 

achieving offsetting changes in fair value or cash flows attributable to 

the hedged risk during the designated hedging period. 

Those are the requirements. They were pretty well understood in and 

around the adoption date of Statement 133; however, as commonly 

happens as a standard matures, the staff has recently observed 

situations of "sloppy" documentation and aggressive interpretations of 

Statement 133's hedge accounting guidance. 224

 

Implementation of SFAS 133 at Fannie Mae 

Prior to SFAS 133, Fannie Mae followed synthetic instrument accounting for debt instruments 

whereby cash flows were synthetically altered through the use of derivatives. As Fannie Mae 

was not a “mark-to-market” entity, the new accounting for derivatives under SFAS 133 would 

significantly affect the volatility of its financial results if hedge accounting were not applied. 

Some entities, such as broker-dealers and investment companies, account for most of or all of 

their assets and liabilities at fair value, with changes therein flowing through earnings (referred 

to as “mark-to-market” accounting). When such entities use derivatives to manage risk, they

often achieve a natural offset in earnings due to the mark-to-market of both the derivatives and

the assets/liabilities that give rise to the risk. Fannie Mae, as well as most banks and finance 

companies, apply a modified historical cost approach to accounting for most financial assets and 

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224 Extract from John James, Professional Accounting Fellow from the Office of the Chief Accountant - US 

SEC, speech at the 2003 Thirty-First American Institute of Certified Public Accountants (“AICPA”) 

National Conference on Current SEC Developments held in December 2003. 
liabilities. Thus, the introduction of fair value accounting for derivatives under SFAS 133 had the 

potential to create significant earnings volatility unless hedge accounting was used to allow an 

offset to the earnings effect of marking the derivatives to market. 

Fannie Mae faced significant challenges in qualifying for hedge accounting. Due to its extensive 

documentation and effectiveness calculation requirements, hedge accounting under SFAS 133 

was most easily adopted by entities with simple, passive hedging approaches in which hedges

are established and allowed to run their course. However, Fannie Mae’s hedging approach was 

neither simple nor passive. The complex nature of funding its massive mortgage portfolio and

managing the associated interest rate risk necessitated an active, dynamic hedging approach to

respond to changing market conditions and portfolio re-balancing requirements. Such an 

environment adds significant complexity to the administrative and systems requirements to 

support hedge accounting. Furthermore, Fannie Mae’s use of option-based derivative products

further complicated the application of hedge accounting, due to additional complexities

associated with such instruments.

Determination to maintain the pre-SFAS 133 accounting 

Despite the challenges noted above, Fannie Mae had a strong desire to retain the status quo of

accrual/synthetic instrument accounting. Fannie Mae’s net interest margin reflects the spread

between the income earned on its assets (interest income) and its cost of funding (interest 

expense). Synthetic instrument accounting provided relatively smoother accounting earnings

and greater predictability of reported financial results, including Earnings Per Share (“EPS”). 

Fannie Mae’s derivatives accounting policy makes several references to derivative transactions 

in which the intended result is for the accounting to continue to mimic synthetic instrument

accounting even after the adoption of SFAS 133.

Minimizing Earnings Volatility a Primary Objective 

Fannie Mae documents relating to its SFAS 133 implementation discuss minimizing earnings 

volatility and maintaining the simplicity of the Enterprise’s operations as the primary objectives 

when Fannie Mae undertook the implementation of the standard.

 225 Earnings volatility would 

naturally arise from those derivatives that did not qualify for hedge accounting and from any 

hedge ineffectiveness resulting from hedging relationships that qualified for hedge accounting. 

OFHEO acknowledges that minimizing earnings volatility and simplifying operations in 

connection with the adoption of SFAS 133 are not prohibited and that many companies likely 

had similar objectives in their implementation of the standard. However, as discussed further 

below, these goals have influenced the development of misapplications of hedge accounting. 

 

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225 Memorandum from Jonathan Boyles, Senior Vice President–Financial Standards and Corporate Tax 

Compliance, to Distribution, Subject: Background on SFAS 133 implementation, March 2, 2003, FMSE 

078540 – 078542, in which Mr. Boyles stated that, “At the time of our implementation efforts there were 

several tenets that we [sic] drove our decisions regarding implementation and derivatives strategies. In 

the simplest terms, these tenets were: 1. Earnings volatility was to be minimized and if there were 

earnings volatility it should be as predictable as possible. 2. We were to leverage off existing systems as

much as possible, 3. Operating earnings needed to be simple and easily understood.”; and presentation 

document, “Examining Our Hedging Strategies-Post FAS 133,” Tim Howard, Peter Niculescu, Linda 

Knight, Leanne Spencer, David Benson, Jonathan Boyles, Bill Quinn and Mary Lewers, May 9, 2003, 

FMSE 027242-027265, bullet three on page 2 of the presentation (FMSE 027243) states, “Goals when 

we adopted FAS 133: minimizing earnings volatility, leverage existing systems, keep operating earnings 

simple...” 
These improper approaches included not assessing hedge effectiveness, not measuring hedge 

ineffectiveness when required, and applying hedge accounting to hedging relationships that do

not qualify for such treatment. 

 

Derivatives Accounting Policies & Procedures 

Fannie Mae’s accounting policies for derivatives post SFAS 133 are contained in the Derivatives 

Accounting Guidelines (“DAG”). The DAG represents Fannie Mae’s effort to detail the potential 

derivative transactions that the Enterprise may enter into, the accounting to be followed for 

such transactions, and the impact the accounting has on earnings. The DAG serves as the 

foundation for Fannie Mae’s derivative accounting. Interviews with Fannie Mae personnel 

indicate that these guidelines also formed the basis for system development efforts to support

SFAS 133. 

The DAG has the appearance of a comprehensive set of accounting policies. However, a close 

review of the guidelines revealed numerous instances of departures from hedge accounting

requirements under SFAS 133. Jonathan Boyles, Senior Vice President – Financial Standards & 

Corporate Tax, is the head of accounting policy formulation at Fannie Mae, and had primary

responsibility for the DAG’s development. Mr. Boyles has referred to some of these matters as 

“known departures from GAAP”.226 Other members of Fannie Mae management refer to these 

matters as “practical applications” of GAAP.227 These departures, or practical applications, had 

the effect of allowing Fannie Mae to apply hedge accounting and the assumption of perfect 

effectiveness

228 to numerous transactions in situations where such treatment was not

appropriate without the necessary documentation and analysis. 

 226 OFHEO interview, Jonathan Boyles, Senior Vice President – Financial Accounting Standards and 

Corporate Tax, August 3, 2004, p. 64. In the interview, Mr. Boyles stated, “We have several known 

departures from GAAP in our adoption of FAS 133. We have cleared those with our auditors. We have 

reported to our auditors on an annual basis the effect of those. And they were comfortable when we

adopted them, and they were comfortable over the last several years when we reported the results of that 

work.” 

227 OFHEO Interview, Leanne Spencer, Controller, August 12, 2004, pp. 28-29. In the interview, Ms. 

Spencer made reference to a “practical application” of GAAP: 

Q: Did KPMG ever request that you perform some ongoing measurement in order to determine whether a 

materiality threshold had been exceeded? 

A: We have had had [sic], over the course of time, we have had had [sic] situations where we've looked at

GAAP, we've said, how do you take this technical literature and how do you apply it to how Fannie Mae's 

business runs, and made a judgment, not Fannie Mae making a lone judgment, but in working with our 

external auditors and their concurrence that what I recall my words are practical application, how you take 

a technical piece of literature, and you try to overlay it into how a company does business and that we 

have periodically have several areas where you do back-testing. 228 OFHEO Interview, Mary Lewers, Vice President—Financial Accounting, July 13, 2004, p. 132. In the 

interview, Ms. Lewers confirmed that perfectly effective hedges are those for which there is no explicit 

assessment or measurement of effectiveness. 

Q: So, if you don't qualify for perfect effectiveness, you would use the long haul method. 

A: Uh-huh. 

Q: And does the long haul method include both assessment and measurement of effectiveness? 

A: Yes, it does. 

Q: So that would mean that for the perfectly effective hedges, there's no explicit assessment or 

measurement of effectiveness; is that correct? 

Special Examination of Fannie Mae 

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A: That's a correct statement. 
The Assumption of Perfect Effectiveness 

Consistent with Fannie Mae’s desire to minimize earnings volatility and maintain simplicity of 

operations, a great deal of emphasis was placed on treating hedges as perfectly effective, 

whereby it is assumed that no ineffectiveness exists in a hedging relationship, and no 

assessment or measurement of effectiveness is performed. 229 In fact, Fannie Mae treats almost 

all of its hedging relationships as perfectly effective. 230 SFAS 133 does allow the assumption of 

no ineffectiveness, but only in very limited circumstances. However, in many instances, as 

discussed further below, Fannie Mae has disregarded the requirements of SFAS in its treatment

of hedges as being perfectly effective. Accordingly, the Enterprise has not properly assessed 

and measured effectiveness as required by the standard. At December 31, 2003, Fannie Mae 

had a notional of $1.04 trillion in derivatives, of which a notional of only $43 million was not in 

hedging relationships.

231 

The importance given by management to an assumption of perfect effectiveness in hedging

relationships is further highlighted by the fact that Fannie Mae’s accounting policy required 

special management approval for derivatives requiring “long haul”

 232 treatment. However,

 229 OFHEO Interview, Janet Pennewell, Senior Vice President—Financial Reporting and Planning, June 

15, 2004, p.197 

Q: Do you believe or is it your understanding that an emphasis is placed by Fannie Mae on structuring 

their hedge strategies to attempt to achieve the "perfect hedge" or no ineffectiveness? 

A: I believe that that was consistent with our objective early on. In fact, I believe that leading into the 

implementation of FAS 133 that we looked at the different derivatives that we were using with an 

objective of trying to use those derivatives and those hedging vehicles that we thought we could assume

were perfectly effective. But I think it's not always the case. 

230 OFHEO interview, Jonathan Boyles, Senior Vice President of Accounting Standards and Corporate 

Tax, August 3, 2004, p. 45, in which Mr. Boyles stated that he would guess over 90% of Fannie Mae’s 

hedges are perfectly effective at any point in time. 

Q: That's what I'm talking about. In terms of what is actually on the books, not in terms of the transactions 

described in the policy, but what's on your books today or at any point in time. Generally how much of the 

portfolio would be treated as perfectly effective? 

A: I would guess over 90 percent, but I don't see those reports. 

OFHEO interview, Mona Patel, Senior Project Manager—Financial Accounting Group, September 8, 

2004, pp. 118-119 

Q: What percentage of your--of the derivatives portfolio would you say qualified for perfect effectiveness? 

[...] 

Q: Any estimates that you may have? 

A: [...]The majority of our linkages get perfectly effective hedge accounting except for a couple of long 

hauls or [sic] the population. So, anything that other [sic] long haul is all perfectly effective accounting.[...] 

Q: And we are not trying to get a precise, but--precise number but just an approximation. Is it five? Is it a 

hundred? Is it two? I mean, just roughly, how many long-haul calculations tend to be performed on a 

given month?

A: Not a given month. There was none, like in one in April. If there are any, they're a handful.

231 Fannie Mae December 31, 2003 10-K, Table 30 “Notional and Fair Value of Derivatives by Hedge 

Designation,” p. 79. These balances exclude mortgage commitments accounted for as derivatives under 

SFAS 149. Note that the $43 million which were not in hedging relationships represent approximately 

0.004% of the total $1.04 trillion notional amount of outstanding derivatives. 

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232 OFHEO Interview, Mary Lewers, Vice President—Financial Accounting, July 13, 2004, p. 132. Fannie 

Mae designates hedge relationships in which it cannot assume perfect effectiveness. In these situations, 

SFAS 133 requires that Fannie Mae assess effectiveness and measure ineffectiveness to qualify for 
Fannie Mae requires no such special approval for hedges treated as perfectly effective -- 

thereby making perfect effectiveness the rule, and long haul treatment the exception. As noted 

above, there are specific requirements that must be met under SFAS 133 to treat hedges as 

perfectly effective. The complex nature of Fannie Mae’s hedging approach makes meeting these 

requirements difficult. OFHEO believes that Fannie Mae did not place sufficient emphasis on 

policies, procedures and approval requirements to ensure that the proper accounting treatment

was applied. Instead, their procedures focused on special review and approval of transactions 

that might cause earnings volatility or operational complexity. 

Hedges that do not meet the criteria for being perfectly effective require an assessment of 

effectiveness that must be performed to qualify for hedge accounting. As noted above, OFHEO’s 

analysis indicates that Fannie Mae has many hedging relationships that do not qualify as 

perfectly effective, yet have been treated as such. Since Fannie Mae has not performed a

proper assessment of hedge effectiveness for such transactions, these transactions do not

qualify for the hedge accounting treatment that they have been given. Instead, the proper 

accounting for such derivatives would be for their fair value changes to be recorded directly 

through earnings. OFHEO believes that the disqualification of hedge accounting for such a

large number of transactions would have a significant impact on Fannie Mae’s reported financial 

results, both prospectively and historically. 

Environment for Formulation of Derivatives Accounting Policy at Fannie Mae 

 

There are a number of issues that are important to understand as it relates to the environment 

in which Fannie Mae’s derivatives accounting policies and practices were developed: 

Financial Standards Group: Significant Reliance on Limited Resources – The

Enterprise relies heavily on its Financial Standards Group for advice on the application of 

accounting policy. There does not appear to be an environment conducive to

questioning or challenging accounting decisions made by the Financial Standards Group. 

Fannie Mae’s Office of Auditing also relies on the Financial Standards Group to formulate 

accounting policy for the Enterprise in accordance with GAAP. Although the Office of 

Auditing reports conclude that Fannie Mae’s accounting for derivatives is in compliance 

with SFAS 133, the Vice President of Office of Auditing (A. Eilers) indicated in her 

testimony that the Office of Auditing verifies compliance with Fannie Mae policy as it is

hedge accounting. This is commonly referred to as the long haul approach. Ms. Lewers confirmed this

definition in her testimony. 

Q: [...]Are you familiar with the terminology that's used in the Derivative Accounting Guidelines known as

the long haul method? 

A: Yes, I am. 

Q: And is the long haul method the method that is used for hedges that are not perfectly effective? 

A: Yes. Long haul would be used in a situation in lieu of perfect effectiveness, if we didn't qualify for 

perfect effectiveness. [...] 

Q: And does the long haul method include both assessment and measurement of effectiveness? 

A: Yes, it does. 

Special Examination of Fannie Mae 

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established by the Financial Standards Group, and does not check for the policy’s 

compliance with GAAP. 233

Despite the significant influence wielded by the Financial Standards Group, it is 

comprised of relatively few personnel.234 OFHEO believes the limited resources devoted 

to complex technical accounting matters has contributed to Fannie Mae’s problems with 

SFAS 133 compliance. 

Lack of Adequate Understanding by Accounting Operations –Accounting and 

treasury operations personnel that are responsible for the implementation of certain 

aspects of the standard lack an adequate understanding of SFAS 133. This lack of 

understanding is attributed to the groups’ significant reliance placed on the Financial

Standards Group. Testimony from various members of the Controller’s organization and 

the Controller indicated that questions relating to the accounting for derivatives could 

only be answered by the Senior Vice President of the Financial Standards Group (J.

Boyles). 235 OFHEO noted that individuals having responsibility for key aspects of the 

SFAS 133 accounting process (such as ensuring hedge designation occurs, or checking

to ensure matching of critical terms) were not knowledgeable about how such activities 

met the requirements as set forth under GAAP. 236 

 233 Audit Report, Subject: Derivatives Controls Audit, March 31, 2003, FMSE 102385-102391. The audit 

report conclusion states, “Controls are in place to capture derivative transactions, monitor counterparty 

risk, monitor FAS 133 compliance, and report accurate financial results.”

Audit Memorandum from Joyce Phillip, Director of Office of Auditing, to Leanne Spencer, Subject: New 

Accounting Standards Review, February 17, 2004. This memorandum was provided by OFHEO staff and 

was not provided through the Fannie Mae Special Examination Production; therefore, no Bates number is

available. The memorandum’s conclusion states, “Fannie Mae’s implementation of FAS 149, FIN 45 and 

FIN 46 is consistent with FASB requirements.” 

The conclusions reached in the two documents referenced above state that the Office of Auditing has 

verified compliance with GAAP. However, these conclusions are not consistent with Ann Eilers’ 

testimony. 

OFHEO interview, Ann Eilers, Vice President -- Office of Auditing, July 23, 2004, p. 29, where she stated, 

“As far as GAAP accounting, that's really the role of Financial Standards who runs -- you know, has a 

team of professionals who basically review GAAP accounting rules, and they would then work with 

KPMG. At the end of the day KPMG ultimately opines on GAAP. Internal audit would not do that. We 

basically opine on the controls around those processes.” 

234 OFHEO interview, Jonathan Boyles, Senior Vice President – Financial Standards and Corporate Tax, 

August 3, 2004, p. 10 

Q: When Greg Ramsey came in, did the size of the group grow in terms of the people reporting to him, or 

when did you get from the four to the eight? I’m just trying to get a sense of timing. 

A: Going from the four to the eight has been within the last 18 months. 

235 OFHEO interview, Mary Lewers, Vice President – Financial Accounting, July 13, 2004, p. 45, in which 

she stated, “Accounting Standards is what I would refer to as our expert advice regarding the translation 

of GAAP into appropriate policy....So I would define myself as someone who was learning this, but that 

the real sort of expert advance (sic) in terms of how to translate this into compliance with GAAP, it really 

rested within the Financial Standards team.” 

236 OFHEO interview, Katarina Skladony, Senior Financial Analyst – Treasury Middle Office, August 26, 

2004, pp. 144-146, in which she stated, among other things, that the Financial Standards Group did not 

make her aware of the requirements of SFAS 133. 

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Q: Ms. Skladony, are you aware that for getting hedge accounting, you have to have contemporaneous 

documentation? 
Disregard of FASB Decisions – Like many entities, Fannie Mae engages in active

efforts to influence the Financial Accounting Standards Board’s (“FASB”) rule making

decisions, with a goal of advancing the accounting positions it views as most favorable 

to the Enterprise. SFAS 133 was no exception in this regard – according to documents 

obtained by OFHEO, Fannie Mae played an active role in lobbying the FASB both prior to 

the issuance of the standard and subsequently. In some instances, despite entreaties to 

the FASB by Fannie Mae for a desired derivative accounting treatment, the FASB

rejected the requested treatment. At times, even though the FASB had rejected the

requested treatment, Fannie Mae disregarded the FASB’s guidance and accounted for

their transactions the way they had originally proposed. This sheds some light on the 

culture and attitude within Fannie Mae – a determination to do things “their way.” 

One such instance relates to certain illustrative transactions included in SFAS 133’s 

Implementation Guidance that were apparently initiated and drafted by the SVP of the 

Financial Standards Group (J. Boyles). These illustrative transactions addressed 

accounting for both “termouts” 237 and “offsetting swaps” discussed in this report. 

OFHEO understands the approach as originally proposed by Fannie Mae would have 

resulted in treatment of these transactions as perfectly effective hedges. The FASB 

ultimately rejected this treatment in the guidance ultimately published in SFAS 133. 

However, Fannie Mae disregarded this guidance and accounted for these types of 

transactions the way they had originally advocated. 238 

 

FANNIE MAE LEGAL COUNSEL: With respect to FAS 133? 

Q: Right. 

A: I'm not familiar with FAS 133 requirements. 

Q: Are you aware that you have to produce documentation at the time the trade is contemplated? 

FANNIE MAE LEGAL COUNSEL: You say again "you." I'm just— 

Q: You meaning she. 

FANNIE MAE LEGAL COUNSEL: Do you understand that's a requirement of FAS 133? That's your 

question? 

Q: Yeah. 

FANNIE MAE LEGAL COUNSEL: Okay. 

A: No. [...] 

Q: So you were not made aware by Financial Standards that contemporaneous documentation is 

required; is that correct? 

A: That's correct. 

237 OFHEO understands the word “term-out” to be used by Fannie Mae generally to describe the 

replacement of discount notes with fixed rate notes or different floating rate borrowings. 238 OFHEO interview, Jonathan Boyles, Senior Vice President – Financial Standards and Corporate Tax, 

August 3, 2004, pp. 177-178. OFHEO notes that this particular example is Example 8 in paragraphs 153-

161 of SFAS 133 

Q: Was that the Example 8 in the appendix— 

A: It was the Fed Funds' example. I don't remember the number. But when FAS 133, when we talked to 

the FASB, and when they wrote FAS 133, what they told us verbally was confirmed with what they had 

written--the two ways that they had talked— 

Q: When you noticed that it was removed from FAS 133 subsequently, did you discuss it any

further with the FASB? 

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A: We did not go back and discuss that with the FASB. We discussed that with our auditors. 
 

Responsibility for “Aggressive” Positions – Accounting policy decisions are 

determined almost unilaterally by Jonathan Boyles and members of his Financial 

Standards team. As noted above, certain accounting positions taken by Fannie Mae are 

contrary to GAAP and at times described as “aggressive interpretations.”

 239 Taking SFAS

133 accounting positions characterized as aggressive or not in compliance with GAAP

appears to be motivated by management objectives of minimizing earnings volatility and 

ensuring simplicity of operations. Based on information and testimony OFHEO has

obtained, it appears that Jonathan Boyles has responsibility for accounting policy 

decisions made by Fannie Mae that resulted in the improper application of SFAS 133. 

Summary of Key Issues Identified 

There are several issues that have been identified by OFHEO, most of which represent

misapplications of the hedge accounting requirements of SFAS 133. Given that the special

examination is continuing, the items outlined below should not be considered an exhaustive list 

of issues identified in connection with Fannie Mae’s application of SFAS 133. These broader 

issues, which affect a large number of Fannie Mae’s derivative transactions, are discussed in 

greater detail in the remaining sections of this report: 

Issue 1: Fannie Mae improperly assumes that derivatives continue to be perfectly 

effective hedges upon their re-designation into new hedging relationships. When 

existing derivatives are re-designated, they generally do not have a fair value of 

zero when the new hedging relationship is established. As such, they violate one 

of the requirements under SFAS 133 for the assumption of no ineffectiveness. 

This issue is prevalent for most derivatives associated with term-outs, which 

represent a large portion of Fannie Mae’s derivatives portfolio. 240 

Issue 2: The accounting for offsetting derivatives was inappropriate from the adoption of 

SFAS 133 through the end of 2003. The Enterprise often entered into offsetting 

swaps rather than terminating an existing swap. The original swap and the 

offsetting swap were incorrectly treated as perfect cash flow hedges and their 

changes in fair value were recorded in Accumulated Other Comprehensive 

Q: So you did not change your accounting as a result of the amendment made by the FASB; is that 

correct? And this was before you applied FAS 133; is that correct? The amendment was made prior to 

you having applied FAS 133. 

A: I believe it was. I forget the date. 239 See Issue 3 herein: Application of Shortcut and Matched Terms Method, Additional Transaction 

Examples, Receive-Fixed Swaptions, for more details on the email from Jonathan Boyles referenced 

above, in which the term “aggressive interpretations” is used. 

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240 Email from Pete Barbera to Jonathan Boyles, Subject: Inventory of FAS 133 transactions, June 2, 

2004, produced via CD 8/11/04 in M Box. Attached to Mr. Barbera’s email was a draft schedule titled 

“Analysis of the March 2004 Book.” The draft analysis categorized approximately $960 Billion of Fannie 

Mae’s notional outstanding derivatives by transaction type (per the DAG) and by hedge classification (CF, 

FV, DNQ and Other) as of the end of March 2004. The thirteen most frequently used transactions 

presented in Mr. Barbera’s analysis match those presented in a letter by Jodie Kelley, Vice President and 

Deputy General Counsel, to Chris Dickerson, July 28, 2004, FMSE 00083. They are 1, 2, 3, 4, 8, 10, 11, 

12, 13, 20, 52, 67 and 71. Of these, OFHEO has identified that 5 are term-out transactions and comprise 

approximately $240 billion of the over $960 billion of outstanding derivative notional balances at March 

31, 2004. 
Income (“AOCI”). Instead, hedge accounting should have been discontinued 

and changes in fair value should have been recorded in earnings. Effective the 

first quarter of 2004, Fannie Mae modified its accounting for these offsetting 

swaps, with the new accounting method being applied prospectively.

241

Issue 3: Fannie Mae has incorrectly applied the “short-cut” method (or “matched terms”

method) in a number of situations. The following are those discussed in this 

report: 

•Receive-fixed swaptions hedging the fair value of debt are incorrectly

accounted for as perfect hedges, even though ineffectiveness would 

generally be expected to exist in such relationships. 

•Callable swaps hedging discount notes are incorrectly treated as perfectly

effective without regard to the option value existing in the derivative but not 

in the hedged item.

•Perfect effectiveness in hedges of anticipated debt issuances has been 

assumed based upon a duration comparison which is not supported by SFAS 

133. 

•Swaps arising from the exercise of a swaption are treated as perfectly 

effective despite having a non-zero fair value at inception. 

•The requirement for matching of reset dates (in order to assume perfect

effectiveness) between the hedged item and the swap in cash flow hedges 

has been modified in the Enterprise’s policy to permit up to a seven day

reset date mismatch. 

•The requirement for matching of maturity dates (in order to assume perfect

effectiveness) between the hedged item and the swap in fair value hedges

has been modified to permit up to a 90 day mismatch. 

Issue 4: Beginning with its initial adoption of SFAS 133, Fannie Mae employed an 

erroneous methodology to account for changes in the time value and intrinsic 

value components of purchased interest rate caps. In November 2002, the 

Enterprise discovered the error, corrected its methodology, and applied the new 

methodology only to new interest rate caps prospectively. The accounting for 

previously existing caps was not corrected and previously reported accounting

results were not evaluated for possible restatement. In its 2002 10-K, Fannie 

Mae described this as a refinement of its methodology rather than a correction of

an error. 

Issue 5: OFHEO has identified a number of problems with Fannie Mae’s hedge 

documentation with respect to its compliance with hedge accounting 

requirements. In several examples reviewed by OFHEO, the documentation was 

ambiguous as to the nature of the hedging relationship or did not clearly identify 

the hedged risk, hedged item or its probability of occurrence – all required under 

SFAS 133 to meet the hedge accounting criteria. In addition, OFHEO noted 

instances of a lack of contemporaneous documentation, such as the occurrence 

 

Special Examination of Fannie Mae 

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241 Memorandum from Jonathan Boyles to Distribution, Subject: Revisions to the December 2003 DAG, 

March 13, 2004, FMSE 113686-113690.
of retroactive hedge designations and the lack of adequate documentation when 

a re-linkage (re-designation) occurs. 

 

Implications of Issues Identified

From our review of documents, emails, testimony and initial interviews with Fannie Mae 

personnel, OFHEO has concluded that there has been an intentional effort by management to 

misapply the accounting rules as specified in the standard in order to minimize earnings 

volatility and simplify operations. 

By improperly assuming perfect effectiveness for many of its hedges, Fannie Mae has failed to 

perform the proper assessment of effectiveness and measurement of ineffectiveness in these 

instances. Furthermore, the Enterprise has many deficiencies in its hedge designation

documentation. Effectiveness assessment, ineffectiveness measurement and proper hedge 

documentation are critical pre-requisites to receive hedge accounting treatment under SFAS 

133. Because the Enterprise has not met these criteria, it should not receive hedge accounting 

treatment for many of its derivatives. Instead, the proper accounting for such derivatives would 

be for their fair value changes to be recorded directly through earnings. 

Prior to 2004, Fannie Mae improperly accounted for certain offsetting derivatives, treating them

as hedges when they did not qualify as such. Additionally in 2001-2002, Fannie Mae improperly 

accounted for certain purchased interest rate caps which may have significantly misstated the 

Enterprise’s earnings and AOCI during those years. These instances raise further questions 

about possible misstatements of prior years’ financial results. These matters also raise concerns 

about Fannie Mae’s financial reporting and disclosures: 

• Fannie Mae was aware that their prior accounting treatment for offsetting derivatives 

was not consistent with GAAP. When this accounting treatment was changed in the 

first quarter of 2004, no mention was made of a possible misstatement of prior 

years’ financial statements or the amounts of such prior misstatements. Fannie Mae 

disclosed in the first quarter 2004 10-Q that the impact of classifying certain 

derivatives as non-hedging was approximately $13 million on that quarter’s pre-tax 

net income. 242 While the actual impact on prior periods is unclear, OFHEO believes it 

could have been larger, because the mark-to-market impact on earnings in the first

quarter 2004 has been dampened by efforts to actively manage the undesignated 

derivatives portfolio. Irrespective of the amounts involved, this is an instance in 

which Fannie Mae knowingly applied improper accounting which furthered their 

objective of minimizing earnings volatility. 

• In 2002, the Enterprise disclosed a change of methodology in its accounting for 

changes in time and intrinsic value of purchased interest rate caps. It did not 

disclose the improper accounting resulting from the earlier approach. OFHEO 

believes that Fannie Mae’s disclosure in the 2002 10-K was not adequate to provide 

a reader with a complete understanding of the matter, or to enable them to discern

that errors had occurred in prior periods. Fannie Mae did not address the correction

of this error. Instead Fannie Mae changed its accounting for new transactions 

 

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242 Fannie Mae March 31, 2004 10-Q, p. 26. 
prospectively, and did not evaluate the impact on prior periods or transactions that

existed at the time the change was made. 

As of December 31, 2003, the balance in AOCI reflects $12.2 billion in deferred losses relating 

to cash flow hedges. 243 Furthermore, carrying value adjustments of liabilities relating to fair 

value hedges amounted to $7.2 billion as of that date.244 The matters noted herein with 

respect to improper application of hedge accounting leads OFHEO to question the validity of the 

amounts reflected in AOCI; as well as amounts reflected as carrying value adjustments, at any 

point in time since the adoption of SFAS 133. For hedges which do not qualify for hedge 

accounting, fair value changes should be reflected in earnings in the period in which the value 

change occurred, with no offset to AOCI or hedged item carrying value. Additionally, the 

possible reclassification of these amounts into retained earnings could have a substantial impact 

on Fannie Mae’s compliance with its regulatory capital requirements. In order to determine the 

actual impact of the matters discussed herein, a substantial investment of resources and 

management’s commitment will be required. 

 243 Fannie Mae December 31, 2003 10-K, p. 80. 

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244 Fannie Mae December 31, 2003 10-K, p. 146. 
Issue 1: Derivative Re-Designations 

Fannie Mae uses a variety of derivative instruments to hedge its interest rate risk. Due to the 

dynamic nature of Fannie Mae’s portfolio, hedging instruments are regularly de-designated from 

old hedging relationships and re-designated into new hedging relationships as the portfolio 

changes. This section discusses Fannie Mae’s assumption of perfect effectiveness in its hedging 

relationships when such re-designations occur. 

Background 

SFAS 133 requires an entity applying hedge accounting to perform an assessment to 

demonstrate a highly effective hedge relationship both at inception and on an on-going basis, 

unless the relationship meets the requirements of the short-cut method245 or where the critical

terms of the hedging instrument and the hedged items match246 such that there will be no 

ineffectiveness in the hedge relationship and the changes in the fair values or cash flows of the 

hedged item are expected to completely offset those of the derivative. 247 The concept of hedge

effectiveness is important under SFAS 133 in two respects: 

•The assessment test is required in order to qualify for hedge accounting. It must be performed

at the inception of a hedge relationship and throughout its life on at least a quarterly basis to 

demonstrate that the hedge has been, and is expected to continue to be, “highly effective.”

 248

•Even though a hedge relationship may be deemed highly effective and qualify for hedge 

accounting, ineffectiveness may exist in the hedging relationship. Ineffectiveness represents

the extent to which changes in the fair value of the derivative are not perfectly matched with 

the changes in fair values or cash flows of the hedged item. The ineffective portion of changes 

in the derivative’s fair value must be recorded in earnings. 

A perfect cash flow hedge has the effect of deferring the recognition of a change in the 

derivative’s fair value in the income statement, by recording all changes in value in AOCI and 

recording no ineffectiveness in the income statement. A perfect fair value hedge results in 

changes in fair value of the derivative being offset by equal changes in fair value of the hedged 

item, resulting with zero ineffectiveness in the income statement. Fannie Mae’s predominant 

approach is to assert that their hedge relationships are perfectly effective due to the matching

of critical terms. We will refer to this as the “matched terms” approach. 

Summary of Issue 

Fannie Mae frequently de-designates and re-designates hedge relationships as it goes through 

the process of re-balancing its liability portfolio. In most instances, the re-designation is caused 

by a term-out, which is a phrase used by Fannie Mae generally to describe the replacement of

discount notes with fixed rate notes or different floating rate borrowings. When a derivative is 

 245 FASB, SFAS 133, paragraph 68, as amended. This paragraph discusses the requirements of the 

shortcut method. 

246 FASB, SFAS 133, paragraph 65, as amended. The concept of matching of critical terms is discussed 

in this paragraph. 247 FASB, SFAS 133, paragraphs 20 (b) and 28 (b), as amended, for fair value and cash flow hedges, 

respectively. 

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248 FASB, SFAS 133, paragraphs 20 and 28, as amended, which relate to fair value and cash flow 

hedges, respectively. 
re-designated due to a term-out, it is the beginning of a new hedging relationship. This requires 

an entity to evaluate the effectiveness of the new hedge relationship, including consideration of

whether the matched terms approach may be applied. As discussed in greater detail below, one 

of the criteria that must be met in order to apply matched terms accounting is that the fair 

value of the hedging instrument at the inception of the hedging relationship be zero. When an 

existing derivative is re-designated, it would typically have a fair value that is not zero, due to 

market changes that have occurred since the instrument’s inception. Thus, it is generally not 

possible to qualify for matched terms treatment upon the re-designation of a hedging 

instrument. Nonetheless, Fannie Mae continues to apply matched terms accounting when such 

situations occur. It is OFHEO’s conclusion that Fannie Mae has improperly applied 

matched terms accounting to derivatives that have been subject to re-designation in 

connection with term-out transactions. By incorrectly applying matched terms 

accounting, Fannie Mae has not only failed to measure the ineffectiveness 

associated with such relationships but they have failed to perform a proper hedge 

effectiveness assessment, which invalidates their ability to receive hedge

accounting treatment. 

Example 1.

Below is an example of a term-out and its effect on the associated swap for purposes of 

illustrating a typical re-designation that Fannie Mae executes as part of their portfolio 

rebalancing. 

Example of a Term-out

Discount Note

Rollover 90-day 

($500 million)

Discount Note

Rollover 90-day

($500 million)

RECEIVE: Libor, Resets every 90-days ($500 million notional)

PAY: 6.785 % – 7 years ($500 million)

PAY: 6.175% MTN 3 – Years ($500 million)

RECEIVE: 6.175 % 3 – Years ($500 million notional)

PAY: Libor, Resets every 90-days ($500 million notional)

7/2/97

Swap 1

Swap 2

Discount 

Notes

MTN Issued

7/2/99

Period A Period B Period C

No Discount Notes Issued

7/2/02

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Description of Transaction: 

• On 7/2 1997, Fannie Mae issues $500M in Discount Notes (“DN”) and enters into Swap #1

(trea ed as a “perfect” cash flow hedge of the forecasted interes payments on the discount 

notes). Swap #1 is a pay-fixed, receive-floating swap with a term of 7 years, the period of 

expected reissuance o DNs. For purposes of this example it is assumed that the swap’s 

interes rate reset dates match the expected timing of DN reissuance and all other cri ical 

terms are matched in order to allow Fannie Mae to assume perfec effectiveness under SFAS 

133. 

/

t t

f

t t

t

/ , r r t ” r

t

/

f

,

t r

f

t t

 

• On 7 2/1999 Fannie Mae issues $500M 6.175% 3-y Medium Te m No e (“MTN ) rathe

than reissuing $500M in DNs. At that time Fannie Mae also enters into swap #2. Swap #2

is a receive-fixed, pay-floating swap that matures in three years. Swap #2 is structured 

such that its cash flows offset those of swap #1 for the three year term of swap #2 (period 

B in the illus ration), with the exception of a differential between the fixed rates of the two 

swaps, which remains constant during that period. 

• Upon the maturity of the MTN, Fannie Mae expects to resume issuing $500M in DNs 

through the remainder of the original 7 year period (period C in the illustration). 

• On 7/2 1999, Fannie Mae de-designates swap # 1 from its original hedge relationship and 

re-designates it, in combination with swap#2, as a “perfect” cash flow hedge o the 

anticipated rollover of $500M of DNs during a future period (period C which is the period of 

time in which the MTN matures and a $500M DN is issued again). As of 7/2/1999, the redesigna ed swap #1 together with swap #2 is hedging a “forward starting” two yea period 

that begins 7/2/2002. 

In Fannie Mae’s DAG, the accounting treatment described for the re-designated hedge

relationship set forth above, and other similar re-designations, is matched terms accounting. In 

many of the transaction examples involving term-outs and re-designations as set forth in the 

DAG, their descriptions indicate an assumption of no ineffectiveness. Based on OFHEO’s 

interviews with Mr. Boyles and other accounting personnel, as well as our reading of the 

Enterprise’s DAG, we understand that in such instances, Fannie Mae has applied the guidance in 

DIG Issue No. G9 Cash Flow Hedges: Assuming No Ineffectiveness When Critical Terms o

Hedging Instruments and Hedged Transac ion Ma ch in a Cash Flow Hedge (“DIG Issue G9”), 

and paragraph 65 of SFAS 133, to assume perfect effectiveness. Moreover, we understand that

in these circumstances Fannie Mae performs no assessment test and no measurement of 

ineffectiveness, which results in the earnings effect of these transactions being the same as the 

synthetic accounting treatment that Fannie Mae followed prior to SFAS 133. 249 OFHEO asserts 

that this accounting is not consistent with the requirements of SFAS 133. 

 

Special Examination of Fannie Mae 

Privileged & Confidential 

Disclosure and/or Duplication Prohibited 

96

249 For example, “Termout Transaction #2” in Fannie Mae’s DAG, states that “changes in fair value of the 

re-designated portion of Swap #1 and all of Swap #2 will be reported in [Accumulated] Other 

Comprehensive Income” and that “This accounting treatment will have the effect of keeping the original 

accrual rate in earnings equal to what would have been recognized under synthetic accounting 

treatment.” 
Accounting Analysis 

Paragraph 65 of Statement 133 states: 

If the critical terms of the hedging instrument and of the entire hedged asset or liability 

(as opposed to selected cash flows) or hedged forecasted transaction are the same, the 

entity could conclude that changes in the fair value or cash flows attributable to the risk 

being hedged are expected to completely offset at inception and on an ongoing basis. 

For example, an entity may assume that a hedge of a forecasted purchase of a

commodity with a forward contract will be highly effective and that there will be no 

ineffectiveness to be recognized in earnings if: 

a. The forward contract is for purchase of the same quantity of the same

commodity at the same time and location as the hedged forecasted purchase. 

b. The fair value of the forward contract at inception is zero. [Emphasis 

added] 

c. Either the change in the discount or premium on the forward contract is excluded 

from the assessment of effectiveness and included directly in earnings pursuant 

to paragraph 63 or the change in expected cash flows on the forecasted 

transaction is based on the forward price for the commodity. 

DIG Issue G9 further expands on the method of matched terms. It states an entity is still 

required to perform and document an assessment of hedge effectiveness at the inception of the 

hedging relationship and on an on-going basis throughout the hedge period, however 

subsequent assessments can be performed by verifying and documenting whether the 

critical terms of the hedging instrument and the forecasted transaction have changed during the 

period in review. Furthermore, the following excerpt from DIG Issue G9 should be noted: 

However, if the critical terms of the hedging instrument or the hedged 

forecasted transaction have changed [Emphasis added] or if there have been 

adverse developments regarding the risk of counterparty default, the entity must

measure the amount of ineffectiveness that must be recorded currently in earnings 

pursuant to the guidance in Statement 133 Implementation Issue No. G7, “Measuring

the Ineffectiveness of a Cash Flow Hedge under Paragraph 30(b) When the Shortcut

Method Is Not Applied.” In addition, the entity must assess whether the 

hedging relationship is expected to continue to be highly effective (using

either a dollar-offset test or a statistical method such as regression analysis).

[Emphasis added] 

When Fannie Mae re-designates a derivative in the manner described in the example above, 

there has been a change in both the hedging instruments used as well as the hedged 

transaction. Thus, upon re-designation this represents a new hedge relationship.250 Accordingly, 

the requirements of paragraph 65, to assume critical terms matching, need to be evaluated in 

connection with the newly designated hedge relationship. In the term-out example (Example 

1), on the date of re-designation, Swap #1 would presumably have a fair value other than zero, 

 

Special Examination of Fannie Mae 

Privileged & Confidential 

Disclosure and/or Duplication Prohibited 

97

250 As noted in the example, Fannie Mae starts with one swap hedging the rollover of existing and future 

discount notes. After the re-designation, it is using two swaps in combination to hedge anticipated 

issuance of discount notes in a future period. 
whereas Swap #2 would presumably have a fair value of zero.

251 As a result of the combination 

of the Swap #1 and Swap #2 having a fair value not equal to zero, the hedge does not meet 

the requirements of paragraph 65(b) as stated above. In addition to being specifically listed in

paragraph 65(b), the concept of a zero fair value at inception as a requirement for 

demonstrating a matching of critical terms is noted in DIG Issue G9 and is also a requirement 

for the shortcut method, which is a concept similar to the matching of critical terms.252 

Example 8 in SFAS 133, set forth in paragraphs 153-161, contains an example transaction – 

Scenario 2 - that specifically illustrates this point. This transaction illustrates a situation very 

similar to a term-out, involving the re-designation of an existing swap in combination with 

another swap. Relevant excerpts of that example are as follows: 

MNO Company enters into an interest rate swap (Swap 1) and designates it as a hedge 

of the variable interest payments on a series of $5 million notes with 90-day terms. 

MNO plans to continue issuing new 90-day notes over the next five years as each 

outstanding note matures. The interest on each note will be determined based on 

LIBOR at the time each note is issued. Swap 1 requires a settlement every 90 days, and 

the variable interest rate is reset immediately following each payment. MNO pays a

fixed rate of interest (6.5 percent) and receives interest at LIBOR. MNO neither pays

nor receives a premium at the inception of Swap 1. The notional amount of the contract 

is $5 million, and it expires in 5 years. 

Because Swap 1 and the hedged forecasted interest payments are based on the same 

notional amount, have the same reset dates, and are based on the same benchmark 

interest rate designated under paragraph 29(h), MNO may conclude that there will be no 

ineffectiveness in the hedging relationship (absent a default by the swap counterparty). 

Scenario 2—Two Interest Rate Swaps Designated as a Hedge of Future Variable Interest 

Payments 

At the end of the second year of the 5-year hedging relationship, MNO discontinues its 

practice of issuing 90-day notes and issues a 3-year, $5 million note with a rate of 

interest that adjusts every 90 days to the prime rate quoted on that day. Swap 1 is no 

longer effective as a cash flow hedge because the receive-variable rate on the swap is 

LIBOR, and the prime rate and LIBOR are expected to change differently. Thus, the

cash flows from the swap will not effectively offset changes in cash flows from the 

three-year note. 

 

Rather than liquidate Swap 1 and obtain a separate derivative to hedge the variability of 

the prime-rate-based interest payments, MNO enters into a pay-LIBOR, receive-prime 

basis swap. The basis swap has a $5 million notional amount and a 3-year term and 

requires a settlement every 90 days. MNO designates Swap 1 and the basis swap 

in combination as the hedging instrument in a cash flow hedge of the variable 

251 These presumptions are based on the nature of typical interest rate swaps, which start with a fair value 

of zero, and thereafter have a positive or negative fair value, depending upon changes in interest rates. 

Special Examination of Fannie Mae 

Privileged & Confidential 

Disclosure and/or Duplication Prohibited 

98

252 OFHEO has observed that Fannie Mae’s policies cite criteria similar to the SFAS 133 shortcut criteria 

as a basis for matching of critical terms. These can be found in the DAG section IV.20 for cash flow 

hedges and section VI.13 for fair value hedges. See DAG, FMSE 112567-113143. 
interest payments on the three-year note. [Emphasis added] On the three-year 

note, MNO pays interest at prime. On the basis swap, MNO receives interest at prime 

and pays interest at LIBOR. On Swap 1, MNO receives interest at LIBOR and pays 

interest at 6.5 percent. Together, the cash flows from the two derivatives are effective 

at offsetting changes in the interest payments on the three-year note. Changes in fair 

values of the two swaps are recognized in other comprehensive income and are 

reclassified to earnings when the hedged forecasted transactions (the variable interest 

payments) affect earnings (as required by paragraph 31). 

SFAS 133, as originally drafted, also contained the following sentence at the end of the above 

example (paragraph 161): 

Because the two swaps in combination meet the conditions discussed in paragraph 68, 

MNO is permitted to assume no ineffectiveness and use the shortcut method illustrated 

in Example 5. 

However, when SFAS 133 was amended by Statement of Financial Accounting Standards No. 

138, Accounting for Certain Derivative Ins rumen s and Certain Hedging Activities, an

amendment of FASB S atement No. 133, (“SFAS 138”),253 the above sentence was deleted.

Paragraph 38 in SFAS 138’s “Background Information and Basis for Conclusions” states: 

t t

t

 

This Statement also deletes the last sentence of paragraph 161 because the hedging 

instrument in Example 8 does not meet the criterion in paragraph 68(b) to 

qualify for the shortcut method. The hedging instrument does not have fair 

value of zero at inception of the hedging relationship. [Emphasis added.] 

This example and the subsequent correction made by SFAS 138 clearly indicates that under 

SFAS 133, re-designated derivatives do not qualify for shortcut or matched terms treatment if

their fair value is other than zero at the time of the re-designation. Accordingly, it is

OFHEO’s conclusion that Fannie Mae incorrectly applies matched terms accounting 

in the term-out example discussed previously as well as in numerous other term-out 

transactions described in its DAG. By incorrectly applying matched terms 

accounting, Fannie Mae has not only failed to measure ineffectiveness associated 

with such relationships but they have failed to perform a proper hedge effectiveness 

assessment, which invalidates their ability to receive hedge accounting treatment.

Further, it should be noted that Fannie Mae’s DAG includes guidance on assuming perfect 

effectiveness. OFHEO noted that Fannie Mae’s internal guidance is consistent with the 

accounting literature with regard to the requirement that the fair value of the hedging 

instrument must be zero at the inception of the hedge relationship, as well as references to DIG 

Issue G9.

254 Thus, Fannie Mae’s assumption of perfect effectiveness upon a hedge redesignation is not only inconsistent with SFAS 133 guidance, it is inconsistent with 

Fannie Mae’s own internal accounting guidance. The DAG also requires a 

253 SFAS 138 was issued in June 2000 and amended SFAS 133 for certain technical matters prior to the 

effective adoption date of SFAS 133 by Fannie Mae. 

Special Examination of Fannie Mae 

Privileged & Confidential 

Disclosure and/or Duplication Prohibited 

99

254 Fannie Mae DAG pp. IV.20 – IV.24 for cash flow hedges and VI.13 - IV.15 for fair value hedges. See 

DAG, FMSE 112652-112656. 
quantitative assessment of effectiveness to qualify for hedge accounting, as well as 

measurement of ineffectiveness, when matched terms criteria are not met.255

Although, these requirements are documented in the DAG, Fannie Mae has not 

performed such assessments and measurements for hedges involving re-designated 

derivatives. 

 

Implications 

The improper accounting for re-designations as described above impacts a substantial portion

of Fannie Mae’s derivatives portfolio. Based on our review of Fannie Mae’s DAG, many of the redesignated hedge relationships as described therein would not qualify as perfect hedges for 

reasons similar to those outlined for the transaction discussed in Example 1. Although further

information needs to be gathered to gain a full understanding of the magnitude of these errors, 

OFHEO understands that as much as 50-75% of Fannie Mae’s derivatives portfolio may have 

been subject to re-designations at some point in time.256 Additionally, in testimony to OFHEO, 

the senior financial analyst in the Treasury Middle Office stated that hedge effectiveness 

assessment and ineffectiveness measurement is performed for only a very small number of 

hedge relationships relative to the total portfolio, and all others are assumed to be perfectly 

effective.

257 Because a proper effectiveness assessment is apparently not performed for the redesignated hedge relationships, they would not qualify for hedge accounting under SFAS 133. 

Such transactions would thus be properly accounted for on a “non-hedge” basis, meaning fair 

value changes are recorded directly to earnings. 

During an interview with Mr. Boyles, he stated that Fannie Mae was aware that the sentence 

referenced above [“Because the two swaps in combination meet the conditions discussed in 

combination meet the conditions discussed in paragraph 68, MNO is permitted to assume no

ineffectiveness and use the shortcut method illustrated in Example 5”] was deleted by SFAS 

138. He further stated that Fannie Mae had performed an analysis prior to its adoption of SFAS 

133 to evaluate the impact of the change, and based on the results of this analysis, decided to 

continue using the assumption of no ineffectiveness and therefore ignoring the change made in

SFAS 138. Mr. Boyles stated that the difference between assuming perfect effectiveness and 

 255 Fannie Mae DAG p. IV.25 for cash flow hedges and VI.16 for fair value hedges. See DAG, FMSE 

112657,112768, respectively. OFHEO observes that Fannie Mae’s DAG calls for the use of a cumulative 

dollar offset test (80-125% is regarded as highly effective) to assess effectiveness in situations where the 

“long haul” method is required. Long haul method refers to situations in which neither the shortcut nor 

matching of critical terms method is applicable and an assessment of hedge effectiveness and 

measurement of ineffectiveness is required. 

256 Internal notes prepared by OFHEO, Re: Interview with Laura Simmons—Treasury Office Operations, 

May 20, 2004. In the interview she indicated that 50%-75% of the portfolio of derivatives is potentially relinked. 

257 OFHEO interview, Katarina Skladony, Senior Financial Analyst-Treasury Middle Office, August 26, 

2004, p. 150 

A: As I recall, as of the end of the last quarter, there were no transactions for which you would have to 

use hypothetical derivative method for ineffectiveness calculation. 

Q: So were there no long haul calculations being performed for the last quarter? 

A: There were no cash flow hedges that would require long haul calculation. 

Special Examination of Fannie Mae 

Privileged & Confidential 

Disclosure and/or Duplication Prohibited 

100

See Mona Patel testimony in; The Assumption of Perfect Effectiveness, herein, for more details relating to 

the number of long hauls performed. 
the amount of ineffectiveness measured using the long haul method was minor.258 In the same

interview, he represented that he believed that any ineffectiveness that was ignored by Fannie 

Mae in term-out transactions was immaterial based on the analysis performed. He also 

indicated that he no longer had the analysis as he had discarded it, along with several other 

items, when he moved offices. 259 Mr. Boyles also acknowledged that there was no quarterly or

annual review of the ineffectiveness resulting from term-out transactions. 

In a subsequent interview, Mr. Boyles stated that a recent analysis had been performed using 

information as of June 30, 2004. He informed OFHEO that this analysis was performed as a 

direct result of some of the issues that were raised by OFHEO as part of this special 

examination. He also stated that the amount of cumulative ineffectiveness resulting from redesignated derivatives was approximately $50 million. Fannie Mae’s auditor, KPMG, had posted 

a “review difference” for this amount.

 260 OFHEO obtained a summary analysis (which had no

supporting documentation attached) which was used to project the ineffectiveness calculation 

across the entire population. OFHEO also participated in a conference call with Fannie Mae in 

which representatives of the Enterprise attempted to explain the methodology that was 

followed in completing the analysis. 261 Mr. Boyles stated that the revised projected economic 

 258 OFHEO interview, Jonathan Boyles, Senior Vice President – Financial Standards and Corporate Tax, 

August 3, 2004, pp. 212-213 

Q: [...]So when this change was made as a result of FAS 138, is our understanding correct that a 

conscious decision was made to continue to apply the treatment irrespective of this change?

A: When 138 was released we also saw that sentence deleted. The background information refers to this 

as not qualifying for the shortcut method. It did not say that the--in the matching concept, that the--one of 

the critical terms was the beginning value starting with zero. This only refers to--and the criteria relates to 

the shortcut method. [...] We also did some analysis that I believe I mentioned earlier, that we showed 

our auditors, as it relates to this transaction, that showed that difference between going long haul and 

assuming no ineffectiveness to be minor. 

259 OFHEO interview, Jonathan Boyles, Senior Vice President – Financial Standards and Corporate Tax, 

August 3, 2004, pp. 225-226 

Q So was that what your example was, an example of not applying matched terms but actually doing long 

haul? 

A: [...]The analysis that we did was the analysis as it relates to if I'm going to take the income amount out 

of OCI, and if I'm going to record the ineffectiveness as expense, and book both of them to the income 

statement, that that analysis showed those amounts to be immaterial difference. And so the accrual that 

will normally occur will capture those differences. And that's what the policy reflects. 

[...]A:[...]Several years ago when I took over the Tax Department, I switched offices, and almost 

everything related to the adoption of 133 I threw in the trash[...]and so I could not find it in my analysis. 

[...] 

260 OFHEO interview, Jonathan Boyles, Senior Vice President – Financial Standards and Corporate Tax, 

August 24, 2004, p. 106 

Q: Was the difference, a $50 million difference, proposed as an adjustment by KPMG or was that not 

proposed? 

A: It was a review difference for them. [...] 

A: The audit isn't done so it's not an audit adjustment. But the review was completed for the quarter so it 

would have been a review adjustment for them. 

Special Examination of Fannie Mae 

Privileged & Confidential 

Disclosure and/or Duplication Prohibited 

101

261 Handwritten notes from conference call held between Fannie Mae and OFHEO, September 7, 2004. 

Fannie Mae explained the analysis that was performed and the approach the Enterprise took to project 

out the sample across the entire population. Fannie Mae was represented by Leanne Spencer, Controller; 

Jonathan Boyles, Senior Vice President – Financial Standards and Corporate Tax; Mark Wiener, Vice 

President of Risk Management; and Jodie Kelley, Associate General Counsel. 
impact of the analysis was a loss of $27 million262 and that Fannie Mae’s external auditor was 

comfortable with the number. While the matter is still under study, our initial conclusion is that 

the analysis procedures performed were not adequate to support Fannie Mae’s conclusion for 

the following reasons: 263

• The analysis was based on a sample of 40 hedge transactions and attempts to

extrapolate these results to the entire population of affected transactions, rather than 

performing a calculation for each affected transaction. We do not believe an accurate 

estimate can be made using such an extrapolation. 

• Fannie Mae only evaluated cumulative ineffectiveness as of a point in time, ignoring the 

fact that the amount of ineffectiveness recorded in earnings on a period-to-period basis 

will fluctuate. 

• As noted earlier, an assessment of effectiveness is required to be performed 

retrospectively and prospectively on a quarterly basis to qualify for hedge accounting. 

The analysis referenced above only addressed measurement of ineffectiveness. In the

call with OFHEO, Mr. Boyles represented that the Enterprise had also performed a 

regression analysis as of June 30, 2004 on a select number of derivative transactions 

out of the 40 transactions that were included in the sample. Such an after-the-fact test 

does not meet SFAS 133 requirements. 

 

In order to gain an understanding of the potential ineffectiveness that can result from a termout transaction, OFHEO performed an analysis using an illustrative $500 million notional swap 

that is assumed to be subject to a term-out similar to the Example 1 Term-out described above. 

This analysis used actual market data to illustrate the accounting effect of such a transaction if 

ineffectiveness is properly measured. See Appendix III. OFHEO’s analysis indicates that, while 

cumulative ineffectiveness can be small (or even zero) at a given period end, it can result in

millions of dollars of ineffectiveness affecting earnings on a period-to-period basis for a single 

hedge relationship. Furthermore, our illustration indicates that if an effectiveness assessment 

test had been properly performed in accordance with Fannie Mae’s policy, the hedge

relationship could fail the 80% to 125% correlation test.264 This would preclude the application 

of hedge accounting in periods in which the test failed. The following graph is summarized 

from OFHEO’s analysis and illustrates the periodic earnings volatility that can occur when 

ineffectiveness is properly measured (assuming the hedge relationship qualifies for hedge 

accounting). 

 262 Handwritten notes from conference call held between Fannie Mae and OFHEO, September 7, 2004. 

Fannie Mae was represented by Leanne Spencer, Controller; Jonathan Boyles, Senior Vice President – 

Financial Standards; and Corporate Tax; Mark Wiener, Vice President of Risk Management; and Jodie 

Kelley, Associate General Counsel. It is OFHEO’s understanding from the call that the revised projected 

economic impact from the analysis was determined by Fannie Mae to be $27 million. 

263 OFHEO had requested all information that was used to prepare the analysis and develop the 

expectations. Fannie Mae mentioned in the call referenced above that they have been working on pulling 

together the information and supporting schedules that supports the analysis. This information was 

originally requested via a subpoena dated August 18, 2004.

Special Examination of Fannie Mae 

Privileged & Confidential 

Disclosure and/or Duplication Prohibited 

102

264 Fannie Mae’s DAG, as well as SEC guidance, requires a dollar offset ratio between the hedging 

instrument and hedged item to fall between 80% and 125% in order to meet the “highly effective” 

requirement to qualify for hedge accounting. See section II.15-17 Hedge Effectiveness Analysis of the 

DAG (FMSE 112604-112606). 
Illustration of Earnings Volatility - Termout

$1,800,000.00

$3,800,000.00

$5,800,000.00

$7,800,000.00

$9,800,000.00

$11,800,000.00

Q3

1999

Q4

1999

Q1

2000

Q2

2000

Q3

2000

Q4

2000

Q1

2001

Q2

2001

Q3

2001

Q4

2001

Q1

2002

Q2

2002

Q3

2002

Q4

2002

Q1

2003

Q2

2003

Q3

2003

Q4

2003

Q1

2004

Q2

2004

Interest Expense

Per Fannie Mae Per OFHEO

As noted above, further information and an in-depth analysis will be required to determine the 

proper treatment of each of Fannie Mae’s hedging strategies and actual impact of these matters 

in relation to Fannie Mae’s total derivatives portfolio for past financial statement periods. 

However, even without any further analysis, OFHEO contends that this matter has significant 

implications to Fannie Mae’s financial statements given the frequent use of term-outs and the

significant earnings impact. The impact that would result from recording changes in fair values 

of such derivatives through earnings could be in the billions of dollars.

Special Examination of Fannie Mae 

Privileged & Confidential 

Disclosure and/or Duplication Prohibited 

103
Issue 2: Accounting for Offsetting Derivatives 

 

Fannie Mae enters into offsetting swaps in which an existing swap (typically a pay-fixed, 

receive-floating swap) is effectively cancelled by a second swap with offsetting terms (i.e., payfloat, receive-fixed). This section discusses Fannie Mae’s accounting treatment of these 

transactions and specifically the Enterprise’s application of cash flow hedge accounting. 

Background 

SFAS 133 describes a cash flow hedge as follows: “An entity may designate a derivative 

instrument as hedging the exposure to variability in expected future cash flows that is

attributable to a particular risk. That exposure may be associated with an existing recognized

asset or liability (such as all or certain future interest payments on variable-rate debt) or a

forecasted transaction (such as a forecasted purchase or sale).”265 Thus, the essence of a cash 

flow hedge is to offset the variability in cash flows of the hedged item. 

Furthermore, SFAS 133 requires that an entity discontinue cash flow hedging prospectively if 

any one of the following occurs:266

•Any of the criteria to qualify for hedge accounting are no longer met.

•The derivative expires or is sold, terminated or exercised. 

•The entity removes the designation of the cash flow hedge. 

After a cash flow hedge has been discontinued, the effective portion of the derivative’s net gain 

or loss shall remain in AOCI and be reclassified to earnings at the time the hedged transaction 

affects earnings, unless the hedged transaction is deemed probable of not occurring, in which 

case any gains or losses would be immediately be reclassified from AOCI to earnings.267

Summary of Issue 

As discussed under Issue 1: Derivative Re-Designations, Fannie Mae frequently goes through 

the process of “re-balancing” its liability portfolio. In this process, it often enters into new 

swaps and other derivatives, many of which are used to offset existing derivatives either fully or 

partially. In many cases, this relates to a “term-out” which, as described earlier, is generally the 

replacement of discount notes with fixed rate notes or other borrowings. Certain term-outs 

result in a situation in which a hedged exposure no longer exists, for instance when short-term

floating rate debt is replaced with long-term fixed rate debt and the variability of future interest 

payments has been eliminated. When this occurs, the swap is no longer matched to an 

exposure, leaving Fannie Mae with the choice of terminating the swap, offsetting it with another 

swap, or re-designating it to another exposure. Assuming no other exposure exists to which the 

swap can be re-designated, Fannie Mae’s typical approach has been to enter into an offsetting

swap to effectively terminate the hedging relationship. When this has occurred, Fannie Mae’s 

past practice has been to continue to account for both swaps as a cash flow hedge, which is not 

consistent with SFAS 133 requirements. It is OFHEO’s conclusion that Fannie Mae has 

inappropriately applied hedge accounting in these circumstances. When the floating 

rate debt has been termed-out cash flow hedge accounting must cease because the 

265 FASB, SFAS 133, paragraph 28. 266 FASB, SFAS 133, paragraph 32. 

Special Examination of Fannie Mae 

Privileged & Confidential 

Disclosure and/or Duplication Prohibited 

104

267 FASB, SFAS 133, paragraphs 32 and 33. 
hedged exposure no longer exists. The two offsetting swaps should both be 

recorded at fair value with changes in their fair values recorded in earnings. 

Although the swaps offset one another, there should still be a net mark-to-market 

impact because the rate on the swaps’ fixed legs (one pay, one receive) would 

differ. 

Example 2.

Below is an example of a situation in which an offsetting swap is used by Fannie Mae in 

connection with a term-out. 

Example of an Offsetting Swap

Discount Note

Rollover 90-day 

($500 million)

RECEIVE: Libor, Resets every 90-days ($500 million notional)

PAY: 6.785 % – 7 years ($500 million)

PAY: 6.175% MTN 3 – Years ($500 million)

RECEIVE: 5.202 % 3 – Years ($500 million notional)

PAY: Libor, Resets every 90-days ($500 million notional)

7/2/97

Swap 1

Swap 2

Discount 

Notes

MTN Issued

7/2/01

Period A Period B

No Discount Notes Issued

Description of Transaction: 

• On 7/2 97, Fannie Mae issues $500M in DNs and enters in o Swap #1 ( reated as a per ect 

cash flow hedge of the forecasted interes payments on the discount no es). Swap #1 is a 

pay-fixed receive-floating swap with a term of 7 years, the period o expected reissuance o

DNs. For purposes of this example, i is assumed that the swap’s interest rate reset dates 

match the expected timing of DN reissuance and all other cri ical terms a e matched in

order to allow Fannie Mae to assume per ect effectiveness under SFAS 133. 

/ t t f

t t

, f f

t

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f

f t

• On 7/2/01, Fannie Mae issues a $500M 6.175% 3-yr MTN to replace a rollover of $500M in 

DNs and enters into swap #2. Swap #2 is a receive-fixed, pay-floating swap that matures 

in 3 years which coincides with the maturity of the MTN and the end of the original 7 year

hedge period. Swap #2 serves to completely offset the effect o Swap #1 except tha the 

two swaps have different fixed interest rates because they were entered into at different

times. The net result of the two swaps is a fixed stream of cash flows over their remaining 

lives, representing the difference in their respective fixed rates. 

Special Examination of Fannie Mae 

Privileged & Confidential 

Disclosure and/or Duplication Prohibited 

105
• Fannie Mae con inues to treat both Swap#1 and Swap#2 as a per ect cash flow hedge over 

their remaining lives and as such all changes in he swaps’ fair values are reflected in AOCI 

and reclassified into earnings as the interest settlements on the swaps accrue. 

t f

t

 

In Fannie Mae’s DAG, they describe the above accounting treatment as “...a practical 

interpretation of the Statement to treat this as a cash flow hedge rather than two speculative 

hedges...” It states further that “This accounting will have the effect of keeping original accrual

rate in earnings equal to what would have been recognized under synthetic accounting 

treatment.”

268 OFHEO asserts that this treatment is not consistent with the requirements of

SFAS 133.

Accounting Analysis 

OFHEO concludes that the accounting treatment described in the above example is not 

compliant with the requirements of SFAS 133. As noted above, cash flow hedge accounting is 

applied when there is an exposure to variable cash flows. In Example 2, the exposure to 

variable cash flows was eliminated when the issuance of discount notes was replaced with a 

fixed rate MTN. Thus, at that time cash flow hedge accounting should have been discontinued 

for swap #1, consistent with the requirements of paragraph 32 of SFAS 133. Both swap #1 and

swap #2 should have been marked-to-market through earnings from that point forward and 

treated as non-hedging derivatives. This conclusion is supported in SFAS 133 by “Example 8 – 

Scenario 1”, set forth in paragraphs 153-158, excerpted as follows: 

MNO Company enters into an interest rate swap (Swap 1) and designates it as a hedge 

of the variable interest payments on a series of $5 million notes with 90-day terms. 

MNO plans to continue issuing new 90-day notes over the next five years as each 

outstanding note matures. The interest on each note will be determined based on 

LIBOR at the time each note is issued. Swap 1 requires a settlement every 90 days, and 

the variable interest rate is reset immediately following each payment. MNO pays a

fixed rate of interest (6.5 percent) and receives interest at LIBOR. MNO neither pays

nor receives a premium at the inception of Swap 1. The notional amount of the contract 

is $5 million, and it expires in 5 years. 

Because Swap 1 and the hedged forecasted interest payments are based on the same 

notional amount, have the same reset dates, and are based on the same benchmark 

interest rate designated under paragraph 29(h), MNO may conclude that there will be no 

ineffectiveness in the hedging relationship (absent a default by the swap counterparty). 

Scenario 1—Two Undesignated Interest Rate Swaps 

At the end of the second year of the 5-year hedging relationship, MNO discontinues its 

practice of issuing 90-day notes. Instead, MNO issues a 3-year, $5 million note with a 

fixed rate of interest (7.25 %). Because the interest rate on the three-year note is

fixed, the variability of the future interest payments has been eliminated. Thus, Swap 

1 no longer qualifies for cash flow hedge accounting [Emphasis added]. 

However, the net gain or loss on Swap 1 in accumulated other comprehensive income is 

not reclassified to earnings immediately. Immediate reclassification is required (and

Special Examination of Fannie Mae 

Privileged & Confidential 

Disclosure and/or Duplication Prohibited 

106

268 This language can be found under example transaction #43 in the DAG, FMSE 113073. 
permitted) only if it becomes probable that the hedged transactions (future interest 

payments) will not occur. The variability of the payments has been eliminated, but it

still is probable that they will occur. Thus, those gains or losses will continue to be 

reclassified from accumulated other comprehensive income to earnings as the interest

payments affect earnings (as required by paragraph 31).

 

Rather than liquidate the pay-fixed, receive-variable Swap 1, MNO enters into a payvariable, receive-fixed interest rate swap (Swap 2) with a 3-year term and a notional

amount of $5 million. MNO neither pays nor receives a premium. Like Swap 1, Swap 2 

requires a settlement every 90 days and reprices immediately following each settlement. 

The relationship between 90-day interest rates and longer term rates has changed since 

MNO entered into Swap 1 (that is, the shape of the yield curve is different). As a result, 

Swap 2 has different terms and its settlements do not exactly offset the settlements on 

Swap 1. Under the terms of Swap 2, MNO will receive a fixed rate of 7.25 percent and 

pay interest at LIBOR. 

The two swaps are not designated as hedging instruments and are reported 

at fair value [Emphasis added]. The changes in fair value are reported immediately in 

earnings and offset each other to a significant degree. 

The excerpt above from SFAS 133 clearly indicates that there is no basis for applying hedge 

accounting after the DN’s are replaced with MTNs because the variability in cash flows 

previously being hedged no longer exists. Furthermore, OFHEO observes that by applying 

hedge accounting to the two offsetting swaps, Fannie Mae was effectively hedging a derivative 

with another derivative, which is not permitted by SFAS 133. Paragraph 29(d) of SFAS 133 

describes one of the criteria that must be met for a forecasted transaction to be designated as a 

hedged item in a cash flow hedge as follows: 

The forecasted transaction is not the acquisition of an asset or incurrence of a 

liability that will subsequently be remeasured with changes in fair value 

attributable to the hedged risk reported currently in earnings. If the forecasted

transaction relates to a recognized asset or liability, the asset or liability is not 

remeasured with changes in fair value attributable to the hedged risk reported 

currently in earnings. 

A derivative is an asset or liability that is remeasured with changes in fair value reported 

in earnings; therefore, it is not eligible as a hedged item in a cash flow hedge 

relationship. 

In March 2004, shortly after the commencement of OFHEO’s special examination, Fannie Mae 

made a decision to de-designate or terminate certain hedging relationships that were classified 

as perfect cash flow hedges.269 OFHEO understands that these hedging relationships included

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269 Memorandum from Jonathan Boyles to distribution, Subject: Revisions to the December 2003 DAG, 

March 13, 2004, FMSE 113686-113690. The memorandum states, “Effective January 1, 2004, any plain 

vanilla PF and RF swaps that are linked with matching terms will be treated as DNQ derivatives with both 

sides marked to market through earnings.” 
those strategies that combined a receive-fixed swap with a pay-fixed swap effectively canceling 

the pay-fixed swap (as illustrated in Example 2) and those that combined a pay-fixed swaption

with a receive-fixed swaption. These relationships were previously treated as perfect cash flow 

hedges. Effective as of January 1, 2004, these swaps are being marked to market through

earnings and are not receiving hedge accounting treatment. According to the 10-Q for the first 

quarter of 2004, the impact on earnings of marking to market these derivatives was a pre-tax 

loss of approximately $13 million.270 OFHEO noted that this change in accounting treatment has 

been done prospectively. Fannie Mae has made no acknowledgement that its prior accounting 

was incorrect. Accordingly, OFHEO believes that they have not properly quantified the financial 

statement impact on prior periods. 

It is OFHEO’s conclusion, based on the accounting analysis above, that these 

offsetting swaps were not valid hedging relationships under SFAS 133 and should 

not have received hedge accounting once the term-out occurred. OFHEO discussed 

the accounting change with Jonathan Boyles to determine whether he believed Fannie Mae’s 

prior accounting was correct. Mr. Boyles stated that he did not believe the prior accounting was 

in error, but he did believe it could be viewed as “aggressive.”271 Mr. Boyles indicated both in

his memorandum and in our discussions that the reasons for the accounting change were 

primarily operational in nature. However, it should be noted that when asked to identify the 

exposure being hedged or the hedged item in these transactions, Mr. Boyles could not recall the 

exposure being hedged.272 It is OFHEO’s belief that Fannie Mae may have made the change in 

policy as a direct response to the special examination. 

Implications 

It appears that the derivative positions to which this issue relates have represented a 

reasonably significant portion of Fannie Mae’s derivatives portfolio in prior periods. The 

magnitude is apparent from the Enterprise’s March 31, 2004 10-Q, which shows that derivatives

with notional and fair value balances of $51 billion and negative $1.6 billion, respectively, were 

treated as non-hedging instruments.273 At December 31, 2003 the same derivatives balances 

were $43 million and $0.274 OFHEO’s understanding is that this change is primarily attributable

to offsetting derivatives for which the accounting was changed in the first quarter of 2004. As 

noted earlier, Fannie Mae disclosed that the income statement effect of this change in the first

quarter of 2004 was approximately $13 million. In initial discussions with Fannie Mae, OFHEO 

was led to believe that this amount might be an approximation of the potential earnings impact 

if the proper accounting method had been applied in prior periods. In discussions with OFHEO, 

Mr. Boyles expressed the view that Fannie Mae’s practical interpretation of SFAS 133 would not 

 270 Fannie Mae March 31, 2004 10-Q, p. 26. 271 Internal notes prepared by OFHEO, Re: Interview with Jonathan Boyles, Senior Vice President—

Financial Accounting Standards and Corporate Tax, May 20, 2004. 272 OFHEO interview, Jonathan Boyles, Senior Vice President – Financial Standards and Corporate Tax, 

August 24, 2004, pp.177-178 

Q: What was the exposure that was being hedged? 

A: The exposure that was being hedged in this instance was the--I have to go back and think about it--I 

don't recall now. Going back, I don't recall what the exposure that was being hedged in this. 273 Fannie Mae March 31, 2004 10-Q, Table 20: Notional and Fair Value of Derivatives by Hedge

Designation, p. 27. 

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274 Fannie Mae March 31, 2004 10-Q, Table 20: Notional and Fair Value of Derivatives by Hedge

Designation, p. 27. 
have resulted in a material difference had a strict adherence to SFAS 133 been followed for 

such transactions, and that the $13 million result in the first quarter of 2004 demonstrated this. 

However, based on a review of several e-mails as well as an interview with Katarina Skladony, 

Senior Financial Analyst in Fannie Mae’s Treasury Middle Office, OFHEO discerned that the 

earnings impact of derivatives that have been marked as non-hedging is actively monitored and 

managed by the Treasurer’s group.275 The following email from Cheryl DeFlorimonte illustrates 

Fannie Mae’s response to the increased population of DNQ276 derivatives resulting from the 

policy change:

277 

In an effort to monitor and manage the earnings impact of the intentional

DNQs, TMO was requested to generate a weekly report showing the change in

the market value and the interest accrual relating to these DNQ swaps. It is 

my understanding that currently, TMO is not in a position to obtain weekly

accruals for these DNQs from their system. As such, TMO has proposed that

they provide the earnings impact report on a monthly basis until the required

system enhancement is made... 

This information led OFHEO to believe that the $13 million recognized in earnings in the first 

quarter is the result of the discontinuation of hedge accounting for those derivatives that were

in offsetting positions as well as certain derivatives that had previously been in valid hedge 

relationships but were intentionally de-designated with the intention of minimizing the earnings 

impact of the offsetting derivatives. The “DNQ” book is apparently being actively managed and 

monitored to ensure that the earnings impact is minimal. The emails indicate that specific

directions have been given to the technology group requesting the development of a weekly

report to facilitate managing the earnings impact of non-hedge derivatives. 

There are several points to note resulting from the above discussion. First, the Enterprise had 

employed improper accounting in prior periods, presumably in order to avoid the earnings 

volatility that might result from proper accounting treatment. There was no basis under SFAS 

133 to defer the mark-to-market of the offsetting derivatives in AOCI. Secondly, Fannie Mae’s 

 275 OFHEO interview, Katarina Skladony, Senior Financial Analyst – Treasury Middle Office, dated 

August 26, 2004, pp. 31-37 31, where she stated, “The DNQ project was initiated by the change in the 

accounting policy earlier this year that as a result of this, there were a number of transactions for which 

the hedge accounting guidelines changed in terms of how they're going to be reported, how the change of 

their market value will be reported, and since it included a fairly extensive number of trades, it was 

determined that there has to be a better process, a more comprehensive process, to make sure that, you 

know, all those transactions are properly identified and reported...Again, I believe that the project is a 

joint project between the Controller and the Treasurer’s.” 

Q: Are you given any instructions from the front office and Treasurer’s to specifically DNQ particular

trades? 

A: Yes, they have given me instructions such as that. 276 DNQ is the terminology used by Fannie Mae to designate those derivative transactions that “do not 

qualify” for hedge accounting. 

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277 Email from Cheryl DeFlorimonte to David Benson and Janet Pennewell, copy to Paul Salfi and Laura 

Simmons, Subject: Report on Earnings Impact from DNQs, February 27, 2004. This email is the 5th email 

in a chain of emails. The latest email (top of page) is an email from David Benson to Laura Simmons, 

Janet Pennewell, Cheryl DeFlorimone, copies to Paul Salfi, Katarina Skladony among others, Subject: 

Report on Earnings Impact from DNQs, March 1, 2004, produced via CD on 8/11/2004 in box M. 
first quarter 2004 disclosure of the earnings impact of DNQ derivatives is not indicative of the 

potential earnings impact that would have been recognized had the proper accounting

treatment been applied in prior periods. In order to evaluate the true impact on past earnings, 

Fannie Mae would have to perform a detailed historical analysis for all such hedge relationships

and quantify the impact of applying the proper accounting treatment.

In order to gain an understanding of the potential earnings impact of marking-to-market the 

offsetting swaps, with changes in fair value being recorded through earnings, OFHEO performed 

an analysis using an illustrative transaction and historical market data. This illustrative 

transaction involved a $500 million, seven year pay fixed swap that was subsequently offset 

with a receive-fixed swap. See Appendix IV. The analysis indicates that for an individual swap, 

the earnings effect of marking the two swaps to market through earnings, together with the 

amortization of prior AOCI amounts, may in fact largely offset one another, but still result in 

earnings volatility. However, the impact for actual transactions may vary, depending upon the 

terms of the instruments involved, actual market conditions and the size of the offsetting swap

portfolio. In contrast, Fannie Mae did not mark the two swaps to market, but reflected them in

earnings on an accrual basis, making the earnings impact much more predictable. The 

following graph is summarized from OFHEO’s analysis and illustrates the periodic earnings

volatility that can result when the proper accounting is applied to offsetting swaps. 

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Illustration of Earnings Volatility - Offsetting Swaps

$8,100,000

$8,200,000

$8,300,000

$8,400,000

$8,500,000

$8,600,000

$8,700,000

$8,800,000

$8,900,000

$9,000,000

$9,100,000

Q3 2001 Q4 2001 Q1 2002 Q2 2002 Q3 2002 Q4 2002 Q1 2003 Q2 2003 Q3 2003 Q4 2003 Q1 2004 Q2 2004

Interest Expense

Per Fannie Mae Per OFHEO

Fannie Mae’s treatment of offsetting swaps is one of many instances in which the Enterprise 

has employed improper accounting, apparently in order to avoid the earnings volatility that 

might result from proper accounting treatment. Furthermore, explicit guidance for this type of 

transaction was provided by the FASB (in Example 8 in SFAS 133), in large part due to Fannie 

Mae’s active discussions with the FASB. However, despite this guidance, Fannie Mae chose to

do the accounting “their way” which provides some insight into the culture and attitudes within 

the Enterprise. 

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Issue 3: Application of Shortcut and Matched Terms Methods 

Fannie Mae’s use of hedge accounting relies heavily on the assumption that the vast majority of

its hedging relationships are perfectly effective and that accordingly no effectiveness 

assessment or measurement of ineffectiveness needs to be performed for such relationships. 

This section discusses Fannie Mae’s application of the matched terms method and the 

assumption of perfect effectiveness. 

Background 

As discussed earlier, hedge accounting under SFAS 133 requires both an assessment of hedge 

effectiveness (initial and on-going) in order to qualify for hedge accounting treatment, as well 

as measurement of the ineffective portion of the hedge through earnings. An exception is 

granted for certain hedging relationships involving interest rate swaps, which qualify for what is 

known as the “shortcut” method. If the shortcut criteria are met, an entity is permitted to

assume that the hedging relationship is perfectly effective and thus perform no assessment of 

effectiveness and no measurement of ineffectiveness. The criteria to qualify for the shortcut

method are summarized as follows:278 

Conditions applicable to both fair value hedges and cash flow hedges: 

a) The notional amount of the swap matches the principal amount of the interestbearing asset or liability being hedged 

b) The fair value of the swap at the inception of the hedging relationship is zero (or if

applicable, reflects the fair value of an embedded call option in the swap which 

mirrors a call option in the hedged item). 

c) The formula for computing net settlements under the interest rate swap is the same

for each net settlement.

d) The interest-bearing asset or liability is not prepayable (unless it contains an 

embedded call or put option that is mirrored in the terms of the swap). 

dd) The index on which the variable leg of the swap is based matches the benchmark 

interest rate designated as the interest rate risk being hedged for that hedging

relationship. 

e) Any other terms in the interest-bearing financial instruments or interest rate swaps 

are typical of those instruments and do not invalidate the assumption of no 

ineffectiveness. 

Conditions applicable to fair value hedges only: 

f) The expiration date of the swap matches the maturity date of the interest-bearing

asset or liability. 

g) There is no floor or ceiling on the variable interest rate of the swap. 

h) The interval between repricings of the variable interest rate in the swap is frequent

(generally three to six months or less). 

 

Conditions applicable to cash flow hedges only: 

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278 FASB, SFAS 133, paragraph 68. Information is summarized from this paragraph. 
i) All interest receipts or payments on the variable-rate asset or liability during the 

term of the swap are designated as hedged, and no interest payments beyond the 

term of the swap are designated as hedged. 

j) There is no floor or cap on the variable interest rate of the swap unless the variablerate asset or liability has a floor or cap. In that case, the swap must have a floor or 

cap on the variable interest rate that is comparable to the floor or cap on the 

variable-rate asset or liability. (For this purpose, comparable does not necessarily 

mean equal. For example, if a swap's variable rate is LIBOR and an asset's variable

rate is LIBOR plus 2 percent, a 10 percent cap on the swap would be comparable to 

a 12 percent cap on the asset.) 

k) The repricing dates match those of the variable-rate asset or liability. 

SFAS 133 also provides that if the critical terms of the hedging instrument and of the hedged 

asset, liability or forecasted transaction are the same, the entity could conclude that changes in 

fair value or cash flows attributable to the risk being hedged are expected to completely offset 

at inception and on an on-going basis.279 As a result, the entity would apply matched terms 

accounting. In this case there would be no ineffectiveness to record and the effectiveness 

assessment would consist of confirming that the critical terms are matched at inception and 

continue to be matched over the life of the hedge.

While the shortcut and matched terms methods appear to be similar, there are subtle but 

important differences in these methods: 

• Under the shortcut method, the entity is allowed to assume no ineffectiveness in the 

hedging relationship, even though some ineffectiveness may exist if it were actually 

measured. 

• Under the matched terms method, a conclusion is reached that there is no 

ineffectiveness. Thus, if the entity were to perform the measurement, no ineffectiveness 

would result. 

• The shortcut method applies only to hedges involving interest rate swaps and existing 

debt instruments, whereas the matched terms method is not restricted to specific 

instrument types. 

Summary of Issue 

Fannie Mae incorrectly assumes perfect effectiveness for many of its hedge 

relationships. Its definitions of matched terms and shortcut criteria are not 

consistent with the requirements of SFAS 133. Accordingly, Fannie Mae does not 

perform an effectiveness assessment or measurement of ineffectiveness as

required, and many of its hedging relationships therefore should not qualify for 

hedge accounting treatment.

Accounting Analysis 

Fannie Mae’s DAG sets forth requirements for assuming perfect effectiveness, which do not 

comply with SFAS 133 in several respects as discussed below: 

 

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279 FASB, SFAS 133, paragraph 65, as amended. 
The Seven-Day Rule: Fannie Mae’s DAG allows reset dates to be mismatched by plus or minus

seven days in cash flow hedging relationships and still assume perfect hedge effectiveness.280 

SFAS 133 only permits an assumption of no ineffectiveness if shortcut criteria are met or if 

critical terms of the derivative instrument exactly match those of the hedged item. In all other

cases, effectiveness assessments and ineffectiveness measurements must be performed. This is 

supported by DIG Issue No. E4 Hedging—General: Application of the Shortcu Method (“DIG 

Issue E4”), which states, in part: 

t

r

 

Question 1: Can the shortcut method be applied if most but not all of the applicable 

conditions in paragraph 68 are met?

Question 1 Response: No. The shortcut method can be applied only if all of the 

applicable conditions in paragraph 68 are met. That is, all the conditions applicable to 

fair value hedges must be met to apply the shortcut method to a fair value hedge, and 

all the conditions applicable to cash flow hedges must be met to apply the shortcut 

method to a cash flow hedge. A hedging relationship cannot qualify for application of 

the shortcut method based on an assumption of no ineffectiveness justified by applying 

other criteria. [Emphasis added]... 

The response to question 1 goes on to say: 

The verb match is used in the specified conditions in paragraph 68 to mean be exactly 

the same or cor espond exactly. 

Furthermore, paragraph 65 of SFAS 133 applies only if “the critical terms of the hedging 

instrument and of the ... hedged forecasted transaction are the same...” [Emphasis added]. 

Fannie Mae’s use of the seven-day rule precludes it from applying shortcut or 

matched terms accounting to cash flow hedges for which reset dates are not exactly 

matched. Because Fannie Mae does not perform an effectiveness assessment or 

measurement of ineffectiveness for such hedge relationships, they do not qualify for 

hedge accounting unless the reset dates are matched exactly. 

Fannie Mae concedes that the plus or minus seven days policy is a departure from GAAP.281 

However, Fannie Mae asserts that they perform an annual analysis to determine what the 

280 Fannie Mae DAG p. IV.22, FMSE 112654. 

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281 OFHEO interview, Jonathan Boyles, Senior Vice President – Financial Accounting Standards and 

Corporate Tax, August 3, 2004, pp. 64-66. In the interview, Mr. Boyles stated “We have several known 

departures from GAAP in our adoption of FAS 133. We have cleared those with our auditors. We have 

reported to our auditors on an annual basis the effect of those. And they were comfortable when we

adopted them, and they were comfortable over the last several years when we reported the results of that 

work.[...] As it relates to the plus or minus seven days, that came down to the realization in the business 

that we--from a business perspective we issue discount notes on an auction basis, on a weekly basis. 

And at times those interest rate swaps would reprice on a Monday, but we're going to issue debt on a 

Wednesday—[...]. And it sometimes might be on a Friday. And then, on average, it's going to be at zero, 

but any individual one might be off by a couple of days. And so we built this practical application as it 

relates to the resetting of those, partially because all of that ineffectiveness is going to roll through as you 

make your payments and partially because it's just the way the business is run. And so we tried to make 

that very narrow, that time frame in which they're allowed to do the relinkages in that.” 
income statement impact would be of measuring ineffectiveness that would result due to the 

mismatch in repricing dates had they not assumed these hedges to be perfectly effective. This 

analysis is prepared primarily to represent to KPMG that the difference on earnings resulting

from assuming perfect effectiveness versus performing a measurement of ineffectiveness is not 

material. There is no hedge effectiveness assessment performed or specified in hedge 

documentation, as required by SFAS 133. Jonathan Boyles stated that due to Fannie Mae’s 

assumption of no ineffectiveness, an assessment of hedge effectiveness is not necessary. 

OFHEO believes it is contradictory on the one hand, to acknowledge that there is ineffectiveness 

in the hedging relationship (which the Enterprise calculates for the external auditors) and on 

the other hand to assert that no assessment is required due to “assumed” perfect effectiveness. 

Fannie Mae performs two analyses, the “average approach” and the “absolute value approach”. 

An internal memorandum explains the quantitative approaches that Fannie Mae utilizes as 

follows: 

The first set of quantitative analysis (“average approach”) incorporates the idea that

there is offset between movements in LIBOR associated with pay-fixed swap funding 

needs which occur before a Benchmark Bill issuance and movements in LIBOR 

associated with pay-fixed swap funding needs which occur after a Benchmark Bill 

issuance. The second set of quantitative analysis (“absolute value approach”) does not 

incorporate this idea of offset and assumes that changes in LIBOR always move against

us, who we believe represents a “worst case” scenario and is highly unlikely.282

Both approaches, however, ignore any ineffectiveness resulting from differences in reset dates 

in the future. The analyses performed calculate ineffectiveness resulting only from differences 

in historical reset dates. 

SFAS 133, DIG Issue No. G7, Cash Flow Hedges: Measuring he Ineffectiveness of a Cash Flow 

Hedge under Paragraph 30(b) When the Shortcu Method Is Not Applied (“DIG Issue G7”), 

prescribes three methods for measuring ineffectiveness for cash flow hedges that are not 

eligible for the shortcut method: (1) change in variable cash flows method, (2) hypothetical 

derivative method, and (3) change in fair value method. The analysis performed by Fannie Mae 

in their quantitative evaluation of ineffectiveness does not conform to the prescribed methods in

SFAS 133, and as such, may produce a different ineffectiveness result than if it had been 

performed using a proper method. Thus, OFHEO contends that not only is Fannie Mae’s 

accounting for these transactions inconsistent with SFAS 133 requirements, but also 

their attempt to quantify the unrecorded ineffectiveness is not consistent with SFAS

133 guidelines for performing such measurements. 

t

t

 

The 90-Day Rule: Fannie Mae’s DAG allows maturity dates of the hedging instrument and the 

hedged item to be mismatched by plus or minus 90 days in fair value hedging relationships and

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282 Memorandum from Ilan Sussan to the Files, Subject: Assessing the Income Statement Impact of 

Applying the Plus or Minus Seven Day Policy to Fannie Mae’s Average Pay-Fixed Swap Book, December

17, 2003, FMSE 032657-032658. 
still assume perfect hedge effectiveness.283 As discussed in relation to the seven-day rule, SFAS 

133 only permits an assumption of no ineffectiveness if shortcut criteria are met or if critical 

terms of the derivative instrument exactly match those of the hedged item. As noted above, 

one of the criteria to assume perfect effectiveness for fair value hedges is that the maturities of

the hedged item and the hedging instrument should be the same. Fannie Mae’s inclusion of 

the 90-day rule in its policy permits the Enterprise to apply a shortcut or matched 

terms approach when it does not meet the requirements under SFAS 133. Applying 

hedge accounting to such transactions without performing an effectiveness 

assessment or measurement of ineffectiveness is not permissible under SFAS 133.

Jonathan Boyles noted that he could not recall how or why the 90-day rule was created or if it 

has been used by Fannie Mae in any of its transactions.284 Further research is required to

determine whether this aspect of the policy has been applied in practice and the magnitude of 

its impact. 

Duration Matching: Fannie Mae’s DAG allowed the Hedge Desk to assume no ineffectiveness in 

hedge relationships as long as the duration of the hedging instrument and the hedged item

were matched, within certain parameters. OFHEO asserts that because the durations and other 

critical terms of the instruments were closely, but not perfectly matched, there should have

been some resulting ineffectiveness in the relationship, requiring measurement and assessment 

procedures. In March 2004, Fannie Mae discontinued the use of duration matching as a 

method to assess the effectiveness of hedging anticipated debt issuances. Effective the 

beginning of the first quarter of 2004, the Enterprise began measuring and accounting for 

hedge ineffectiveness. 285 Mr. Boyles acknowledged that this was a departure from GAAP. 286 As 

such, an analysis had historically been performed on an annual basis to determine if the 

amounts that would have been recorded by using the long haul method would be material. 

Management’s justification for using such an approach is that they believed “from an economic

 283 Section VI.14 of the DAG outlines the criteria required to assume no ineffectiveness for fair value 

hedges. Item 1 states “The expiration date of the swap matches the maturity date of the interest-bearing 

asset or liability that is being hedged within 3 months” (FMSE 112766). 284 OFHEO interview, Jonathan Boyles, Senior Vice President of Accounting Standards and Corporate 

Tax, August 3, 2004, p. 103, in which he states “I don't recall why we have that plus or minus three 

months in the policy, what was the genesis of that. But presumably it was because we felt that that plus or 

minus three months was immaterial. I'm not aware that that's used because in a typical termout they will 

match the terms in a typical termout.” 

285 Memorandum from Jonathan Boyles to the File, Subject: Revisions to the December 2003 DAG, 

March 13, 2004, FMSE 113686-113690. 286 OFHEO interview, Jonathan Boyles, Senior Vice President – Financial Accounting Standards and 

Corporate Tax, August 3, 2004, pp. 64-65. In the interview, Mr. Boyles stated, that “We have several 

known departures from GAAP in our adoption of FAS 133. We have cleared those with our auditors. We 

have reported to our auditors on an annual basis the effect of those. And they were comfortable when we

adopted them, and they were comfortable over the last several years when we reported the results of that 

work.” 

Q: As it relates to 133. You said there were several departures from GAAP. 

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A: The purpose there was really twofold: one, we felt like in the case of the duration shortcut, we felt--if 

you think about duration, duration is a sensitivity of an instrument's--of the instrument to interest rates. 

And so, you know, FAS 133 built in the concept of a shortcut so you can match notionals and match 

maturities and repricing dates and assume no ineffectiveness when really a better economic hedge would 

be to match duration, not notionals...
standpoint, the correlation from matching durations between the anticipated debt and actual 

debt to be issued is better than just matching notional and payment/reset dates.” 287 In 2001 

and 2002, such amounts were considered to be immaterial by Fannie Mae; however, in 2003 

the amount was approximately $12 million, which prompted the discontinuation of duration 

matching effective January 1, 2004. Duration matching is another instance where Fannie Mae 

has distorted the provisions of SFAS 133 to assume perfect effectiveness, though not 

warranted. 

Use o Shortcut Criteria as a Basis for Matched Terms Accounting: The term “shortcut 

accounting” was noted in many instances within Fannie Mae’s documentation, including the

DAG, hedge designation documents and emails between Fannie Mae employees. In addition, 

Fannie Mae’s policy requirements for assuming perfect effectiveness are based on SFAS 133’s 

shortcut criteria, which was confirmed through an interview with Jonathan Boyles.288 However, 

Fannie Mae employees have stated that they do not utilize the shortcut method as referenced in 

paragraph 68 of SFAS 133, and that the term “shortcut” is “loosely” used by Fannie Mae 

employees to describe the matched terms method, per SFAS 133 paragraph 65.

289 

f

 

Even though the special exception provided by the FASB for use of shortcut criteria is only 

permitted for interest rate swaps,

290 Fannie Mae’s policy applies this criteria to other types of

derivatives as well based on its position that such criteria results in perfect effectiveness and if

those criteria are met, matched terms accounting can be applied.

291 However, OFHEO believes 

287 Memorandum from Jonathan Boyles to the File, Subject: Revisions to the December 2003 DAG, 

March 13, 2004, FMSE 113686-113690. 288 OFHEO interview, Jonathan Boyles, Senior Vice President of Accounting Standards and Corporate 

Tax, August 3, 2004, p. 77. 

Q: Also with respect to these conditions that are used to assume no ineffectiveness, would it be fair to say 

that these are based upon the shortcut criteria that are outlined under FAS 133, paragraph 68, which I 

assume you're familiar with? 

A: Mm-hmm, I believe they would be based on that. 

p. 85 

Q: [...]so for fair value hedges, would you agree that these criteria are based on the shortcut criteria in 

FAS 133? 

A: Yes, I believe they're based on the shortcut criteria. 289 OFHEO interview, Jonathan Boyles, Senior Vice President of Accounting Standards and Corporate 

Tax, August 3, 2004, p. 88. 

Q: [...]So I guess after considering what E4 says, I'd again ask you how Fannie Mae's application of 

shortcut is consistent with GAAP. 

FANNIE MAE LEGAL COUNSEL: When you're saying shortcut, are you talking about shortcut under 133 

or what they sometimes loosely refer to as shortcut? 

Q: I'm talking about how the company applies the criteria in its policy for assuming perfect effectiveness 

and how that's consistent with the criteria we've just looked at based on DIG Issue-- 

A: I would not have expressed Fannie Mae's policy to be applying the shortcut method but to be applying 

the terms matching.[...] 290 SFAS 133 paragraph 68 and DIG Issue E4, question 2. 

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291 Fannie Mae DAG, page IV.24, states the following with respect to cash flow hedges: “Fannie Mae also 

hedges the variability in cash flows by entering into certain option contracts, including caps (for liabilities), 

floors (for assets), and pay-fixed swaptions (for Discount Notes). Fannie Mae must meet the same criteria 

outlined above to assume that a hedge will be entirely effective at offsetting the hedged transaction’s 

variability in cash flows.” See FMSE 112656. Furthermore, Fannie Mae DAG page VI.15 states the 

following with respect to fair value hedges: “Fannie Mae also hedges the variability in fair values by 

entering into certain option contracts, including receive-fixed swaptions. The instrument underlying the 
that in some cases, particularly fair value hedges, ineffectiveness can exist in a hedging 

relationship even though criteria similar to shortcut are met. For transactions not subject to the 

shortcut method, other items can cause ineffectiveness and must be considered in determining 

whether matched terms accounting can be applied.292 Thus, in order to assume perfect 

effectiveness for a hedging relationship that does not meet the shortcut criteria, an entity would

need to perform a calculation to demonstrate that no ineffectiveness exists. This point is 

described by DIG Issue E4 which states, in part: 

 

Although a hedging relationship may not qualify for the shortcut method, the application 

of regular fair value hedge accounting may nevertheless result in recognizing no 

ineffectiveness. For example, the characteristics of the hedged item and the hedging

derivative may, in some circumstances, cause an entity’s calculation [Emphasis added]

of the change in the hedged item’s fair value attributable to the hedged risk to be an 

amount that is equal and offsetting to the change in the derivative’s fair value. In those 

circumstances, because there is no ineffectiveness that needs to be reported, the result 

of the fair value hedge accounting would be the same as under the shortcut method.

Based on the guidance discussed above, it is inappropriate for Fannie Mae to apply the shortcut criteria to derivatives other than interest rate swaps as a basis for matched terms 

accounting. Such treatment would only be supported if a calculation demonstrates that those 

criteria do, in fact, result in perfect offset between the hedging instrument and the hedged

item. Fannie Mae has not demonstrated that its application of matched terms 

accounting results in perfect effectiveness and has not performed an effectiveness 

assessment or measurement of ineffectiveness for such hedge relationships. 

Accordingly, they do not qualify for hedge accounting.

Additional Transaction Examples 

The following are additional examples of hedge accounting transactions for which perfect 

effectiveness has been incorrectly assumed yet permitted in the DAG. These examples are not 

a complete list of all the sample transactions contained in the DAG for which OFHEO believes 

the accounting policy is incorrect. The selected transactions discussed below highlight some of 

the frequently used transactions that have been identified as problematic during the course of 

the examination. 

1. Receive-fixed swaption hedging a medium term note 

2. Callable swap hedging discount notes 

3. Discount notes hedged with funding swaps293 and received fixed swaptions

option contract (i.e., receive-fixed swap) and the debt being hedged must meet the same criteria outlined 

above to assume that a hedge will be perfectly effective at offsetting the hedged transaction’s change in 

fair value if and when the option is exercised.” See FMSE 112767. OFHEO understands the references to 

“same criteria outlined above” to refer to the criteria outlined for interest rate swaps earlier in the DAG. 

292 Such items may include differences between the fixed rates of the hedging instrument and hedged 

item, intervals between interest reset dates on the hedging instrument, or changes in creditworthiness of 

the derivative counterparty, for example. These matters are not considered under the “shortcut” method. 

Special Examination of Fannie Mae 

Privileged & Confidential 

Disclosure and/or Duplication Prohibited 

118

293 For purposes of this report, a funding swap is defined as a pay-fixed swap. 
1. Received-Fixed Swaption Hedging a Medium Term Note 

Example of a Receive-Fixed Swaption

RECEIVE: 7.0018% 5 – Years ($500 million notional)

PAY: Libor, Resets every 90-days ($500 million notional)

7/2/97

MTN

Swaption

7/2/99

Period A Period B

PAY: $500 million 7.00% Bullet, 7-year

21 basis points per year-2

years

- r

.

t

 

Description of Transaction: 

• On 7/2/97, Fannie Mae issues $500M in bullet debt with a 7 year maturity and ente s into a 

swaption that gives Fannie Mae the option to enter into a receive-fixed pay-variable swap 

on 7/2/1999. The underlying swap is out-of-the money at the inception of the hedge, 

meaning its fixed rate is lower than current market rates The underlying swap (and thus 

the option) will gain value as rates fall, providing protection against increases in the fair 

value of its debt obligation as rates fall. The option is a European style option, meaning it is 

exercisable at its expiration date and Fannie Mae elects to pay for the option over the two 

year option period. The cos is 21 basis points per year. 

• Fannie Mae recognizes changes in the time value component of the option through earnings 

over the life of the option (in this case, 2 years). 294 

Special Examination of Fannie Mae 

Privileged & Confidential 

Disclosure and/or Duplication Prohibited 

119

294 This election is made pursuant to SFAS 133, paragraph 63. An option’s value is comprised of two 

elements, time value and intrinsic value. Intrinsic value represents the extent to which the option is “in the 

money” based on a comparison of market interest rates to the option’s strike rate. Time value represents 

the remaining value attributed to the option contract by the market. Conceptually, time value can be 

viewed as the value attributed to the probability that the option could move further into the money during 

its life. Paragraph 63 permits companies to exclude the time value component of options and only focus 

on the intrinsic value in assessing effectiveness. If the time value is excluded in a valid fair value hedging 

relationship, then it will be recorded through earnings. The effective portion of the intrinsic value will also 
• Changes in the intrinsic value of the swaption (the value attributable to he underlying swap 

becoming “in the money”) during Period A will be recognized in earnings along with an 

equal and offsetting adjustment for the change in fair value of the debt in period A Fannie 

Mae treats the intrinsic value por ion of the swap as being “perfectly effective ” 

t

.

t .

t

 

• When the swap is exercised, Fannie Mae treats the new swap as a perfect fair value hedge 

of the change in fair values of the bullet debt during period B. As such, changes in the fair

value of the swap will be recognized in earnings along with an equal and offsetting 

adjustmen for the change in fair value of the debt in Period B. 

Hedge Accounting Issues: 

The above transaction is one of Fannie Mae’s thirteen most frequently used transactions.295 In

the above example Fannie Mae synthetically creates callable debt. In accounting for this 

transaction, Fannie Mae is a) improperly assuming no ineffectiveness during the option period 

(period A), and b) improperly assuming no ineffectiveness when the swaption is exercised in

period B. 

Issue A

In this transaction, Fannie Mae is assuming perfect effectiveness based on the assumption that 

critical terms are matched using “short-cut like” criteria for matching of terms. However as

noted earlier, the short-cut method does not apply to instruments other than swaps (such as 

swaptions). Thus, in order to assume perfect effectiveness, there must be a demonstration that 

the fair values of the hedging instrument and the hedged item do, in fact, offset one another

(see earlier discussion of DIG Issue E4). In a hedging relationship such as the one illustrated 

above, it is likely that there would be some ineffectiveness due to differences in the fixed rate

of the underlying swap versus that of the MTN, and possibly other factors. OFHEO understands 

that Fannie Mae has not performed a calculation to support their claim of perfect effectiveness 

and has not specified any such calculation methodology in their DAG or related documentation. 

As such Fannie Mae has not properly measured and assessed effectiveness for such 

transactions and is not in compliance with the hedge accounting requirements of 

SFAS 133. 

Furthermore, based on a review of the hedge designation documentation and the DAG, these 

documents fail to define the hedged risk in such a way to specify that the option is a onedirectional hedge (i.e., to be effective as a hedge, the hedged risk would need to be defined in

such a way to indicate that it provides protection against fair value changes due to decline of 

rates below a certain level). Fannie Mae’s DAG and related designation documentation for such 

transactions merely describe the swaption as hedging fair value changes in the debt. With the 

hedged risk defined in this way, there is no basis for expecting the change in the swaption

intrinsic value to perfectly offset the change in fair value of the bullet debt, because the 

swaption intrinsic value can fluctuate only in one direction (experiencing a gain only) whereas 

the value of the bullet debt can fluctuate in both directions (experiencing either gain or loss). 

SFAS 133 specifically requires documentation of the nature of the hedged risk and how the 

be recorded in earnings with an offsetting amount reflected in earnings as a fair value adjustment of the 

hedged item. 

Special Examination of Fannie Mae 

Privileged & Confidential 

Disclosure and/or Duplication Prohibited 

120

295 Letter from Jodie Kelley, Fannie Mae Vice President and Deputy General Counsel to Chris Dickerson, 

OFHEO, dated July 28, 2004, FMSE1 00083, in which Ms. Kelley lists Fannie Mae’s thirteen most 

frequent transactions. 
derivative’s effectiveness in offsetting that risk will be addressed. Such a description of the 

hedged risk is also critical to facilitating a calculation of the change in fair value of the debt 

attributable to the risk being hedged which would be necessary to support an effectiveness 

calculation as discussed above. Fannie Mae has not properly documented the hedged 

risk associated with this hedging relationship and thus is not in compliance with 

SFAS 133’s hedge accounting requirements.

 

Issue B

If the swaption is exercised by the Enterprise, it would typically do so because the swaption is 

“in-the-money,” meaning the underlying swap has a positive value. When the swaption is 

exercised and the swap is entered into, the assumption of no ineffectiveness cannot be made 

due to the swap’s positive fair value at the start of the new hedging relationship (which would 

become a two-directional hedge, mitigating both fair value gains and losses in the debt).296 As 

discussed earlier in this report, paragraphs 65 and 68 of SFAS 133 require the fair value of the 

hedging relationship at inception to be zero in order to assume perfect effectiveness. Therefore,

in order to qualify for hedge accounting, assessment and measurement of effectiveness using 

the long haul method would be required. Fannie Mae does not perform an assessment 

and measurement of effectiveness for swaps entered into in connection with the 

exercise of swaptions. Therefore, such transactions do not qualify for hedge 

accounting under SFAS 133. 

In our discussions with Fannie Mae about their accounting for swaptions, they expressed the 

view that their accounting was appropriate under SFAS 133. Yet in an email dated April 17, 

2001, from Jonathan Boyles to several members of management, Mr. Boyles discusses a 

proposal made by the FASB relating to the accounting treatment for the time value of options. 

In the email, Mr. Boyles describes Fannie Mae’s accounting for transactions involving receivefixed swaptions as “aggressive.” It states: 

...the accounting treatment we currently utilize for our receive-fixed swaptions 

is aggressive (we have KPMG’s approval) and not one we would want to flash 

in front of the FASB for comment or the treatment could get worse... 297 

When Mr. Boyles was asked about his reference to Fannie Mae’s swaption accounting as 

“aggressive,” he was unable to recall why he had characterized it as such. 298

296 The exercise of the swaption constitutes the termination of the original hedging relationship per 

paragraph 25b of SFAS 133 which states that hedge accounting is discontinued when the “derivative 

expires or is sold, terminated or exercised.” As such, a newly designated hedge relationship must be 

established for the swap entered into upon exercise. 

297 Email from Jonathan Boyles to several members of management, April 17, 2001, Subject: Recent 

FASB Proposal on the time value of options, FMSE 096460-096462. 298 OFHEO interview, Jonathan Boyles, Senior Vice President of Accounting Standards and Corporate 

Tax, August 3, 2004, p. 184. 

Q: Jonathan, do you recall what you meant by your "accounting treatment for receive-fixed swaptions is

aggressive"?

Special Examination of Fannie Mae 

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121

A: I don't recall what I would have meant by that. I don't know why I would have called it that because I'm 

not sure I would view it as aggressive.[...] 
Conclusion: 

It is OFHEO’s conclusion that Fannie Mae incorrectly applies matched terms accounting and 

assumes no ineffectiveness in the receive-fixed swaption example, both before and after the 

swaption is exercised. In addition, as a result of incorrectly applying matched terms accounting, 

Fannie Mae failed to perform an assessment of hedge effectiveness, the absence of which 

precludes Fannie Mae from qualifying for hedge accounting for such transactions. The 

aggressive interpretation of matched terms is consistent with Fannie Mae’s objectives of 

minimizing earnings volatility and simplifying operations. 

2. Callable Swap Hedging Discount Notes

Example of a Callable Swap

Discount Note Rollover 90-day ($500 million)

PAY: 7.1031%--7 year swap that is callable after 5 years ($500 million)

RECEIVE: Libor, Resets every 90-days ($500 million notional)

7/2/97

Swap 1

Discount 

Notes

Period A

Description of Transaction: 

/

f t

.

• On 7/2 97, Fannie Mae issues $500M in DNs and simultaneously enters into Swap #1, which 

matures after 7 years. 

• Swap #1 is callable after 5 years. This results in its gaining value as rates rise, but only 

losing value to a limited degree as rates fall and the call feature becomes “in-the-money.” 

• Fannie Mae treats Swap #1 as a per ect cash flow hedge during the period which i is

outstanding 

• Changes in the fair value of Swap #1 will be recognized by Fannie Mae in AOCI in periods 

where Swap #1 is outstanding. Amounts in AOCI will be reclassified into earnings in the 

same periods during which the forecasted transaction occurs, through recognition of interest 

accruals and settlements on the swap. 

Special Examination of Fannie Mae 

Privileged & Confidential 

Disclosure and/or Duplication Prohibited 

122
Hedge Accounting Issues: 

 

There are several issues related to the above shown transaction [Example of a callable swap]. 

In accounting for the transaction, Fannie Mae: a) assumes no ineffectiveness although the call 

option embedded in the swap is not mirrored in the discount notes; b) is inappropriately 

recording both the intrinsic and time value in AOCI; and c) is improperly documenting their 

hedge strategy by failing to outline that the strategy is one-directional. 

Issue A

Fannie Mae is treating the callable swap as a perfect cash flow hedge of the forecasted interest 

payments associated with the anticipated reissuance of existing and future discount notes. 

However, the call option in the swap is not mirrored in the hedged item. As discussed in 

previous sections of the report, paragraphs 65 and 68 of SFAS 133 require the critical terms of 

the swap to match those of the underlying hedged item in order to assume no ineffectiveness,

including the call option feature.299 Conceptually, the hedge relationship cannot be assessed as

perfectly effective because the change in fair value of the swap is expected to be different than 

changes in cash flows of the discount notes due to the additional value of the option, which is 

not present in the discount notes. Generally, in order to qualify for hedge accounting, it would

be necessary to separate the derivative’s time and intrinsic value components, as discussed in

Issue B. Fannie Mae’s assumption of perfect effectiveness for the entire change in 

fair value of the derivative is not consistent with the hedge accounting 

requirements of SFAS 133. 

Issue B

By including all changes in the derivative’s fair value in AOCI, Fannie Mae is in essence 

assessing effectiveness using the entire value (both intrinsic and time value) of the instrument, 

and treating it as perfectly effective. For all other option based derivatives, Fannie Mae 

separates the time and intrinsic value in assessing and measuring effectiveness. When OFHEO 

questioned Mr. Boyles on the rationale for not separating the time value from the intrinsic value 

in assessing effectiveness for callable swaps, he stated that the Enterprise was following the 

guidance in DIG Issue G20 Cash Flow Hedges: Assessing and Measuring the Effectiveness of a 

Purchased Option Used in a Cash Flow Hedge (“DIG Issue G20300”). However, the December

2003 DAG does not make any reference to the fact that Fannie Mae had adopted DIG Issue 

G20, which requires specific designation language to that effect. 301 Additionally, DIG Issue G20

299 FASB, SFAS 133, paragraph 68 (e). 300 DIG Issue G20 states that when designating a purchased option as hedging the variability in cash 

flows, the assessment of effectiveness can be based on total changes in the option's cash flows (that is, 

the assessment will include the hedging instrument's entire change in fair value—its entire gain or loss), 

rather than documenting that the assessment of effectiveness will be based on only the changes in the 

hedging instrument's intrinsic value as permitted by paragraph 63(a) of FAS 133. 301 OFHEO interview, Jonathan Boyles, Senior Vice President of Accounting Standards and Corporate 

Tax, August 24, 2004, pp. 186-187 

Q: I'd like to just get back to transaction number 32, the callable swap, and I guess the question is what 

were you doing--you mentioned you were applying G20. Where in the policy is it stated that you're 

applying G20 in your derivatives accounting guidelines? 

Special Examination of Fannie Mae 

Privileged & Confidential 

Disclosure and/or Duplication Prohibited 

123

A: It does not--I mean we'll be more explicit in our next version in the end of 2004, but the policy and the 

practices of G20. 
states that it applies to “purchased options and combinations of only options.” This language 

indicates that DIG Issue G20 does not apply to swaps containing embedded options. 

Furthermore, the initial version of the DAG, released prior to the issuance of DIG Issue G20, 

included the same accounting for this transaction that is being followed today. Thus, an

assertion that this accounting treatment is based on DIG Issue G20 is unsupported.

302 Finally, 

in May 2004, we noted drafts of potential changes to Fannie Mae’s DAG indicating that Fannie 

Mae was considering separating the time and intrinsic value for callable swaps. 303 Fannie 

Mae’s inclusion of both time and intrinsic value changes of the callable swap in AOCI

is not consistent with the requirements of SFAS 133 or the Enterprise’s own 

practices for other options based strategies. 

Issue C 

Based on OFHEO’s review of the hedge designation documentation and the DAG, these 

documents fail to define the hedged risk in such a way to specify that the option is a onedirectional hedge (i.e., to be effective as a hedge, the hedged risk would need to be defined in

such a way to indicate that it provides protection against cash flow changes due to increases in 

rates but only against declines in rates below a certain level – that at which the call feature is 

“in-the-money”). Fannie Mae’s DAG and related designation documentation for such 

transactions merely describe the callable swap as hedging cash flows attributable to interest 

payments on discount notes. With the hedged risk defined in this way, there is no basis for 

expecting the change in the swap’s fair value to perfectly offset all changes in cash flows of the 

discount notes, because the swap fair value would experience gains as rates rise, but would 

only experience losses to a limited degree as rates fall; whereas the cash outflows of the 

discount notes can both increase and decrease as rates rise or fall. SFAS 133 specifically 

requires documentation of the nature of the hedged risk and how the derivative’s effectiveness 

in offsetting that risk will be addressed. Such a description of the hedged risk is also critical to 

facilitating a calculation of the change in hedged cash flows attributable to the risk being 

hedged in order to support an effectiveness calculation. Fannie Mae has not properly 

documented the hedged risk associated with this hedging relationship and thus is

not in compliance with SFAS 133’s hedge accounting requirements.

Fannie Mae was apparently aware that this accounting treatment was aggressive in 2000, one 

year before the adoption of SFAS 133. In an email, Kim Stone, a former employee of Fannie 

Mae and manager in the Financial Accounting Standards Group, wrote: “As it is, using the 

cancelable swap under the short-cut method is very aggressive.” 304

 

Conclusion: 

It is OFHEO’s conclusion, based on the accounting analysis above, that Fannie Mae’s accounting 

for the callable swaps as perfect hedges, as well as the recognition of the entire option value in

302 OFHEO interview, Jonathan Boyles, Senior Vice President of Accounting Standards and Corporate 

Tax, August 24, 2004, p. 187 

Q: What were you doing prior to G20 being effective?

A: We were doing the same accounting treatment.

303 Email from Ilan Sussan, Financial Standards, to various individuals at KPMG including as an 

attachment “DAG – PowerPoint Slides”, 5/24/2004, produced via CD 8/11/04 in M box.

Special Examination of Fannie Mae 

Privileged & Confidential 

Disclosure and/or Duplication Prohibited 

124

304 Email from Kimberly Stone, former manager in Financial Accounting Standards, to Joseph Rosenberg, 

August 10, 2000, FMSE 078731-078732. 
AOCI, is inappropriate. As is the case in other examples discussed herein, there was no 

assessment of hedge effectiveness performed, and thus, Fannie Mae should not have received 

hedge accounting. 

For purposes of illustrating the earnings impact of not assuming perfect effectiveness, but 

instead measuring and recognizing ineffectiveness correctly, OFHEO prepared an illustrative 

transaction using actual market data to show its potential impact on earnings using a $500 

million callable swap. The complete analysis can be found at Appendix V. Per OFHEO’s analysis, 

the dollar-offset approach required by Fannie Mae’s DAG for assessing effectiveness indicates 

that this hedging relationship could fail to qualify for hedge accounting. 305 The amount of 

ineffectiveness varies from quarter to quarter which would have led to additional volatility in 

earnings. If the hedge is not deemed highly effective (within the 80% to 125% range), hedge 

accounting should be terminated as of the last date the derivative was considered to be highly

effective. Additionally, even if the hedge did qualify as being highly effective, the amount of 

ineffectiveness could fluctuate from quarter to quarter causing additional volatility in earnings. 

This is illustrated by the following graph, which is summarized from OFHEO’s analysis. 

Illustration of Earnings Volatility - Callable Swap

$7,500,000

$8,000,000

$8,500,000

$9,000,000

$9,500,000

$10,000,000

$10,500,000

3Q

1997

4Q

1997

1Q

1998

2Q

1998

3Q

1998

4Q

1998

1Q

1999

2Q

1999

3Q

1999

4Q

1999

1Q

2000

2Q

2000

3Q

2000

4Q

2000

1Q

2001

2Q

2001

Interest Expense

Per Fannie Mae Per OFHEO

 305 Fannie Mae’s DAG, as well as SEC guidance, requires a dollar offset ratio between the hedging 

instrument and hedged item to fall between 80% and 125% in order to meet the “highly effective” 

requirement for hedge accounting, FMSE 112604-112606. 

Special Examination of Fannie Mae 

Privileged & Confidential 

Disclosure and/or Duplication Prohibited 

125
3. Discount Notes Hedged with Funding Swaps and Received-Fixed Swaptions

Example of Discount Notes Hedged by Funding 

Swap and Receive-Fixed Swaption

Discount Note Rollover 90-day ($500 million)

RECEIVE: Libor, Resets every 90-days ($500 million notional)

PAY: 6.785 % – 5 years ($500 million)

RECEIVE: 6.175 % 3 – Years ($500 million notional)

PAY: Libor, Resets every 90-days ($500 million notional)

7/2/97

Funding

Swap

Discount 

Notes

Swaption

Period A Period B Period C

Lockout period -- 5 

basis points 

premium/year

7/2/99

.

-

.

ff

r t t

 

Description of Transaction: 

• On 7/2/1997, Fannie Mae issues $500 million in DNs and simultaneously enters into a 

pay-fixed funding swap in which they receive LIBOR. 

• In period B, they enter into a swaption which gives Fannie Mae the option to enter into 

a receive-fixed swap on 7/2/1999. The cost of the option is 5 basis points per year. 

• Fannie Mae would exercise the option if the LIBOR swap rate falls below the fixed rate 

on the underlying receive-fixed swap (i.e., the swaption is “in-the-money”) This would 

partially offset the loss on the funding swap and lower Fannie Mae’s effective debt cost. 

This combined transaction is similar economically to using a callable swap. 

• The combination of the receive fixed swaption (intrinsic value only) and the funding 

swap would be treated by Fannie Mae as a cash flow hedge of future DN issuances 

Fannie would assume no ine ectiveness because the critical terms of the combined 

derivatives a e deemed o match the hedged deb . Changes in the time value of the

option would be recorded in earnings. 

• If the swaption is exercised, the two offsetting swaps would be treated as a perfect cash 

flow hedge during period C. 

Special Examination of Fannie Mae 

Privileged & Confidential 

Disclosure and/or Duplication Prohibited 

126
Hedge Accounting Issues: 

Several issues exist in the above shown transaction, most of which are similar to the issues 

discussed in the previous transactions. In reviewing Fannie Mae’s accounting for this type of 

transaction, OFHEO noted the following issues with respect to the application of hedge 

accounting:

a. Fannie Mae separates the time and intrinsic value components of the option which is 

inconsistent with their treatment of the callable swap discussed above, even though the 

transactions are economically similar. While this treatment appears proper for this 

transaction, it highlights the improper treatment of time value associated with the 

callable swap. 

b. The combined swap and swaption are treated as perfectly effective once the swaption 

is entered into, although the funding swap has a fair value other than zero at the 

inception of this new hedging relationship. As noted for other strategies described 

within this report, the non-zero intrinsic value of the combined instruments at inception 

of the hedging relationship precludes the ability to assume perfect effectiveness for this 

strategy. 

c. The DAG and related documentation fail to document that the hedging strategy is onedirectional due to nature of the option values. This issue was also noted with respect to 

the receive-fixed swaption and callable swap transactions discussed in this report, and 

violates the hedge accounting documentation requirements of SFAS 133. 

d. Upon exercise of the swaption, Fannie Mae in the past continued to treat two offsetting 

swaps as cash flow hedges in combination, even though they do not serve to mitigate

cash flow variability associated with the discount notes (because the cash flows of the 

two swaps offset one another). This is similar to the issue discussed relating to 

offsetting swaps in this report (Issue #2). This practice was discontinued by Fannie Mae 

in the first quarter of 2004. 

Conclusions: 

Based on the accounting analysis above, OFHEO has concluded that Fannie Mae’s accounting 

for the pay-fixed swap and the receive-fixed swaption in combination as a perfect hedge is not 

justified under SFAS 133. Additionally, since no hedge assessment is performed, the hedge 

relationship should not qualify for hedge accounting. The offsetting swaps resulting from the 

exercise of the swaption should not have received hedge accounting in past periods and instead

their changes in fair value should have been marked to market through earnings. Finally, the 

documentation of the risk hedged by the combined swap and swaption does not adequately

reflect the nature of the hedging relationship and further calls into question Fannie Mae’s hedge 

accounting for such transactions.

Implications 

Fannie Mae’s inappropriate assumption of no ineffectiveness based on its application of the 

short-cut or matched terms approaches set forth in its DAG and as discussed herein calls into 

question the accounting treatment for a significant portion of the Enterprise’s derivatives 

portfolio. The approaches employed by Fannie Mae have not only served to reduce the earnings 

Special Examination of Fannie Mae 

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Disclosure and/or Duplication Prohibited 

127
volatility and lessened the operational complexity associated with the application of SFAS 133, 

but have potentially misstated the Enterprise’s financial results in a significant way. The 

transactions discussed in this section for which accounting problems have been identified are 

among the most common strategies employed by the Fannie Mae. 

While OFHEO has not quantified the effects of the misstatement on current or past periods 

resulting from the improper application of the short-cut or matched terms approach, from a

qualitative perspective, as stated earlier, almost all of Fannie Mae’s hedges receive short-cut 

treatment, or assume no ineffectiveness. Of the thirteen most frequent hedging transactions 

identified by Fannie Mae, issues relating to the concept of no ineffectiveness have been

identified for seven of such transactions. As of December 31, 2003, amounts deferred in AOCI

due to cash flow hedge accounting were negative $12.2 billion,306 and carrying value 

adjustments of hedged items in fair value hedges amounted to approximately $7.2 billion. 307 

As a result of the invalidation of hedge accounting, a significant portion of these amounts could 

be reversed and put into earnings. However, the determination of the exact amounts of any 

earnings adjustments and the periods in which they should be effected will require a substantial

amount of analysis, time and resources on the part of the Enterprise. 

 306 Fannie Mae December 31, 2003 10-K, p. 80. 

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307 Fannie Mae December 31, 2003 10-K, p. 146. 
Issue 4: Interest Rate Caps 

Background 

Fannie Mae purchases interest rate caps to hedge exposures to increases in interest rates on its

discount notes or floating rate borrowings. Under SFAS 133, Fannie Mae applies cash flow 

hedge accounting to the caps and is therefore required to fair value the caps at each reporting 

date. To the extent effective, fair value changes are recorded in AOCI, and the ineffective 

portion is recorded in earnings. 

To illustrate the mechanics of a purchased cap, assume Fannie Mae issues floating rate debt 

and does not wish to pay interest exceeding 5%. Fannie Mae can purchase an interest rate cap 

with a strike rate of 5% to hedge the variability in cash flows from the floating rate debt 

attributed to rising interest rates. In the event interest rates rose to 7%, the counterparty to 

the derivative agreement would pay Fannie Mae the difference of 2% (7% - 5% representing 

the difference between strike and current interest rate), leaving Fannie Mae with an effective 

interest cost of 5%. 

The cap is a series of individual options on interest rates for each quarterly or monthly period in

the contract (referred to as “caplets”). An option’s value is comprised of two elements, time

value and intrinsic value. Intrinsic value represents the extent to which the cap is “in-themoney” based on a comparison of market interest rates to the cap’s strike rate. Time value 

represents the remaining value attributed to the option contract by the market. Conceptually, 

time value can be viewed as the value attributed to the probability that the option could move 

further into the money during its life. 

In Fannie Mae’s application of hedge accounting, changes in intrinsic value are deemed to

represent the “effective” portion of the hedge. This is because increases in the intrinsic value of 

the cap serve to offset related increases in forecasted interest payments on hedged borrowings. 

As such, Fannie Mae records changes in the intrinsic value component through AOCI, deferring

their recognition in earnings until the future interest payments occur and affect earnings. 

Changes in the time value component are recorded directly to earnings as they occur.

SFAS 133 does not specify a single methodology to be used in allocating an instrument’s value 

between time and intrinsic components. One methodology is to compare the cap strike rate to 

the current “spot” interest rate and derive a resulting intrinsic value for the entire cap 

agreement (in Fannie Mae terminology the “Trader Approach”). An alternate methodology 

would be to calculate the intrinsic value of each individual caplet by comparing the cap strike

rate to the respective point on the forward curve (in Fannie Mae terminology the “Zero Volatility 

Approach”). In both approaches, the time value would represent the difference between the 

total fair value of the cap308 and its calculated intrinsic value. While either method may be

deemed acceptable, the two methods yield different results. Thus, one method must be

 

Special Examination of Fannie Mae 

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Disclosure and/or Duplication Prohibited 

129

308 The total fair value of the cap would be derived from an appropriate option pricing model. 
consistently applied. For example, a cap may have zero intrinsic value under the Trader 

Approach because the strike rate is higher than the current market interest rate. However, in a 

typical upward sloping yield curve, that same cap may have some intrinsic value under the Zero

Volatility Approach because the forward rates relating to the later periods of the term are higher 

than the strike rate. 

As described above, when interest rate caps are purchased, an upfront premium is paid. To

make future determinations of changes in time and intrinsic values for accounting purposes, it is 

necessary to allocate the initial value of the option premium between time and intrinsic value 

components. 

Summary of Issue 

Until the fourth quarter of 2002, Fannie Mae treated the entire upfront premium payment as 

time value because the strike rate was above the current interest rate at the time of purchase. 

The Enterprise used the Trader Approach to determine intrinsic value at the inception of a cap 

contract. However, for subsequent calculations at each reporting date, Fannie Mae calculated 

intrinsic value using the Zero Volatility Approach. As a result, during the time from adoption of 

SFAS 133 (January 2001) through the third quarter of 2002, Fannie Mae was applying an 

inconsistent methodology in its determination of time and intrinsic value. Because 

many of the caps purchased by Fannie Mae had intrinsic value at the time of purchase under 

the Zero Volatility Approach, yet had no intrinsic value at inception under the Trader Approach, 

this inconsistent methodology resulted in misstatements of changes in time value and intrinsic 

value reported in earnings and AOCI, respectively. 

The misstatement that occurs when this inconsistent methodology is applied can be illustrated 

by the following simple example. Assume an interest rate cap is purchased for $1,000,000 and 

its value is further broken down as follows under the two approaches: 

Trader 

Approach 

Zero Volatility 

Approach 

Time Value $1,000,000 $ 500,000

Intrinsic Value 0 500,000

 Total Value at inception 1,000,000 1,000,000

In addition, assume that the above options were purchased near quarter-end and that as of the 

quarter-end reporting date, there had been no change in interest rates or in the total fair value 

of the cap contract. Under either approach, if applied consistently, there would be zero change

in the option time value or intrinsic value, and no gain or loss recorded through earnings or 

AOCI.

However, when the inconsistent approach applied by Fannie Mae is used at the quarter-end

reporting period, the following result would be reflected: 

Time Value Intrinsic Value 

Ending Value – Zero Volatility Approach $ 500,000 $ 500,000

Beginning Value – Trader Approach 1,000,000 0

 Change in Value (500,000) 500,000

Special Examination of Fannie Mae 

Privileged & Confidential 

Disclosure and/or Duplication Prohibited 

130
 

As a result, Fannie Mae would have recorded a loss in earnings for change in time value of 

$500,000 and a gain in AOCI for change in intrinsic value of the same amount, when in fact 

there was no change in the instrument’s value. Furthermore, because no change in interest

rates had occurred, there would have been no change in the forecasted interest payments that 

were being hedged by the caps. As such there would be no basis under SFAS 133 to record a

gain in AOCI as there had been no corresponding change in the underlying hedged item. 

OFHEO has determined that the above accounting for the cap represents an error in the 

application of SFAS 133. 

As a result of using the Trader Approach at inception and the Zero Volatility Approach on 

subsequent reporting dates, Fannie Mae was overstating its option premium expense as well as

gains recorded in AOCI due to changes in intrinsic value. It appears that the largest impact of

this treatment would have been in the quarter in which a cap contract is executed, due to the 

immediate premium expense and AOCI gain that would be recognized relating to the inception

intrinsic value. There would also be an effect on earnings in periods later in the life of the cap 

contracts (to which the original intrinsic value relates), as the inception intrinsic value gains are 

reclassified into earnings as payments are made on the cap. 

In the fourth quarter of 2002, Fannie Mae changed its accounting for the premium paid at 

inception for interest rate caps.309 Effective October 1, 2002, Fannie Mae began to allocate the 

initial premium paid to both time value and intrinsic value, using the Zero Volatility Method. 

This change was implemented prospectively, that is for new caps purchased after September 

30, 2002.

310 Fannie Mae concluded in an internal memorandum addressing this issue that they 

believed that this change qualified as a change in accounting analogous to that described in

paragraphs 23 and 24 of APB 20.

311

 309 Fannie Mae December 31, 2002 annual report on form 10-K, Notes to Financial Statements, 

Significant Accounting Policies, p. 113. 310 Information has been obtained from the following sources: 

1. Fannie Mae December 31, 2002 annual report on form 10-K, Notes to Financial Statements, 

Significant Accounting Policies, p. 113.

2. Memorandum from Jonathan Boyles to File with Distribution, Subject: Proposal to Change Fair 

Value Estimate of IV/TV Decompositions for Caps, January 29, 2003, FMSE 055014-055016. 

3. OFHEO interview, Jonathan Boyles, Senior Vice President—Financial Accounting Standards

and Corporate Tax, August 24, 2004, pp. 211, 214 

Q: [...]it was being treated prospectively. You didn't go back and correct some of the, your prior 

periods? 

A: We didn't feel there was a need to correct because we deemed it to be a change in estimate, 

so we refined our estimation process. Now our describe that in our disclosures[...] 

Q: [...]when talking about the effect of th [sic] change in running an analysis, did anyone go and 

perform analysis what would be the impact on the quarterly basis had the consistent estimation

methodology been used throughout the life of an option? 

A: I don't recall. I believe there was a lot of analysis done at the time[...] 

Special Examination of Fannie Mae 

Privileged & Confidential 

Disclosure and/or Duplication Prohibited 

131

311 Memorandum from Jonathan Boyles to File with Distribution, Subject: Proposal to Change Fair Value 

Estimate of IV/TV Decompositions for Caps, January 29, 2003, FMSE 055014-055016, in which Mr. 

Boyles stated, “In addition, even though we think this change should be analogized to paragraphs 23 

and 24 of APB-20, if one were to conclude that this is a change in estimate the accounting treatment 

would be the same.” 
It is OFHEO’s belief that the accounting change made by Fannie Mae is correcting an

inconsistent application of a methodology and not a change in methodology to calculate fair 

values and therefore should be treated as a correction of an error. As illustrated in the example 

above, the inconsistent application results in a misstatement of amounts recorded in both AOCI 

and earnings. A correction of an error would require the prior period financial statements to be 

restated. 

Accounting Analysis 

APB 20’s scope includes changes in accounting principles, accounting estimates, or reporting 

entity. It also covers reporting of a correction of an error in previously issued financial 

statements. 

Is it a Change in Accounting Principle? 

Paragraph 7 of APB 20 states that a change in accounting principle “results from adoption of a 

generally accepted accounting principle different from the one used previously for reporting

purposes.” This statement includes not only accounting principles and practices but also the

methods of applying them, or when choosing from among two or more generally accepted 

accounting principles, such as two amortization/depreciation methods, alternative methods of 

revenue recognition under long-term contracts, or alternative inventory pricing methods. 

The above change did not entail a choice of a new generally accepted accounting principle 

different from the one previously applied. Rather, it represented a change to correct an 

inconsistency in prior application. It therefore should not be considered a change in 

accounting principle.

Is it a Change in Accounting Estimate? 

A change in accounting estimate is due to the occurrence of new events, as more experience is 

acquired, or as additional information is obtained. Paragraph 11 of APB 20 highlights a change 

in estimate affected by a change in accounting principle. “Changes of this type are often

related to the continuing process of obtaining additional information and revising estimates and 

are therefore considered as changes in estimates for purposes of applying this Opinion.” 

The change in the way Fannie Mae used to account for the premium at inception did not result

from the occurrence of new events or as more experience was acquired or as additional 

information was obtained. It was based upon an apparent realization that the prior 

methodology was causing incorrect financial statement results. It therefore cannot be

considered a change in estimate.

Is it an Error in Financial Statements? 

Paragraph 13 of APB 20 states “Errors in financial statements result from mathematical 

mistakes, mistakes in the application of accounting principles, or oversight or misuse of facts 

that existed at the time the financial statements were prepared. In contrast, a change in 

accounting estimate results from new information or subsequent developments and accordingly 

from better insight or improved judgment.” 

Special Examination of Fannie Mae 

Privileged & Confidential 

Disclosure and/or Duplication Prohibited 

132
In OFHEO’s view, Fannie Mae’s change in methodology resulted from a previous oversight or an

inconsistent application of accounting principles. Fannie Mae’s old methodology resulted in 

amounts recorded in AOCI when no corresponding change had occurred in the forecasted 

hedged item, which is clearly inconsistent with the cash flow hedge accounting provisions of 

SFAS 133. The offset to the error in AOCI is a misstatement in option premium expense. 

Therefore, the above change should have been treated as a correction of an error, 

resulting in the correction and re-statement of prior periods’ financial statements.

Fannie Mae’s interpretation of the relevance of APB 20 

Fannie Mae treated the above change to be similar to that of a change in a method of 

amortization as discussed under paragraph 23 of APB 20. They accounted for the change in 

accordance with the guidance in paragraph 24 of APB 20, which relates to a new method of 

amortization applied to newly acquired assets. Paragraph 24 states that the Enterprise should

use the new method “for all additional new assets of the same class but continue to use the 

previous method for existing balances of previously recorded assets of that class. For that type 

of change in accounting principle, there is no adjustment of the type outlined in paragraphs 19-

22312, but a description of the nature of the change in method and its effect on income before

extraordinary items and net income of the period of the change, together with the related per 

share amounts, should be disclosed.” 

The excerpt below from Fannie Mae’s 2002 10-K sets forth Fannie Mae’s disclosure of the

change in methodology.

During the fourth quarter of 2002, we refined our 

methodology for estimating the initial time value of interest 

rate caps at the date of purchase and prospectively adopted

a preferred method that resulted in a $282 million pre-tax 

reduction in purchased options expense and increased our 

diluted EPS for 2002 by $.18. Under our previous valuation 

method, we treated the entire premium paid on purchased 

“at-the-money” caps as time value with no allocation to 

intrinsic value. Our new methodology allocates the initial 

purchase price to reflect the value of individual caplets, some 

of which are above the strike rate of the cap, which results in 

a higher intrinsic value and corresponding lower time value 

at the date of purchase. This approach is more consistent 

with our estimation of time value subsequent to the initial 

purchase date. This change does not affect the total expense 

that will be recorded in our income statement over the life of 

our caps and has no effect on our non-GAAP core business 

earnings measure.

 

Special Examination of Fannie Mae 

Privileged & Confidential 

Disclosure and/or Duplication Prohibited 

133

312 These paragraphs discuss the recording of a cumulative effect of a change in accounting principle, the 

disclosure of pro-forma effects of retroactive application, and a change in depreciation method for 

previously recorded assets. 
Reporting a Correction of an Error 

Reporting a correction of an error in the financial statements of a prior period discovered 

subsequent to their issuance should be reported as a prior period adjustment (paragraph 36 of 

APB 20). In addition, APB 9, Reporting the Results of Operations, states “when comparative

statements are presented, corresponding adjustments should be made of the amounts of net 

income (and the components thereof) and retained earnings balances (as well as of other 

affected balances) for all of the periods reported therein, to reflect the retroactive application of

the prior period adjustments.” 

Implications 

The implications of treating the above change prospectively as a change in accounting rather

than a correction of an error is that the earnings and OCI amounts have been misstated for the 

years 2001, 2002 and likely for 2003 and possibly later periods depending upon the original 

maturity of the cap contracts and the future periods to which the inception intrinsic value 

relates.

The table below has been extracted from a memorandum from Jonathan Boyles and provides 

some indication of the potential dollar impact. 313 However, OFHEO contends it does not 

provide one with an accurate measure of the quarterly impact on earnings or AOCI. 

New Methodology Old Methodology 

Purchase

Period 

Purchase

Premium* 

Intrinsic 

Value* 

Time Value* Intrinsic 

Value* 

Time Value*

2001 248.0 128.7 119.3 0 248.0

2002 1055.0 544.0 511.0 0 1055.0

2002: Q4** 489.7 257.8 231.8 0 489.7

* All figures in millions of dollars 

** The New methodology was first implemented in Q4, 2002. 

Using the 2002 information presented above for discussion purposes, it appears that options 

were purchased prior to the fourth quarter for an initial premium of $565.3 million ($1,055 

million less $489.7 million). 314 Based on the amounts listed under the column titled New 

Methodology, approximately $286.2 million ($544 million - $257.8 million) should have been 

recorded as intrinsic value and $279.2 million ($511 million - $231.8 million) should have been 

recorded as time value during the first three quarters of 2002. This means that when applying 

the Old Methodology, option premium expense was overstated by $286.2 million in the quarters 

when these options were purchased, and accumulated AOCI gains/losses were 

overstated/understated by the same amount. Interest expense would also be understated in the 

future periods to which the inception intrinsic value relates. The specific periods affected would 

need to be determined based upon the terms of the individual cap contracts. 

 313 Memorandum from Jonathan Boyles to File with Distribution, Subject: Proposal to Change Fair Value 

Estimate of IV/TV Decompositions for Caps, January 29, 2003, FMSE 055014-055016. The table is on 

page 3 of the document (FMSE 055016). 

Special Examination of Fannie Mae 

Privileged & Confidential 

Disclosure and/or Duplication Prohibited 

134

314 As stated in the table, the new methodology was implemented starting in the fourth quarter of 2002. 
Additionally, Fannie Mae’s 10-K describes the change as a prospective change to a “preferred

method” 315 of accounting. However, in a memorandum written by Jonathan Boyles in 2003,316

he refers to the matter as an inconsistency in approaches. Mr. Boyles reference to the 

inconsistencies in the memorandum has not been disclosed in the 10-K. In fact, the disclosure 

discusses a refinement in methodology317 and makes no reference to the inconsistent 

application of methods, which OFHEO believes represents an accounting error. 

The above analysis and discussion show that Fannie Mae has incorrectly accounted 

for and reported a correction of an error in its financial statements. This is yet another 

example of how Fannie Mae has corrected errors in their accounting for derivatives only on a 

prospective basis. The impact on specific periods is unclear. Further detailed information and 

detailed instrument-by-instrument analysis will be required to make a precise determination of 

the complete financial statement impact on all periods affected. 

 315 Fannie Mae December 31, 2002 annual report on form 10-K, Notes to Financial Statements, Summary 

of Significant Accounting Policies, Derivative Instruments and Hedging Activities, p. 113. 316 Memorandum from Jonathan Boyles to File with Distribution, Subject: Proposal to Change Fair Value 

Estimate of IV/TV Decompositions for Caps, January 29, 2003, FMSE 055014-055016, in which Mr. 

Boyles stated, “As the dollar amount of our cap purchases has grown over time, this inconsistency in 

approaches has led to growing differences in our decomposition of IV/TV.” 

Special Examination of Fannie Mae 

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Disclosure and/or Duplication Prohibited 

135

317 Fannie Mae December 31, 2002 annual report on form 10-K, Notes to Financial Statements, Summary 

of Significant Accounting Policies, p. 113, states, “During the fourth quarter of 2002, we refined our 

methodology for estimating the initial time value of interest rate caps at the date of purchase and 

prospectively adopted a preferred method that resulted in a $282 million pre-tax reduction in purchased 

options expense and increased our diluted earnings per share for 2002 by $.18.”
Issue 5: Hedge Accounting Documentation Issues

 

The importance of designation, documentation and risk management is emphasized by the

FASB in the basis for conclusions of SFAS 133. Paragraph 385 states: 

The Board decided that concurrent designation and documentation of a hedge 

is critical; without it, an entity could retroactively identify a hedged item, a

hedged transaction, or a method of measuring effectiveness to achieve a

desired accounting result. The Board also decided that identifying the nature 

of the risk being hedged and using a hedging derivative consistent with an

entity's established policy for risk management are essential components of

risk management and are necessary to add verifiability to the hedge 

accounting model.

The designation and documentation requirements were acknowledged by Franklin Raines in 

“Answers from the CEO,”

 318 in which he stated: 

The hedge accounting treatment for each individual transaction is determined

-- and documented in writing -- before we enter into the transaction. And it 

cannot subsequently be changed.

—Franklin Raines, Answers from the CEO 

Background 

SFAS 133, paragraphs 20(a) and 28(a) for fair value and cash flow hedges respectively, require 

an entity to document at inception of the hedge the following:

(1) management objective and strategy for entering into the hedge; 

(2) identification of the hedging instrument; 

(3) the risk being hedged; and 

(4) how hedge effectiveness will be assessed. 

In addition to the above criteria, paragraph 28(a) (2) of SFAS 133, which applies to cash flow 

hedges, goes on to state that the level of detail that must be documented at the inception of

the hedge regarding identification of the forecasted transaction must be “with sufficient 

specificity so that when a transaction occurs, it is clear whether that transaction is or is not the 

hedged transaction.” 

318 Fannie Mae website, Answers from the CEO. Fannie Mae describes this section of its website as 

follows, “This section of our Web site is designed to help visitors better understand the company's 

approach to the issues we face. As part of our continuing effort to be best-in-class in corporate 

governance and transparency, Chairman and Chief Executive Officer Franklin D. Raines is committed to 

answering investors' most frequent questions about Fannie Mae's business. This section provides plain 

talk about how we operate to provide liquidity to the homeownership markets.” The answer shown is in 

response to the following question, “Why do you have confidence that you have done your derivatives 

accounting properly?”

http://www.fanniemae.com/ceoanswers/derivativesaccounting.jhtml 

Special Examination of Fannie Mae 

Privileged & Confidential 

Disclosure and/or Duplication Prohibited 

136
Fannie Mae’s documentation of a hedge relationship in support of hedge accounting for 

transactions entered into by the Long Term Funding Desk includes the following:319

• Termsheets describing the hedging instrument and the hedged item 

• The linkage of the derivative with the hedged item (as reflected in the “DEBTS” system) 

• The transaction descriptions for permitted hedging strategies in the DAG 

Termsheets are produced at the time a derivative is entered into the system. The termsheets 

identify if the hedge relationship qualifies for hedge accounting. Additionally, when the 

derivative qualifies for hedge accounting, the termsheet identifies the hedged item, the hedging 

relationship, the type of hedge and how effectiveness will be measured. The DAG indicates 

that the termsheet forms the initial hedge designation documentation for derivatives entered 

into by the Long-term Funding Desk. The linkage in the DEBTS system associates the 

derivative with the hedged item. The transaction descriptions in the DAG attempts to include all 

potential hedging strategies that Fannie Mae may enter into and describes the accounting that

should be followed for each such strategy. 

Katarina Skladony, a Senior Financial Analyst in Fannie Mae’s Treasury Middle Office, is 

responsible for ensuring that the derivatives and hedged item are properly linked to a hedged

item within DEBTS. The termsheets, which are generated once the derivative is entered into 

and verified by the back office, serve as the initial documentation of the hedge relationship.320

OFHEO understands there is no reconciliation performed between the termsheet and the 

ultimate hedge linkage in DEBTS. Ms. Skladony also indicated that the final determination of 

the nature of the hedging relationship (fair value or cash flow) and the hedged item is made by

the Controller’s Financial Accounting group and not by Treasury Middle Office.321 The ability for 

 319 OFHEO interview, Jonathan Boyles, Senior Vice President of Accounting Standards and Corporate 

Tax, August 24, 2004, p. 138, where he stated that: “We have viewed, for our documentation, we have 

viewed a combination of termsheets, our accounting policy manual, and the transcription in our systems 

linkages in combination as all of the documentation, so you can look at those, and you'll see what the 

linked items are, you'll see what the accounting is, you'll see if the risk is being hedged, you'll see the 

terms matching pieces in there.” 

320 OFHEO interview, Katarina Skladony, Senior Financial Analyst – Treasury Middle Office, August 26, 

2004, p.10, where she stated that, “[...]the back office verifies the securities and produces the initial term 

sheet that includes the hedge designation. The back office then distributes this documentation to the 

Controllers[...]. 321 OFHEO interview, Katarina Skladony, Senior Financial Analyst – Treasury Middle Office, August 26, 

2004, pp. 78-79 

Q: ...Is that the normal process that Controllers make the decision whether it's a cash flow hedge or a fair 

value hedge? 

A: Correct. 

Q: In all instances? 

A: Correct. 

Q: And how often do they do that? 

A: They do it on monthly basis when we pass them on, all the relinkage files. [...] 

Q: Up until when Controllers make that determination that it's a cash flow hedge or a 

fair value hedge, is there no determination whether it's a cash flow hedge or a fair value hedge? 

A: When the dynamic links are created, the determination is not made what type of 

hedge it is. That is determined by Controllers FAS 133 system from when that information is passed to 

that system. [...] 

Q: Does Controllers also make the determination that the trade is DNQ? 

Special Examination of Fannie Mae 

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137

A: Correct. 
Accounting to change the ultimate treatment of a hedge’s designation is not consistent with the 

standard’s requirements for concurrent designation and documentation noted above. 

The Financial Accounting Group is the business owner of the FAS 133 (accounting) system and 

is responsible for recording accounting entries relating to the system. Ms. Mona Patel, Senior 

Project Manager – Financial Accounting Group, indicated that the FAS 133 system receives 

information from DEBTS on a daily basis. A program is run in the FAS 133 system at the end of 

the month to determine the hedge classification (cash flow hedge or fair value hedge) based on 

the terms of the derivatives received from DEBTS. There is no reconciliation between the 

hedge classification as determined on the term sheet and that in the FAS 133 system. 

If there is a change in linkage in DEBTS, the hedge classification may change. Based on the 

interview with Ms. Patel, if the hedge classification changes for a particular derivative from the 

prior month, the FAS 133 system assumes that the change in hedge classification is effective 

from the start of the month even though the linkage may have changed on the last day of the 

month.322 As part of the month-end FAS 133 accounting process and prior to posting of journal 

entries, the Financial Accounting Group runs an exception report which identifies all derivatives 

that do not qualify for hedge accounting. This report is sent to Treasury who will review the 

report and evaluate whether any changes should be made to the linkages. Treasury advises 

the Financial Accounting Group of changes to linkages as a result of those derivatives that are 

on the exception list which may qualify for hedge accounting. These retroactive changes in

linkages are inconsistent with the contemporaneous documentation requirements of SFAS 133. 

Summary of Issues 

There are several instances where OFHEO believes the hedge documentation is inadequate and 

does not meet requirements of SFAS 133 to qualify for hedge accounting. The inadequacies are 

categorized as follows: 

• Ambiguity of hedging relationship 

• Hedged risk not properly defined 

• Hedged item not specifically identified in certain fair value hedges 

• No termsheet produced for re-linkages 

• Designation not contemporaneous 

• Unclear definition and probability of hedged transaction in cash flow hedges 

• Retroactive linkage of hedging instruments with hedged items 

 322 OFHEO interview, Mona Patel, Senior Project Manager – Financial Accounting Group, September 8, 

2004, pp. 52-53 

Q: So, what would be the entry that you would pose [sic] for the entire month? 

A: Okay. The system would pose [sic] prior month as a cash flow hedge, so it would book the market 

value over to either a gain or a loss on the balance sheet as derivatives in a gain or a loss, and the offset 

would be to OCI, other comprehensive income. Next month, that swap is a fair value hedge so the 

system would report again the derivatives in a gain or loss, and it would also record--it would also adjust 

the debt basis. So, the derivatives would be recorded as a gain or loss and offset to the P&L, and you 

would also adjust your debt basis offset to the P&L. 

Q: So, would it be for the entire change in fair value from the first of the month of the 

month through June 30th in the swap value and in the debt or the hedged item value debt for the entire 

month, even though the link changed only mid-month. 

A: Yes. 

Special Examination of Fannie Mae 

Privileged & Confidential 

Disclosure and/or Duplication Prohibited 

138
Ambiguity of hedging relationship 

In our review of termsheets generated by DEBTS we noted that certain termsheets contained 

ambiguous hedge designation language. For instance, in some cases the term sheet designates

the same derivative as both a cash flow and a fair value hedge. An example of this is in a termout transaction similar to the one described under Issue 2: Derivative Re-Designations.323 In

such situations, OFHEO noted term sheets that described a debt swap324 as a fair value hedge 

of the MTN issued at the beginning of period B, and also a cash flow hedge (in combination

with swap #1) of the forecasted issuance of DN’s in period C. Such a dual designation is not

permitted under SFAS 133, which requires specific identification of the hedged item at the 

inception of the hedging relationship. 

OFHEO understands that the linkage between the hedged item and the hedging instrument in 

the DEBTS system is done through an automated process whereby the system “finds” a 

combination of derivatives and debt instruments that can be linked together in a hedging 

relationship. In the term-out example, the ambiguous documentation would allow DEBTS to 

assign the debt swap to either a fair value or a cash flow hedge relationship and still appear to 

be consistent with the hedge designation on the term sheet. It also appears that this

ambiguous designation approach would allow linkages between derivatives and hedged items to 

be changed after the fact and still appear to be “consistent” with the original designation 

documentation. 

Hedged risk is not accurately defined 

In instances involving option products, OFHEO has noted the hedge documentation does not 

appropriately identify the hedged risk. For example, as discussed earlier in relation to hedges 

using receive-fixed swaptions, the termsheets describe the strategy as one that synthetically 

converts fixed rate debt to floating, and the hedged risk as changes in fair value of the debt

attributable to the benchmark interest rate. However in reality, Fannie Mae is only protected 

against changes in fair value due to a decline in interest rates below a certain level, and the 

fixed rate debt is only synthetically converted to floating rate if and when the swaption is 

exercised. In these cases, the documentation fails to properly identify the hedged risk as 

required to receive hedge accounting under SFAS 133. Similar deficiencies in documentation of 

the hedged risk exist for strategies involving pay-fixed swaptions and callable swaps 

Hedged item not specifically identified in certain fair value hedges 

OFHEO also noted that when Fannie Mae uses receive-fixed swaptions in fair value hedges of 

fixed rate debt, its policy is not to identify the debt instrument being hedged until the option 

becomes “in-the-money.” This approach is not consistent with the requirement in paragraph

21(a) of SFAS 133 that the hedged item be “specifically identified as either all or a specific 

portion of a recognized asset or liability or of an unrecognized firm commitment.” It also 

appears inconsistent with Fannie Mae’s assertion of perfect effectiveness for such transactions, 

since it is impossible to make such a determination without identifying the terms of the hedged

item. 

 323 Referred to as “Term-out transaction #2” in the DAG. FMSE 112990-112991. 

Special Examination of Fannie Mae 

Privileged & Confidential 

Disclosure and/or Duplication Prohibited 

139

324 For purposes of this report, a debt swap is defined as a receive-fixed swap. 
Absence of termsheets for re-linkage 

Fannie Mae regularly “re-links” its derivatives and hedged items, which often represents the 

designation of a new hedge relationship prospectively under SFAS 133. When derivatives are 

re-linked in this manner there is no termsheet created to document the new hedge relationship 

that has been established. Since re-linking derivatives is a recurring practice at Fannie Mae,

and the DAG indicates that termsheets serve as a primary hedge designation document, OFHEO 

believes that a significant number of hedge relationships may not have the appropriate 

documentation to qualify for hedge accounting under SFAS 133.

Designation not contemporaneous 

As mentioned above, it appears that the final determination of the hedge relationship is made 

by the Controller’s Department upon review of information populated in the SFAS 133 system 

from DEBTS. This information is updated approximately monthly. This seems to indicate that

the hedge relationship is not final and is potentially subject to change until reviewed by the 

Controllers group. This would appear to be inconsistent with the contemporaneous designation

requirements of SFAS 133. Additionally, no termsheets are produced at the time of relinkage

and the only hedge documentation that is available is the linkage in the DEBTS system. The 

absence of a termsheet could allow Fannie Mae to make retroactive changes to the linkages in 

DEBTS without any audit trail of changes. 

Additionally, Fannie Mae’s DAG and operating practices allow them seven days to identify and 

document the hedged item. This practice is inconsistent with the requirements of

contemporaneous hedge documentation. To illustrate the practices followed by Fannie Mae, 

the following is an excerpt from an email from Paul Salfi, Director of the Financial Standards

Group, to Jonathan Boyles discussing the fact that Fannie Mae has seven days to document a

hedge relationship. 325 It states the following: 

We have a situation where Treasurer’s wants to override automated linkages 

of DNQ basis swaps to PF swaps to avoid long haul on the combination.

Instead, they want to keep the basis swaps DNQ and the PF swaps with 

termouts such that the combination is perfectly effective. The questions are

when is the effective date of the original linkages of basis swaps and PF 

swaps and do we give them a grace period of 7 days to correct the error.

Below are my thoughts on what the guidance should be that I wanted to run

by you: 

Since my understanding is that our policy has been to link derivatives within 7

days of settlement to attempt to get hedge accounting for the derivative, we 

have seven days from the reset dates of the PF swaps to correct the error

made by DEBTS. My understanding is that DEBTS linked basis swaps that

 325 Email from Paul Salfi to Jonathan Boyles, copy to Ilan Sussan, Subject: Re: 

315SWD441_linkage_analysis.xls – Please approve link changes, April 21, 2004, produced via CD 

8/11/04 in Box M. This email is the 3rd in a chain of emails. The most recent email (on top) is an email 

from Paul Salfi to Jonathan Boyles, April 22, 2004, subject: same as above. 

Special Examination of Fannie Mae 

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were DNQ to PF swaps effective on the PF reset dates below, but that we did

not want this linkage. 

If we correct the linkages within 7 days of the PF reset dates below, we would

honor the new designations not the ones on 4/12 to be effective beginning on

the PF reset dates below. The PF swaps had adequate funding through the 

PF reset dates below, so the PF reset dates below are considered to be the 

effective date of the original designations as this the beginning point from

which the PF swaps needed to get hedge accounting. The basis swaps would 

be DNQ under the new designations. 

Unclear definition and probability of hedged transaction in cash flow hedges 

A number of Fannie Mae’s hedging strategies represent cash flow hedges relating to interest 

rate risk associated with existing and forecasted issuance of DNs. In many situations, DNs are 

subsequently replaced (“termed-out”) with other forms of borrowings, such as fixed or floating 

rate MTNs. Fannie Mae’s DAG contemplates the occurrence of term-outs by virtue of the 

transaction descriptions contained therein, many of which are examples of various forms of

term-outs. When a term-out occurs, Fannie Mae’s practice is to continue to retain any 

accumulated hedge gains or losses in AOCI because future interest payments are still expected 

to occur.

326 The nature of Fannie Mae’s funding and hedging strategy and in particular the 

regular occurrence of term-outs have certain implications regarding hedge accounting under 

SFAS 133, namely: 

• How the hedged transaction has been defined in the designation documentation -- 

specifically whether such designation is made “broadly” to encompass interest payments 

generally on a portfolio that consists of DNs as well as instruments that may 

subsequently replace them, or whether the designation is “specific” to DNs only; 

• Whether the hedged transaction (as defined) is deemed probable of occurring which is a 

requirement to qualify for cash flow hedge accounting both at inception and on an 

ongoing basis; and 

• Whether a term-out or similar transaction indicates that the hedged transaction (as 

defined) is deemed “probable of not occurring” which would mean that: a) any amounts 

accumulated in AOCI should be reclassified into earnings; and b) the ability to apply 

hedge accounting to similar hedge relationships would be called into question. 

The implications of these issues are summarized in the following endnote excerpt from DIG 

Issue G13 Cash Flow Hedges: Hedging the Variable Interes Payments on a Group of Floating

Rate Interes -Bearing Loans (“DIG Issue G13”):

t -

t

 

How the hedged forecasted transaction is designated and documented in a 

cash flow hedge is critically important in determining whether it is probable 

that the hedged forecasted transaction will occur. In the cash flow hedge in

Example 8, had the hedged forecasted transaction been narrowly 

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326 Even though the DNs are no longer issued, they have been replaced with another interest-bearing 

debt instrument. This treatment is pursuant to Example 8, Scenario 2 in SFAS 133, and in particular, 

paragraph 160. 
limited to the interest payments on specific future debt issuances

rather than on the five-year borrowing program [Emphasis added], the

failure to engage in those future debt issuances would cause the related

derivative net gain or loss in OCI to be immediately reclassified into earnings

pursuant to paragraph 33 because it would have been probable that the 

hedged forecasted transactions would not occur. Furthermore, that failure, if

part of a pattern of having hedged forecasted transactions cease being 

probable of occurring, would call into question both an entity's ability to

accurately predict forecasted transactions and the propriety of using hedge 

accounting in the future for similar forecasted transactions, pursuant to

paragraph 494. 

The accounting treatment applied by Fannie Mae, as well as the transaction examples 

documented as part of its DAG, appear to imply an approach of “broad” designation to future

interest payments, rather than a specific or narrow designation to interest on DNs only. 

However, OFHEO has observed the following elements of Fannie Mae’s hedge accounting 

documentation and approach that appear to be inconsistent with an approach of broad 

designation:

• Term sheets representing the inception hedge designation documentation refer 

specifically to DNs and not a broad designation to include interest payments on other

borrowings, such as MTNs, resulting from a term-out. 

• Within DEBTS, derivatives are “linked” to specific DNs for purposes of designating the 

relationship and matching of terms (and in most cases, for asserting perfect 

effectiveness). This is inconsistent with a broad designation scheme. OFHEO 

understands that when broad designation approaches are used for hedging of shortterm borrowings, standard industry practice is that matched terms or “short-cut” like 

approaches are not used. Instead, effectiveness is assessed and measured based on 

the derivatives’ relationship with the reset and other characteristics of the entire

portfolio (or portion thereof being hedged) and not based on specific debt instruments.

This ambiguity in Fannie Mae’s documentation has serious implications for its cash flow hedge 

accounting associated with DNs. If the assertion is made that a narrow designation scheme is 

being used, the occurrence of term-outs would require that amounts accumulated in AOCI be 

reclassified to earnings when the term-out occurs, and would call into question the ability to 

apply cash flow hedge accounting to such transactions in the future due to the frequency of 

term-outs. Conversely, if the assertion is made that a broad designation scheme is used, the 

treatment of hedges as perfectly effective based on matching to specific DN issuances would be

invalid and would disqualify hedge accounting due to the lack of an appropriate assessment of 

effectiveness. 

Furthermore, Fannie Mae’s DAG and related documentation do not appear to explicitly address 

the matter of probability of forecasted transactions (irrespective of whether they have been 

defined in a broad or specific manner). Because forecasted transactions must be deemed 

probable to qualify for cash flow hedge accounting, an analysis should be performed and

periodically updated to support this assertion, based on factors such as business plans, 

forecasted growth of the mortgage and debt portfolios, sources of future funding, etc. Based on

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the information obtained and reviewed by OFHEO, it is unclear how Fannie Mae has addressed 

this requirement. 

Retroactive linkage of hedging instruments with hedged items 

 

Through the special examination of Fannie Mae, OFHEO has noted instances in which Fannie 

Mae has retroactively re-linked a hedging instrument to a hedged item in order to qualify for 

special hedged accounting treatment. Retroactive re-linkage to obtain special hedge accounting

is not permitted by SFAS 133. The retroactive linkages appear to have occurred for several 

reasons including: 

• re-linking a derivative to a different hedged item due to a failed correlation analysis with 

the original hedged item, 

• re-linking a derivative to an eligible hedged item due to an erroneous system linkage to 

an ineligible hedged item, and 

• re-linking a derivative to a different hedged item at the request of the front office in 

order to achieve the trader’s original intent. 

In the March 31, 2003 Derivatives Controls Audit, the Fannie Mae Office of Audit conclusion 

recommended that the controls over the re-linkage of derivatives to debt and other derivatives 

needed to be clarified.327 In the report it stated: 

This may occur when the hedged debt is called or when a derivative is 

termed-out. We noted that procedures for re-linking derivatives are not well

documented, and review and approvals are not robust. 

Specifically, we noted that the Hedge Accounting guidelines do not address

the process for linkages and type [sic] types of re-linkages allowed. We noted 

one instance in which a derivative was re-linked to a debt instrument

retroactively to reduce the amount of hedge ineffectiveness at month end.

Although the financial statement impact was minimal, retroactive re-linkages

do not conform to FAS 133 requirements. 

As a response, a memorandum was drafted in October of 2003 by the Financial Accounting 

Standards group outlining Fannie Mae’s procedures with respect to the manual re-linking of 

term-outs.328 However, the memorandum did not address retroactive linkages or re-linkages. In 

an interview with Katarina Skladony in which retroactive re-linkages were addressed, the 

witnesses testified that situations in which retroactive re-linkages were made were rare329. The 

327 Derivatives Controls Audit Report, Office of Auditing, March 31, 2003, Paul Jackson, Audit Director, 

FMSE 102385-102391. 

328 Memorandum written by Paul Salfi to File with Distribution, Subject: Manual ReLinking of Termouts: 

Procedures, Documentation, and Examples, October 15, 2003, FMSE 027422-027426. 

329 OFHEO interview, Katarina Skladony, Senior Financial Analysis-Treasury Middle Office, August 26,

2004, p. 23 

A: In this case, a trader asked me to find out whether such an option even exists. It's not a standard rule 

that in all the circumstances we always go and make change for the system. We determine, you know, 

whether such a change is appropriate in the first place, and if it's not appropriate, then we don't make a 

change. 

Q: How often does something this happen? 

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A: It does not happen often. I think that this would be a fairly rare situation. 
following emails were identified by OFHEO during its examination, of instances in which 

retroactive re-linkages have occurred at Fannie Mae. 

In an email dated 1/6/2004 from Katarina Skladony to Mona Patel and copying several 

individuals in Treasury Middle Office, Front Office and Financial Reporting, Ms. Skladony makes

a retroactive re-linkage per the request of a trader from the front office.330 The email states: 

Enclosed spreadsheet shows the proposed linkage changes in order to bring

the termout linkages in line the [sic] trader’s intent at the time of buyback. I

highlighted in yellow the linkages that need to be reversed and restored. In

addition, I typed in blue all additional linkages that need to be broken. 

In the same chain of emails, a message on the same day from Linda Knight to several 

individuals including Laura Simmons, Donald Sinclair and Katarina Skladony, Ms. Knight 

stated:331

I just spoke to Janet Pennewell who confirmed the guidance from yesterday.

Controllers just finished meeting with Peat who concurs with this guidance. 

We can go ahead and change linkages to the traders intent at the time of the 

buyback. That means we can establish the links that were intended from Don 

Sinclair’s spreadsheet on 12/16...Finally, Peat confirmed that we cannot 

change the spreadsheet so we cannot adjust anything related to spreadsheet 

mistakes... 

The excerpt above illustrates that Fannie Mae had treated the front office documentation 

created by Donald Sinclair (the spreadsheet referred above) as hedge designation

documentation in an effort to correct an accounting linkage error. As mentioned earlier, per 

Jonathan Boyles, Fannie Mae’s hedge designation documentation consists of “a combination of 

termsheets, our accounting policy manual, and the transcription in our systems linkages...”. 332 

Also as noted earlier, termsheets are not prepared for documentation of re-linkages and there is 

no other formally established means for hedge designation upon a re-linkage. This makes a

retroactive re-linkage such as the one described above questionable since there is no formal

document that can be referred to as the proper source of hedge designation. Instead, Fannie 

Mae made the designation based on a spreadsheet that was represented as the “trader’s 

intent.” Had there been a termsheet in place to establish the re-linkage, such document would

presumably have represented the trader’s intent and there would be no question about the 

proper course of action. Absent a formal document used for designation of the hedge 

relationship upon a re-linkage, the ability exists to retroactively change designations in order to 

 330 Email from Katarina Skladony to Laura Simmons, Donald Sinclair with a copy to Mona Patel, January 

6, 2004, Subject: Corrected Termout Linkages due to 12/18/03 Buyback – PLS APPROVE, produced via 

CD 8/11/04 in M box. 

331 Email from Linda Knight to Laura Simmons, David Benson, Donald Sinclair, Ursula Schaefer, Nadine 

Bates, Katarina Skladony; Copes to Janet Pennewell and Peter Niculescu, January 1, 2004, Subject: 

Buybacks, produced via CD 8/11/04 in M box. 

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332 OFHEO interview, Jonathan Boyles, Senior Vice President – Financial Standards and Corporate Tax, 

August 24, 2004, p.138. 
achieve a desired accounting result. This is not permitted under SFAS 133. Paragraph 385 of 

SFAS 133 states: 

The Board decided that concurrent designation and documentation of a hedge is critical; 

without it, an entity could retroactively identify a hedged item, a hedged 

transaction, or a method of measuring effectiveness to achieve a desired 

accounting result... [Emphasis added.] 

 

 

In a 2001 email from Katarina Skladony to Mona Patel, Ms. Skladony stated:

Please note that I am going to make the below manual change in linkage for 

313SWI540. The 50M link 313SWI540 – 313SWD758 was qualified for long 

haul method. However, in the process of effectiveness calculation Don had a

problem to reach 80-120% correlation range and asked me to seek alternative 

linkage to 313SWI540. I found 313SWD979 reset determination dates of which 

and 313SWI540 meet the 7 day window requirement and thus qualify for the 

short cut method.”333

This above excerpt illustrates that retroactive re-linking was being applied to hedges in order to 

achieve hedge accounting treatment in situations in which the hedge effectiveness criteria

(through a correlation analysis) was not met. This is clearly an example of retroactive 

designation in order to achieve a desired accounting result and is not permitted under SFAS 133 

per the reference above. 

 

Implications

The numerous documentation issues described above appear to have serious implications for 

Fannie Mae’s hedge accounting. Many of these matters relate to routine, commonly occurring 

transactions at Fannie Mae. Under SFAS 133, the lack of adequate, contemporaneous hedge 

designation documentation precludes a company from qualifying for hedge accounting. This has

been reiterated by the SEC staff.334 Failure to receive hedge accounting means the fair value 

changes for such derivatives should be recorded through the income statement without 

receiving any offset, or matching with, the earnings affect of the hedged item. Given the billions 

of dollars of mark-to-market value of Fannie Mae’s derivatives and the fact that the vast 

majority of them are currently receiving hedge accounting, the potential impact of these 

documentation issues on Fannie Mae’s reported financial results and regulatory capital appears 

to be substantial.

333 Email from Katarina Skladony to Mona Patel and Prasad Chintamaneni with a copy to Donald Sinclair, 

March 5, 2001, Subject: 313SWI540 switch from long haul to short cut, FMSE 100488-100490. 

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334 See reference to December 2003 speech of John James in background section of this report. 
ACCOUNTING OVERSIGHT 

As part of the special examination of Fannie Mae, OFHEO reviewed the following four aspects of

the Enterprise’s financial reporting practices: (1) accounting policy development, (2) accounting

policy review, (3) segregation of duties and (4) key person dependency. OFHEO concentrated

examination efforts on evaluating the roles and responsibilities of the executives in the 

Controller’s Department and the related controls that support the integrity of the financial 

reporting process. OFHEO believes that a lack of proper segregation of duties exists within 

Fannie Mae’s Controller’s Department which has created an environment that is not conducive 

for developing safe and sound financial reporting practices. AICPA Statement on Auditing

Standards 1 (SAS 1) offers the following guidance on the responsibility of management for 

adopting sound accounting policies:

Management has the responsibility for adopting sound accounting policies, for 

maintaining an adequate and effective system of accounts, for the safeguarding of

assets, and for devising a system of internal control that will, among other things, help

assure the production of proper financial statements. The transactions which should be

reflected in the accounts and in the financial statements are matters within the direct 

knowledge and control of management. The auditor's knowledge of such transactions is 

limited to that acquired through his examination. Accordingly, the fairness of the 

representations made through financial statements is an implicit and integral part of 

management's responsibility. The independent auditor may make suggestions as to the 

form or content of financial statements or he may draft them in whole or in part, based 

on management's accounts and records. However, his responsibility for the statements 

he has examined confined to the expression of his opinion on them. The financial

statements remain the representations of management.

335

Fannie Mae, accounting policy recommendations are the responsibility of Jonathan Boyles. 

During testimony, Tim Howard explained that the accounting policy development process is 

such that the SVP for Financial Standards has the authority to recommend a specific policy, the 

Controller has the responsibility and authority for approving accounting policy, and the CFO has 

the general responsibility for the adopted accounting policies.336 Based on evidence reviewed

during the Special Examination, OFHEO believes that the accounting policy development 

process within the Controller’s Department lends itself to the formation of accounting policies 

that are aggressive in nature and which do not comport with a strict interpretation of GAAP as 

promulgated by the Financial Accounting Standards Board (FASB). 

In addition, OFHEO identified critical resource shortages and a lack of technical accounting 

expertise within the Controller’s Department which resulted in key person dependencies. 

 335 American Institute of Certified Public Accountants (AICPA) 2002 Codification of Auditing Standards

and Procedures, Statement of Auditing Standards No. 1, Section 110.02. New York, NY: AICPA. 

336 OFHEO Interview, Mr. Tim Howard, August 5, 2004, p. 21 

Q: Who has the authority for formulating accounting policy at Fannie Mae? 

A: Jonathan [Boyles] has the authority for recommending a specific accounting policy. Leanne [Spencer] 

has line responsibility for what policy is actually adopted. And I have general responsibility for ensuring 

that the process works well and produces a quality result. 

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OFHEO believes that these weaknesses resulted in an environment that impeded independent 

thinking and encouraged an inadequate level of policy and procedure development and 

documentation. A basic component of good corporate risk oversight is a sound internal control 

environment supported by a prudent system of “checks and balances” between the risk taking

and control functions of an organization. Necessary components of this are both an

independent risk management and audit function. Also, those responsible for the transacting or 

risk-taking business should not responsible for the settlements, financial reporting or recording 

of the transactions into the Enterprise’s books and records. 337 

Accounting Policy Development

The financial reporting responsibilities at Fannie Mae reside in the Controller’s Department and 

ultimate responsibility for certification of the financial statements lies with Franklin Raines, 

Chairman of the Board and Chief Executive Officer (CEO), Tim Howard, Vice Chairman and 

Chief Financial Officer (CFO) and Leanne Spencer, Senior Vice President and Controller. The 

Controller’s Department, relative to the areas under review, is organized as follows: 

Timothy Howard 

Vice Chairman - CFO 

Sam Rajappa Leanne Spencer 

SVP Operations Risk SVP – Controller

Janet Pennewell Jonathan Boyles

 SVP - Financial Reporting SVP - Financial Standards & Tax Vacant

SVP – Financial Accounting 

Mary Lewers 

VP – Financial Accounting 

Fannie Mae’s accounting policy development process begins in the Financial Standards group 

under the purview of Jonathan Boyles. Financial Standards has the corporate responsibility to 

recommend accounting policy for Fannie Mae. Jonathan Boyles explained that new accounting 

policies originate primarily from two sources. First, the Financial Standards group follows new 

accounting rules as they develop at the FASB, EITF and SEC. If it is determined that the new 

standards will have an impact on Fannie Mae’s business, then Financial Standards will draft 

accounting policy for recommendation to the Controller. Secondly, the Financial Standards 

group receives requests from the business units to review new and/or proposed business 

products developed at Fannie Mae, and Financial Standards will develop accounting policy for 

 

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337 Group of Thirty, Enhancing Public Confidence in Financial Reporting, Washington DC, 2003, p. 14. 

“Financial control and risk management must be fully independent of the risk taking side.” 
recommendation to the Controller. The Controller is then responsible for reviewing the 

proposed policies for compliance with GAAP and ensuring that the financial accounting practices 

implemented are done so in a safe and sound manner. 

During the Special Examination, OFHEO found no evidence of formal written procedures which 

govern the development of accounting policy at Fannie Mae. In fact, when questioned about 

documentation of the accounting policy development procedures, Jonathan Boyles indicated 

that he was not aware if any existed: 

Q: Jonathan, is there a formal procedure for that to take place? 

A: I’m not sure what you mean by a formal procedure. 

Q: A formal procedure for the business unit to contact you. 

A: There’s a policy that they’re supposed to contact me. 

Q: Is that in writing anywhere? 

A: I don’t know that it’s in a policy manual out to people. I don’t know that it’s in 

writing or not.338

OFHEO believes that maintaining formal accounting policy development procedures is necessary

to meet management’s responsibility for adopting sound accounting policies and devising a 

system of internal control that will help assure the production of proper financial statements, as 

outlined in SAS 1. The lack of written policy development procedures results in a disorganized 

process and the improper development of Enterprise’s policy. 

In fact, OFHEO noted that the development of the Purchase Premium and Discount 

Amortization Policy, a critical accounting policy for the Enterprise, was directed by Mr. Tim 

Howard, with significant involvement by Ms. Leanne Spencer and other members of the 

Controller’s Department. However, the policy was developed without input from the Financial

Standards group. During testimony, Jonathan Boyles commented on Financial Standards’ 

involvement in the policy as follows:

Q: Are you familiar with this document [Purchase Premium and Discount Amortization 

Policy]? 

A: Yes. 

Q: Is this document a policy of the Enterprise for amortizing purchase premium and 

discount? 

A: I believe this policy, this document is a procedures document for amortization. 

Q: And would you describe this procedures document as being distinct from a policy 

document? 

A: Yes, I would. I would consider this two different things. 

Q: Now this is maintained outside of your accounting policy manual; correct? 

A: Correct. 

Q: Now did you approve this document? 

A: I don’t recall approving this document. 

Q: Do you recall reviewing this document at the time that it was adopted? 

A: I don’t recall reviewing this document at the time it was adopted.339

 338 OFHEO Interview, Jonathan Boyles, August 3, 2004, pp. 11-12. 

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339 OFHEO Interview, Jonathan Boyles, August 24, 2004, pp. 7-8. 
It should be noted that although during testimony Jonathan Boyles specifies that the document 

represents procedure rather than the Enterprise’s policy, Fannie Mae provided the Purchase 

Premium and Discount Amortization Policy referenced above in response to an OFHEO 

subpoena requesting the Enterprise’s accounting policies related to SFAS 91. 

This occurrence highlights the disorganization that results when clearly defined policy 

development procedures are not in place. Moreover, upon review of the Purchase Premium and 

Discount Amortization Policy, Jonathan Boyles indicated that aspects of that policy do not 

comport with GAAP: 

Q: I’d like to refer you then to the last page or second page of this document [Purchase 

Premium and Discount Amortization Policy], FMSE 074524, and I wanted to specifically 

ask about two policy provisions. 

A: Uh-huh 

Q: And these policy provisions are both indicated in the last paragraph. Do you want to 

read that last paragraph again?... 

A: Okay. 

Q: The first sentence of this paragraph states: If our catch-up moves beyond one within 

two percent of combined portfolio net interest in guaranty fee income, we will book 

monthly “on-top” adjustments that bring us back to within the plus or minus one 

percent range within our three-year planning period. Is that a provision that you 

recollect discussing with the outside auditors, KPMG? 

A: I don’t recall discussing that provision. 

Q: Is that a provision that you had approved at all? 

A: I don’t recall approving it. 

Q: Okay. In your opinion is that provision permitted under Generally Accepted 

Accounting Principles? 

A: No, I don’t believe that would be allowed.

Q: Then there is, I’d like to direct your attention to the last sentence. 

A: Uh-huh 

Q: States that –I’m sorry—the last two sentences state: Should our catch-up ever 

exceed two percent of the combined portfolio interest and guaranty fee income, 

however, we will bring it back to within the one to two percent range within a six month 

period. After that time, we will continue our monthly “on-tops” to return the catch-up to 

the plus or minus one-year range within a three-year horizon. Is that policy provision—

let me rephrase that. Do you recall having discussed that policy with the outside 

auditors? 

A: I don’t recall discussing this second page with the outside auditors. 

Q: Okay. 

A: As I mentioned earlier, I was surprised when I saw it in April or May. 

Q: Would the policy—I’m sorry—would that provision in that paragraph, in your opinion, 

be in accordance with Generally Accepted Accounting Principles? 

A: No, I don’t believe it would be. I don’t believe anything on this—that I’m aware of—

on the second page has ever been implemented in practice.

340

 

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340 OFHEO Interview, Jonathan Boyles, August 24, 2004, pp. 11-13. 
OFHEO contends that the lack of formal policy development procedures within the Controller’s 

Department resulted in the formation of accounting policies that are not consistent with GAAP. 

During our examination, OFHEO identified other instances, related to the accounting policies for 

hedge accounting under SFAS 133, in which aspects of the policy did not comport with a strict 

compliance with GAAP. During testimony, Jonathan Boyles characterized these instances as 

“known departures from GAAP,” and claimed that they represented a practical application of the 

accounting standards: 

Q: With respect to the overall approach and the concept of assuming no ineffectiveness,

do you believe that there are situations in which Fannie Mae is applying that when it’s

not consistent with the guidance in FAS 133? 

A: We have several known departures from GAAP in our adoption of FAS 133. We have 

cleared those with our auditors. We have reported to our auditors on an annual basis 

the effect of those. And they were comfortable when we adopted them, and they were 

comfortable over the last several years when we reported the results of that work. 

Q: What were the reasons for you not applying GAAP in its strict conformity? 

A: As is relates to what?

Q: As it relates to 133. You said there were several departures from GAAP. 

A: The purpose there was really twofold: one, we felt like in the case of the duration 

shortcut, we felt—if you think about duration, duration is a sensitivity of an instrument’s 

–of the instrument to interest rates. And so, you know, FAS 133 built in the concept of 

a shortcut so you can match notionals and match maturities and repricing dates and 

assume no ineffectiveness when really a better economic hedge would be to match 

duration, not notionals. If somebody on the business side wanted to eliminate interest 

rate risk, they wouldn’t necessarily match up notional or maturity. They would match up 

durations. Those durations would get you that. When we developed the duration 

shortcut, we felt like it was in the spirit of 133 while not exactly to the letter, and so we 

built that into our adoption of 133 because we felt like that was within the tenets of 133 

of a match, and then on an annual basis, we would report back to our auditors and the 

management what the effect of – had we gone long haul on those transactions and not 

taken the duration shortcut, what that effect would have been on earnings.[...]341 

However, testimony of the CFO indicates that he was not apprised of these “known departures

from GAAP” that existed within the Enterprise’s accounting policies: 

Q: Do you believe that all elements of the Enterprise’s accounting policies are consistent 

with Generally Accepted Accounting Principles? 

A: Yes, I do. 

Q: And would you have held that belief as well for the last several years?

A: Yes.342

Q: We understand from Jonathan Boyles’ testimony that the company identified certain 

instances in which the company’s accounting practices or policies depart from GAAP. Is

that consistent with your understanding? 

A: No, It’s not. 

 341 OFHEO Interview, Jonathan Boyles, August 3, 2004, pp.64-65. 

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342 OFHEO Interview, Timothy Howard, August 5, 2004, p.53. 
Q: And he’s never informed you of instances where – that he would characterize as 

known departures from GAAP? 

A: I have not heard that term.343 

In this instance, the lack of formal accounting policy development procedures has led to a 

breakdown in communication regarding the Enterprise’s accounting policies compliance with 

regulatory standards. OFHEO noted that this instance is particularly egregious given the CFO’s 

responsibility for certifying the financial statements with the SEC. The lack of communication 

between Financial Standards and the CFO is a result of the internal control weaknesses that 

result in the absence of written accounting policy development procedures. 

Additionally, a review of evidence gathered during the Special Examination highlighted 

instances in which personnel within Financial Standards characterized aspects of the 

Enterprise’s hedge accounting policies as being aggressive. In an email dated August 10, 2000 

with the subject line, Receiver Swaption + Bullet Swap = Cancelable Swap?, a former Senior 

Project Manager within the Financial Standards group writes:

“We could not analogize the combination of the bullet swap and the swaption to be

treated like the cancelable swap and qualify for the shortcut method. As it is, using the 

cancelable swap under the shortcut method is very aggressive.”344

In a subsequent email dated April 17, 2001 to several members of management, including Tim 

Howard and Leanne Spencer, with the subject line, Recent FASB proposal on the time value of 

option, Mr. Boyles writes: 

“Secondly, the accounting treatment we currently utilize for our received fixed swaptions 

is aggressive (we have KPMG’s approval) and not one we would want to flash in front of 

the FASB for comment or the treatment could get worse.”345

During testimony, the CFO expressed a level of awareness and tolerance for the aggressive 

nature of the Enterprise’s accounting policies: 

Q: Has any company officer or employee ever informed you that the company’s 

accounting policies or interpretation of accounting policies was aggressive? 

A: Certain policies, not in the plural but in the singular, have been described as such at 

various times. And again, I don’t view that as alarming or inappropriate.346 

However, based on evidence reviewed during the Special Examination, OFHEO believes that the 

Audit Committee of the Board of Directors was not apprised, at the time they were 

 343 OFHEO Interview, Timothy Howard, August 5, 2004, pp. 59-60. 

344 Email from Kimberly Stone, to Joseph Rosenberg, and cc to Jonathan Boyles, Donald Sinclair, 

Warren Fitzgibbon and Mary Lewers, dated August 10, 2000, Subject: Receiver Swaption + Bullet Swap 

= Cancelable Swap ?, FMSE 078731-078732. 

345 Email from Timothy Howard to Jonathan Boyles and cc to Leanne Spencer, Tom Lawler, Peter 

Niculescu, Linda Knight, Jayne Shontell, Janet Pennewell, Hal Gann, Mary Lewers, Richard Swick, 

Kimberly Stone, Richard Stawarz, dated April 17, 2001, Subject: Recent FASB proposal on the time value 

of options, FMSE 096460-096461. 

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346 OFHEO Interview, Timothy Howard, August 5, 2004, pp. 49-50. 
implemented into the Enterprise’s accounting policies, of these “known departures from GAAP” 

and instances where the Enterprise adopted aggressive accounting policies. During testimony,

when questioned regarding whether the accounting policies characterized as being aggressive 

were reported to the Audit Committee, Tim Howard responded as follows: 

Q: Has Jonathan Boyles ever informed you that the company's accounting policies or

interpretation of accounting policy were aggressive? 

A: I'm almost certain he has, but I can't recall a specific instance. 

Q: Would you ever then inform the Audit Committee of the board of such an opinion 

held by your Financial Standards head? 

A: No, because again, I don't view the label aggressive accounting as being a bad thing. 

It is descriptive of relative positioning compared to the GAAP line. That's why I want to 

find out more about the specific incidents. And if it's uncomfortably close to the line, we

will change it. It's not take it to the board. It's don't do it. 

Q: Have you ever informed the board or Audit Committee of the board of such an

opinion held by your Financial Standards Department head? 

A: Not to my recollection.347

OFHEO believes that the control weaknesses identified in the accounting policy development 

process at Fannie Mae have allowed the formation of accounting policies that are aggressive in

nature and which do not comport with GAAP. Additionally, OFHEO contends that the lack of 

formal policy development procedures has resulted in a breakdown in communication regarding 

the Enterprise’s policies compliance with regulatory standards and less than full disclosure to 

the Audit Committee of the Board of Directors.

In addition to the weaknesses that exist within the control environment surrounding the 

accounting policy development process, evidence suggests that for the period under 

review, the Enterprise did not maintain a complete and updated database of accounting 

policies which could be easily accessed by Fannie Mae personnel. During testimony, the 

Controller asserted that the general structure for maintaining accounting policies at 

Fannie Mae is in the Financial Accounting Policy Guide, which is periodically updated and 

posted to the Enterprise’s intranet. However, during the examination, OFHEO identified

instances in which critical accounting policies were maintained outside of the designated 

online database for accounting policy and outside of the offline Financial Accounting 

Policy Guide. In order for the accounting policies to be effective, it is imperative that 

the business units who rely on the guidance to evaluate proper performance of business 

operations, have access to a complete accounting guide listing all of the Enterprise’s 

accounting polices and procedures. 

Accounting Policy Review 

The internal review of proposed accounting policies is performed by the Controller. During 

testimony, the CFO confirmed that it is ultimately the Controller’s responsibility to decide which 

policies to approve and implement. The CFO further explained that he views the Controller’s 

position as an “internal check” on the Financial Standards group.348 During our examination, 

 347 OFHEO Interview, Timothy Howard, August 5, 2004, pp. 50-51. 

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348 OFHEO Interview, Mr. Tim Howard, August 5, 2004, pp. 19-20 
OFHEO noted that while the Controller has the responsibility for reviewing proposed accounting 

policies for compliance with GAAP, she is not a Certified Public Accountant (CPA). The 

accounting policy development process as currently practiced is circular as the Controller relies 

on the Financial Standards group to provide guidance on whether or not accounting policies 

conform to regulatory standards. The effective result of the process as described is that the 

Financial Standards group develops and also approves accounting policy. 

Furthermore, during testimony, the CFO indicated that in situations where the Controller has a 

difference of opinion from the accounting policy recommendation developed by Financial 

Standards, the matter is brought to him for a final decision: 

Q: Since Jonathan provides recommendations to Leanne, I assume implicit in her 

authority is the ability to evaluate those recommendations, but ultimately establish 

policy she judges to be appropriate, which may in fact deviate from Jonathan’s 

recommendations. 

A: In theory that could happen. What’s occurred in practice, for as long as I can 

remember, is when that is the case, Leanne does not make those decisions without 

consultation with me, which is—that’s something that I have put in to practice as a, I 

think, good process check. Again, if you have a recommendation for the subject matter 

expert, that his or her supervisor—there’s a difference of a point of view, there’s an

issue there. And one of the things that I am good at doing in the company is ferreting

out the merits and drawbacks of resolving issues in different ways. So I am invariably

asked to participate in the process. And then whatever the final judgment is, I will likely 

be involved in it. 

Q: And I assume that that’s actually happened, that it’s not just hypothetical? 

A: Yes, it has. Again, if you ask me for specific recollections, I would probably rack my 

memory to come up with one. But it doesn’t just work that way in the controller’s area. 

It works that way in all areas that I oversee. That’s the one way I think I add some

benefit, by holding the various responsibilities I’ve got.349

It should be noted that the CFO is also not a CPA nor does his technical background include 

accounting related experience. OFHEO does not believe that the accounting policy

development review process is sufficient to function as a “check” on the propriety of accounting 

policies as it relates conformity with GAAP. 

OFHEO questioned the Controller about the process that she undertakes to ensure that the 

Enterprise’s accounting policies are in compliance with GAAP. The Controller responded that

 

Q: How would you describe the distinction of responsibilities between Financial Standards headed up by 

Jonathan [Boyles], and then alternatively, Leanne Spencer and the Controller’s Group that she oversees? 

A: Well, Jonathan is the subject matter expert on accounting policies, so he is the person that we look to 

for not only advice but decisions around how to implement the various financial standards requirements. 

Leanne is supervisor, overseer. She is a internal check on Jonathan, and in my role as sitting on top of 

the overall department, I look first to Jonathan for his subject matter expertise, do rely on Leanne’s 

thoroughness in engaging on issues and her sense for when an issue needs to come to my attention, and 

frequently issues are brought up to me, both to inform me, and in some cases to seek my counsel on

decisions. So that’s how I think about it. Jonathan’s the subject matter expert, and Leanne is an engaged 

participant in the process. 

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349 OFHEO Interview, Timothy Howard, August 5, 2004, pp. 24-26. 
she relies on the advice of the external auditor in determining whether the accounting policies

comply with regulatory standards: 

Q: How do you assure yourself that the company's policies are in accordance 

with GAAP? 

A: I hire technical experts to staff the Financial Standards Unit, and then I 

liberally use our external auditors and our external auditors' national office to 

review policy and to have check-offs on the policy, and we really are in a mode 

to where we check with them frequently, and we want to make sure we don't 

have habits where we move forward and then inform them of what we did. Our

habits are have them along with us, and be with us along the way as we are 

looking at items of a policy nature.350 

As noted above, SAS 1 states that it is the responsibility of management to develop sound 

accounting policies as the primary responsibility for the financial statements rests with 

management. Part of that responsibility includes devising a system of internal control that will, 

among other things, help assure the production of proper financial statements. The standard

also describes the scope of an auditor’s activity: “As part of their audit, they will assess the 

accounting principles used. However the auditor’s responsibility for the statements he/she has 

examined is confined to the expression of his/her opinion of them. The financial statements 

remain the representation of management.”351 It is the responsibility of management to ensure 

that the Enterprise maintains the internal expertise to properly develop, approve, and 

implement accounting policy. 

The testimony of the CFO, Controller, Vice President of Financial Accounting, Director of

Financial Accounting, and the head of the Office of Auditing, all referred to KPMG as the final 

arbiter of the Enterprise’s compliance with GAAP.

352 This provides insight into management’s 

“liberal use”353 of its external auditors as the first check on the appropriateness of the 

Enterprise’s accounting policies. However, it is ultimately the responsibility of management to

determine sound accounting policies for the Enterprise354 – the burden of management can not 

be shifted to the external auditor. OFHEO views the Enterprise’s reliance on the external 

auditor to determine the propriety of accounting policy as an indication of a lack of adequate

 350 OFHEO Interview, Leanne Spencer, August 12, 2004, pp. 24-25. 351 American Institute of Certified Public Accountants (AICPA) 2002 Codification of Auditing Standards

and Procedures, Statement of Auditing Standards No. 1, Section 110.02. New York, NY: AICPA. 

352 OFHEO Interview, Mr. Tim Howard, August 5, 2004, pp. 19-20 

Q: How would you describe the distinction of responsibilities between Financial Standards headed up by 

Jonathan [Boyles], and then alternatively, Leanne Spencer and the Controller’s Group that she oversees? 

A: Well, Jonathan is the subject matter expert on accounting policies, so he is the person that we look to 

for not only advice but decisions around how to implement the various financial standards requirements. 

Leanne is supervisor, overseer. She is a internal check on Jonathan, and in my role as sitting on top of 

the overall department, I look first to Jonathan for his subject matter expertise, do rely on Leanne’s 

thoroughness in engaging on issues and her sense for when an issue needs to come to my attention, and 

frequently issues are brought up to me, both to inform me, and in some cases to seek my counsel on

decisions. So that’s how I think about it. Jonathan’s the subject matter expert, and Leanne is an engaged 

participant in the process. 

353 OFHEO Interview, Leanne Spencer, June 22, 2004, p. 24-25. 

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354 American Institute of Certified Public Accountants (AICPA) 2002 Codification of Auditing Standards

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technical expertise within the Controller’s Department. OFHEO believes that although the 

Controller has the ultimate responsibility for approving accounting policies at Fannie Mae, the 

processes as practiced rely heavily on the SVP of Financial Standards and the external auditor 

to determine compliance with GAAP. OFHEO asserts that the accounting policy review process 

does not provide a sufficient internal independent verification of recommended policy and does 

not provide reasonable assurance that the accounting policies adopted by the Enterprise are in 

compliance with GAAP. 

Additionally, OFHEO noted that although internal audit procedures indicated that test work was 

performed to assess compliance with regulatory standards, the Office of Audit (OA) does not

conduct an independent review of accounting policies to determine compliance with GAAP. 

According to the CFO, Internal Audit has no role in determining whether or not Fannie Mae’s 

accounting policies are consistent with GAAP. The CFO asserts that the role of the OA is to

evaluate the internal controls of accounting processes relative to the internal policy: 

Q: What is Internal Audit's responsibility for evaluating the company's accounting 

policies? 

A: Their primary responsibility is to do audits to ensure that the policies are 

followed by those they govern in a fashion consistent with our [internal] 

standards.355

As it relates to the review of accounting policies, the CFO does not look to the OA to review the 

Enterprise’s accounting policies for propriety under GAAP; he instead looks to the outside 

auditor. Sam Rajappa, Senior Vice President of Operations Risk (Director of the Office of Audit)

confirmed that his team does not provide any review of the Enterprise’s accounting policies 

relative to GAAP: 

Q: Are audit procedures directed at determining whether or not the company has 

been in compliance with GAAP? 

A: Audit procedures are directed at auditing to the standards established by 

Financial Standards and approved by KPMG.356

Fannie Mae’s organizational structure and accounting policy development review process has

created material deficiencies in the Enterprise’s ability to effectively review financial accounting 

policies. OFHEO determined that as a result of the lack of technical skill of the executives who 

serve as a control check of the policy development process, management over relies on the SVP 

of Financial Standards and the external auditor to perform this key function. OFHEO believes 

that the policy development review process, as currently practiced, does not adequately fulfill 

management’s responsibilities, which has resulted in the development of accounting policy that 

is aggressive in nature and an environment that acquiesces to the development of policies that

do not comport with a strict interpretation of GAAP. 

Segregation of Duties 

OFHEO examined the roles and responsibilities of the executives in the Controller’s Department 

and the related controls that support the integrity of the financial reporting process. During the 

 355 OFHEO Interview, Timothy Howard, August 5, 2004, p.36. 

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356 OFHEO Interview, Sam Rajappa, June 17, 2004, p.10. 
examination, OFHEO noted several instances in which the executives in the Controller’s 

Department lacked a proper segregation of duties. One example of this is the lack of

segregation of duties regarding the amortization of deferred price adjustments. OFHEO 

believes that these instances represent critical conflicts of interest and are not conducive for 

developing safe and sound financial reporting practices. Statements on Auditing Standards 55

(SAS 55) issued by the Auditing Standards Board (ASB) “provides guidance on the independent

auditor’s consideration of an entity’s internal control structure in an audit of financial statements

in accordance with generally accepted auditing standards,” as follows: 

Control Procedures 

11. Control procedures are those policies and procedures in addition to the control 

environment and accounting system that management has established to provide 

reasonable assurance that specific entity objectives will be achieved[...] 

• Segregation of duties that reduce the opportunities to allow any person to be in a 

position to both perpetrate and conceal errors or irregularities in the normal course 

of his duties – assigning different people the responsibilities of authorizing 

transactions, recording transactions, and maintaining custody of assets[...]

357

The standard emphasizes the importance of segregating responsibilities of individuals who are 

in a position to authorize and record transactions in establishing a strong control environment 

around financial reporting.

Chief Financial Officer (CFO)

 

OFHEO noted that the CFO has a myriad of responsibilities, which include risk management, the 

retained portfolio, the accounting function, investor relations, treasury, and financial reporting 

and he also has responsibility for evaluating and making compensation recommendations for 

the Head of the Office of Auditing, Mr. Sam Rajappa. When asked to describe his current 

position at Fannie Mae, the CFO responded as follows: 

Q: I want to start off with just some questions related to your background and

experience. Can you describe your current position at Fannie Mae? 

A: Boy, how much time do we have? [Laughter.] 

A: My title is vice chairman and chief financial officer. As vice chairman I have a fairly

wide range of corporate strategy oversight management responsibilities, part of a fourperson Office of the Chairman includes Frank Raines, the chairman and the chief 

operating officer and Tom Donilon, who’s executive vice president for law and policy. 

Beyond that, I also serve informally as the Enterprise’s chief risk officer. Back, I guess, 

in November of 2000 Frank asked me to take on those responsibilities, and we

effectuated that by moving the credit policy function out of the reporting, the chief 

operating officer reporting to me, and that gave me direct reports of all people who 

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357 American Institute of Certified Public Accountants (AICPA) 2002 Codification of Auditing Standards

and Procedures, Statement of Auditing Standards No. 55. New York, NY: AICPA. 
either set risk policy or did risk analytics. So that’s a second level of responsibilities I 

have. 

I direct the person who manages our on-balance sheet mortgage portfolio. That’s Peter 

Niculescu. Prior to November of 2002 I had direct oversight responsibility for the three 

functions that composed that business, the portfolio strategy function, the mortgage

acquisition function, and the Treasurer’s Office. In November that passed to Peter, but I

retain active involvement as a overseer of the business. 

As chief financial officer I have the accounting control function, with Leanne Spencer

heading that up, reporting to me. In addition to financial reporting, we also do business 

planning, tax, and accounting policy. Investor Relations reports to me directly. 

A small group called Corporate Financial Strategies, headed by Tom Lawler, who I 

believe you talked to, serves as a standard setter and the group that ensures that we’re 

looking at risk consistently across the company. Tom reports to me.

And finally I have, indirect or dotted line reporting from the auditor. Sam Rajappa 

reports directly to the chairman of the audit committee, but for the last I think year and 

a half, maybe two years, he has reported on a dotted line basis to me. Previously he 

also reported to our chief operating officer. 

So that covers the range of responsibilities I currently have. Like in the past I’ve had 

others, but not significantly different from what I have now.358

The CFO indicated a wide range of functions that fall within his purview of responsibility, 

several of which potentially impair the CFO’s independence. According to the best 

practices outlined in, Enhancing Public Confidence in Financial Reporting, written by the 

Group of Thirty, “financial control and risk management must be fully independent of 

the risk taking business.”359 The Group of Thirty is comprised of members from both the 

public and private sectors and academia. The Group issues guidance on economic,

financial, and policy development. In fact, during his testimony, Mr. Howard stated that 

he is currently serving as a member of The Group of Thirty: 

Q: Have you yourself been involved in meetings with standard setters, accounting 

standard setters such as the SEC or FASB to discuss the company's accounting policies? 

A: Both. I've been a number of meetings with FASB board members, including the 

chairman, and also been to the SEC. And one other thing I'll mention that falls into that 

category is there is an outfit called the Group of 30, that you may or may not have

heard of. It's a group of basically international financial policy makers that are the 

board of a nonprofit headquartered here in Washington. Last year they decided to do

something they've never done before which is attack accounting policy, and they put

together a steering committee. 

 

 358 OFHEO Interview, Tim Howard, August 5, 2004, pp. 6-8. 

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359 Enhancing Public Confidence in Financial Reporting, The Group of Thirty, Washington, D.C., p.14. 
The chairman of the board of trustees is Paul Volcker, who I've known for some time. 

Paul asked me to serve on the task force to look at the issue of fair value versus 

historical cost for international financial institutions. But Bob Herrs [ph] was on that as 

a observer, Susan Bies from the Fed, Jim Leisenring from the IASB. So that's an 

accounting policy group. I also head that interaction. We met three times in the course

of putting together our report, twice in New York and once in London.

360

As part of his responsibility for the retained portfolio, the CFO has the authority to 

approve transactions related to mortgage acquisitions and derivatives. He also has the 

authority to set risk management strategies which are used to develop the financial

forecast. Additionally, he has the authority to determine how the financial transactions 

are reported in the financial statements. This lack of segregation of duties is 

inappropriate and contradicts the following public statement made by Franklin Raines, 

Fannie Mae’s CEO: 

 “Those entering into business transactions and accountable for business results do not 

determine the accounting of those ransactions. 361 t ” 

– Franklin D. Raines 

OFHEO asserts that commensurate in the CFO’s responsibility is the ability to set a 

financial target through his duties as Vice Chairman and the ability to meet the financial 

target via his duties as CFO. 

Best practices necessitate controls that ensure the independence of management. In

addition, while executive compensation for management is ultimately the responsibility 

of the Compensation Committee of the Board of Directors, the CFO significantly 

influences the evaluation and makes compensation recommendations for the head of

the OA. OFHEO contends that this reporting line is inappropriate. 

Senior Vice President – Financial Reporting and Planning

 

During discussions with Janet Pennewell, Senior Vice President – Financial Reporting and 

Planning, OFHEO noted a similar conflict of interest corresponding to her roles and 

responsibilities. When asked to describe her current responsibilities, Janet Pennewell indicated 

that she is responsible for forecasting the financial statements as well as financial reporting: 

Q: So in 1999 you took on the responsibilities in Financial Reporting that you—describe 

what happened in 1999 again, if you would. 

A: Sure. In 1999 I was promoted to Vice President, and before my promotion I was in 

charge of the business planning function, which resides within the Controller’s 

Department, and when I was promoted to Vice President in 1999, also took on 

responsibility for financial reporting and for financial accounting. 

Q: In 1998 were your responsibilities in the business planning function quite a bit 

different from what you started doing in 1999? 

360 OFHEO Interview, Tim Howard, August 5, 2004, pp. 39-40. 

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361 See, Answers from the CEO: Why do you have confidence that you have done your derivative

accounting properly?,” http://fanniemae.com/ceoanswers/derivativesaccounting.jhtml. 
A: I retained the responsibility for the business planning function, but then took on 

additional, significant additional responsibility. 

Q: Right. So in 1998 would you have had any responsibility for forecasting income?

A: Yes. That’s what—that’s what the Business Planning Group does. It forecasted 

essentially profit and loss statement, balance sheets for the company as a whole, out of 

our three or four-year planning horizon, and also for our business areas.362

OFHEO asserts that this dual role presents a significant conflict of interest. Janet Pennewell, in 

her role as SVP of Financial Reporting and Planning, has the ability to affect the amounts of 

reported net income in order to achieve planned results. 

During testimony, Janet Pennewell further described that her responsibilities included modeling 

the purchase premium and discount amortization as well as recording the amortization to the 

financial statements: 

Q: So some of the—in forecasting income back in 1998 you also—would you have also 

had some oversight over the tracking of premium and discount amortization? 

A: In—not officially. We began, my team and myself, began to get involved peripherally 

in the tracking of premium—the modeling of premium and discount amortization in

maybe mid 1998, and then the responsibility for the modeling necessary to come up 

with the level yield factors was transferred to my area officially in 1999.363

Having the dual responsibility of modeling the amortization and reporting amortization results to 

the financial statements under the authority of a single individual is a major control weakness 

that undermines the integrity of the financial reporting process. 

Director of Financial Reporting

In addition, OFHEO noted that a single individual is responsible for the modeling, reporting and 

accounting for SFAS 91. During his testimony, Jeffrey Juliane, Director of Financial Reporting, 

explained his responsibilities related to the purchase premium and discount amortization 

process as follows: 

Q: Can you walk us through your employment at Fannie Mae? 

A: I came on at Fannie Mae. I was working in the corporate planning area in charge of 

the mortgage portfolio forecast, worked extensively with the mortgage portfolio area in 

terms of generating their quarterly forecast numbers and stayed. That was my primary 

focus for the first year of employment there. 

At that point in time, we had Jonathan Boyles’ area was responsible for doing FAS 91

calculations. We identified a need to increase the expertise in that area. Then it came

underneath me in Q1 of 1999, so at that point in time I had a combined role of doing a 

corporate plan from the portfolio perspective as well as doing FAS 91 forecasting or FAS 

91 accounting. 

 362 OFHEO Interview, Janet Pennewell, June 15, 2004, pp. 8-9. 

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363 OFHEO Interview, Janet Pennewell, June 15, 2004, p. 9. 
That stayed that way until mid-2000 and then I moved over to be a part of the financial 

reporting team where I was in charge of new product development from the accounting 

perspective as well as FAS 91. That stayed that way until toward the end of 2001 when 

I got asked to help do accrual accounting implementation on a STATs system as well as 

doing FAS 91.... 

Q: And who do you report to? 

A: I formally report to Mary Lewers. 

Q: And you say formally? 

A: (Witness nods) 

Q: Can you explain that? 

A: For—I’ve always had a dotted-line relationship with Janet, especially when it comes 

to FAS 91 related activities. 

Q: That would be Janet Pennewell? 

A: Yes.364

Jeffrey Juliane is currently responsible for both modeling the purchase premium and discount 

amortization amount as well as recording that amortization amount to the financial statements. 

This is a control weakness that subverts the soundness of the financial reporting process as 

there is no independent check on the amortization modeling, forecasting and reporting 

processes. Again, OFHEO asserts that Jeffrey Juliane’s dual responsibility of calculating the 

modeled amortization results and recording amortization for purposes of financial reporting

represents a conflict of interest and undermines the integrity of the modeling process. 

SVP of Operations Risk (Head of Internal Audit)

During testimony, OFHEO noted that Sam Rajappa, Senior Vice President – Operations Risk, 

serves as the head of the Office of Audit (OA) and reports to the CFO. OFHEO concludes that

the OA should independently report to the Audit Committee of the Board of Directors and not to

management such as the CFO. Based on evidence gathered during the Special Examination, 

OFHEO believes that Sam Rajappa does not have independence from the CFO. During 

testimony, the CFO indicated that he has “indirect or dotted line reporting from the auditor.” 

Tim Howard qualified the statement by noting that, “Sam Rajappa reports directly to the 

chairman of the Audit Committee, but for the last I think year and a half, maybe two years, he 

has reported on a dotted line basis to me. Previously he also reported to our chief operating 

officer.”

365 Although the CFO characterized his reporting responsibility as that of a “dotted line,” 

OFHEO noted that the CFO participates in the annual performance evaluation and makes 

compensation recommendations for Sam Rajappa: 

 

Q: Who does Mr. Rajappa's performance review? 

A: I write it, but I do it with very significant input from Tom Gerrity, the chairman of the 

Audit Committee. 

Q: Similarly, for your direct reports, do you also perform their evaluation? 

A: Yes, I do. 

364 OFHEO Interview, Jeffrey Juliane, June 8, 2004, pp. 8-10. 

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365 OFHEO Interview, Tim Howard, August 5, 2004, p. 8. 
Q: Are you also involved in making compensation recommendations for these 

individuals?

A: Yes. Although for people at the senior vice president level and above, we do it

collaboratively. We have a group of executives we call our senior leadership team, 

which is the Office of the Chairman and six other executive vice presidents, who meet as 

a group, and talk about the performance of all of our senior officers, and we make the 

compensation decisions collectively. I will make a recommendation to the group about 

the compensation of each of my officers, but the compensation is ultimately determined 

by the results of the discussions that take place at the senior leadership team meeting. 

Q: Would you also make the compensation recommendation for Sam Rajappa as well? 

A: I do, but that is also determined by the group as a whole.366

 

OFHEO believes that Sam Rajappa should report directly to the Audit Committee of the Board of 

Directors. The position should be independent from the CFO. The current organizational 

structure which gives the CFO the authority to evaluate and affect compensation decisions for 

the head of the OA critically impairs the independence of the OA. 

OFHEO also believes that the current roles and responsibilities of the executives within the 

Controller’s Department do not meet management’s responsibility to “sufficiently segregate 

duties in order reduce the opportunities to allow any person to be in a position to both 

perpetrate and conceal errors or irregularities in the normal course of his duties,”367 as outlined 

in SAS 55. As a result, the current control environment is not structured to promote safe and 

sound financial reporting practices. It should be noted that this conflict of interest and 

underdeveloped segregation of duties was formally noted on several occasions by the Office of 

Audit, including in their July 9, 2003 Amortization Audit Report.

368 

Moreover, OFHEO contends that OA failed to follow standards established by the Institute of 

Internal Auditors (IIA) for evaluating risk exposures relating to impairments of auditor 

independence and objectivity. IIA standards on individual objectivity provide the following 

guidance regarding impairments to internal auditor independence: 

Internal Auditors should refrain from assessing specific operations for which they were 

previously responsible. Objectivity is presumed to be impaired if an internal auditor 

provides assurance services for an activity for which the internal auditor had 

responsibility within the previous year.369

During testimony, Sam Rajappa indicated that prior to serving in his current role as the head of 

Internal Audit, he held the position of Controller for the Enterprise: 

 366 OFHEO Interview, Tim Howard, August 5, 2004, p. 13. 367 American Institute of Certified Public Accountants (AICPA) 2002 Codification of Auditing Standards

and Procedures, Statement of Auditing Standards No. 55. New York, NY: AICPA. 

368 The Fannie Mae Audit Report issued by the Office of Auditing on the Amortization Audit dated July 9, 

2003 states the following: “We noted key-person dependencies in both the data and modeling processes. 

A limited number of individuals have a strong understanding of the amortization processes. Improved

policies over these areas would provide better support for procedures performed and would reduce key 

person dependencies.” FMSE 023745-023752. 

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369 The Institute of the Internal Auditors’ Standards for the Professional Practice of Internal Auditing, 

Attribute Standards – 1130.A1 
Q: Mr. Rajappa, could you describe your current responsibilities at Fannie Mae? 

A: Yes, I am Senior Vice President for Operations Risk now, and I head up the internal 

audit function, and I have a staff of 57 auditors, including me. 

Q: And how long have you had those responsibilities? 

A: I've been in this job since January of 1999. 

Q: And what is your prior employment history and responsibilities with Fannie Mae? 

A: I was the Controller from 1994 through end of 1998. 

Q: And how long have you had those responsibilities? 

A: I've been in this job since January of 1999.370

Based on Sam Rajappa’s testimony, it appears that for the fiscal year 1999, the OA function did 

not meet IIA standards relative to auditor independence. As Sam Rajappa served as the 

Controller for the period of 1994 thru 1998 and subsequently acted as the head of the Internal 

Audit function, he was given the authority to audit his own work, which represents a major 

conflict of interest. 

Key Person Dependency

Information obtained during the examination demonstrates that critical shortages of qualified 

accounting specialists existed within the Controller’s Department during the period under 

review. The shortage of staff and technical accounting expertise created key person 

dependencies for crucial accounting policy development areas. The problem was exacerbated 

as Fannie Mae was challenged with fulfilling the necessary requirements to complete 

registration with the Securities and Exchange Commission (SEC), while also complying with an 

increasing number of accounting standards that impacted their business. 

The Financial Standards Group

 

The Financial Standards group, which is headed by Jonathan Boyles, is presently staffed with 8

employees. During testimony, Jonathan Boyles indicated that his Financial Standards staff

doubled to reach its current number during the past 18 months.371 Jonathan Boyles explained

that he started as a manager in 1994, at which point in time the Financial Standards group 

consisted of himself and one direct report: 

Q: Could you describe what the progression of your positions and job responsibilities

have been during that time? 

370 OFHEO Interview, Sam Rajappa, June 17, 2004, p. 7. 371 OFHEO Interview, Mr. Jonathan Boyles, August 3, 2004, pp. 9-10 

Q: So what was the size of the group when you started? 

A: When I started there were two managers and a director. When my boss moved on there were – I was 

acting head of the department as a manger, and I had one person reporting to me. After I got promoted I 

replaced my head count essentially, and for a while there were two people reporting. I don’t remember 

the years, but, you know, got approval for a third. And then gradually got a fourth. And then this past year 

we hired Greg Ramsey as the lead Vice President. 

Q: When Greg Ramsey came in, did the size of the group grow in terms of the people reporting to him, or 

when did you get from the four to the eight? I am just trying to get a sense of timing. 

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A: Going from the four to the eight has been within the last 18 months. 
A: Sure. I started in 1994 as a manager in the Financial Standards Department. I was 

promoted to Director of the Financial Standards Department around 1997. I was 

promoted to Vice President, Financial Standards Department 2001, I believe. And I was 

promoted to Senior Vice President of Financial Accounting Standards and Corporate Tax 

in 2004....372

 

Q: So what was the size of the group when you started? 

A: When I started there were two managers and a director. When my boss moved on 

there were--I was acting head of the department as a manager, and I had one person

reporting to me. After I got promoted I replaced my head count essentially, and for a 

while there were two people reporting. I don't remember the years, but, you know, got

approval for a third. And then gradually got a fourth. And then this past year we hired 

Greg Ramsey as the lead Vice President.

373 

It should be noted that SFAS 133 became effective for fiscal years beginning after June 15, 

1999; Fannie Mae voluntarily registered its common stock with the SEC effective March 31, 

2003, filing reports for the FY2002 financial statements; and SFAS 149 became effective for 

contracts entered into or modified after June 30, 2003. 

In addition to developing accounting policy for the Enterprise, the SVP of Financial Standards 

and Tax also devotes some of his energies to corporate tax issues. Jonathan Boyles is also 

called upon to prepare analyses such as due diligence support for counterparties and reviews of 

investee companies. Financial Standards is also responsible for drafting the language that 

appears in the publicly filed 10K and 10Q statements and the Administrative Finance Report. 

Additionally, the group is often required to do special projects such as reviewing accounting 

issues related to Freddie Mac. Financial Standards regularly provides management with 

analyses comparing Freddie Mac’s financial disclosures to their own in order to highlight issues 

of concern or explain differing financial statement presentations.374 

372 OFHEO Interview, Jonathan Boyles, August 3, 2004, p. 7. 373 OFHEO Interview, Jonathan Boyles, August 3, 2004, pp.9-10. 374 OFHEO Interview, Mr. Jonathan Boyles, August 3, 2004, pp. 12-14

Q: So, in addition to being involved in providing accounting guidance, and you know, could you describe 

what the full extent of your responsibilities are? 

A: The full extent of my responsibilities, as it relates just to accounting policy? 

Q: You can start with that, and then – it sounds like you have other responsibilities too. I’d like to hear that 

too. 

A: Right. As it relates to accounting policy, my responsibilities are to provide the accounting policy to the 

departments within the company and to the Financial Reporting Department. We also provide training to 

the company if there’s a need for accounting training, whether it’s on old existing rules or on something 

new. That will go not just for what affects Fannie Mae, but oftentimes we’ll do training on what affects our 

customers but may not have a direct impact on the company. My role is to provide that guidance to those 

who are responsible for implementing the guidance, and I act as a consultant and get brought in where 

necessary. I mean, “I” in that regard, I mean me and my team. 

Q: And other responsibilities besides accounting – 

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A: Other responsibilities that we do, I often get asked to do special projects within the company. We have 

occasionally bought into, during the dot.com craze, several investments in companies that were in the 

mortgage market, and that we had an interest in the technology. Me or my team would do due diligence, 

financial due diligence on those companies as part of the decision-making process, would report up 

through those who would make that decision. We do due diligence on counter-party risk. We’ll go out to 
Given the technical accounting support necessary for Fannie Mae to comply with regulatory 

requirements for implementing the new standards from the FASB and registering its common

stock with the SEC along with its regular operational activities, OFHEO believes that Fannie Mae 

management failed to adequately staff the Financial Standards function to sufficiently meet

these requirements. In fact, the Controller commented on the need to increase staffing for the

Financial Standards group as part of Jonathan Boyles’ 2002 Performance Review: 

I believe FAS 149 knocked us off our horse which had begun to canter. We are 

only slowly building momentum. In hindsight, and I know you agree, Paul [Salfi] 

was not nearly strong enough to lead this huge effort. We recognized this and 

we are taking action to staff your organization appropriately and to add a strong

head of accounting policy.375

OFHEO believes that management across business operations was aware of the lack of 

accounting expertise within the Controller’s Department.376 However, management appears to 

have been slow taking action to remedy the situation. 

In addition, based on evidence reviewed during our examination, OFHEO determined that there 

is limited technical accounting expertise at Fannie Mae, as the SVP of Financial Standards is 

heavily relied upon for all matters accounting related at the Enterprise. OFHEO noted that

executives within the Controller’s Department exhibit only a “high level” understanding of the 

relevant GAAP standards that support the Enterprise’s accounting policies. 

Controller

 

When questioned regarding the Enterprise’s accounting treatment of interest only (IO) and 

principal only (PO) securities, Leanne Spencer deferred her comments to Jonathan Boyles citing

my companies as part of a broader team. We’ll do the financial due diligence where others will look at 

other risks of our counter-parties, and we do other special projects like that, most things as it relates to 

Freddie Mac and Freddie Mac’s accounting gets done out of my department. My department’s also 

responsible for drafting the 10K, the 10Q, and it’s responsible for drafting the administrative finance 

report, both of those. 

375 Performance Review, Jonathan Boyles, by Leanne Spencer, 2002 (FMSE 220363). 

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376 The 2003 Performance Evaluation from Tim Howard to Leanne Spencer, dated December 30, 2003, 

states the following: “The one consistent development theme in the survey was the resource issue. It was 

mentioned somewhere in the survey by each of the four peers who reviewed you: “she needs to fill out 

her team and invest more in her functions.” “I think the area for development is in realizing how much the 

world has changed and needing to get ahead of those changes in terms of her organization, resource 

levels and other investments needed for today’s controllership function.” “She needs more depth in 

certain functions.” “The fact that her staff is overworked and under such extreme resource pressure is 

apparent.” And one of your direct reports said: “I believe she has a pride issue that prevents her from 

asking for more help and as a result, she doesn’t have more time to actually perform her management 

duties. Because she runs such a lean shop her employees also don’t have much time to develop her 

skills or attend training.” I know you’re on top of his now, but as the survey indicates, both you and I let 

this get a little further along than we should have without raising it up on our priority lists – which our 

peers clearly noted.” FMSE 220315-220318 
that she did not have an understanding of the GAAP standards which validate the Enterprise’s 

accounting treatment: 

Q: We’re going to talk a little bit about Fannie Mae’s accounting for IO and PO 

securities. Now we understand from some of the previous discussions we’ve had that 

the company’s policy is to account for IO and PO securities on a combined basis; is that 

correct? 

A: I have a limited recollection of this area, so I would not represent myself as having

expertise in this matter. But I am aware of IO/POs combined. I believe we have talked

to you about this before. 

Q: Do you – are you familiar with the criteria that the company uses for making that 

decision in terms of combining IOs/POs from an accounting standpoint? 

A: I have a high level understanding, but I wouldn’t have a detailed – I wouldn’t have a

detailed understanding. 

Q: Who would have a detailed understanding? 

A: The SVP of Financial Standards, and traders in the portfolio business who he would

be interacting with. 

Q: So would you have an understanding of what basis in GAAP was used to get to that 

conclusion? 

A: I would not.377

As the corporate Controller is considered a critical member of the management team at Fannie 

Mae, OFHEO finds her inability to comment on the regulatory accounting standards which 

govern the Enterprise’s accounting policy unacceptable. Particularly in light of the CFO 

testimony that he viewed it as ultimately the Controller’s responsibility to decide which 

accounting policies to approve and implement. 

 

Evidence reviewed as part of the Special Examination indicated that the Controller’s function 

was also overworked and had persistent resource issues during the period under review. In the 

Controller’s 2001 performance review, the CFO made the following comment regarding 

workload management and staff development within the Controller’s Department. 

Once we get overloaded, things slip. They don’t get done as thoroughly, with 

the degree of coordination, or in the right priority as would be the case

otherwise.378

The Controller’s 2002 performance report echoed the 2001 report. The CFO urged the 

Controller to focus on staff development and coaching.

379 Also, the CFO noted the 

following feedback from fellow officers regarding the lack of resources in the Controller’s 

function. A survey revealed that the lack of resources in the Controller’s Department 

 377 OFHEO Interview, Ms. Leanne Spencer, August 12, 2004, pp. 68-70. 

378 2001 Performance Review: Leanne Spencer, by Timothy Howard (FMSE 220309). 

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379 The 2002 Performance Evaluation from Tim Howard to Leanne Spencer, dated December 30, 2002, 

states the following: “Truth to be told, Leanne, it was your subordinates’ comments about your attention to 

their development needs that caused me to hesitate to recommend you for “SE” consideration this year, 

notwithstanding the phenomenal year you had on the results side. If you get your people development 

skills up, you should be able to waltz across the SE goal line.” FMSE 220311-220314. 
was identified across business functions and these comments were noted in Leanne

Spencer’s 2003 annual performance review: 

“She needs to fill out her team and invest more in her functions.” 

“I think the area for development is in realizing how much the world has 

changed and needing to get ahead of those changes in terms of her

organization, resource levels and other investments in today’s controllership 

function.” 

“She needs more depth in certain functions.” 

“The fact that her staff is overworked and under such extreme resource pressure

is apparent.” 

“Because she runs such a lean shop her employees also don’t have much time to 

develop their skills or attend training.”380

Interviews with other executives within the Controller’s Department revealed a similar limited 

knowledge of accounting standards and indicated a significant reliance on Financial Standards 

regarding technical accounting matters. 

Vice President for Financial Accounting

 

During testimony, Mary Lewers, Vice President of Financial Accounting, indicated that she has 

been employed at Fannie Mae for 21 years working in various financial accounting positions. 

Mary Lewers noted that the responsibility to produce accurate financial statements rests with 

others. She insisted that her responsibility is limited to accounting operations and ensuring that 

“...the transactions are processed and that the accounting is appropriate as per the guidance 

that would have been provided to my team.”381

Q: So, with respect to these various areas then, is it your group's responsibility 

to ensure that the transactions are accounted for properly in accordance with

generally accepted accounting principles? 

A: The responsibility of my group would be to work alongside the Financial 

Standards group. The Financial Standards group would establish the Fannie 

Mae's policy for Accounting. And so then the individuals on my team would be; 

their responsibility is to manage the processes and to ensure that our accounting 

is in compliance with that policy.382 

OFHEO noted that she characterized her current level of knowledge as limited regarding 

amortization of purchase premium, insisting that she is still working on developing an 

380 2003 Performance Review: Leanne Spencer, by Timothy Howard (FMSE 220317). 381 OFHEO Interview, Mary Lewers, July 13, 2003, pp. 15-16. 

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382 OFHEO Interview, Mary Lewers, July 13, 2003, p.20.
understanding of the broader concepts behind FAS 91.383 Mary Lewers testified that she is 

becoming familiar with this area for which she currently has the responsibility to manage. She 

was assigned these duties in 2003. 

When questioned regarding aspects of the Enterprise’s hedge accounting policies and its 

compliance with GAAP, Mary Lewers asserted that she relies on Financial Standards to 

determine compliance with regulatory standards:

Q: Do you believe it is in compliance with FAS 133, the specific discussion that we've 

just had in terms of having just a second swap at the inception of the second hedge

relationship be equal to zero? 

A: I have been--I'll go back to kind of what I said earlier. FAS 133 is a very technical 

area of accounting, and it's one that I rely upon the expert advice of the Financial 

Standards Group to establish our policy, and that my understanding of our policy is that 

we assess the fair market value of zero at the beginning of each of these hedge 

instruments that we enter into and that that's the point where we apply that test. 

Q: So does that mean--is your answer implying that you think it's consistent with FAS 

133? ... 

A: And I'll go back to that I have found that FAS 133 is a very complicated area of 

accounting, and it's one that I look to get expert advice on how to interpret--the 

interpretation into our policy, and so I rely upon the information supplied to me by 

Accounting Standards, and that that appears to be appropriate accounting to me based 

on that advice. 

Q: You're a CPA yourself, right? 

A: Yes, I am. 

Q: Have you given these issues a great deal of thought yourself? 

 383 OFHEO Interview, Ms. Mary Lewers, July 13, 2004, pp. 241-243 

Q: Ms. Lewers, I think we spoke to you earlier about your involvement in the amortization process on

another date. I just wanted to clarify some of that quickly today. Could you tell us what your involvement 

and responsibility is with respect to the process of calculating amortization? 

A: Are you referring to FAS 91? 

Q: Yes. 

A: Historically, my involvement with FAS 91 has been a very limited component of this accounting. In that 

accounting I had responsibility for what used to be PDS, became PDI, and the iPDI, which was a system 

that tracked balances and that received factors from another system, and then the PDS/PDI/iPDI, that 

system would take balances, apply factors, and then generate an amortization amount that would then be

booked to the general ledger. And so that piece of the FAS 91 process was my area of responsibility. 

Q: And has that changed at all over time? 

A: In the past, I think about last summer maybe, the organization – we did some reorganization of 

individuals, and so the individuals who have responsibility for this area now reports in to me. And so I’m in 

what I would call a transition phase in that I have been learning and working developing an understanding 

of the broader concepts behind FAS 91. But that effectively Janet Pennewell has really been more the 

supervisor in charge of this area. 

Q: I guess in the past year you’ve been becoming more involved in the process. Is that a fair statement? 

A: Well, I haven’t really devoted much time to it until the last few months, and my – so I’m not – I have not 

mastered this subject area. 

Q: As of today, if there was an important management decision to be made regarding the process of 

amortization, would you be involved in that decision?

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A: I would probably be involved in hearing the discussion that went on, but I would not be the one making 

the decision. 
A: I spend a fair amount of time on this, but I have to also remind everyone that this is

not my only area of responsibility, and that my responsibility covers a broad range of 

accounting topics. This is an area that--so it's one of several areas that I work with, and

it's one that has--it's a very technical area and it's one that--there are people in the

company, in Fannie Mae, who work on this on a more day-to-day basis than myself. 

Q: FAS 133 is one of the company's critical accounting policies, is that correct? 

A: Yes, it is384

OFHEO believes that the Vice President for Financial Accounting does not have sufficient 

knowledge of the technical accounting requirements related to SFAS 91 and SFAS 133 to 

adequately perform her duties. Based on Mary Lewers’ testimony, it appears that she takes no 

responsibility for ensuring that the accounting policies that are being implemented are in 

compliance with GAAP and over relies on the Financial Standards group for interpretation of the 

accounting standards. 

OFHEO noted that staffing shortages also exist in the Controller’s department related to FAS

133 accounting. In a memorandum dated February 2, 2004, from Cheryl DeFlorimonte, 

Director, Accounting and Audit, the situation was described as a crisis: 

This memo serves to bring to your attention, my concern about the limited resources 

that are currently in place to meet ongoing FAS 133 production challenges, as well as to 

spearhead the re-engineering initiative. 

With one and a half business analysts currently assigned to FAS 133, monthly 

production operations is in crisis. This situation has been exasperated by the recent

DNQ policy change. As a result of this change, there are additional data requirements 

for monthly processing, new reconciliations and validations, manual overrides and 

additional manual journal entries. Further, we continue to flush out additional issues

associated with this recent policy change. 

Coupled with these production challenges, is the increasing demand on our limited 

resources to spearhead the FAS 133 re-engineering project. Currently, with total 

resources of one and a half business analysts and a part time contractor to undertake 

both production and the re-engineering project, we are at high risk for slippage on both 

fronts. In fact, both activities cannot be successfully performed with the present 

resources....385

Conclusion

OFHEO believes that Fannie Mae failed to adequately exercise their duty to develop sound

accounting policies at Fannie Mae. The Enterprise failed to develop an internal control system 

to ensure that accounting policy was sufficiently developed and reviewed. A combination of 

heavy workload, weak technical skills and a weak review environment contributed to the 

development of key person dependencies. Fannie Mae relies on just a few individuals to make 

key decisions, particularly those related to accounting policy development. A cornerstone of 

 384 OFHEO Interview, Mary Lewers, July 13, 2003, pp.152-153. 

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385 Memorandum attached to email from Cheryl DeFlorimonte to Leanne Spencer, Subject: FAS 133 

Resources, dated February 2, 2004, DeFlorimonte 08112203 
sound corporate oversight is the control structure itself. The board of directors and 

management are responsible for promoting high ethical and integrity standards, and for 

establishing a culture within the organization that emphasizes and demonstrates to all level of 

personnel the importance of internal controls. 

It is management’s responsibility to ensure that Fannie Mae operates in a safe and sound 

manner and has proper segregation of duties, an adequate level of controls to support its key 

business processes, and clear and appropriate accounting policies. In addition, it is 

management’s responsibility to ensure that key control function personnel are competent and 

qualified to execute their daily responsibilities.386 OFHEO contends that the CFO, as the primary 

manager for key financial reporting and accounting areas, failed in providing adequate oversight 

to key control and reporting functions within the Enterprise. In addition, he developed and 

rewarded387 a staff that collectively does not possess the skills necessary to ensure that Fannie 

Mae has proper accounting policies, adequate resources to support proper implementation of

such policies, and an effective system of internal controls.

 386 Both the Group of Thirty and the Basel Committee on Banking Supervision both emphasize it is 

management’s responsibility to ensure that key control function personnel are competent and qualified to 

execute their daily responsibilities. 

Group of Thirty Report, Enhancing Public Confidence in Financial Reporting, Washington DC 2003, p. 14. 

Bank for International Settlements, Basel Committee on Banking Supervision, Framework for the 

Evaluation of Internal Control Systems, January 1998, p. 11. 

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387 Id., p. 12. The Committee on Banking Supervision also states that, “In reinforcing ethical values, 

banking organizations should avoid policies and practices that may inadvertently provide incentives or 

temptations for inappropriate activities. Examples of such policies and practices include undue emphasis 

on performance targets or other operational results, particularly short term ones; high performancedependent compensation rewards; ineffective segregation of duties or other controls may offer 

temptations to misuse or conceal poor performance; and insignificant or overly onerous penalties for 

improper behaviors. 
APPENDIX I 

Estimation Methods Used for Modeling the Catch-Up

A. Background

In assessing the methods and discipline applied by Fannie Mae for determining prepayments 

used to calculate the catch-up, OFHEO has concluded that Fannie Mae 1) designed and 

applied estimation methods, and 2) selected assumptions used in the calculation of 

the catch-up, for the improper purpose of managing its current and prospective 

financial results. In addition, OFHEO has determined that Fannie Mae applied 

methodologies for determining prepayment assumptions that were alternatively 

different for the retrospective adjustment and prospective amortization required 

under SFAS 91. 

In order to calculate the quarterly adjustment necessary to recognize a constant effective yield 

required by SFAS 91, the Enterprise needed to calculate the estimated life of the mortgage

loans and securities associated with the deferred price adjustments to be amortized. The 

estimated life of such mortgage assets is a function of expectations regarding the likelihood of 

consumers to prepay their mortgages, which itself is a function of future interest rates. If 

future interest rates decline, then consumers would likely be disposed to refinance mortgages 

they have previously financed at higher rates. Alternatively, if future rates increase, there 

would be a reduced incentive to refinance since doing so would only result in the consumer 

obtaining a higher rate mortgage. 

The propensity of consumers to refinance is intuitively understood by many. However, the 

methods for forecasting future interest rates, and determining the impact of these forecasts on

the rate at which consumers will prepay their mortgages, is better understood by finance 

professionals or economists with experience in such modeling. While these professionals 

themselves may disagree on the specific assumptions and models that may be used to forecast

prepayments, there are nevertheless methods, and an accepted discipline in applying those 

methods, that most such professionals would agree on. The methods used by Fannie Mae 

were less sophisticated than the Enterprise had the capability to support, and 

furthermore produced flawed results.

 

The December 2000 policy codified the methodology by which each quarter’s catch-up amount 

would be estimated; 

 

The catch-up position is calculated using the average of five interest rate

scenarios – the base rate together with the four sensitivity runs that encompass 

a 95% confidence interval around that base rate (currently +/- 60 and 120 basis 

points388).389 The base rate will normally be consistent with the rate that is used 

388 Basis point (bps) is defined as one hundredth of a percentage point (0.01%). 

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389 While the policy to this day specifies that the scenarios around the base rate will be +/- 60 and +/- 120, 

the interest rate scenarios applied around the base were changed to +/- 50 and +/- 100 immediately after 

the policy was adopted for the calculation of the Q1 2001 amortization estimate. This range of scenarios 

was consistently applied for the period 2001 through to the current period in 2004. 
in our most current business plan. However, if circumstances exist that cause us 

to use a different a different rate path we will document the rationale for the 

rate path used. At all times the base rate and the standard sensitivities will 

encompass a 95% confidence interval around the rate that was used. 

In providing commentary regarding the functionality of amortization modeling software 

the Enterprise was using, Ms Janet Pennewell also commented on management’s views 

concerning the use of the multiple interest rate scenarios390 (also referred to as “rate 

paths”) described in the amortization policy: 

Q: [...] Ms. Pennewell, do you recall any discussion around the ability of BancWare to 

manipulate factors to produce an array of recognition streams? 

A: Yes. 

Q: And can you elaborate on that? 

A: Sure. At this point your previous question, we talked about a group of us working on 

how to enhance our models and begin thinking about formalizing a policy for our 

premium and discount. And again, our thinking really was that you have a current

interest rate pattern today, and our recognition was that FAS 91 requires you to try to 

project what you think the average life of your mortgages is going to be. Obviously, 

that first requires that you can project what interest rates are going to be, and then 

within that interest rate path know what prepayments are going to be so that you can 

get a correct effective life to calculate your constant effective yield. 

 And we recognized that we weren't very good at projecting where interest rates were 

going to be, and even if we could accurately project where interest rates were going to 

be, that we--that there was then a range of very reasonable prepayment assumptions 

that would fit with that interest rate projection. 

 And so we were in the process of saying, well, we don't want to run one scenario

with one interest rate assumption and fool ourselves into thinking that that with 

precision is, is exactly what our catch-up position is. And so we were beginning the 

process of figuring out how to put together a policy that would address a couple very

key pieces of assumption risk, namely, our ability to forecast interest rates, and our 

ability to, within an interest rate path, to, with precision to project what prepayments 

were going to be, and to want to have a modeling tool that gave us the flexibility to 

potentially, say, use BancWare run 5, 10 different scenarios, maybe in different interest 

rate paths that might capture the kind of variation that you really would expect to 

happen in interest rates, and then average them together. 

 So BancWare, initially, is my recollection, was set up to say you kind of put in one 

path of interest rates, and then whatever catch-up number that produces, that you 

would—the assumption in BancWare was that you would record that to income. Instead 

we thought what we needed was not just one path of interest rates, but again a range 

of paths of interest rates where we may want to average them together, recognizing the 

lack of precision that's inherent in projecting interest rates and prepayments. 

 And so then we needed a model that would then give us the flexibility to not just 

book our entries or produce our factors--because the BancWare and then later AIMS is a 

system that we used to calculate what--calculate factors that allow us to record the 

 

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390 OFHEO Interview, Ms. Janet Pennewell, June 15, 2004, pp. 21-24 
constant effective yield. Those factors the actually get fed into another system which

actually calculates the amount that would get booked through the general ledger. 

 Anyway, so, in order to produce a good set of factors we needed a model that

didn't just, say, give me one interest rate path and produce one set of factors. We

needed the ability to, as I said, capture a range of assumptions and adjust the factors to 

reflect that range of assumptions.

B. Development of Amortization Estimation Methods

 

The first written recommendation by the amortization policy analysis group concerning the 

modeling of interest rates and prepayments was contained within the September 23, 1999 

memorandum391 to Tim Howard from Janet Pennewell. This memorandum noted that while 

amortization was estimated and recorded using a single flat rate path, the Enterprise used 

multiple rate paths (up 75 bps, up 150 bps, down 50 bps and down 100 bps) for the purposes

of forecasting earnings. The memorandum went on to state the recommendation that the 

multiple rate paths used for forecasting, also be used for the purposes of estimating and 

recording deferred price adjustment amortization.

392 This memorandum further recommended 

that the forecast be determined using “a probability weighted average of the base plus four 

standard scenarios.”

393

Another memorandum394 to Tim Howard, dated December 16, 1999, recommended that the up 

and down scenarios be established by determining the respective +/- one standard deviation395

(1 std.) and +/- two standard deviation (2 std.) rate paths. The memorandum further 

recommended the specific statistical weighting to be assigned to each of the rate paths; 

weighting values of 30% for the base rate path, 20% for both the up and down 1 std. rate 

paths, and 15% for the up and down 2 std. rate paths. Other analysis396 also included within 

the memorandum suggested that the ranges used for the up and down 1 and 2 standard 

deviation rate paths be the up 75bp, down 50bp and up 150bp, down 100bp rate paths 

referenced in the September 23rd memorandum. 

While finance professionals and economists may disagree on the specific probabilities

associated with upward or downward movements in interest rates, they would most certainly 

agree that significant (2 standard deviation) upward or downward movements in interest rates 

are less likely to occur than more modest (1 standard deviation) upward or downward

movements. In addition, many finance professionals would also agree that a 1 or 2 standard

deviation upward movement would be inherently larger than a 1 or 2 standard deviation 

391 Memorandum from Ms. Janet Pennewell to Mr. Tim Howard, dated September 23, 1999, Subject: 

Policy on Purchase Premium/Discount Management. FMSE-SP 000106-000109

392 As far as OFHEO can determine, the Enterprise did not use multiple rate paths to determine the 

estimate of deferred price adjustments amortization – or catch-up – until after it formally adopted its 

accounting policy for ‘purchase premium and discount amortization’ in December 2000 

393 Memorandum from Ms. Janet Pennewell to Mr. Tim Howard, dated September 23, 1999, Subject: 

Policy on Purchase Premium/Discount Management, FMSE-SP 000106-000109. 394 Memorandum from Ms. Janet Pennewell and Mr. Jeff Juliane to Mr. Tim Howard dated December 16, 

1999, Subject: Catch-up Policy. FMSE 217559-217569. 395 Standard deviation is a statistical measure of the historical volatility and generally a measure of the 

extent to which numbers are spread around their average. 

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231 Memorandum from Ms. Janet Pennewell and Mr. Jeff Juliane to Mr. Tim Howard dated December 16, 

1999, Subject: Catch-up Policy. FMSE 217567. 
downward movement. While this last point is debatable, it is clear that thus far in their 

thinking, Fannie Mae also agreed with this conclusion. 

A memorandum397 dated April 5, 2000 from Mr. Jeff Juliane to Ms. Leanne Spencer provided a 

first quarter updated 2000-plan analysis of the catch-up. This analysis utilized probability 

weighted rate paths to project catch-up amounts for the years 2000 to 2003, using the five 

interest rate scenarios, but instead modified the up and down 1 and 2 standard deviation 

movements to be a consistent basis point magnitude of +/- 60bps and +/- 120 bps respectively 

representing a change from the Enterprise’s earlier forecasting assumptions. 

On May 8th 2000, another memorandum398 from Mr. Jeff Juliane now recommended that a

simple average -rather than a probability weighted mean- of the five rate paths be used. 

Analysis included with this memorandum provided equal weights to each of the rate scenarios. 

The effect of this change was to reduce slightly the estimate of positive (income) catch-up for 

each of the current and subsequent years. 

Another memorandum dated June 21, 2000, from Mr. Jeff Juliane to Mr. Tim Howard describes

the impact of an alternative estimation method known as mean reversion. Mean reversion is a 

statistical term to describe, in this instance, a tendency that interest rates in the +/- 120bp 

‘shock’ scenarios would trend back or revert to a “rolling five year average.” This assumption 

had an additional modest impact to reduce the estimate of positive (income) catch-up over the 

forecast horizon to December 2003. In the memorandum, Mr. Juliane noted the following: 

It is worth noting that the mean catch-up difference between the Freddie399

mean reversion technique and our standard sensitivity methodology is not that

large, $61.1 million at December 2003. This is due to the natural hedge that is 

occurring between our core book of business and the REMIC and GFEE books of

business. 400

Still another memorandum,401 dated September 15, 2000, from Ms. Janet Pennewell to Mr. Tim 

Howard provided another analysis of estimated catch-up over a forecast horizon through to 

December 2003. This analysis showed an even larger decrease in the estimate of positive 

(income) catch-up through to 2003, of approximately $261.4 million over the June 21, 2000 

analysis. This analysis differed from previous ones in that the use of short-term constant 

 397 Memorandum from Mr. Jeff Juliane to Ms. Leanne Spencer, dated April 5, 2000, Subject: 

Amortization Sensitivities, FMSE-SP 000236 – 000238. 

398 Memorandum from Mr. Jeff Juliane to distribution, dated May 8, 2000, Subject: Amortization/Catch-up 

Management Process, FMSE 217527 to FMSE 217531. The distribution list includes Mr. Tom Lawler, Ms. 

Leanne Spencer, and Mr. Rene LeRouzes.

399 This was referred to as the “Freddie Method” because the Enterprise had understood it to be the 

methodology employed by Freddie Mac. OFHEO’s procedures did not extend to determining if this 

method was ever employed by Freddie Mac 

400 Memorandum from Mr. Jeff Juliane to Mr. Tim Howard, dated June 21, 2000, Subject; Amortization 

Policy Runs, FMSE 217521 – FMSE 217526.

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401 Memorandum from Ms. Janet Pennewell to Mr. Tim Howard, dated September 15, 2000, Subject: 

Amortization Policy, FMSE-SP 000016 to FMSE-SP 000028. The distribution list includes Ms. Leanne 

Spencer, Mr. Jeff Juliane, and Mr. Tom Lawler. 
prepayment rates (CPRs) was extended from 3 months to 24 months. This had the effect of 

reducing the estimate of positive catch-up (income).402

The table below shows the progressive change in forecasted catch-up under the different 

methods described in the previously noted memorandum: 

 

5-Apr-00 8-May-00 21-Jun-00 15-Sep-00 Difference

Analysis Analysis Analysis Analysis 4/5 to 9/15

December-00 $183.0 $179.3 $122.9 $88.8 ($94.2)

December-01 $222.0 $219.0 $184.3 $125.5 ($96.5)

December-02 $258.0 $255.0 $242.6 $165.1 ($92.9)

December-03 $292.2 $290.7 $297.3 $206.3 ($85.9)

Base rate path used 8.65% 8.65% 8.06% 8.40%

Book used Jan-00 Jan-00 Apr-00 May-00

Reference FMSE-SP 000237 FMSE 217529 FMSE 217523 FMSE-SP 000018

Date

OFHEO has concluded that the Enterprise sought to maintain a positive level of catch-up when 

the amortization policy was formulated in 2000. OFHEO also believes that the effort of continual 

iterative analysis, and subsequent choices in methodology made by Fannie Mae management, 

reflected a consciously determined objective to understate the amount of estimated catch-up

itself to better facilitate 1) shifting income between reporting periods (from 2000 to 2001) or 2) 

converting earnings that would otherwise be subject to volatility to earnings that would be 

recognized in a more stable pattern. The contention that income was shifted from 2000 to 

2001 will be demonstrated by other actions taken by management as described in Section D of 

the Report. 

The methodological choice to migrate from a probabilistically determined mean catch-up to one 

determined by calculating a simple mean is not grounded in any sound statistical or finance 

theory. Moreover, calculating a simple mean did not reduce the effort or complexity of

estimating the catch-up in any meaningful way. Furthermore, while modifying the up and down

rate paths - so that they were equal in their basis point magnitude - is a defensible simplifying 

accounting convention; it is clear that the Enterprise had a previously established view on, as 

well as capability to support, what management previously regarded as better practice. Third, 

while mean reversion was not incorporated as a standard convention of the Enterprise’s 

estimation methodology, management nevertheless adopted – as part of the December 2000

policy – the ability to use a different rate path. This flexibility extended to choosing not only 

the level of interest rates used in the base rate path, but also other assumptions regarding 

interest rate behavior. The manifestation of this flexibility included assumptions made by 

management – in the estimate of Q2 2003 deferred price amortization - regarding their 

expectation that interest rates would rise from historic lows back to higher levels. In this 

 

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402 Untitled, undated document from Mr. Tim Howard to Ms. Janet Pennewell labeled “Notes for Janet” 

states “Lost $78 million in catch up due to methodology change (short term CPR’s were changed from 3 

months to 24 months) to slow down the recognition of discount into income in request to reducing the 

positive catch-up and transferring income into outer years.” FMSE-SP 002590 
instance, the employment of this discretionary assumption allowed management to increase 

income in a measured way. The ability to exercise such judgment in determining rate paths 

was even better than mean reversion because it could be employed at the discretion of

management. 

C. Use of Multiple Rate Paths

Beyond the specific assumptions used to develop the multiple rate paths, the use of multiple 

rate paths itself had two further significant effects on the estimate of deferred price 

amortization: 

1. Fannie Mae was generally asymmetrically exposed to changes in interest rates 

insofar as the income statement impact of deferred price adjustment amortization

was concerned. Asymmetrical exposure means that the financial impact to the 

Enterprise of interest rate movements in one direction is greater than the impact of

rate movements of similar magnitude in the other direction. In 2000, and for most 

other subsequent periods, downward movements in interest rates affected the 

Enterprise’s net income greater than upward movements of similar magnitude. This 

effect is illustrated by the following analysis of data taken from the sensitivity 

modeling results for the forecast of December 2000 catch-up included in the 

September 15, 2000 memorandum: 

Estimated Deviation 

Catch-up From Base

Up 120 bps - 9.6% $139.9 $18.5

Base - 8.40% $121.4 -

Down 120 bps - 7.2% ($2.5) ($123.9)

Source: Memorandum from Ms. Janet Pennewell to 

Mr. Tim Howard, dtd 9/15/200, FMSE-SP 000018.

Rate Path Scenario

 

As can be seen from the above analysis, the income statement impact of $123.9 

million in expense of the down 120bps scenario is much more dramatic than the 

$18.5 million income statement impact to income of the up 120bps scenario. This 

asymmetrical effect of interest rate moves on deferred price adjustment amortization 

was consistent with the Enterprise’s typical portfolio profile. This effect and profile 

was well understood by management.403

 403 An undated memorandum titled “Suggested Amortization Strategy” states the following: “On the 

second issue, I would recommend that the desired level of the catchup at any given time be equal to the 

average of the “up 120bp” catchup estimate, the “down 120 bp” catchup estimate, and the “base” catchup

estimate, assuming the base catchup estimate were zero. Given the asymmetric nature of our catchup – 

the catchup usually becomes more negative when rates go down that [sic than] it becomes positive when 

rates go up, following the asymmetric response of prepayments to changes in interest rates – this 

recommendation would imply that our target catchup level will usually be somewhat positive.” The 

memorandum also contains handwritten notes indicating “from Tom April 00,” which was confirmed by 

testimony provided by Mr. Tim Howard to be referring to Mr. Tom Lawler. FMSE 217556-217557 

Special Examination of Fannie Mae 

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The consequence of using multiple rate paths to determine an estimate of average 

catch-up was that the estimated amount of catch-up would be lower (during this 

time period) than if just the base rate path was used. The analysis below, using 

Fannie Mae sensitivity modeling for the forecast of December 2000 catch-up 

included in the various memoranda referenced previously, illustrates this effect 

further. 

 

5-Apr-00 8-May-00 21-Sep-00

Analysis Analysis Analysis

Base Path - Est. Catch-up $160.1 $160.1 $96.2

Mean - Est. Catch-up $146.1 $142.3 $70.1

Difference ($14.0) ($17.8) ($26.1)

Method Applied Weighted Avg. Simple Avg. Simple Avg.

Reference: FMSE-SP 000237 FMSE-217529 FMSE-SP 000018

Rate Path Scenario

In her testimony cited previously, Ms. Pennewell explained the rationale for using 

multiple rate paths: 

Anyway, so, in order to produce a good set of factors we needed a model that 

didn't just, say, give me one interest rate path and produce one set of factors. 

We needed the ability to, as I said, capture a range of assumptions and adjust 

the factors to reflect that range of assumptions.404

In fact, however, Fannie Mae did not use the multiple rate paths to establish the

prospective estimated life over which deferred price adjustments would be amortized. 

Mr. Jeff Juliane confirmed this in his testimony:

 

Q: Would the – I think – you testified earlier the base scenario would be the one 

that would be used for the factor change that would occur the month after the 

quarter end? Is that correct? 

A: That’s correct. 405

In later testimony during that same interview: 

404 OFHEO Interview, Ms. Janet Pennewell, June 15, 2004, p. 24 

405 OFHEO Interview, Mr. Jeff Juliane, August 31, 2004, pp. 141-142 

Q: I think you justified [sic. testified] earlier that the base-rate scenario would be the one that would be 

used for the factor change that would occur the month after the quarter end; is that correct? 

A: That is correct. 

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Q: So the question I have is what impact would the multiple scenarios have on 

the factors used to amortize premium and discount balances going forward? 

A: Can I ask you back what I think you’re asking? 

Q: Uh-huh. 

A: Are you asking, to the extent what are the nonbase runs, how do those 

nonbase runs impact the factors? 

Q: Going forward, yes.

A: Currently, they don’t. 

Q: So, if the multiple scenarios are based upon the uncertainty of future interest

rates, but they really don’t affect the amortization in the future, then what is the 

multiple scenarios used for? 

A: Let me step back. They impact the prospective recognition of amortization to

the extent that the five runs lead us to be outside of compliance with policy and 

take an on-top. We also have identified this as a requirement in our current 

rebuild of the AIMS system, so we are now – I don’t know if you guys have 

heard this yet, we are getting re-engineered right now, and we’re going to have

a system called MARS, Modeling And Reporting System. And when we do rate 

changes, it’s going to be based upon all five scenarios. 

It was an operational implementation thing that we couldn’t do it when we went 

with AIMS. It was something that we discussed, but we couldn’t operationally 

implement it when AIMS went live.406

The multiple rate scenarios of future interest rates, therefore, only impacted the 

retrospective (historical) element of the amounts required to be recognized by SFAS 91. 

Effectively, Fannie Mae was applying different estimated lives in the calculation of 

deferred price adjustment amortization. One set of estimated lives – based upon a 

methodology that resulted in lower estimates of catch-up than the base rate path would 

have suggested – for the determination of the current quarter’s retrospective 

adjustment, and another set of estimated lives – based solely upon the base rate path – 

for the determination of the rate of prospective amortization. 

2. The use of the multiple rate paths also had the effect of reducing the volatility of the 

retrospective adjustment required under SFAS No. 91. This effect is demonstrated in 

the graphs provided in the section titled “Historical Analysis of Accounting for Deferred 

Price Amortization.” The reason for this is that the change in quarterly catch-up, from 

period to period, is going to be greater if that change is based upon fluctuations in one 

rate path, versus the fluctuation in multiple rate paths that are averaged together. 

When five rate paths are averaged, the resultant impact from change to one rate path is 

likely to be partially offset from the resultant impact of change to a different rate path. 

In that regard, deferred price adjustment amortization - using a multiple rate path

estimation method – is going to be less affected by fluctuations in rates, than it will be 

by sustained upward or downward trends in rates. 

The behavior of results produced by the Enterprise’s method for estimating deferred 

price adjustment amortization was also understood by management. Mr. Tim Howard 

commented on this:407

 

Special Examination of Fannie Mae 

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406 OFHEO Interview, Mr. Jeff Juliane, August 31, 2004, pp. 144-145.
Q: Do you have a sense for how frequently the modeled estimate would exceed 

a plus or minus 1-percent threshold? 

A: The modeled estimate? The calculated catch-up amount?

Q: Yes.

A: No, I don’t. It will do that when interest rates are trending more often than 

when they’re simply volatile at random- 

 

OFHEO has concluded that the use of multiple rate paths facilitated the shifting of 

income from 2000 to 2001 and also served to reduce the volatility of the current 

quarter’s retrospective adjustment of deferred price adjustment amortization for all 

reporting periods. 

D. The Application of Estimation Methods in 1999 and 2000

 

OFHEO’s conclusion that Fannie Mae management purposefully selected methods to 

understate the estimate of catch-up for prospective periods is corroborated by the 

Enterprise’s actions in applying estimation methods during the time frame 

coincident with the development of those methods. 

 

Except where specifically noted otherwise, the following information408 was provided to OFHEO 

by Fannie Mae. In addition, certain information has been specifically highlighted (circled) and 

referenced. 

407 OFHEO Interview, Mr. Tim Howard, August 5, 2004, pp. 158-159. 

Special Examination of Fannie Mae 

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408 Document titled “Fannie Mae PDA Catch-Up.” Typed notation indicates “Forwarded to Peat on

10/06/00.” Handwritten notation indicates “to KPMG 10/6/00.” FMSE-SP 002434 
Unapplied Corporate Fannie Mae 30 Yr Fixed FRM CPR Basis Point

PDAMS REMICS On-Tops Total Current Coupon1 Rate Mortgage Based on Difference2

Dec-98 (178.2) (298.0) 276.5 (199.7)

Jan-99 (76.7) (74.5) 17.9 (133.3) 6.28 6.79 6.75 0.04

Feb-99 (95.1) (73.0) 34.8 (133.3) 6.69 6.81 6.75 0.06

Mar-99 (66.7) (78.7) 32.5 (112.9) 6.64 7.04 7.00 0.04

Apr-99 (69.0) (81.3) 46.6 (103.7) 6.66 6.92 7.00 (0.08)

May-99 (73.9) (81.3) 60.5 (94.7) 6.99 7.15 7.00 0.15

Jun-99 (53.7) (144.6) 66.7 (131.6) 7.21 7.55 7.25 0.30

Jul-99 (55.7) (142.5) 75.9 (122.3) 7.52 7.63 7.25 0.38

Aug-99 (56.3) (121.6) 82.9 (95.0) 7.69 7.88 7.25 0.63

Sep-99 2.5 (68.5) 88.9 22.9 7.45 7.90 7.90 0.00

Oct-99 2.6 (66.2) 99.8 36.2 7.46 7.85 7.90 (0.05)

Nov-99 4.4 (66.2) 121.9 60.1 7.60 7.74 7.90 (0.16)

Dec-99 6.7 (59.0) 136.3 84.0 7.80 7.91 7.90 0.01

0.00

Jan-00 (14.6) (48.0) 127.6 65.0 8.10 8.21 8.05 0.16

Feb-00 (20.4) (48.0) 127.6 59.2 8.01 8.33 8.05 0.28

Mar-00 (20.0) 23.6 127.6 131.2 7.96 8.24 8.05 0.19

Apr-00 (44.9) 60.7 119.7 135.5 8.08 8.15 9.00 (0.85)

May-00 (46.0) 64.8 111.9 130.7 8.24 8.45 9.00 (0.55)

Jun-00 (59.2) 48.0 104.1 92.9 7.92 8.52 8.40 0.12

Jul-003 (56.5) 57.0 96.3 96.8 7.94 8.29 8.40 (0.11)

1 source: www.ubs.com

2 Computed by determining the difference between the rate provided in the column labeled '30 Yr Fixed Rate Mortgage'

and the rate provided in the column labeled 'FRM CPR Based on'

3 Fannie Mae did not provide OFHEO with a similar analysis for periods subsequent to July 2000.

Period

c

a

b

f

e

d

 

The above information provides the actual catch-up calculated historically by Fannie Mae and 

the related underlying interest rate assumptions. As can be seen, the relationship between 1) 

the interest rate upon which prepayment rates (“CPR”409) were based, and 2) the rate identified

by the Enterprise as the 30 year fixed rate mortgage (“FRM”), is tenuous. The basis point

difference between these two rates varies and, furthermore, the basis point difference is also 

sometimes negative and sometimes positive. In addition, it is clear that the CPR rate used for 

forecasting is held steadier by management than the FRM rate would otherwise suggest. 

Lastly, the Fannie Current Coupon Rate410 is also provided for comparison purposes as well. 

Changes in the Fannie Mae Current Coupon Rate correlate more closely to the FRM rate, than

the FRM rate correlate to the CPR rate. At a minimum, Fannie Mae’s selection of interest rate 

assumptions does not seem to have been determined in a systematical and objective method. 

The following is an analysis of certain specific actions that Fannie Mae management took with 

regard to setting the CPR rate. It should be understood, however, that OFHEO is conducting 

further review of the catch-up estimation rate setting process for periods both before and after 

1999 and 2000. 

 409 CPR stands for Constant Prepayment Rate. 

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410 The pass-through coupon in the mortgage-backed securities (MBS) market trading at or nearest to - 

but not exceeding - par. 
June ’99 (Note a): In June of 1999, the Enterprise had increased the percent of the REMIC

book which could be modeled to support the calculation of the constant effective yield required 

under SFAS No. 91. However, the modeling of a greater portion of the REMIC book had had an

adverse impact on the catch-up. According to a memorandum411 dated July 15, 1999, the 

incremental impact on the catch-up of the additional REMIC’s was approximately $72.5 million 

additional expense. When all other factors are considered, including a rate change from 7.00% 

to 7.25%, the negative catch-up associated with the REMIC book increased by $63.3 million. 

This brought the estimate of the total negative catch-up back over $100 million to negative 

$131.6 million. 

September ’99 (Note b): Three months later, the Enterprise’s catch-up had swung from the 

negative $131.6 million to a positive catch-up of $22.9 million – a large swing of $154.5 million 

of unrecognized positive income. $21 million412 of this swing can be accounted for by the 

modeling of additional REMICS. The remainder of the increase is due to the ‘in-use’413 rate 

change from 7.25% to 7.90%. 

As previously noted, it is difficult to draw precise conclusions from the relationship between 30 

year fixed mortgage rate and the ‘in use’ rate used to estimate prepayments. On the one hand, 

the change between the August versus the September 30 year mortgage rate was only 2 basis 

points. On the other hand, the 30 year fixed mortgage rate had in fact risen 86 basis points

since March 1999, when the ‘in use rate’ was at 7.00%. However, a memorandum414 from Mr. 

Jeff Juliane, dated one month before the September 2000 catch-up estimate was prepared, 

provides his perspective on the rate change: 

In the upcoming month, we will be initiating a rate change from our current 7.25% level 

to our Q3 Forecasted Rate Path of 7.90%. We would expect the quarterly change and 

subsequent slowdown in prepayment speeds to allow for further earnings flexibility and 

a subsequent improvement in the near term. 

March ’00 (Note c): The estimated catch-up for March ‘00 was determined in April ‘00. A 

memorandum415 from Mr. Jeff Juliane to Ms. Leanne Spencer, dated April 5, 2000, states that: 

"The Q1 sensitivities include the impact of process enhancements for REMICs, which 

now support the modeling of approximately 93% of the underlying book. This added

approximately $63.5 million additional catch-up income, and an average catch-up 

improvement of $30.1 million throughout the forecast horizon." 

 411 Memorandum from Mr. Jeff Juliane/ Rene LeRouzes to distribution, dated July 15, 1999, Subject: 

PDAMS/REMIC Results (May Book). Distribution included Ms. Janet Pennewell. FMSE-SP 003089 – 

FMSE-SP 003092 

412 Memorandum from Jeff Juliane/Rene LeRouzes to distribution, dated October 15, 1999, Subject: 

PDAMS/REMIC Results (August Book), distribution included Ms. Janet Pennewell. FMSE-SP 000328 

413 ‘In-use rate’ is a Fannie Mae term that refers to the rate being used to estimate prepayments. 

414 Document titled ‘Fannie Mae PDA Catch-up’. Typed notation indicates forwarded to Peat on 10/06/00. 

Handwritten notation indicates “to KPMG 10/6/00.” FMSE-SP 002434

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415 Memorandum from Jeff Juliane/Rene LeRouzes to distribution, dated October 15, 1999, Subject: 

PDAMS/REMIC Results (August Book), distribution included Ms. Janet Pennewell, FMSE-SP 000327-

000330 
The modeling of the additional REMICS also had the effect of increasing the March 2000 catchup to a positive (income) $131.2 million – above the informal pre-policy catch-up threshold.416 

The impact on estimated catch-up for prospective years is demonstrated on two schedules of 

sensitivity analysis that were attached to the April 5, 2000 memorandum.417 The first schedule 

shows the Year 2000 sensitivity analysis using the January book with 93% REMICS modeled, 

while the second schedule shows the Year 2000 sensitivity analysis using the previous October

book with 76% REMICS modeled. A comparison between these two schedules shows the

average catch-up improvement $30.1 million throughout the forecast horizon associated with 

the increased REMIC modeling, as well as an additional increase in catch-up due to the 

increasing rate environment: 

5-Apr-00 5-Apr-00

76% Remics 93% Remics

Dec-00 $115.5 $183.0 $67.5

Dec-01 $168.2 $222.0 $53.8

Dec-02 $215.8 $258.0 $42.2

Dec-03 $261.2 $292.2 $31.0

Base rate path used 8.05% 8.65%

Book used Oct-00 Jan-00

Reference FMSE-SP 000237 FMSE-SP 000238

Date Difference

Recall that at the end of 1998 Fannie Mae was confronted with the challenge of a larger than 

anticipated estimated current loss, of which approximately $200 million was deferred to 

subsequent periods. The situation now presenting itself to the Enterprise was the circumstance 

of a large unrecognized current period income, along with the expectation of greater forecasted

unrecognized income (positive catch-up) over its planning horizon. 

Coincidentally, the analysis in the April 5th memorandum418 was also the analysis whereby 

Fannie Mae changed its proposed catch-up estimation method to utilize up and down rate paths

of similar magnitude. Had this change in estimation method not been made, the forecast of 

future positive catch-up would have been even greater. 

 416 OFHEO Interview, Ms. Leanne Spencer, June 22, 2004, p. 61 

Q: You said before there was roughly a hundred million dollar threshold. 

A: I said that previously in when we were talking about inherent limitations of the model, what the model 

could do and couldn’t do, that our auditors understood those limitations, and that it was an unwritten 

policy that was not documented, but it was an established practice we had in operating on our auditors 

that a plus or minus 100 million represented the acknowledgement of the imprecision that exists in this 

estimation process in connection with our model. 

417 Id., memorandum from Mr. Jeff Juliane to Ms. Leanne Spencer, dated April 5, 2000, Subject:

Amortization Sensitivities. FMSE-SP 000236–000238. 

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418 Id., FMSE-SP 000237. 
April ‘00 (Note d): The estimated catch-up for April ’00 was determined in May ’00. A

memorandum419 from Jeff Juliane, dated May 23, 2000, notes that “Management has 

determined to implement a rate change with the April Book.” If the challenge however was 

large unrecognized income and large estimates of forecasted catch-up raising the ‘in use’ rate

would seem to make these challenges larger. One factor, that offset the effect of increase in

the base rate, was a change in the book. This offsetting impact as well as the change to the 

book was highlighted in an undated document titled ‘Notes for Janet – Explanation of results’ in 

a section of the document referencing a rate change from 8.05% to 9.0%, it states: 

 

Picked up $75 million in catch-up due to rate change and lost $30 million in catch-up 

due to change in book (recognizing too much discount into income). The amount of 

discount added from October of 1999 through April of 2000 was $1.4 billion dollars.420

 

Further mitigating the impact – on both current period as well as forecasted prospective catchup - of the decision to increase the ‘in use’ rate, was another decision, also reflected in the May 

23rd memorandum, to recognize $54.3 million of income. This had the effect of reducing both 

the current period catch-up as well as the forecasted catch-up. 

Lastly, also coincident with the decision to raise rates, was the further decision – reflected in

the May 8th memorandum421 - to use an un-weighted simple average rather than a 

probabilistically weighted mean of the multiple rate paths. 

May ’00 (Note e): The estimated catch-up for May ’00 was determined in June ’00. A 

memorandum422 dated June 16th from Rene LeRouzes highlights managements decision to 

recognize still more income. The memorandum states: “the Q2 sensitivities include $15.7 

million of applied on-tops (GFEE: $3.7 million, NII: $12.0 million) booked as of May.” 

Accordingly, another memorandum,423 dated June 26th provides a catch-up summary analysis 

showing the reduction of $70 million ($54.3 million from note d, plus $15.7 million as indicated 

in this note) from both the current period as well as the forecasted catch-up. However, the 

catch-up May ’00 remains at $130.7 million, well in excess of the $100 million mark. 

June ’00 (Note f): The estimated catch-up for June ’00 was determined in July ’00. The 

challenge of too high a level of forecasted catch-up in subsequent years continued to be

419 Memorandum from Mr. Jeff Juliane/ Mr. Rene LeRouzes to distribution, dated May 23, 2000, Subject: 

PDAMS/REMIC Results (March Book), FMSE-SP 000299 to FMSE-SP 000302. Distribution includes Ms. 

Janet Pennewell. 

420 Undated document titled: Notes for Janet – Explanation of results. This document was provided to 

OFHEO by Ms. Janet Pennewell, pursuant to OFHEO’s subpoena for information issued to her. The full 

reference indicated reads; ‘Picked up $75 million in catch-up due to rate change and lost $30 million in 

catch-up due to change in book (recognizing too much discount into income). The amount of discount 

added from October of 1999 through April of 2000 was $1.4 billion dollars.’ FMSE-SP 002590 

421 Memorandum from Mr. Jeff Julianne to distribution, dated May 8, 2000, Subject: Amortization/Catchup Management Process, FMSE 217527 to FMSE 217531. Distribution includes Mr. Tom Lawler, Ms. 

Leanne Spencer, and Mr. Rene LeRouzes. 

422 Memorandum from Rene LeRouzes to distribution, dated June 16, 2000, Subject; Q2-2000 Catch-up 

Sensitivities. Distribution included Mr. Tim Howard, Mr. Tom Lawler, Ms. Leanne Spencer and Ms. Janet 

Pennewell. FMSE-SP 002608-002609.

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423 Memorandum from Mr. Jeff Juliane/Mr. Rene LeRouzes to distribution, dated June 26, 2000, Subject; 

PDA/REMIC Results (April Book). Distribution includes Ms. Janet Pennewell. FMSE-SP 002611-002612.
addressed in earnest. Analysis prepared on July 10th contrasts one scenario with a 9.00% ‘in 

use’ base rate path, and a flat rate curve,424 with another scenario that used a 8.40% ‘in use’ 

base rate path, and a curve that used lower short-term interest rates for the first 24 months of 

the rate curve. The difference between these two methodologies was significant:

Q2 2000 Q2 2000

Version 1 Version 2 Difference

Dec-00 $155.2 $88.8 ($66.40)

Dec-01 $198.8 $125.8 ($73.00)

Dec-02 $238.1 $165.1 ($73.00)

Dec-03 $275.1 $206.3 ($68.80)

Method Mtg rate flat 24 mos. Sht term rates 

Base rate path used 9.00% 8.40%

Book used April '00 Book May '00 Book

Reference FMSE-SP 002822 FMSE-SP 002591

Date

The estimation method using short-term rates for the first 24 months of the rate curve had the 

effect of reducing the estimate of unrecognized income for all prospective periods. This

estimation method was also the method formally recommended by the working group to Tim 

Howard in the memorandum425 dated September 15, 2000. Furthermore, Fannie Mae in fact 

also changed the ‘in use’ base rate path for the estimation of the June ’00 catch-up from 9.00% 

to 8.40%. In addition to lowering the forecast of catch-up for prospective years, the change 

also addressed the other challenge of high (above 100 million) current period catch-up. 

Accordingly, the quarterly catch-up decreased approximately $38 million to $92.9 million. 

Although it is somewhat difficult to evaluate, the decision to lower the base rate path by 60

basis points to 8.40%, seems to be too large a decrease to be explained by the interest rate 

environment alone. Fannie Mae’s own analysis of catch-up and ‘in use’ rates used to determine 

prepayments, shows that 30 year fixed mortgage rates in fact rose to 8.52% from 8.45%. 

Alternatively, OFHEO’s analysis of interest rates shows that rates did indeed decline, but not by 

enough to justify the full amount of the decrease. OFHEO’s analysis shows that the 10 year 

treasury and Fannie Mae Current Coupon declined by only 32bps and 34bps respectively. 

Perhaps the rationale for both the change in estimation method as well as the decline in the ‘in 

use’ base rate path is also provided by the undated document426 titled ‘Notes for Janet – 

Explanation of results.’ In a different section of the document referencing a rate change from

9.0% to 8.4% it states:

 424 Fannie Mae’s catch-up estimation method heretofore utilized a flat rate curve. 

425 Memorandum from Ms. Janet Pennewell to Mr. Tim Howard, dated September 15, 2000, Subject: 

Amortization Policy, FMSE-SP 000016-000028. Distribution includes Ms. Leanne Spencer, Mr. Jeff 

Juliane, and Mr. Tom Lawler. 

Special Examination of Fannie Mae 

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183

426 Undated document titled: Notes for Janet – Explanation of results. FMSE-SP 002590 
Lost $20 million in catch-up due to rate change and picked up $30 million in catch-up 

due to change in book (recognizing to little discount into income). Lost $78 million in

catch up due to methodology change (short term CPR’s were changed from 3-months to

24-month) to slow down the recognition of discount into income in request to reducing 

the positive catch-up and transferring income into the outer years. 

E. Conclusion

Fannie Mae’s formulation, selection and application of estimation methods seems to 

have been made for the purposes of achieving desired results rather than for 

achieving good faith estimates of the highest quality. Furthermore, the estimation 

methods were not consistently applied to both the retrospective adjustment, and 

prospective amortization required by SFAS 91. Lastly, the selection of market rate 

assumptions was not made in an objective and consistent manner. Instead, priority 

was given to the financial statement impact of these assumptions. 

Special Examination of Fannie Mae 

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184
APPENDIX II 

Summary of SFAS 133, Accounting for Derivatives and Hedging Activities

The hedge accounting framework in SFAS 133 results in a matching of the earnings effect of

the change in fair value (or cash flows) of the derivative and that of the hedged item, by

offsetting them against one another in the same accounting period. As hedge accounting is 

elective, companies are able to designate a derivative as a hedging instrument at any time and 

apply hedge accounting prospectively as long as the related criteria are satisfied. Qualifying for

hedge accounting is important to many entities because of this matching effect that it provides 

in the income statement. 

Under SFAS 133, hedges can be classified as fair value hedges or cash flow hedges. The 

objective of a fair value hedge is to use a derivative to mitigate the variability in the fair value 

of the hedged item. In a fair value hedge, both the changes in the fair value of the hedging 

derivative and the changes in the fair value of the hedged item (usually an asset or a liability) 

attributable to changes in the risk being hedged are recorded in earnings.

427 Effectiveness for a 

fair value hedge is determined as the extent to which the changes in the fair value of the 

hedging instrument offset the changes in the fair value of the hedged item attributable to the

risk being hedged. The net difference represents the hedge ineffectiveness. The objective of a

cash flow hedge is to mitigate the variability of cash flows relating to a hedged item (usually a 

forecasted transaction) using a derivative. In a cash flow hedge, changes in the fair value of 

the hedging instrument are recorded in AOCI for the effective portion of the hedge, while the 

ineffective portion is recorded immediately in earnings. Amounts accumulated in AOCI are 

reclassified from AOCI to earnings in the period in which the hedged item affects earnings.428 

Hedge accounting is permitted only if the derivative is highly effective in hedging the identified 

hedged risk associated with the hedged transaction at inception and throughout the term of the 

hedging relationship.429 That is, in order to qualify for hedge accounting, the changes in the 

fair value or cash flows of a hedged item attributable to the risk being hedged must be 

expected to be largely offset by the related changes in the fair value of the hedging instrument. 

This expectation must be updated at least quarterly.430 Additionally, a hedger is required to 

support its expectation by either qualitative or analytical means referred to as an effectiveness 

“assessment.” SFAS 133 provides the hedger flexibility in identifying the methodologies used in 

assessing the effectiveness of these hedges; however, the methodologies selected must be 

reasonable and applied consistently to all similar hedges. Such methodologies must also be

specified in documentation prepared at the inception of the hedge and may not be changed 

retroactively. 

SFAS 133 recognizes that a certain level of hedge inefficiency exists in almost every hedging 

relationship, even those that are deemed to be highly effective. That inefficiency, referred to as 

hedge ineffectiveness, may result because of differences in tenors, indices, repricing dates, 

 427 FASB, SFAS 133, paragraph 22. 428 FASB, SFAS 133, paragraph 31. 429 FASB, SFAS 133, paragraphs 20 (b) and 28 (b) for fair value and cash flow hedges. 

Special Examination of Fannie Mae 

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185

430 FASB, SFAS 133, paragraphs 20 (b) and 28 (b) for fair value and cash flow hedges. 
credit worthiness, liquidity, etc. between the hedging derivative and the hedged item. To the 

exten hedge ine fectiveness exists, it must be measured and recorded in earnings immediately. 

Thus, at least on a quarterly basis, an entity is required to measure the ineffectiveness in the 

hedge and report it immediately in the financial statements. SFAS 133 prescribes the 

methodologies that should be used to measure the ineffectiveness in hedging relationships, and 

such methodologies may differ from those used to assess the effectiveness of that relationship. 

Accounting prior to the effective date of SFAS 133 ignored hedge ineffectiveness. 

t f

 

In addition to the assessment test, documentation of the hedging relationship is critical to 

qualify for hedge accounting. As part of the hedge designation, the hedger must identify, at a

minimum, the following information:431

• The nature of the risk being hedged and a description of the hedging instrument and 

the hedged item 

• A description of how the hedging instrument’s effectiveness in offsetting the change in

fair value or cash flows will be assessed and measured 

• A description of how the designated hedging relationship is consistent with the 

established risk management practices. 

SFAS 133 requires that this information be documented concurrently with the designation of the 

hedge to avoid accounting abuses. Once the designation and documentation is complete for an

individual hedging relationship, hedge accounting will be afforded prospectively for that specific 

relationship. There can be no retroactive designation of any hedging relationships.

Special Examination of Fannie Mae 

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186

431 FASB, SFAS 133, paragraphs 20 (a) and 28 (a) for fair value and cash flow hedges, respectively. 
APPENDIX III 

Example of a Term-out Transaction 

Description of Transaction: 

• On 7/2/1997, Fannie Mae issues $500M in DNs and enters into Swap #1. Swap #1 is a payfixed, receive-floating swap with a term of 7 years, the period of expected reissuance of DNs. 

For purposes of this example it is assumed that the swap’s interest rate reset dates match the 

expected timing of DN reissuance and all other critical terms are matched in order to allow

Fannie Mae to assume perfect effectiveness under SFAS 133.

• On 7/2/1999, Fannie Mae issues $500M 6.175% 3-yr MTN rather than reissuing $500M in 

DNs. At that time Fannie Mae also enters into swap #2. Swap #2 is a receive-fixed, payfloating swap that matures in 3 years. Swap #2 is structured such that its cash flows offset 

those of swap #1 for the three year term of swap #2, with the exception of a differential 

between the fixed rates of the two swaps, which remains constant during that period. 

• Upon the maturity of the MTN, Fannie Mae expects to resume issuing $500M in DNs through 

the remainder of the original 7 year period. 

• As of 7/2/1999, the re-designated swap #1 together with swap #2 is hedging DNs to be 

issued over a “forward starting” two year period that begins 7/2/2002. 

Hypothetical Derivative 

• Since the hedged transactions represent discount notes to be issued in a “forward starting” 

period, as noted above, OFHEO believes a hypothetical forward starting pay-fixed swap 

should be used for purposes of measuring hedge ineffectiveness based on the guidance 

provided in DIG Issue G7 and for assessing effectiveness using the dollar offset method. 

• The forward starting swap (“hypothetical derivative”) is assumed to be on market terms 

(such that the fair value is zero) as of 7/2/99 (the inception of the new hedging 

relationship), with a forward starting date of 7/2/02, and maturity date of 7/2/04, consistent

with the period in which future interest payments are hedged. 

• In order to measure and assess effectiveness, changes in the fair values of the hedging 

instruments (swap#1 and #2 combined) are compared to changes in the fair value of the 

hypothetical derivative. 

• The terms of the two swaps and the hypothetical derivative are summarized as follows: 

Special Examination of Fannie Mae 

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187
Swap #1 Swap #2 Hypothetical Swap #3 

Notional 500,000,000 Notional 500,000,000 Notional 500,000,000

Pay 6.7850% Receive 6.1750% Pay 6.6999%

Receive LIBOR Pay LIBOR Receive LIBOR

Trade Date 6/30/1997 Trade Date 6/30/1999 Trade Date 6/30/1999

Effective 07/02/1997 Effective 07/02/1999 Effective 07/02/2002

Maturity 07/02/2004 Maturity 07/02/2002 Maturity 07/02/2004

FixPayFreq Semi-annual FixPayFreq Semi-annual FixPayFreq Semi-annual

FltPayFreq Quarterly FltPayFreq Quarterly FltPayFreq Quarterly

Special Examination of Fannie Mae 

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188
Analysis: See Next Page for Explanatory Notes.

A B C D E F G H I J K L M N 

# Date

Swap#1 

CLEAN

Swap#2

CLEAN A + B

Hypothetical

Swap#3 

CLEAN

Period

Change in C

Period

Change in D E - F

E/F

(period

dollar 

offset)

Cumulative

Change in 

Hedge (1&2)

Cumulative

Change in 

Hypothetical

Swap#3

I/J

(cum. dollar 

offset)

Cumulative

OCI

Cumulative

Ineffectivenss (P&L) Period 

Entr

- 06/30/1997 0

1 09/30/1997 (9,521,840)2 12/31/1997 (16,632,572)3 03/31/1998 (18,385,686)4 06/30/1998 (21,234,550)5 09/30/1998 (43,037,438)6 12/31/1998 (34,911,044)7 03/31/1999 (23,050,566)8 06/30/1999 (8,953,548) - (8,953,548) - -

9 09/30/1999 (5,110,527) (1,748,228) (6,858,755) 1,411,246 2,094,793 1,411,246 683,547 148.4% 2,094,793 1,411,246 148.4% 1,411,246 683,547 1,41

10 12/31/1999 3,327,731 (7,518,361) (4,190,629) 3,388,930 2,668,126 1,977,684 690,442 134.9% 4,762,918 3,388,930 140.5% 3,388,930 1,373,989 1,97

11 03/31/2000 8,685,601 (10,273,290) (1,587,689) 5,320,495 2,602,940 1,931,565 671,375 134.8% 7,365,859 5,320,495 138.4% 5,320,495 2,045,364 1,93

12 06/30/2000 7,178,852 (9,422,879) (2,244,028) 4,036,143 (656,339) (1,284,351) 628,012 51.1% 6,709,520 4,036,143 166.2% 4,036,143 2,673,377 (1,28

13 09/29/2000 (1,055,865) (4,554,754) (5,610,619) 58,410 (3,366,591) (3,977,733) 611,143 84.6% 3,342,929 58,410 5723.2% 58,410 3,284,519 (3,97

14 12/29/2000 (13,446,023) 1,971,108 (11,474,914) (6,413,309) (5,864,296) (6,471,719) 607,423 90.6% (2,521,367) (6,413,309) 39.3% (2,521,367) - (2,57

15 03/30/2001 (24,658,180) 8,770,759 (15,887,421) (11,464,170) (4,412,507) (5,050,861) 638,354 87.4% (6,933,873) (11,464,170) 60.5% (6,933,873) - (4,41

16 06/29/2001 (20,589,573) 9,656,575 (10,932,998) (7,189,426) 4,954,423 4,274,744 679,679 115.9% (1,979,450) (7,189,426) 27.5% (1,979,450) - 4,95

17 09/28/2001 (39,108,456) 13,280,986 (25,827,470) (22,751,233) (14,894,472) (15,561,807) 667,336 95.7% (16,873,922) (22,751,233) 74.2% (16,873,922) - (14,89

18 12/31/2001 (33,476,184) 10,365,191 (23,110,993) (20,790,673) 2,716,477 1,960,560 755,916 138.6% (14,157,445) (20,790,673) 68.1% (14,157,445) - 2,71

19 03/29/2002 (26,870,835) 5,237,763 (21,633,072) (20,048,413) 1,477,921 742,260 735,661 199.1% (12,679,524) (20,048,413) 63.2% (12,679,524) - 1,47

20 06/28/2002 (34,700,899) 227,618 (34,473,281) (33,617,300) (12,840,209) (13,568,888) 728,679 94.6% (25,519,733) (33,617,300) 75.9% (25,519,733) - (12,84

21 09/30/2002 (41,285,067) - (41,285,067) (40,553,564) (6,811,786) (6,936,263) 124,477 98.2% (32,331,519) (40,553,564) 79.7% (32,331,519) - (6,81

22 12/31/2002 (38,000,308) - (38,000,308) (37,370,431) 3,284,759 3,183,133 101,626 103.2% (29,046,760) (37,370,431) 77.7% (29,046,760) - 3,28

23 03/31/2003 (33,405,434) - (33,405,434) (32,878,576) 4,594,873 4,491,855 103,019 102.3% (24,451,887) (32,878,576) 74.4% (24,451,887) - 4,59

24 06/30/2003 (27,799,169) - (27,799,169) (27,374,944) 5,606,266 5,503,632 102,634 101.9% (18,845,621) (27,374,944) 68.8% (18,845,621) - 5,60

25 09/30/2003 (20,720,113) - (20,720,113) (20,401,152) 7,079,056 6,973,792 105,264 101.5% (11,766,565) (20,401,152) 57.7% (11,766,565) - 7,07

26 12/31/2003 (13,853,676) - (13,853,676) (13,640,999) 6,866,437 6,760,154 106,283 101.6% (4,900,128) (13,640,999) 35.9% (4,900,128) - 6,86

27 03/31/2004 (7,096,170) - (7,096,170) (6,989,183) 6,757,506 6,651,816 105,690 101.6% 1,857,378 (6,989,183) -26.6% - 1,857,378 4,90

28 06/30/2004 (156,247) - (156,247) (153,902) 6,939,923 6,835,281 104,642 101.5% 8,797,301 (153,902) -5716.2% - 8,797,301 

29 07/02/2004 - - - - 156,247 153,902 2,346 101.5% 8,953,548 - - 8,953,548 

TOTAL P&L===========> 

189 

Special Examination of Fannie Mae 

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Explanatory Notes:

• The columns labeled as A and B represent the fair values of the pay-fixed (swap #1) 

and receive-fixed swap (swap #2), respectively for each quarter-end. 

• Column C represents the combined fair value of swaps #1 and #2. 

• Column D reflects the fair value of the hypothetical swap for each quarter-end. 

• The fair values in the analysis represent “clean” fair values. These clean fair values 

exclude the interest accrued on the swaps. Fair values have been calculated based on

actual market rates for the dates presented. 

• The columns labeled E and F represent the quarterly change in fair value for the swaps 

and the hypothetical swap, respectively. 

• Column H represents the period-to-period432 dollar offset ratio, provided for 

informational purposes. This ratio represents the change in value of the hedging 

instruments as a percentage of the change in value of the hedged item (represented by 

the hypothetical instrument) for each quarterly period. The period-to-period dollar 

offset ratio is one way of assessing the effectiveness433 of the hedging relationship 

(another is to use cumulative dollar offset ratio, as discussed below). For purposes of 

assessing whether a hedge is highly effective, the ratio should be between 80%-125%. 

If the ratio falls outside the range, the hedge does not qualify for hedge accounting, if

the period-to-period method is used. 

• Columns I and J represent the cumulative change in fair value of the swaps and the 

hypothetical swap, respectively, since the inception of the re-designated hedge 

relationship (7/2/99). 

• Column K represents the cumulative dollar offset ratio. This represents the change in

value of the hedging instruments as a percentage of the change in value of the hedged 

item since the inception of the hedging relationship. As noted above, cumulative dollar 

offset is another way in which to assess hedge effectiveness. The DAG identifies the

cumulative dollar offset method as Fannie Mae’s approved method to assess hedge 

effectiveness. Had Fannie Mae utilized the cumulative dollar offset approach for 

assessing effectiveness, the swaps would have failed to qualify for hedge accounting at 

the end of the first quarter of the hedging relationship (9/30/99).434 If Fannie Mae were 

to later attempt to qualify for hedge accounting it would need to “re-start” its cumulative 

calculation beginning with a new inception date. Such calculations are not presented in 

the example. 

• Column L indicates the cumulative balance in AOCI and is adjusted to reflect the lower 

of the absolute cumulative changes in fair value since inception between the 

hypothetical swap and the actual swap. 

• Column N represents the change in AOCI from quarter to quarter. 

 432 A “period” in these examples refers to a quarter. 

433 The method chosen to assess effectiveness must be elected and documented at inception of the

hedging relationship per paragraph 62 of SFAS 133 and DIG Issue E8 Hedging—General: Assessing

Hedge Effectiveness Of Fair Value And Cash Flow Hedges Period-By-Period Or Cumulatively under a

Dollar-Offset Approach.

190 

Special Examination of Fannie Mae 

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434 Note that Fannie Mae would also have been required to perform an assessment of effectiveness at the 

inception of the hedge relationship. As noted, Fannie Mae’s DAG specifies the use of dollar offset for its 

assessment test, however, it is unclear how that test is to be applied at the inception of the hedge. 
• Column O represents the amount of overhedge, i.e. amount by which the periodic

change in fair value of the actual swaps (column E) is greater than the periodic change 

in AOCI (Column N). This amount is the ineffectiveness that is recorded in P&L for the 

quarter. 

• Column P represents the prior period AOCI amortization into earnings (the balance in 

AOCI relating to the funding swap prior to re-designation is amortized into earnings over 

the original life of the swap). For the purposes of this example, the amortization has 

been calculated ratably. 

• Column Q is the net P&L effect that would result from these entries.

• This analysis assumes that all interest payments and accruals on the swaps would also 

be recorded in interest expense, consistent with Fannie Mae’s method. Thus, column Q 

represents the net difference between OFHEO and Fannie Mae methodologies. 

Implications of this Analysis: 

Fannie Mae does not perform the above calculations when a term-out occurs. Instead, they

account for both swaps as being perfectly effective hedges and incorrectly record the changes 

in fair value of the swaps in AOCI. The result of accounting for these swaps as perfectly 

effective hedges is that the earnings effect is reflected on an accrual basis over the lives of the 

swaps, avoiding any volatility arising from the changes in fair values of the swaps. The analysis 

OFHEO has prepared presents the entries that would also be required in addition to the accrual 

entries recorded under Fannie Mae’s approach, if the accounting were properly applied. 

The following observations can be made as a result of this analysis: 

• Column Q reflects the net difference in earnings that would be recorded if

ineffectiveness had been properly measured, assuming the hedge passed the 

effectiveness test (see point below). Note that even if the hedge were deemed highly

effective, there would be periodic earnings volatility, sometime in the millions of dollars, 

if the proper accounting treatment were applied. 

• Fannie Mae’s DAG provides for an assessment of effectiveness using the dollar offset

approach. The above analysis indicates that this particular swap would fail such a 

hedge effectiveness test and therefore not qualify for hedge accounting for at least 

some of the periods during the term of the hedge. This would require all changes in fair 

value of the derivatives to be recorded in earnings during such periods. 

Conclusion: 

If Fannie Mae accounted for the term-out transactions in accordance with GAAP, there would

have been significant volatility in earnings caused by ineffectiveness and/or the failure of hedge 

relationships to qualify for hedge accounting, based on the dollar offset assessment test they 

define in their policy. 

191 

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APPENDIX IV

Example of an Offsetting Swap 

Description of Transaction: 

• On 7/2/97, Fannie Mae issues $500M in DNs and enters into Swap #1. Swap #1 is a 

pay-fixed, receive-floating swap with a term of 7 years, the period of expected

reissuance of DNs. For purposes of this example it is assumed that the swap’s interest 

rate reset dates match the expected timing of DN reissuance and all other critical terms 

are matched in order to allow Fannie Mae to assume perfect effectiveness under SFAS

133. 

• On 7/2/01, Fannie Mae issues a $500M 6.175% 3-yr MTN to replace rollover of $500M 

DN and enters into swap #2. Swap #2 is a receive-fixed, 5.202%, pay-floating swap

that matures in 3 years which coincides with the maturity of the MTN and the end of the 

original 7 year hedge period. Swap #2 serves to completely offset the effect of swap #1 

except that the two swaps have different fixed interest rates because they were entered

into at different times. The net result of the two swaps is a fixed stream of cash flows 

over their remaining lives, representing the difference in their respective fixed rates. 

• The terms of the two swaps are summarized as follows: 

Swap #1 Swap #2 

Notional 500,000,000 Notional 500,000,000

Pay 6.7850% Receive 5.2020%

Receive LIBOR Pay LIBOR

Effective 07/02/1997 Effective 07/02/2001

Maturity 07/02/2004 Maturity 07/02/2004

FixPayFreq Semi-annual FixPayFreq Semi-annual

FltPayFreq Quarterly FltPayFreq Quarterly

192 

Special Examination of Fannie Mae 

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Analysis: See Next Page for Explanatory Notes.

A B C D E F 

# Date

Swap#1

CLEAN

Swap#2

CLEAN

Period Change

in Swap #1

Period Change 

in Swap #2

C + D

Net P&L

Prior Hedge OCI

Amortization

- 06/30/1997 0

1 09/30/1997 (9,521,840)2 12/31/1997 (16,632,572)3 03/31/1998 (18,385,686)4 06/30/1998 (21,234,550)5 09/30/1998 (43,037,438)6 12/31/1998 (34,911,044)7 03/31/1999 (23,050,566)8 06/30/1999 (8,953,548)9 09/30/1999 (5,110,527)

10 12/31/1999 3,327,73111 03/31/2000 8,685,60112 06/30/2000 7,178,85213 09/29/2000 (1,055,865)14 12/29/2000 (13,446,023)15 03/30/2001 (24,658,180)16 06/28/2001 (21,967,722) -17 09/28/2001 (39,111,008) 18,407,588 (17,143,286) 18,407,588 1,264,302 (1,830,644) 

18 12/31/2001 (33,476,184) 14,619,596 5,634,824 (3,787,992) 1,846,832 (1,830,644) 

19 03/29/2002 (26,870,835) 9,880,730 6,605,350 (4,738,865) 1,866,484 (1,830,644) 

20 06/28/2002 (34,700,899) 19,321,190 (7,830,065) 9,440,460 1,610,395 (1,830,644) 

21 09/30/2002 (41,285,067) 27,682,822 (6,584,168) 8,361,632 1,777,464 (1,830,644) 

22 12/31/2002 (38,000,308) 26,287,794 3,284,759 (1,395,028) 1,889,731 (1,830,644) 

23 03/31/2003 (33,405,434) 23,608,545 4,594,873 (2,679,250) 1,915,624 (1,830,644) 

24 06/30/2003 (27,799,169) 19,910,748 5,606,266 (3,697,796) 1,908,470 (1,830,644) 

25 09/30/2003 (20,720,113) 14,789,064 7,079,056 (5,121,685) 1,957,371 (1,830,644) 

26 12/31/2003 (13,853,676) 9,898,954 6,866,437 (4,890,109) 1,976,328 (1,830,644) 

27 03/31/2004 (7,096,170) 5,106,751 6,757,506 (4,792,204) 1,965,302 (1,830,644) 

28 06/30/2004 (156,247) 112,629 6,939,923 (4,994,122) 1,945,801 (1,830,644) 

29 07/02/2004 - - 156,247 (112,629) 43,618 (21,967,722) 

TOTAL P&L==========> 21,967,722

193 

Special Examination of Fannie Mae 

Privileged & Confidential 

Disclosure and/or Duplication Prohibited
Explanatory Notes:

• The columns labeled as A and B represent the quarter-end clean fair values of the initial 

pay-fixed swap (swap #1) and the offsetting, receive-fixed swap (swap #2), 

respectively. 

• The columns labeled C and D represent the quarterly change in fair value for swap #1 

and swap #2, respectively. 

• Column E represents the Net P&L from the mark-to-market of the two swaps. 

• Column F represents the amortization from AOCI to earnings relating to the previously

existing hedge relationship. 

• Column G represents net P&L for the period after taking into account the amortization of 

the balance from AOCI into earnings. 

Implications of this Analysis: 

It is OFHEO’s understanding that from a hedge accounting perspective, Fannie Mae enters into

swap #2 to offset swap #1. Although there is no remaining exposure to be hedged, Fannie 

Mae accounts for these swaps as perfectly effective hedges. The changes in fair value for both

swaps, the original pay-fixed swap and the offsetting receive-fixed swap, are recorded in AOCI. 

The result of accounting for these swaps as perfectly effective hedges is that the earnings effect

is reflected on an accrual basis over the lives of the swaps, avoiding any volatility arising from 

the changes in their fair values. The analysis OFHEO has prepared presents the entries that

would also be required in addition to the accrual entries recorded under Fannie Mae’s approach, 

if the accounting were properly applied. 

The following observation is made as a result of this analysis: 

• Column G reflects the net difference in earnings that would be recorded if the proper

accounting were applied. 

 

Conclusion: 

If, after the execution of the offsetting swap, Fannie Mae had accounted for the pay-fixed swap

and the offsetting receive swap in accordance with GAAP and recorded the changes in fair value 

of the swaps in earnings, it would have resulted in volatility in earnings. 

194 

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Privileged & Confidential 

Disclosure and/or Duplication Prohibited
APPENDIX V 

Example of a Cancelable Swap 

Description of Transaction: 

• On 7/2/1997, Fannie Mae issues $500M in DNs and enters into Swap #1. Swap #1 is a payfixed, receive-floating swap with a term of 7 years, the period of expected reissuance of DNs. 

For purposes of this example it is assumed that the swap’s interest rate reset dates match the 

expected timing of DN reissuance and all other critical terms are matched in order to allow

Fannie Mae to assume perfect effectiveness under SFAS 133.

Hypothetical Derivative 

• Since the hedged transactions represent discount notes to be issued over a seven year 

period, OFHEO believes a seven year hypothetical non-cancelable swap should be used for 

purposes of measuring hedge ineffectiveness based on the guidance provided in DIG Issue 

G7, and for assessing effectiveness using the dollar offset method. 435

• The hypothetical non-cancelable swap is assumed to be on market terms (such that the fair 

value is zero) as of 7/2/97 (the inception of the new hedging relationship), with a start date

of 7/2/97, and maturity date of 7/2/04, consistent with the period over which the discount 

note issuances are hedged. 

• In order to measure and assess effectiveness, changes in the fair values of the hedging 

instrument (swap#1) is compared to changes in the fair value of the hypothetical derivative. 

Swap #1 Swap #2 (Non-Callable 

Hypothetical)

Notional 500,000,000 Notional 500,000,000

Pay 7.1031% Pay 6.7850%

Receive LIBOR Receive LIBOR

Effective 07/02/1997 Effective 07/02/1997

Maturity 07/02/2004 Maturity 07/02/2004

FixPayFreq Semi-annual FixPayFreq Semi-annual

FltPayFreq Quarterly FltPayFreq Quarterly

Callable On 07/02/2001 Callable On n/a 

 

195 

Special Examination of Fannie Mae 

Privileged & Confidential 

Disclosure and/or Duplication Prohibited

435 Fannie Mae has elected not to separate the time and intrinsic value components of the callable swap 

and has not identified optionality in the transaction being hedged. As such, the hypothetical is a swap 

with no option feature. 
Analysis: See Next Page for Explanatory Notes.

A B C D E F G 

# Date

Swap#1

CLEAN

Swap#2

CLEAN

Period Change 

in Swap #1

Period Change in

Swap#2

C/D

(period dollar

offset)

G/H

(cumulative 

dollar offset)

Cumulative

OCI

P

- 06/30/1997 (0) 0

1 09/30/1997 (6,856,921) (9,521,840) (6,856,921) (9,521,840) 72.0% 72.0% (6,856,921) 

2 12/31/1997 (11,312,269) (16,632,572) (4,455,348) (7,110,733) 62.7% 68.0% (11,312,269) 

3 03/31/1998 (12,815,287) (18,385,686) (1,503,018) (1,753,114) 85.7% 69.7% (12,815,287) 

4 06/30/1998 (14,271,875) (21,234,550) (1,456,588) (2,848,864) 51.1% 67.2% (14,271,875) 

5 09/30/1998 (28,200,079) (43,037,438) (13,928,204) (21,802,888) 63.9% 65.5% (28,200,079) 

6 12/31/1998 (20,280,281) (34,911,044) 7,919,798 8,126,394 97.5% 58.1% (20,280,281) 

7 03/31/1999 (14,169,710) (23,050,566) 6,110,571 11,860,477 51.5% 61.5% (14,169,710) 

8 06/30/1999 (5,146,137) (8,953,548) 9,023,573 14,097,018 64.0% 57.5% (5,146,137) 

9 09/30/1999 (2,308,078) (5,110,527) 2,838,060 3,843,021 73.8% 45.2% (2,308,078) 

10 12/31/1999 3,698,686 3,327,731 6,006,764 8,438,258 71.2% 111.1% 3,327,731 

11 03/31/2000 6,931,412 8,685,601 3,232,725 5,357,870 60.3% 79.8% 6,931,412 

12 06/30/2000 5,854,847 7,178,852 (1,076,564) (1,506,749) 71.4% 81.6% 5,854,847 

13 09/29/2000 1,217,927 (1,055,865) (4,636,920) (8,234,716) 56.3% -115.3% - 

14 12/29/2000 (1,732,822) (13,446,023) (2,950,749) (12,390,158) 23.8% 12.9% (1,732,822) 

15 03/30/2001 (2,498,793) (24,658,180) (765,971) (11,212,158) 6.8% 10.1% (2,498,793) 

16 06/29/2001 (175,990) (20,469,902) 2,322,803 4,188,279 55.5% 0.9% (175,990) 

Assume swap is canceled as the option was in the money

196 

Special Examination of Fannie Mae 

Privileged & Confidential 

Disclosure and/or Duplication Prohibited
Explanatory Notes:

• The columns labeled as A and B represent the quarterly clean fair values of the actual and 

hypothetical swap, respectively. 

• The hypothetical swap is created to mirror the terms of the discount notes being hedged.

The clean value excludes the interest accrued on the swaps. 

• The columns labeled C and D represent the quarterly change in fair value for swap #1 and 

swap #2, respectively. 

• Column E represents the period-to-period dollar offset ratio; provided for informational 

purposes. 

• Column F represents the cumulative dollar offset ratio. The dollar offset ratio is a 

measure of the degree to which a hedging instrument (callable swap) has been effective 

in offsetting the change in fair value of the hedged item (discount notes, represented by 

the hypothetical swap). For purposes of assessing whether a hedge is highly effective, 

the ratio should be between 80%-125%. If the ratio falls outside the range, the hedge 

does not qualify for hedge accounting. The DAG identifies the cumulative dollar offset 

method as Fannie Mae’s approved method to assess hedge effectiveness. Had Fannie 

Mae utilized the cumulative dollar offset approach for assessing effectiveness, the swaps 

would have failed to qualify for hedge accounting at the end of the first quarter of the 

hedging relationship (9/30/97).436 If Fannie Mae were to later attempt to qualify for 

hedge accounting it would need to “re-start” its cumulative calculation beginning with a 

new inception date. Such calculations are not presented in the example.

• Column G indicates the cumulative balance in AOCI and is adjusted to reflect the lower of

the absolute cumulative changes in fair value since inception between the hypothetical 

and the actual swap. 

• Column H represents the change in AOCI from quarter to quarter. 

• Column I represents the amount of overhedge, i.e. amount by which the periodic change

in fair value of the actual swap (column C) is greater than the periodic change in AOCI 

(column H). 

• Fannie Mae does not perform the above calculation and assumes that the entire change in

fair value should be posted to AOCI. 

Implications of this Analysis: 

Fannie Mae does not perform the above calculations when executing a callable swap to hedge 

discount notes from a hedge accounting perspective. Instead, they account for the callable swap

as being “perfectly effective” and incorrectly record the changes in fair value of the swap in AOCI. 

The result of accounting for the swap as perfectly effective is that the earnings effect is reflected 

on an accrual basis over the life of the swap, avoiding any volatility arising from the changes in 

fair values of the swaps. The analysis OFHEO has prepared presents the entries that would also 

be required in addition to the accrual entries recorded under Fannie Mae’s approach, if the 

accounting were properly applied. 

The following observations can be made as a result of this analysis: 

 

Special Examination of Fannie Mae 

Privileged & Confidential 

Disclosure and/or Duplication Prohibited 

197

436 Note that Fannie Mae would also have been required to perform an assessment of effectiveness at the 

inception of the hedge relationship. As noted, Fannie Mae’s DAG specifies the use of dollar offset for its 

assessment test, however, it is unclear how that test is to be applied at the inception of the hedge. 
Special Examination of Fannie Mae 

Privileged & Confidential 

Disclosure and/or Duplication Prohibited 

198

• Column I reflects the net difference in earnings that would be recorded if ineffectiveness 

had been properly measured, assuming the hedge passed the effectiveness test (see point 

below). Note that even if the hedge were deemed highly effective, there would be 

periodic earnings volatility, sometimes in the millions of dollars, if the proper accounting 

treatment were applied. 

• Fannie Mae’s DAG provides for an assessment of effectiveness using the cumulative dollar 

offset approach. The above analysis indicates that this particular swap would fail such a 

hedge effectiveness test and therefore not qualify for hedge accounting for at least some 

of the periods during the term of the hedge. This would require all changes in fair value 

of the derivatives to be recorded in earnings during such periods. 

 

Conclusion: 

If Fannie Mae accounted for the callable swap as described above, which is consistent with how 

the hedge was designated, there would have been significant volatility in earnings caused by 

ineffectiveness and/or the failure of hedge relationships to qualify for hedge accounting. Had 

Fannie Mae designated the relationships differently, and separated the time and intrinsic value, it 

is possible that hedge accounting could have been achieved, though volatility would have still 

resulted from having recorded time value changes in earnings.