The Banking Industry Struggles with SFAS 133

The Federal Home Loan Bank of Dallas (FHLB Dallas) and the Federal Home Loan Bank of Atlanta (FHLB Atlanta) announced plans Monday to restate their financial statements for the years 2001 through 2004 and the first quarter of 2005. The Federal Home Loan Bank of Indianapolis (FHLBI) had announced its intention to issue restatements for the same periods on Friday. All three regional banks in the Federal Home Loan Bank System, were found to have incorrectly applied a provision of Statement of Financial Accounting Standards 133, Accounting for Derivative Instruments and Hedging Activities (SFAS 133).

Neither FHLB Dallas nor FHLBI anticipate that the corrections to their hedge accounting will have a material effect on their financial statements. In its statement, FHLB Atlanta said that once the review of all hedging transactions had been completed, the Bank may be required to make adjustments which could be material to the Bank’s financial statements.

“In the course of preparing for SEC registration we discovered accounting errors related to SFAS 133,” said Martin L. Ledger, President-CEO of FHLB Indianapolis, in the Bank’s statement. “We do not believe this correction detracts from FHLBI’s core strengths or its progress toward achieving FHLBI’s strategic plan.”

Lee Puschaver, Executive Vice President and CFO of FHLB Atlanta said in the Bank’s announcement, “While we took great care in implementing SFAS 133 in 2001, including a review by our independent auditors, SFAS 133 is a very complex accounting standard.”

The three banks had adopted a “short cut” method of hedge accounting provided for in SFAS 133 in which an assumption can be made that the change in fair value of a hedge item exactly offsets the change in value of the related derivative. The banks used this short cut method in hedge accounting for interest rate changes. FHLB Atlanta said it had also used the method for other transactions, including the Bank’s convertible advance products and zero coupon bonds.

The FHLB Atlanta statement described circumstances where hedge accounting would be used. It said that if a hedging relationship meets certain criteria specified in SFAS 133 including appropriately documenting compliance with the criteria at the time the hedging relationship is established, it is eligible for hedge accounting and the offsetting changes in fair value of the hedge item may be recorded in earnings.

What is called the ‘long haul” method of hedge accounting requires the bank, according to FHLB Atlanta, to evaluate the effectiveness of the hedging relationship on an ongoing basis and to calculate the changes in fair value of the derivative and related hedged item independently. SFAS 133 does not permit the institution to apply the long haul method retroactively, the FHLB Dallas statement said.

SFAS 133 gained prominence in relation to Fannie Mae’s hedge accounting, which was questioned in a report issued by the Office of Federal Housing Enterprise Oversight (OFHEO) last fall and was a major factor in the company’s accounting problems. The company had incorrectly used the short cut method allowed by SFAS 133, according to Gregory Eller, accounting manager of the Federal Home Loan Bank of Seattle.

The Washington Post reported in November 2004 that OFHEO had accused Fannie Mae of violating FAS 133. “Fannie said yesterday that if its hedge accounting is invalidated, it could be required to retroactively report $13.5 billion of losses and $4.5 billion of gains, netting a $9 billion decrease in earnings since the beginning of 2001,” the Post said.

Fannie Mae had long argued that FAS 133 produced a distorted picture of its earnings because the rule forced it to include unrealized gains and losses on its income statement, according to the Post.

Commenting on Fannie Mae’s problems and the issues that banks face with complex accounting standards, Eller says, “In the old days, for an accounting standard that said “no,” an auditor might have passed on a “not quite” judgment call, but would have insisted that a ”not even close” would be challenged. In today’s environment, the “not quite” judgments earn the response, “What part of the word don’t you understand?”

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