EXPERT REPORT

OF TIMOTHY

LUCAS

In

re Fannie Mae

Securities

Litigation

United States District

CouP

District

of Columbia

MDL No
Consolidated Civil

1668 04-cv-O1 639

Action

No

RJL

Submitted November

15 2010

Confidential

Qualifications

have years
until

over 35 years experience as
retirement
in

Certified

Public

Accountant

CPA
and

For 14

my

May

of 2002

served

as Director

of Research

Technical

Activities

for the Financial

Accounting

Standards

Board

FASB
was

or

the

Board

The

FASB

is

designated the

by the accounting profession

to define

Generally

Accepted

Accounting

Principles the

in

United States

GAAP
staff

As Director

responsible

for supervising

FASBs

professional

research

which

comprised 50
to

CPAs PhDs

and

support

staff

also participated

in

the debates

and

procedures leading
in

new accounting standards
project

In

particular derivatives

was
and

significantly

involved

the

Boards
of

technical

on

accounting for for

hedging

which

led to the

issuance

FASB

Statement 133 Accounting

Derivative

Instruments

and Hedging
the

Activities

Statement
time

133

No

other

project

absorbed
also

as

much of
as

Boards time

or

my

During that same Task Force

period

19882002
is

served

Chairman accounting

of the Emerging
professionals

Issues

EITF
with the his

The EITF

group

of senior

who meet

regularly

FASB

and the Chief
to

Accountant
discuss

of the Securities
resolve financial

and

Exchange

Commission
that
arise in

SEC or
practice

designee

and

reporting

issues

Before becoming was
Project

the Director

of Research
to

and Technical Before joining
public with

Activities

at

the

FASB
was
to

Manager

there

from

1979
Sells

1986

the

FASB

in

1979
1972

an auditor

for Deloitte

Haskins

Big

accounting firm from
responsibility

1979
public

When

left

the firm

was an Audit Manager

for overseeing

company
hold

audits

Bachelor of Arts
as

degree

in

Economics degree
list

and
all

Bachelor of Science from Rice
University

degree
in

in

Accounting

as well

Master of Accounting
includes

Houston
years

Texas
list

My
of
or
all

resume which
cases
in

of

all

my

publications

over the
in

last

ten

and

litigation or

or

any administrative over the

proceeding
last

which
is

served

an expert
Exhibit

report

testified

at

trial

by deposition

four

years

attached

as

Confidential

II

Assignment

have

been

retained

by

KPMG

in this

litigation

to address

certain

accounting
to

issues

pertaining relevant

to the application time

of Statement 133
also

in

the time

frame from 2001 and

2004

the

period

have

been
to

retained

to

identi

explain

certain

relevant

financial

accounting concepts have case
read

and

respond
reports offer

to certain

opinions

expressed

by other experts
Berliner

in

this

matter
in this

the expert

of John

Barron and

Robert

submitted

In

this

report

some comments on

the contents

of those

reports

that

are related

to

Statement 133

In connection

with

my work my

on

this

engagement career For

have

called

on

the

knowledge

and

experience gained and of

during

professional

My
my

opinions

are

based on

my
the

experience

expertise

in

financial

accounting

work

in

connection with
rate

preparation

my

report

have
in this

billed

KPMG

at

my
no

regular financial

hourly

of $650
the

am
of

independent
this

of the parties and

litigation

have

interest

in

outcome case

matter

my

fees are

in

no respect

contingent

upon

the

outcome

of

this

reserve

the right to

supplement

my

opinions that

based

on the opinions

expressed

by

plaintiffs

experts

and

any additional

information

might become

available

III

Snmmary Overview

of Opinions

In

my

opinion

as

more fully discussed

below Fannie Maes approach
and
appropriate application

to

implementation
the relevant

of Statement 133

was

reasonable

of

GAAP
regarding

in

time period hedging

Further for certain

specific

issues that

have

been

raised

Fannie

Maes

transactions

as described

below
and

have

found

that the

companys

approach

to applying

Statement 133

was

reasonable

appropriate

Fannie

Mae

identified as

13

transactions

that

were

most

significant

making

up

96% of

the
at

hedge

transactions

outstanding

of March

31 2004

based

on

notional

amounts

FMCIV-05 00700330

0390

Confidential

IV

Overview

of

GAAP
of accounting conventions
at

GAAP
accepted accountants

is

body

rules

and

procedures that provide
standard

define

accounting
follow

practice

particular financial

point

in

time and and
in

that

when
in

preparing

statements

related

footnotes.2

Financial

statements

prepared

accordance

with

GAAP

are

way

which

companies

report

their

financial

position

and the results of operations
interested parties

to current

and

prospective

investors

and
series

creditors

and

to other

such as regulators
to
set

The FASB has

issued

of Statements of Financial
characteristics that seeks

Accounting
to

Concepts
in

out the objectives

and

qualitative

it

achieve

GAAP

financial

statements
financial

Those

Concepts
is

Statements recognize

that the objective

or

purpose

of

GAAP
and

statements

to

provide readers of the statements including
understandable information

investors

creditors

with reliable and
information
is

about the economics

of

company

That

intended

to

be useful

to

people
stock

who

are

making

economic

decisions

such as whether

to

buy

or

sell

companys

or to

extend
is

loan to the

company
financial

The Concepts
statements

Statements also recognize
the

that

there

cost to

preparing to

and that

both

accounting standards
cost benefit

and the procedures developed

implement them

should meet

practical

test.3

Over the years
the private sector4

GAAP

has developed
the

from
its

number of sources

primarily

within

including

FASB

and

staff5 the

EITF

and

the

Accounting

AU

Section

411

The Meaning
effective

of Present

Principles

March
Financial

15

1992

AU
of

Fairly

in

Conformity

With Generally Accepted

Accounting

Section

411
No
Objectives

See

FASB

Statement

of

Accounting Statement

Concepts
Financial

of Financial Reporting

by

Business

Enterprises and

FASB

Accounting

Concepts

No

Qualitative

Characteristics

of Accounting About

Information
at

FASB
under been
to

Facts

FASB 2007
to establish

available

at http//www.fasb.orglfacts/index.shtml

The
held

SEC

has

statutory the

authority Securities

financial

accounting

and

reporting
its

standards

for publicly the

companies
policy has

Exchange
private

Act of

1934

Throughout
to the

history that

however
the private

Commissions

to rely the

on

the

sector
in

for this function public

extent

sector

demonstrates

ability

fulfill

responsibility

the

interest.
sellers including

The

standards

of

predecessor Bulletins Staff

standard

Opinions

of

the

Accounting Procedure

Principles

Board and adopted

Accounting by See
the

Research

of

the

AICPAs
that
at

Committee

on Accounting
include

have

been Guides

FASE
the

FASB

pronouncements 2007

are authoritative

Implementation

QAs
the

FASB

Facts

About

FASB

available

at http//www.fasb.org/facts/index.shtml

Since
organization
in

1973

Financial

Accounting

Standards

Board

FASB

has

been

the

designated

continued

on

next

page

Confidential

Standards Executive Committee of sources
within

AcSEC

There

was

in

the relevant

time period

hierarchy

GAAP.6

10

GAAP

is

not frozen

or finished

it

continues

to

evolve over time

There

are

number of
because unclear which

areas

that

are subject

to

ongoing

efforts to

improve authoritative
given type

guidance
or
is

the existing

guidance
conflicting

does not specifically
or not effective
in

address

of transaction
to

incomplete guidance

communicating

the transactions

the

applies

11
that

GAAP

is

not

an exact wide

science

Courts have

recognized

that

GAAP

is

term of Supreme

art

encompasses
for

range

of acceptable
that

procedures.7
is

The United

States

Court

example has observed
identical

GAAP

far from being

canonical

set

of rules that

will ensure

accounting treatment treatments

of identical transactions...
the choice

tolerate

range

of reasonable

leaving

among

altematives

to

management.. 12
both

Applying

GAAP

often

requires

significant the

professional

judgment

on the part and the
to
all

of

company

professionals

who

prepare

companys

financial

statements

professionals that

who

audit

them
in

GAAP

does not provide
statements

unambiguous
for

answers

the

questions

come up

preparing

financial

todays
is

corporations

and

it

never will The accountant understand the rules and

who

prepares

the financial

statements

expected

to study

and

then

to exercise

professional

judgment

in

applying

them to the

continued private reports Securities reaffirmed

from

previous

page
standards entities

sector

for establishing

of Those

financial standards

accounting are

that

govern

the preparation as

of

financial

by nongovernmental and Exchange
in its

officially

recognized

authoritative Section 101

by and

the

Commission 2003
Policy

SEC
as

Financial and
the

Reporting American

Release
Institute

No
of

April

Statement Conduct

Certified

Public

Accountants
in

Rule 203 Rules of
original The

Professional

amended

May 1973 and May

1979

parentheticals

GAAP
Section

Hierarchy 411

in

AU

18

The

1999 2004 was FASB recently
of
Financial

set

forth

in

the

authoritative to

auditing the

literature

in

particular into
its

in

completed

project

move

GAAP

Hierarchy

literature

See Statement Principles

Accounting

Standards

No

162 The Hierarchy of Generally Accepted

Accounting
In re

Issue

No

302

May 2008
675
n.22

Tool Thor

IKON Office Solutions Inc Sec Litig 277 F3d 658 Co Connr 439 U.S 522 544 1979
Power
Tool 439

Cir

2002

citing

Thor

Power

U.S

at

544

Confidential

companys
situations

specific

transactions

and

situations.9

As

the

companys may be

transactions

and

change
to

or as

accounting guidance
are

evolves

it

appropriate

for the

accountant
not

change

policies that

used to apply

GAAP

Such

change however

does

mean
at

that the policies applied

in

previous

periods to

based on judgments appropriately conclude
that

made wrong
those

that

time were wrong
in

It

is

inappropriate

accounting policies were
to

just

because changes
in later

transactions

and

situations

caused the accountant undertaking
test
is

change

policies

period
is

The

nature

of the accountants
test

such that

conformity with

GAAP

reasonableness

rather

than

an absolute

13

The

use

ofjudgrnent

is

an important
reporting reasonable

and

unavoidable

part

of

GAAP

Although

financial

statements

are basically to

results

of operations and

in

past

periods

GAAP

requires

the accountant

make

judgments
to interpret

estimates

based on current and apply

information them
in

including

judgments

of how

GAAP

pronouncements of

practical

and cost effective

manner

Often new

interpretations
in

GAAP
for

subsequent
future

to the date

of the financial report

may

require

change

the

judgment

reports

But that new interpretation
prepared the
in

does not make

the previous

financial

statements

wrong

They were

conformity with

GAAP

based

on the best information

reasonably available

at

time

Derivatives

Hedging

and Hedge

Accounting

14
interest in

loan

contract

between

lender

and

borrower may
for
interest

provide

for the

payment
rate

of

various

ways

Some

contracts

provide

payments

at

fixed

e.g

5%
of

for the

life

of the contract

The popular
the contract

30-year

fixed-rate

mortgages
at

are

an example

this

contract

Alternatively

may provide
contract

for interest

rate that

floats
intervals

or

varies

with

specified

index

Under

such

the rate

is

reset

at

specified

See Remarks

by chairman
principles every

Arthur

Levitt

SEC
to

the

Numbers
straitjacket

Game New
Accountants
innovative

York
are

September wise enough
so they

28
to

1998

Our
cannot

accounting
anticipate that

werent

meant

be

know

they

business
flexibility

structure to adapt

or every to

new and

transaction

develop

principles

allow

for

changing

circumstances.

Confidential

For example there are adjustable every year based on the then

rate

mortgages

referred

to as

ARMs

that

reset the rate

current

rate

on specified

U.S

Treasury securities

15
other

Derivatives

are contracts

that

provide

for the parties to

make payments
specified

or

transfer

assets to each

other

based on

formula that incorporates price or foreign

underlying

variable

such as an interest rate of on
derivative
is

security

exchange one
party

rate

common
to

example
interest

an

interest

rate

swap

in

which and

agrees

pay the other
to

stated

notional

amount

at

fixed

rate

the other

party

agrees

pay pay

interest

on the same
rate

amount

at

floating

rate

So

for

example

party

might agree
agrees to

to

fixed

of

3% on

the notional

amount

of$lO million while

party

pay

interest

on

the

same amount
only as
is

at

the floating

rate

LIBOR

The

notional

amount under no

is

provided

in

the

contract

base for the calculation by either party payments

of periodic
the

payments

the contract

that

amount

not

paid

Typically

contract

requires

initial

payment of

from each

either party

and

interest

are

settled

net so depending
to the

on the

level

LIBOR

period

one

of the parties makes

payment

other

16
there

Viewed

in

isolation

an

interest

rate

swap may seem

like

strange

instrument but
into

are practical

economic
for

uses

for

such contracts
rate

company might
debt outstanding case

enter

an
that

interest

rate

swap

example
driving fixed

if

it

had

floating

and

was worried
enter

rates

would
it

increase

up

its

interest

expense

In that

it

would

swap

where fixed

agreed to pay
If rates

rate

and

receive

floating

rate

often referred

to as

pay

swap

do

go

up

the

interest

on the debt

will increase

but the increasing

payments go

received

from the swap
will

counterparty to

will offset the increase

Of course

if

rates

down

the

company
that

have

make payments
have

under the swap that offset the reduced
it

interest

on the debt

otherwise

would

benefited

The company
if

has

protected but has

itself

from an undesirable

outcome

increased
interest

interest

payments
if

rates

go

up
The

it

given

up the potential upside
or not to

lower

payments
is

rates

decrease
decision

decision

to

hedge
the

hedge

particular

risk

exposure

an economic

quite

apart

from

accounting for the hedge

LIBOR
published

or the

London
It

Interbank often

Offered as

Rate

is

market

interest

rate that varies

with

market

forces

and

is

daily

is

used

reference

for variable

or floating rate loans

Confidential

VIE

History of Statement

133

17

FASB

Statement 133 Accounting
is

for Derivatives

and

Hedging

Activities

Statement
133

133
in

the

primary
after

GAAP

literature

for derivative

instruments

Statement

was

issued

1998

12

years

of development

effort

by the

FASB
and 1986

18

Increasing

innovation
the

including cited

new when

varieties

of derivatives
the decision
in

new
to

uses

for

them

was one of
agenda
highly

the reasons

FASB

it

made

add

to

its

broad

project

on accounting for financial
that involved use

In the

990s
or
in

series

of

publicized

losses

of derivatives

for speculation

failed

hedges
cases

added

to the pressure

for the

FASB

to address

accounting for derivatives
not apparent

In

many

the losses

came

as

surprise

because

it

was

from the financial
that

statements

that

the

company was
used to
limit

using risk

derivatives

The FASB recognized however
involving the
interest

derivatives

were
is

often

The

transaction

rate

swap
global

described

above

an example and
related

In

Statement 133
innovations

itself

the

Board

noted

Changes

in

financial

markets

financial

have

led to the

development
foreign

of new

derivatives

used to

manage Many

exposures to risk including
that

interest

rate

exchange

price and changes
the

credit risks

believe

accounting standards
risk

have

not kept

pace

with those
believe

Derivatives

can

be useful

management

tools

and

some

that

inadequacy of
the

of

financial

reporting

may have

discouraged their use by contributing
financial reporting also

to

an

atmosphere

uncertainty

Concem
surrounding

about inadequate
large derivative

was heightened by

publicity

losses

at

few companies.2

19

The accounting

for certain

types

of derivatives

had

been had

previously to reason

addressed

in

the

GAAP
practice

literature but for

many

transactions

the accountant

by analogy and
for the

was

diverse.13

Many

thought that

if

derivative

was

acquired

purpose

of

hedging For
interest

risk rate

the derivative

should be accounted

for as part
if

of the hedged

transaction

swaps

the

EITF had agreed

that

the

swap was hedging

an outstanding

Statement
12

133 133
Issue

207 212
84-36
Interest

Statement See EITF Contracts

Rate

Swap

Transactions

and

FASB

Statement

80 Accounting

for Futures

Confidential

debt

it

would

be appropriate Under
that

to use

an accounting
if

approach

called

synthetic
rate

instrument

accounting.4
into

approach
in

the

company had
the

floating

debt

and
the

had

entered

pay-fixed

swap

as

the

example
if

above
were and

company would

treat

combined would simply

results

of the two
interest

instruments

as

they

one

synthetic changes
further
in

instrument
the
fair

It

record

expense

at

the fixed

rate

ignore

value

of the swap

This
that

is

called

hedge

accounting

and

is

discussed

below

The FASB concluded was
impractical In

developing

separate

accounting model

for

each

type

of derivative

Statement 133 the Boards goal was to develop
derivatives

broad

accounting model be used

for

all

types

of

and

to define

when and how hedge

accounting should

20

The Boards
Between

gestation

process

for

Statement 133 was long of Statement 133 and
in

difficult

and
the

contentious
issued

1986

and the issuance

June of 1998 proposed

Board

six different

documents
three

defining

the issues

describing

accounting
for

approaches
formal

including

exposures of conclusions and
public

and

drafts with

opportunities the

comment

letters

from accountants Board
noted held 131

companies

who

followed

process
that extensive

During that period due

the

meetings on the subject
is

After

process the Board
project

in

Statement 133 This Statement and
is

an

additional

step

in

the

Boards

on financial and

instruments

intended

to address

the

immediate problems of having
is

about the recognition
all

measurement measured of
this at

of derivatives
value
in

while the Boards vision
statement

financial

instruments

fair

the

of financial
as the

position

pursued
to address

Certain

provisions
in

Statement will be reconsidered on
financial instruments.15

Board

continues

the

issues

its

broad project

21
with

The

process

of developing

the

accounting for derivatives

and

hedging

did

not

end

the issuance

of the statement

Before the ink was dry the implementation
called issues

FASB

anticipating

greater

than

normal volume

of complex

took the unprecedented Implementation people expected them
to the to

step

of establishing

group became

of expert practitioners

the Derivatives

Group which
positions

known

as the

DIG

That group
arose

included

be

in

to see

implementation

issues

as they

and

to

bring

Boards

14

See EITF Statement

Issue

84-36

Interest

Rate

Swap

Transactions

133

J2I6

Confidential

attention

The DIG met
Eventually

periodically

to discuss

issues

and

recommend
referred
to

solutions

to the

Board

over 150

DIG

statements

of guidance

as

issues

were

published

22

The Board

also

received

requests

to

amend

the

new standard

The Board

first

amended

Statement 133 by issuing

Statement 137

in

June 1999

to defer

the effective

date
in

Subsequent June 2000
the

amendments of
and 149
in

number of 2003

provisions

were contained and

in

Statements

138

April
in

Throughout

this

period

for several

years

thereafter

SEC

staff

was

active

generating

comments

to registrants

and

in

frequent

public

comments

interpreting

the

standards

23
growing

The end
book

result

of

all

of

this

well

intentioned

activity

was

to

build

formidable and
difficult

of rules

Statement 133

implementation ended

became

significantly

challenge
their

Several

hundred
efforts

public

companies

up restating financial tatements under the standard
both the as
it

when

implementation

were

deemed

inadequate

was

later

interpreted.16

Subsequent
the rules

to the relevant

time period
less difficult

SEC

and

the

FASB

have
those

moved

to

make
it

less

complex would

and

to

comply
additional

with.1

Absent

SEC 24
133

efforts

is

likely

there

have

been

numerous

restatements

In

June 2008

the

FASB

issued

an exposure

draft

proposing to amend

Statement

yet

again

The

stated

objectives

of that project

were to

Simpli accounting
Improve model and
the financial associated

for

hedging

activities

reporting

of hedging
useful

activities

to

make

the

accounting

disclosures

more

and easier to understand for users of

financial

statements

Resolve under

major practice

issues

related

to

hedge

accounting that have

arisen

Statement 133 Address
differences resulting

from recognition
instruments

and
the

measurement accounting
for

anomalies hedged

between
items

the

accounting

for derivative

and

or transactions.8

See

e.g http//www.cfo.com/articIe.cfm/6874855/c
Nine Year Comparison
at at

2984409/ftarchives
21

see

also

Audit

Analytics

2009

Financial Resiatements The

2009
on March

SEC made
issued

an

announcement
Drafts

the

EITF

meeting and

FASB

Exposure

dated

June an

62008

15 2007 May 26 2010
of

see

infra

paragraph

51

and

the

See Accounting

for Hedging

Activities

Amendment

FA SB Statement

133

at

ii available

at

http//www.fasb.org/drafiled

hedgingamendment_st133.pdf

Con

fidentiat

25
the

In the

Background

and

Basis

for

Conclusions section
as

of the 2008

exposure

draft

Board

commented on

the reasons

for the project

follows

Since the effective numerous
to issues

date

of Statement 133 the
aspects

FASB
and

has been

asked to address
but not limited

on many

of hedge

accounting

including

issues related

to assessing

hedge
in

effectiveness the

measuring hedge agreed
in

ineffectiveness

As

result the

May 2007
for

Board

to

add

project

to

its

agenda decided
it

to reconsider that for the

hedge

accounting guidance hedging
to
activities

Statement 133 The Board
to

accounting

should be simplified with the guidance
to

make
the

easier

preparers

of financial

reports

comply

and
the

financial

reporting

of hedging

activities

should be improved
to investors

make
other

hedge of

accounting results more useful
financial information.9

and transparent

and

users

26
applied changes

In

summary

the

Board

concluded

that

Statement 133 as
to

it

has

been

interpreted

and

is

unduly rigid changing
to

complex and
the threshold

difficult

comply

with

The Boards proposed
quantitative evaluation

include

for

hedge

accounting

from

of highly
to qualify

effective
for

qualitative

evaluation

of reasonably would

effective

making

it

easier

hedge
after

accounting
the
initiation

The
of

proposal

also require

reassessment of circumstances suggest most designation cash flows would assume no be
that

effectiveness

hedging

relationship

only

if

the

hedge

may no
risks

longer

be reasonably
all

effective

It

would
values

eliminate

of

specific

so that

generally

changes

in

the

fair

or the

part

of the hedge

It

would

also

eliminate

all

of the approaches

that

ineffectiveness

27

The

FASBs
as

effort to simplify

the rules for

hedge

accounting
that
it still

has not

been
to

completed
effort

of of

this

writing but the Board

has

announced
instruments

intends

pursue

this

as part

broader project

on financial

rather

than

as

separate draft

expedited

project

The Board
on

included

many of

the provisions

of the 2008

exposure

in

an exposure

draft issued

May 26 2010

Accounting

for Financial Instruments and

Revision to the Accounting

for Derivative

Instruments and Hedging Activities

19

Id

A3
Confidential

10

VII

Overview

of Statement

133

28

At some level the
articulated

FASB

tried

to take

principles-based

approach
as

to

Statement 133 of the

The Board
standard
all

four

fundamental

decisions

to

serve

cornerstones

derivatives

were were

to

be recognized on the balance be measured
at fair

sheet

all

derivatives

to

value

only

items

meeting the definitions

of assets and

liabilities

were to be shown as such transactions0

special

hedge

accounting was to be available

only for qualifying

With

all

derivatives

on balance and
losses

sheet

and

measured changed

at

fair

value

it

was

necessary the

to

account

for the gains

as the values

Under Statement 133
the derivative
is

accounting for the gains and
effective

losses

depends

on whether

designated

as and and

as

hedge

If the relationship are

does not qualify
in

for

hedge

accounting

gains

losses

on the derivative

recognized

earnings

29
called

Statement 133 provides fair value

for

two

different

kinds

of hedging

strategies.2

These
is

are

hedges
in

and

cash flow hedges
value

In

some
liability

strategies

the objective

to

protect

against

losses

the

fair

of an asset or
for

For example the holder buy
derivative to

of

100 shares

of

XYZ

stock currently

selling

$100

per

share could

protect

it

from the risk that the price
if

of the stock

might decline would
if

That derivative

would

pay

the holder

the share

price

declined

The hedge
for

require the stock

however
price

that

the investor

give 133

up

at

least

some of

the upside

potential

gains

went
fair

up

Statement

provides

for

fair value on both

hedge

accounting for such and
the

strategy

For

value

hedge
in

gains

and

losses

the derivative

hedged on

asset or

liability

are

recognized on the
the

earnings other

If the

hedge

works

as

expected
value

the gains

one

side offset the losses

Fannie

Mae made

its

fair

hedge
its

accounting transparent
securities

disclosing

cumulative

adjustment to the value

of

debt

from hedge

accounting.22

20

Statement Arguably

133 Statement
133 that relevant

21

provides

third strategy

for foreign

currency

hedges

but

is

not

here

22

2003

Form 10-K

at

146

Ill

Pa

Confidential

30
cash

In

other

strategies

the objective

is

to protect the

against

adverse

changes

in

an expected
rate

flow
with

Paragraphs
interest

15

and

16

above

gave

example

of the company with floating such as

debt
is

payments
will

that

vary

with

market index

LIBOR
would

If the

company

concerned
in

that rates

go

up

it

might enter into
provides for

derivative

that

effectively

lock

fixed

rate

Statement 133

cash flow

hedge

accounting for such
are

strategies the balance

In

cash

flow hedge gains or losses on the derivative

shown
gains

in

section

of

sheet

called

other comprehensive
hedged
item affects

income
earnings
at

or

OCT

The

or losses

remain

in

OCI

until

the

which

time they are moved works
the as anticipated

out

of

the balance

sheet

and

included

in

earnings

as

well

If the

hedge

the

gains

and

losses

will offset

in

the

same

future

period

reflecting

economics

of the

effective

hedge
future

in

the

income

statement planned
is

cash

flow hedge of debt

strategy rather

may
than

involve

forecasted

cash

flow such as

issuance

an

existing

asset

or

liability

Cash can

flow hedge
in

accounting
section

transparent

The

reader

of the financial stockholders
that are held
in

statements

see

the

OCT

of the statement

of changes

in

equity cash

and

in

related

table the amount

of any gain or loss on derivatives

flow hedge

relationships.23

31
deferred

In

summary

if

the strategy

qualifies

for

hedge
affects

accounting eamings

gains

and

losses

are

and

recognized

when

the

hedged

item

for cash
item

flow hedges
fair

or

offset

by currently of hedging

recognizing

gain or loss to avoid

on the hedged
losses

for

value

hedges

The purpose

activities

is

economic
the

and

volatility

The FASB

recognized that accounting needed
accordingly

to

reflect

economics

of effective

hedges and of hedge
the

provided for hedge
is

accounting

in

Statement 133
that

The purpose
not
reflect

accounting
underlying

to

avoid

volatility

of financial statements
cash

would
fair

economics
gains

Both and

flow hedge on hedging

accounting derivatives

and
in

value

hedge
period

accounting
as losses losses

work
gains

to

recognize

losses

the

same

and

on the related
derivatives

hedged would

transaction

Absent
earlier

hedge
than

accounting
losses

gains

and

on

hedging

be recognized

and

gains

on the hedged

23

2003

Form 10-K

at

80 table

31

124

12

Confidential

positions

generating

accounting

volatility

that

would

misrepresent

the

economics

of the

transaction

32
133

Not every One of
to the

derivative

transaction

can qualify
for

for

hedge

accounting
is

under hedge

Statement
is

conditions

for qualifying

hedge
said to

accounting be effective

that

the

expected sometimes
derivative

be

highly

effective
item

hedge

is

if

the

losses

and

gains

on the hedged

are offset

by gains

and sometimes

losses on the

33

Statement 133
in

introduced

the idea

of measuring ineffectiveness Simply compare
value the

Ineffectiveness

is

easy to understand
fair

fair

value

hedge
change

amount

of the change item

in

the

value

of the derivative changes
is

to the

in

the

fair

of the hedged
is

Assuming
For

one
cash

of those

gain

and the other
those

is

loss

the difference

ineffectiveness

flow hedges
eliminate or

however
reduce

including

involving

forecasted

transactions

the objective

is

to

variability

in

future

cash

flows
cash flows

If there

is

ineffectiveness

it

is

necessary

to convert

differences

in

those

future

into

an

amount
that

of gain or loss to

be recognized
than

After

Statement 133

was issued
gains

it

became

apparent

there

was more
cash

one

supportable

way

to

measure

or losses

from ineffectiveness

in

flow

hedge.24

VIII

Assumption of No

Ineffectivcness

34
in

Statement 133

sets forth

requirements for assessing

and

measuring ineffectiveness

paragraphs 62-70 methods method and
to

Those

paragraphs are attached

as Exhibit

The FASB

did

not

specify

be used for that purpose hedge
effectiveness

recognizing

that

appropriateness

of

given

of assessing

can depend

on the nature
also

of the risk being

hedged would

the type

of hedging
in

instrument

used.2S
that

The FASB

recognized that there
qualify as highly derivative

be situations would
the entity

which

determining
critical

hedge

relationship

would
the

effective

be easy

If the

terms of the hedged hedge would

item

and

hedging

match

could assume

that the

be sufficiently

highly

effective

that

24

See

DIG

Issue

25

Statement

133

62
Confidential

13

measurement
these

of

in

effectiveness

was unnecessary
be
literally

The Board and
that

understood that the hedges would
not

in

relationships

would

not

perfect

ineffectiveness

be

zero enough

but that the ineffectiveness

could

be

determined to be inconsequential

or small

to

ignore

35
qualify

While
for

paragraph 65 clearly contemplates
ineffectiveness

number of

relationships with

that

would

an assumption of no
to

ANT

approach

no computation
to recognize

being

necessary

measure Board

ineffectiveness did

and which

no accounting
instruments

entry

made

any

ineffectiveness

the

not

specify

or relationships

would

qualify the

and

did

not

set

forth

list

of the
this

critical

terms

except

in

several

examples6 Thus
terms based on

accountant

who would

apply

approach

must assess

the

critical

understanding the economics

of the relationship

36

Paragraph
case

68 of Statement 133
interest rate

is

special

case

of the
the

ANI

approach
did
set

In

the very

common

of hedging
the

risk with

swap

Board

out the

critical

terms and relieved Those

accountant

of the responsibility

of assessing

the

economics
as the

of the

relationship

relationships

became known

among

practitioners

shortcut

method 37
It

is

clear

that

the

Board

intended

to provide

for

ANT

approaches

beyond

the

paragraph 68 shortcut
Disclosures

method

In

recent

amendment of 133 Statement 161
Activities the

About

Derivative

Instruments and Hedging encompasses
its

FASB

notes

that the

assumption of no ineffectiveness paragraph

the shortcut

method

and other

methods

In

A65
the

commenting
states that

on

reasons

for not requiring

disclosure

of the extent might

of such
reflect

methods
negatively that

Board
entities

Those

Board

members

noted

that

this

disclosure

on

appropriately

use the shortcut

method

as well

as other

methods

assume

zero

ineffectiveness

38

Apart from the special

case

of paragraph which
the

68

to apply

an

ANT

approach

under an
the

Statement 133 the entity must
understanding

identify

terms are critical hedged
item

which

requires

of the economics

affecting

and the derivative

To

apply

26

Examples

are

found

in

paragraphs

65 155

and

161

of Statement

133

14

Confidential

AN
term

approach
in

it

may

also

be necessary to determine what

match

means

for

each

critical

the context

of the particular hedge

39
change

The Board
in

understood that hedges are rarely
value will equal to the

if

ever perfect change
in

in

the

sense

that

the

the derivative

penny

the

the

hedged

position

Further some terms may be impractical might mature on the same day two
transactions to as

to

match
item but Even

exactly
it

For example
difficult

derivative

hedged same

could be

to

arrange
all

for the

happen

at

the

instant

transaction

that

meets

the

criteria

for the

paragraph 68
is

shortcut method
Statement 133

will generally

have

some

ineffectiveness

but the

amount

minimal
like

and
all

does not require
explicitly

measurement
that

or recognition.27

Statement 133 Statement need

FASB

Statements
to immaterial

provides

the

provisions

of

this

not

be applied

items.28

40
have

For the

ANI

approach

it

should be sufficient
that
is

for the

critical

terms to be those and
for

That

the potential to

to create

ineffectiveness

more than
than

inconsequential

match
create

be

difference

in

those

terms smaller
than

what

would

have
staff

the potential

to

ineffectiveness

that

is

more

inconsequential

The SEC
cited

has explicitly currency occurred

recognized the validity of hedging
within relationship the

this

approach

The example

was

foreign

where
but

the settlements

of the hedged

item

and the derivative

same month

on

different

days9

27

Paragraph assuming
discount

70 of Statement no
ineffectiveness

133

recognizes

this

Comparable
achieving

credit perfect

risk at inception offset the

is

not

condition

for

even

though
the rate
fair

actually value credit

would

require or

that the

same

rate

be

used the

to

determine
discount

of

the

swap

and of
to

hedged

item

hedged
as well

transaction as to the the that

To

justify

using the

same

the

risk related
fair

both

parties

to the

swap

debtor interest

on

hedged
are

interest-bearing

asset

in

value

hedge
have and

or the to

variable-rate

asset

on which because
easily

payments
is

hedged by
the

in
not

cash

flow of

hedge
interest

would

be

the

same

However
are not

complication

caused

interaction
is

rate risk

credit to

risk

which no

separable
in

comparable hedge of

creditworthiness rate

considered

necessary

condition

assume

ineffectiveness

interest

risk

DIG
all

Issue the

E-4 notes
applicable the

Statement
conditions
in

133

acknowledges 68

in

paragraph

70

that

hedging some

relationship

that

meets

of

paragraph

may

nevertheless

involve

ineffectiveness 133 permits application

notwithstanding of
28

supposed

assumption does
not

of no ineffectiveness such
ineffectiveness

Yet Statement
currently
in

the

shortcut

method which
following

recognize

earnings

Statement

133

56
Mr
Barron
in

29

See info paragraph inconsequential

51

takes

issue

with

the

use

of

the

terms

practical

applications

and one
next

ineffectiveness

Fannie

Maes

implementation of Statement

133

In

my

view on

of

continued 15

page

Confidential

41
effective

In

my

opinion

an

ANI

approach

is

an appropriate

way

to apply

133

in

cost

manner

IX

Fannie

Maes

Use of Derivatives

42
interest

understand

that

Fannie

Mae made 31 2000

extensive

use

of derivatives

in

managing

rate risk

At December
total

Fannie

Mae

held

approximately Fannie

1400

derivative

contracts

with

notional

amount
assets

of $324.7

billion.30

Maes

assets consisted

mostly of fixed rate mortgage with various Although
frequently debt cash maturities

To

finance

these

assets

Fannie

Mae

had

liabilities

including notes

significant fixed rates basic

amount

of short term discount and

notes

the discount

had

they

matured

were refunded rolled over program

at

market rates
so the

The

objective

of the hedging vary with
the

was

to structure

the

flows

interest

expense

would
if

interest

earned

on

its

assets

locking discount

in

positive

spread
rise

For example

interest rates

went
rate

up

interest

on the rolling
assets

notes

would
result

while interest income
or

on the fixed

mortgage spread

remained

constant
entered

The

could reduce
contracts the derivative

even

eliminate

the positive

Fannie

Mae
cash

into derivative

including

interest rate

swaps

so

that

the

combined

flows of the debt from which even
its

and

would were

have

stable

relationship

with the cash

flows

assets

Hedging
to

activities

an important
relatively

part stable

of Fannie

Maes

business

model

was
as

intended

produce

consistent

profit

margins on

its

portfolio

interest

rates

and

mortgage

prepayments

varied

Fannie

Mae

Implementation

of Statement

133

43
would

understand

that

Fannie

Mae
to

recognized before
it

Statement 133 Fannie and

was

issued

that

it

be complex
effort

and

difficult

apply

to

its

business

Mae

undertook an
as well as

extensive

to

plan

for transition

working

with

its

auditor

regulators

continued the

from

previous
in

page
every

FASBs

objectives
is

Statement While
is

is

to

make

sure

practical

application ineffectiveness

is

possible

and

cost
in

of

the

implementation Statement
to

reasonable

the

words

inconsequential term
for

do

not

appear

133

in

my

view

that an

perfectly

acceptable

amounts was

of

ineffectiveness to denote

small

enough

be

not

recognized fhose

under
that

ANI
be

approach

inconsequential

intended

amounts

much

smaller
30

than

would

simply immaterial

See

FMCI V-OS 00394376

at

4380

16

Confidential

employees Derivatives

from different

parts

of the organization
as

result

of that effort was the which

Accounting

Guidelines known
policies for

the

DAG

was The

sizeable

book

setting forth the

companys

applying

Statement

133

DAG

included

diagrams describing
outline

pictorially the

cash flows to and and
its

from the counterparty

as well

as

an

form description

of the transaction

accounting.32

44

The volume

of transactions
the
fact

the

number of hedging
guidance

strategies to

the

complexity from the

of and of

Statement 133 and
the

that additional

continued

emerge Fannie

DIG

SEC
volume

combined

to

make implementation
computerized

major challenge approach
there

for

Mae
of

Because

the

of transactions Fannie
that

was an

essential

part

implementation
software available

Mae

discovered

that

was no

readily

available

off the

shelf

would

meet

its

needs.33

45
define

As

part

of

its

extensive

effort to

implement
qualify

Statement 133 Fannie
for an

Mae

decided

to

series

of relationships Fannie

that

would

assumption of no
the transactions

ineffectiveness

Under and

this

approach
as

Mae

would where

generally

limit

they

entered

into

designated

hedges to those and
there

it

would no

be easy to assess that the hedge
to recognize
in

was

very highly

effective

would because

be
the

ineffectiveness

eamings and the
into

during the term of the hedge
derivative matched.34

critical

terms of the hedged

item

This approach would

meant that Fannie been

Mae

would

not enter

some
been

transactions

that otherwise

have have an

economically
for

attractive

that

would

have

economic
but

hedges
not

and that would
for

qualified

hedge

accounting under

Statement 133

would

have

qualified

ANI

approach

46
of the
not

understand that there were

occasional

transactions

that

fell

outside

the

parameters
did

AN

guidelines

because the
for the

critical

terms did not match
ineffectiveness

Since

these

transactions

qualify

DNQ

assumption of no

although

they

did

qualify

for

hedge

accounting

ineffectiveness

was

calculated

using

long-haul

and

recorded

The

See
32

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Jonathan

Boyles

civil

276-77

September

16 2009

Statement

65
Confidential

17

fact

that

ineffectiveness

amounts

for these

DNQ

transactions

were

also

inconsequential

amounts

to

de facto periodic

reconfirmation

of the reasonableness

of the

implementation.35

47 swap
the

Fannie

Mae

also

made

extensive

use

of options

and

swaptions

an

option

to acquire

as

hedging
value

instruments of these

As

permitted as the

by Statement 133 Fannie hedging
in

Mae

designated

intrinsic

instruments

derivative

the

time value

was
in

not

part as

of the hedging

relationship

and changes

the

time value

were

recognized

earnings

they occurred

48

Tn

my
and

opinion

Fannie

Maes

approach of

to

implementation
in

of Statement 133 time period

was

reasonable

appropriate

application

GAAP

the relevant

XI

Issues

Raised

by Fannie

Mae

Implementation

49
Fannie

The

following

sections

discuss

certain

issues that

have

been

raised

specific

to

Maes

hedge

transactions

Was

it

reasonable
in
its

under

GAAP

in

the relevant time period
to

for

Fannie on
the

Mae
basis

as

it

described

letters to the

SEC36

assume no

ineffectiveness

of item

analysis

that

showed

that

minimal

variances

between
to

the

terms

of the hedged

and the hedging
ineffectiveness

instrument would be

expected

produce

inconsequential

amounts of

50
way
to

As noted above

in

my

opinion

an ANI

approach

is

reasonable

and

appropriate

apply Statement 133

and

is

specifically

provided for

in

paragraph which

Further to terms are
item

apply an critical
derivative

ANI

approach

under

Statement 133 the entity must of the economics
is

identify the

based on

an understanding
the

affecting

hedged

and the

To

apply

ANI

approach

it

also

necessary

to

determine what

match

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Mr
all

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that

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chosen produce
the

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paragraph

narrowly exactly

as

paragraph
with

68

requiring reading

that

terms

could

possibly could to

ineffectiveness use

must match approach on
the
in

Even

such
criteria

of
to

paragraph

65 one
be

support

of

an

ANI

for transactions

that

met

calculated this

limit ineffectiveness

inconsequential

amounts

based

language
all

provisions

of

Statement

need

not

applied

to immaterial

items which

appears

FASB

Statements

18

Confidential

means

for

each
to

critical

term

in

the context

of the particular hedge between
the
critical

The

critical

terms would
item

be deemed
that

match

when

the difference

term of the hedged
is

and

of the hedging
is

instrument

are small

enough
its

that

ineffectiveness

inconsequential

That

the

approach

Fannie

Mae SEC

used

in

adoption

of Statement 133

5L

As

noted

above

the

staff

endorsed

very

similar application

of an ANI

approach

The minutes of

the

EITF meeting of March 15 2007
indicated that
in

report

An SEC
applied

staff

member

situations

in

which

registrants

have
the

the item

critical

terms match

method

when

the

terms of the hedge

and

hedged been

do not exactly
registrants

match
would

but the other

provisions

of paragraph 65 have

satisfied

generally the

be expected

to
conclusion that

Evaluate and
the

support

reasonableness item to

of the original matched
that the

terms of the hedge Perform

and the hedged assessment

quantitative

confirm

relationship

was

highly If the results

effective

and that any ineffectiveness
that there

was de minimis
basis to assert that the

confirm

was

reasonable effective

terms

matched

that

the relationship

was

highly

and

that

any

ineffectiveness

was

de minimis

continued application

of hedge hedging
within the

accounting may be acceptable.38
relationship

The example
hedged
item

cited

was

foreign

currency occurred

where

the settlements

of the

and the derivative

same

month

but not

on the same

day

52

In

addition
similar

2001

publication

distributed

by another
dates

Big

accounting
rate

firm

describes

approach

applied

to the repricing

of an

interest

swap

company may
ineffective not exactly

believe

that

its

interest

rate

risk

hedge

design

is

marginally the

perhaps

because the repricing

dates

of the swap and
the

hedged

item

do

match

However
that say could

the incur

company can approximate
as long as

maximum

amount

of ineffectiveness
reasonable clearly

market
If
this

interest

rates

remain within
is

range

between

4% and 8%
as

worst case
policy

ineffectiveness that

immaterial

company might be able to establish
as long

no earnings
certain

adjustment will be recorded

market conditions

remain within

38

See http//www.fasb.org/jspIFASB/Page/03-1 Heads

5-O7mtg_minutes.pdf

footnote

omitted

see

also

Deloitte

Up

Vol 14

Issue

dated

March

19 2007

available

at

http//www.deloitte.com/view/en

US/us

Communications/Saa7e33d39Ofbl

1OVgnVCM

00000ba42fOOaRCRD.htm

19

Confidential

range
the

This policy

would
not

be solely based on the guidance
to immaterial

that

the

provisions

of

Statement need

be applied

items.39 approach

53
2007

Another

Big

accounting firm recognized

this

was widely

practiced

in

publication

Many

registrants for

have

historically evaluated provisions that

the effectiveness

of hedging
possibility

relationships creating potential

only those

may have

reasonable

of

more

than

de minimis amount

of ineffectiveness pose only were
often

Other sources

of
rise

ineffectiveness

i.e
believed

those

that

remote chance
evaluated aspects

of giving

to In

significant practice

amount
entities

of ineffectiveness
that

only qualitatively of hedging and

many

only the material

relationship

i.e
to

the

critical

terms need

to be quantitatively

assessed

documented

qualif5i in

for the application believe
critical

of hedge
the

accounting under
item

FAS 133

For

example many
within the

practice the

that

if

hedged

and the derivative were

settle

same month
matched
for

terms of the hedging of applying

relationship

sufficiently

purposes

paragraph 65 of the Standard and
the qualitative

Therefore assessment
formally

no quantitative of those

assessment

was performed

de minimis sources

of ineffectiveness

may

not

have

been

documented

Our

historical

perspective that

has

been

that

if

there

were

any sources

of variability

in

hedging

relationship

were not perfectly matched might
still

an assumption of no
acceptable
if

ineffectiveness

under

paragraph 65

have

been

an entity had any amounts

reasonably demonstrated an expectation of ineffectiveness would
its

of high effectiveness

and

that

be de minimis.40 approach
in
its

54

Fannie

Mae

described

letter

to

the

SEC

in

the following

terms

Although

FAS

133 requires With
respect

an assessment
to

of effectiveness

it

does not prescribe

methodology
assessment and hedged

many of Fannie Maes hedge
is

relationships

of hedge

effectiveness

based on matching

key terms of the derivative

item including Based on
this

consideration

of the credit worthiness of the derivative
effectiveness

counterparty
the

method have

of assessing

we concluded

that also

hedge

relationship that as long

would
as the

no or inconsequential

ineffectiveness relationship

We

concluded

key matching

terms of the hedge

were

FMCIV-03
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Developments of

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for

and Hedging
at

Comprehensive emphasis
in

FASB Statement

Amended and
40

Interpreted

4.36

Dec

2001

original

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PricewaterhouseCoopers 393-94

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to

Accounting

for

Derivative

and

Hedging

2007
Confidential

20

maintained on
periodic

there

was no need

to

measure

ineffectiveness

on

individual

transactions

basis.4

55
were

In

summary

Fannie

Maes

application

of an

ANI

approach
that

using

critical

terms that

matched

within

defined

limits calculated

to assure

unrecognized and

ineffectiveness

was

inconsequential

was

reasonable

and

appropriate

was

consistent

with the interpretation

of Statement 133

that other

knowledgeable

accountants

adopted

Was
no

it

reasonable

under
on

GAAP

in the

relevant

time period for Fannie
as

Mae

to

assume

ineffectiveness

hedges

of discount
rates

notes such
reset

DAG

transaction number
as

when

the dates on which the swap of the discount

were not the same

the dates of

issuance roll over

notes but were within

1-

days
of
its

56
notes

One of Fannie Maes hedging
Discount notes of each
interest

strategies

was

hedge

of the rollover on

discount

are short

term notes

Fannie

Mae
in

issues

regular wilt be

basis

on based on funding match

Wednesday
then-current

week
rates

Because

the notes

issued

the future

priced

the discount

note

program
issuances

is

effectively cash

floating

rate

source

The

interest

payments of
its

on the thture

have

flow risk

To
to

better

the characteristics

assets

to lock in
flows
It

spread Fannie Mae needed
achieve
that goal

have

funding of the

source

with

fixed

interest

cash

could

with

combination would be

discount

note

program

and

derivative

such as

swap.42

The swap

pay-fixed-

receive-floating

instrument

extending for the period
its

of time that Fannie
such as 10

Mae

estimated

would

match

the

life

of some of

fixed

rate

assets

years

57

Fannie

Mae

applied

an

ANI

approach
with

to these

hedges

Because 90

the

discount

notes

were issued only on Wednesdays swaps
with

and

fixed maturities

e.g

days

while available

90 day reset intervals might have
to

been

issued

on any day of the of the swap

week
occur

it

was

not practicable

have

the

maturities

of the notes
if

and

the reset

on the

same

day

Fannie

Mae

determined that

the dates

were

within

1-

days

the resulting

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ineffectiveness

would
date

be inconsequential

That

is

one

of the

critical

terms was the

reset/maturity

and 1-7 days was

match.43

58

understand that Fannie
that

Mae

did

quantitative

assessment
prior to

of the amount and

of

ineffectiveness

could result from the 1-7 day policy
that

adoption

that they

reconfirmed subsequent

and updated
analysis

assessment

in

2003

Those

analyses

concluded

and

has confirmed45

that the

amount

of ineffectiveness

was

inconsequential

59
previous

This

is

an example

of the general
cited
in

application that

of an

ANT

approach

described

in

the

question

The guidance

discussion

from Ernst
the

Young
of dates

in

2001
are

and

from the
close

SEC

and

PricewaterhouseCoopers
matched.46 In

in

2007
the

uses

example
to

that

but not exactly described

my

opinion

approach

the discount

note

hedging of

program

above days was nnder
for

including

the use

of the ANT

approach

and the definition

match
Was
no
it

as

1-

reasonable

and

appropriate

application

of Statement 133

reasonable

GAAP

in

the

relevant

time period

for

Fannie

Mae

to

assume
the

ineffectiveness

termouts

DAG

transactions

number

2-4 13 and

20

when

fair

valne of the

initial

swap

was not zero

at

the date of the termout

60

Term-outs are

variation

on the discount
discount

note

hedge hedge

Sometimes

because of
notes

market conditions would be replaced swap

during the term of
with

note

the

90-day discount would
enter

medium-term
the

fixed-rate

note

Fannie Mae and

into

pay-floating the original

so that

combined

cash

flows of the note
cash

swap

are the

same

as

discount

notes and the combined

flows of

all

three

instruments

are the

original

fixed rate

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46

51-53

22

Con fidentia

61
hedge of swap

understand that one

possible

criticism

of the application
the term-out

of an

ANT

approach

to

accounting for term-outs
the
fair

is

that

if

one believes
not

requires

redesignation

value

of that swap

would

be zero

at

the

time of redesignation

62
at

The paragraph 68 shortcut method
Regulators

requires

that

the

swap have

fair

value

of zero of
this

designation

and 65

auditors

have
such

taken

very

literal

rules-based

view

requirement
rule
is

Paragraph
to

includes

no

requirement

In

my

opinion

the

same

rigid

not required

qua1if

for the

ANI

approach

under paragraph approach

65

especially

for cash

flow hedges and
cost

Because

paragraph 68 provides
for very

mechanical
defined

reducing the effort
that

of hedge

accounting
the

specifically

transaction

happens

to

be

frequently

encountered
is

Board

defined

very specific

qualiing

tests

Because Board

the

ANT

approach
attempt to

potentially

applicable

to

wider range of transactions
in

that the

did

not

describe

specifically

except

some examples

the

approach

is different.47

63

note

that

the

termout transactions

are similar to

and
It

in

fact

were the inspiration be true
the
in

for example example
that

in

paragraphs 159-161
fair

of Statement 133

would
at

also

that

the

value

of the
the

first

swap would

not

be zero

the date

second

swap

was added
derivatives

Nevertheless
are effective
at

Board

concluded changes swaps
in

Together
the
interest

the cash

flows from the two on the.three-year comprehensive the mention
is

offsetting

payments
in

note income

Changes and

in

fair

values

of the two
to earnings affect

are

recognized

other

are reclassified

when as

the

hedged

forecasted

transactions

variable

interest

payments

earnings

required

by paragraph

No

made of any recognized

ineffectiveness

64
included

Mr Barron
in

makes

reference

page 40
that

to

an amendment of example
to the

that

was
deleted

Statement 138

He

notes

reference

shortcut

method

was

Mr
not

Baron

recognizes

pages

9-1

and

35
12

that

Statement

133

incorporates that

both

the

shortcut

method
did

1168 and

the

matched

terms method
133

1165
rests

His primary on
the idea

conclusion that the

Fannie

Maes
not the

accounting

comply

with or

Statement

page

accounting

could extends

quali

for the for than

matched
the

terms

ANI

approach matched
there
is

In reaching

that

conclusion

he

incorrectly

requirements different value

shortcut

method

to the

terms approach no
requirement

As
under

described paragraph

above 65
for

the

two

are
initial

more
fair

he

appreciates

In particular

zero

or for

terms
48

to

exactly 133

match

Mr

Berliner

makes original

similar

argument

page

3-10

Statement

11161

parentheticals

in

23

Confidential

and

concludes

that

the intent

of the amendment was to preclude

an assumption of no
undeleted portion values

ineffectiveness

He does above
in

not

make

reference

to the

remaining

of the of the two

paragraph quoted swaps

In

my

opinion

the

language

in

fair

are recognized

other

comprehensive

income..

contained

in

the

amended

example
technical

clearly correction

describes

an

ANI

approach
to

The Statement 138 amendment was
paragraph 68 and the short
all

to delete

the reference

cut from what

should

have

been

an example

of

paragraph 65

ANI

approach

along

65
developed
be thought

believe

that

in

the relevant

time period have hedge had

when Fannie Maes
views
or

policies

were should
at

reasonable

people could
continuing

different

on

whether

term-out

of as

single

relationship

new hedge

relationship

the

time

of the term-out requiring
that
it

redesignation the

of the hedge hedge

with regard to swap

understand

was known
discount

at

time the original
involves

was

put

on that term-outs rolled over been

could

occur

The

basic

note

hedge
put
in

discount

notes

issued

periodically as part

after

the

hedge

is

place

The medium term
swap

note

might have
out

viewed

of that rollover and
since

process
the cash

Since

the original overall

was never

of
rate

hedge
that

relationship

flows

achieved

the desired

fixed

was

the

objective

of the strategy
that there

with

or

without hedge

the

term-out one

might reasonably
redesignation

have
is

reached

the conclusion

is

single

relationship

and no

necessary

66
fact

Even
that

if

the

termout

is

considered

new hedge

relationship use

and

redesignation

the

swap
that

has

non-zero

fair

value

does not preclude

of an ANI approach
in

understand

Fannie

Mae
did

in

addition

to relying

on the guidance
to

the

example

in

paragraphs 159-161
resulting

also

quantitative value

assessment

determine that the ineffectiveness occurred

from the non-zero

fair

of swap

when

the term-out

was

inconsequential.49

67
helpful

The
but

term-out

transactions

are

complex

The example

in

paragraphs 159-161

is

it

does not address

all

the details

of application
instruments

of 133 to these
did achieve

transactions

It

appears

that the overall

combination

of these

the objective

of

FMs

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Confidential

cash

flow hedge
reasonable

In

my

opinion

the

approach

to

accounting

for term-outs

described

above

was

and

appropriate

application

of Statement 133

Was
no

it

reasonable

under when
at

GAAP ia

the relevant
in

time period hedge

for

Fannie

Mac

to

assume
the

ineffectiveness

using swaptions

varions

strategies

even

though

fair

value of the swap

the date of exercise

would not be zero

DAG

transactions

10

11 67 and 68
convert
it

71
is

swaption
to

an instrument
specified

that

gives

the holder

the right

but

not the obligation

to

swap with

terms

at

future

date
sided

As

with

other

option

instruments

the

buyer pays

premium

at

origination

and

has

one

protection

Statement 133
item

clearly value

contemplates that changes
in in

hedge

strategy or

can

designate certain

as the

hedged
In

changes

in

or

cash

flows above
it

below

level

such

strategy

the option not

will

always be
but

the

money when
expire

is

exercised
In

if

it

was
use

out

of the money

it

would
for

be

exercised

would

worthless and

my

opinion

of an

AN

approach

such

strategies

was

reasonable

appropriate

application

of Statement 133.50

Was
no

it

reasonable

under when

GAAP

in

the relevant time period
as the critical

for

Fannie

Mae

to

assume

ineffectiveness

using dnration

term

in

hedges

of anticipated

debt issuances

69
assets

Anticipatory

debt

hedges
to acquire

were

used when time
in

Fannie

Mae

planned
to

to

issue debt

to

fund
the

it

was committed

short

the future

up

30

days

Because

assets

Fannie
rate

Mae was

committed
than

to acquire

had

fixed rate

and

the currently

available

funding

was lower
to

the rate

on the assets
spread

Fannie

Mae

entered

into derivative

transactions

lock-in

the positive

over the estimated

life

of the assets.5

70

Fannie

Mae

applied

an

ANI

approach

to

accounting for these
the
critical

hedges

In

its

duration

matching approach

Fannie

Mae

defined

term as the product of

Mr

Barrons

report

pages
the

45-47
non-zero
as

objects
fair

to these
at

transactions date

and

notes

that

it

is

the not

same
agree

issue

as the

termout
should

transactions

value

the

ot exercise

As noted
it

do

that this

necessarily

be viewed

new

relationship

or that

even

if

is that

precludes

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of

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Confidential

duration

and

notional

amount
to

Duration
in

is

direct

measure

of the sensitivity

of the value

of
value

fixed-rate

instrument

changes

interest

rates

based on the weighted
instruments with the

average same

present

of have

all

of the cash same

flows of the instrument
to small

Two
in

duration

will

the

sensitivity

changes
with the

interest

rates

and

thus will

be more

effective

hedges than and
in

two

instruments

same
an

final

maturity

Duration
value

is

more
change

sophisticated with

exacting

measure
rates

of how

much

instruments was

fair

will

change

interest

The same

duration

matching hedge

used for both and

the business

decision

of selecting

an economically
that the use

appropriate

relationship

for the

accounting amount
is

understand

of the product and

of duration

and

principal/notional

standard

approach

in

finance

economics.52

71

Fannie

Mae

defined

certain

ranges

of duration
that

as

matching

closely did

enough

to ensure

inconsequential

ineffectiveness

understand

Fannie

Mae

initially

quantitative

assessment
periodically

of the effect updated
that

of duration assessment

differences

within

the selected

ranges

and

that they

for selected

transactions.53

72

As noted above
It

the

FASB

did

not

try

to define

the

critical

terms for an

ANI
to

approach
understand

is

necessary

for the accountant

who would
and

apply an

ANI

approach

the

economics

of the instruments

to identify

based on that understanding
inconsequential the
critical

the

critical

terms and
In

how

precisely use

they

must match

to ensure with

ineffectiveness

my

opinion

of an ANI
appropriate

approach

term defined

in

terms of duration

is

reasonable

and

application

of Statement 133

Was

it

reasonable

under

GAAP

in the

relevant

time period
in target dollar

for

Fannie between

Mae
the

use hedged

de

minimis test of ineffectiveness item and the hedging measuring

based

on

changes

yield

instrument as of hedges

part of

offset

approach

to assessing

and

ineffectiveness

of anticipated

issuances of longer dated

debt
did

73

understand that Fannie
for the

Maes

approach

provided for occasions

when
situation

hedge

not qualify

assumption of no ineffectiveness

ANI

If

such

arose the

52

understand

that

if

the

products

match
also

closely

and See

the

durations

match

closely

then

mathematically

the

principal/notional

amounts

must
at

be close V-OS

Expert

Report of Dwight
at

Grant

See

FMCIV-05 00394376

4400 FMCI

00700330

0372-88

26

Confidential

DAG
with

provided

that

Fannie

Mae

would

assess

effectiveness

using the

dollar offset approach
in

de minimis test
is

Under
to

the dollar offset

approach
item

change
the

the

fair

value

of the

derivative

compared
ratio
is

the

change

in

the

hedged

and

hedge

is

deemed

highly

effective

if

the

between
in

80-125%
both values
in

This method
are

will predictably If the relevant

fail

on many

occasions

when

the

changes
the

small

markets were

essentially

unchanged
even

changes and

$1000000
If the dollar

hedge
offset

might be method

$l
is

and

-$0.50

for

ratio

of

50% or

$1

$O.50
DIG E-8
when

to

be used which
so that

was

clearly

contemplated

see

it

needs to include change

provision

numerical
call

results outside

of the 80-125

range

the absolute

is

de minimis do not

into

question

the expectation

of high

effectiveness.54

74
use

am
of

aware

of
test

2003

SEC
of

staff

speech that some have
offset

interpreted
is

to proscribe

the

de minimis do

as part

dollar

method

because that

viewed

as

two
be

methods.55

not agree

with that interpretation
to

of Statement 133
as discussed

believe

it

would

an inappropriate
it

amendment
use

Statement 133 because
offset

above

it

would

make

impractical

to ever

the dollar

method

75

In

my

opinion

Fannie

Maes

use of

de minimis
reasonable

test

as part

of

dollar offset

approach

to assessing

ineffectiveness

was

and appropriate

application

of

Statement 133

Was

Fannie

Maes

approach

to

hedge documentation
documentation
relevant

which

viewed

the

DAG

and the
of

computerized
the

system as parts of that of Statement 133

reasonable time period

interpretation

requirements

in the

76

As

spelled

out

in

EITF

topic

D-102

documentation

of

hedge

should

include

identification

of

The hedging

instrument

derivative

54

Mr
as

Barron of

page

47

and

Mr

Berliner

page

3-18
such
that

both

assert

that

Fannie

Maes
that

use did

of
not

de minimis
use

test

part

the

dollar

offset

method

of

assessing

effectiveness
test is

for transactions necessary part

an

ANI
method and

approach Statement John

was 133

inappropriate clearly

As noted above
the use

of

the

dollar

offset

contemplated
National

of

method SEC
Developments

James AICPA

Conference
1211

on

Current

Dec

11 2003

available

at

http//www.sec.govfnews/speech/spch

O3jmj.htm

27

Confidential

The hedged The
nature

item

or transaction

of the risk being hedged
that will that will

The method The method

be used retrospectively be used to measure

and

prospectively

to assess

effectiveness

ineffectiveness

The extent form and
received considerable

level

of precise
as

detail

of that documentation
auditors

was something
worked
increased to

that

attention

accountants

and regulators documentation

implement
first

Statement 133

In

general expectations

for

over the

years

of implementation

77
into the

understand that

some of

the

hedge

documentation

Fannie

Mae

relied

on was coded of Statement of that

computer

systems that were developed documentation
rigid
in

as part

of the implementation above
the

133

Statement 133 requires

and

as noted

the interpretation

requirement has been
there
is

increasingly

the years

after

Statement was issued but
In

no

requirement that Fannie

all

documentation

has to be on paper and
appropriate

my

opinion

the

approach

Mae

followed was reasonable

Did Fannie
the

Maes

use of the terminology
to

shortcut method
affect the

in the

original

version

of

DAG

when

referring

an

ANI

approach

substance

of compliance

with

Statement

133
has

78

The term shortcut method
discussed
in

come

to

be associated
in

only with

interest

rate

swap

transactions

paragraphs 68-70

Early

the

life

of Statement 133

at

Fannie

Mae

and

elsewhere

that

usage was not always consistently

observed
outlined

by practitioners
in

causing some confusion shortcut

One

could

also describe

the

method

paragraph 65 as

79
refer to

In

my

opinion

the

fact

that

the

word shortcut was used
problem approaches

in

the

first

edition

DAG

to

ANT

approaches

is

not

substantive

The

DAG

includes

an

understandable description reviewed

of the hedging

Fannie

Mae

used for the transactions

On
80

Volatility

It

has

been

suggested to

that

one

of Fannie

Maes

objectives

in

its

implementation

of

Statement 133

was

reduce

the

volatility

of reported
with

earnings

Mr

Barron notes

page

15
28

that

management of Fannie Mae

disagreed

certain

provisions

of Statement 133

Confidential

and

that

one

of managements
true

objectives

in

implementing

new

GAAP

standards

was

to

reflect

the

economics

of our business without

He

follows

that with

the observation

that

the

true economics

complying
objective

with

GAAP

is

unacceptable
strategy

note

that

eliminating

volatility

is

the business

of any hedging
represent the

and

that

eliminating

accounting
is

volatility

that

does not reasonably of any hedge

economics

of

business

transaction

always the objective

accounting
all

In the

development
to
fair

of Statement 133 the
with gains

FASB

recognized that simply marking would

derivatives

value

and

losses

to earnings

show

volatility

not representative

of the actual

economics accounting
years to

when

the derivative

is

part

of an effective

hedge

and

would

be inappropriate over several

That was the reason hedge

for the

investment of significant
the extent

efforts

develop

accounting

To

Fannie

Maes

hedges were effective
faithful

economically
financial

hedge

accounting provides would
that

better

more

representationally

reporting

than

the application

of Statement 133
has

without

hedge

accounting were
an

understand

subsequent
that

analysis

shown
not

that

Fannie

Maes

hedges of

economically approach

effective

and

the ineffectiveness

recognized due

to the use

ANT

was

minor.56

November

2010

Timothy

Lucas

Date

56

See Expert Report of Dwight
its

Grant
earnings

As

noted

above occurred

Fannie As

Mae
result

recognized the

changes

in

the

time

value

of were

options

and swaptions

in

as they

earnings

Fannie

Mae

reported

quite

volatile

29

Confidential

Exhibit

Resume

Timothy

Lucas

3863

Attley

Drive
980 7759

Louisville
E-mail

TN

37777

865

Tim@LucasFR.com

Experience

LUCAS

Financial Reporting Consultant on have
that included issues related consulting to

May
Generally Accepted
corporate as well

2002

to

Date

Independent Engagements
past

Accounting

Principles

GAAP
with both

with

management on
as appropriate legal counsel

problems identified accounting
as

accounting

might require

restatement
involved various

for prospective
in

transactions testiFying and investigations

Other engagements
consulting roles
in

working
civil

with

an expert

and

criminal

legal proceedings and

SEC

Neenah Member

Paper Inc
of the Board and Chairman of the Audit Committee of
this

2004

to

Date

NYSE Company
1988
to

Financial Accounting Director of Research

Standards

Board

FASB
EITF
the Director position

2002

and Technical
Issues

Activities

Chairman Emerging
As
the leader
full

Task Force
staff

of the

FASBs technical
Members
health

was on

the
in

same

level as the

seven

time Board
including

That
care

role involved

active

participation

all

major

FASB

projects

retiree

costs income

taxes

not for profit organizations instruments topics notably

impairment
derivatives professionals timely those regular basis

of assets and

stock

compensation
as

and various Chairman
debate

financial the

hedging-

Also served
six

of

EITF
Board

group

of top accounting
issues

that

met

times

year to

and and
in

resolve

financial

reporting also

on
in

The Chief Accountant As Director played
at

of the

SEC

FASB

Members

participated with

meetings speeches

key role sponsored

the

FASBs

communications
Institute

program

major conferences
the staff
all Institute

by the American

of

CPAs
and

Financial

Executives International
quarterly issues

of Management Accountants bank
regulators to discuss

and

numerous
activities

others met accounting

with the

SEC

and

with

FASB

Responsible for

aspects

of administration
staff

recruiting evaluation

training

assignments

etc

for the

FASB

technical

Previous Experience

Gordon

Capital an investment banking
Project

and

brokerage firm and Concepts
director adjunct

1986 1979 1972 1976 1969

to to
to

1987 1985 1979 1979 1972

FASB
Deloitte Jesse

Manager

leading audit

projects

on Pensions and

1-laskins

Sells

manager

staff training

Jones Graduate

School

of Business

Rice

University Center

to to

LT.j.g Education

U.S Navy

Supply Corps Navy

Finance

BA
30

Economics

1968 BS Accounting 1976
Jesse

1969 Rice University Houston
School Rice

Texas Houston Texas
Confidential

Master of Accounting

Jones Graduate

University

Publications

have

authored

in the

preceding

ten

years
from formal
updates

The FASB
Accounting
are created

publishes

range of technical
pieces

documents
to regular

Statements of Financial and

Standards to research by teams of staff and

on process

agenda
for that

All

of those from

as Director not

of Research

was

responsible

process

1988

through

May

of 2002

Most do

identi

an author

Cases in litigation or testified at
trial

or any

administrative in the

proceeding

in

which

have

served an expert

report

or by deposition

preceding four years

In

Court Testimony

United States of America United States District Court Case

Prabhat Goyal Northern District of California San
Francisco Division

No

CR-04-0201

MJJ

Costa Brava
Fairfax

Partnership Circuit

III

L.P

Goodman

Company LLP

County

Court

Virginia

Case

No

CL

2005-7931

Alan Schein
Circuit

and

Results

Technologies

Inc

Emst

Young LLP County
Florida

Court of the Seventeenth 03-000266

Judicial

Circuit

Broward

Case

No

CACE

03

Adeiphia Communications

Corporation

et

al

Motorola
06-01

Inc

et

al

U.S

Bankruptcy

Court Adversary

Case

No

558-reg

By Deposition AOL Time Warner
Superior

Securities

Litigation

Court of the State of California County of Los Angeles Judicial Council Coordination Proceeding Nos 4322 4325 and Court of

Common

Pleas Franklin

County Ohio Case
United States

No

O3cvhO7

7932

Schering-Plough

Corporation

United States District Court
Civil

District

of

New

Jersey 5-48-19846

Action

No 05-257515K
Corp

Bank of America
Arbitration

ABN AMRO

Bank

N.V

Securities

And Exchange

Commission
Bartek and

Microtune

Inc

Douglas

Nancy

Richardson

United States District Court
Civil

Northern District of Texas

Action

No

3-O8CV1 105-B

311

Confidential

Alstom

SA

Securities

Litigation

United States District Court
Civil

Southern

District

of

New York

Action

No

03-CV-6595VM

Served
In

an expert
to

report on the matters
that
listed

addition
in

reports

above

in

the

last

four

years

have

served

expert

reports

seven other matters

are

covered

by confidentiality

agreements

32

Confidential

Exhibit Statement 133 Paragraphs 62-70

Section

Assessment

of Hedge

Effectiveness

Hedge

Effectiveness

Requirements

of This Statement

62

This Statement requires
the
fair

that

an entity define
the

at

the time

it

designates
in

hedging
offsetting
It

relationship

method
value

it

will

use to assess
cash flows

hedges

effectiveness to the risk

achieving

changes
requires assess
at

in

or offsetting

attributable consistently basis

being hedged

also to

that

an entity use that defined of the hedge
effective identifies

method

throughout the hedge whether
to
it

period

inception to

and
in

on an ongoing
achieving

expects

the

hedging
part

relationship the

be highly

offset

and

measure the ineffective
to

of

hedge

If the entity
it

an improved
the existing

method hedging

and wants

apply and

that

method
the relationship for either

prospectively

must discontinue

relationship not specify or

designate

anew

using

the

improved hedge of

method This Statement does
is

single

method

assessing

whether

expected method

to

be highly

effective

measuring hedge

ineffectiveness

The

appropriateness

given

of assessing

hedge

effectiveness

can depend

on the nature an entity
for

of the risk being hedged should assess
similar

and

the type

of hedging hedges
in

instrument similar

used

Ordinarily however
different

effectiveness

for similar

manner use of

methods

hedges should

be justified

63

In

defining
in

how hedge
assessment

effectiveness
all

will

be assessed

an entity must specify

whether

it

will include permits value

that

of the gain or loss on
entity to

hedging
part

instrument This Statement instruments time

but does

not

require an

exclude

all

or

of the hedging

from the assessment
If the effectiveness

of hedge of hedge

effectiveness with the

as follows contract
is

an option time value

assessed

based on changes be excluded

in

the

options

intrinsic

value

the

change

in

of the contract

would

from the

assessment

of hedge

effectiveness

If the effectiveness

of
that

hedge
is
its

with
intrinsic

an option
value

contract

is

assessed

based on changes
the

in

the

options
the

minimum value
value

plus

the effect

of discounting

change

in

volatility

of the contract

would

be excluded

from the assessment

of hedge

effectiveness If the effectiveness

of

hedge
to

with

forward or fUtures
in

contract

is in

assessed
fair

based on of the
or futures

changes
contract

in

fair

value to the

attributable

changes

spot prices

the

change

the

value

related

changes

in

the difference

between of hedge

the spot price effectiveness

and the forward

price would In

be excluded

from the assessment
in

each

circumstance above changes
with

the

excluded
that

component

would

be included method

currently

in

earnings together
ineffectiveness

any
in

ineffectiveness

results

under the defined

of assessing should
is

As noted
that

paragraph

62

the effectiveness

of similar hedges generally of the gain or loss on of
gain or loss

be assessed excluded hedging
in

similarly assessing

includes

whether

component components

derivative

effectiveness

No

other

on the designated

instrument

may be excluded
the effectiveness

from the assessment

of hedge

effectiveness

64
consider the

In

assessing the

of

cash

flow hedge an entity generally
in if

will

need

to

time value

of money
is

if

significant important

the the

circumstances hedging

Considering the effect
involves periodic

of cash

time value

of money

especially

instrument

33

Confidential

settlements

An

example

of

situation futures

in

which

an entity likely would

reflect

the

time value

of

money

is

tailing

strategy

with

contracts contracts

When
used
in

using

tailing

strategy earnings

an entity adjusts

the size or contract

amount

of futures

hedge

so that

or expense
do
not
distort

from reinvestment
the results

or finding

of daily settlement
offset

gains

of the hedge To assess
reflect

of expected of

or losses on cash flows when
perhaps

the futures
tailing

strategy

has been
value

used
the

an

entity could forecasted

the

time value

money

by comparing instrument

the present

of

hedged

cash

flow with

the results

of the hedging

65
If the

Whether
there

hedging
will

relationship

qualifies

as highly
in

effective earnings

sometimes
during the

will

be easy to

assess and
critical

be no

ineffectiveness

to recognize

term of the hedge
liability

terms of the hedging
cash
in

instrument

and

of the entire hedged
transaction

asset or

as
could

opposed conclude expected assume
highly

to selected that to that

flows
fair

or

hedged
or cash

forecasted

are the

same

the entity are

changes

value
at

flows attributable and on an ongoing of

to the risk

being hedged

completely offset hedge of

inception

basis For example an forward contract
in

entity will if
at

may
be

forecasted

purchase

commodity with
to

effective

and that there will be no
contract as the
is

ineffectiveness

be recognized

earnings

The forward same time and The
fair

for

purchase

of the same purchase
inception

quantity

of the same

commodity

the

location value

hedged

forecasted
at

of the forward contract
in

is

zero
is

Either the

the

change

the discount

or

premium on the forward contract
directly
in

excluded

from

assessment
in

of effectiveness
cash flows

and

included

earnings
is

pursuant

to

paragraph 63 or the
for the

change

expected

on the forecasted

transaction

based on the forward price

commodity

66

Assessing hedge

effectiveness

and

measuring the ineffective
ineffectiveness

part

of the hedge however from the following

can be more

complex For example hedge among others
between
the basis

would

resuJt

circumstances

difference transaction

of the hedging hedging

instrument instrument
in

and and

the

hedged
gui
Id

item

or

hedged

such

as

Deutsche
that

markbased
those bases

Dutch

erbased

hedged

item

to the extent
in

do not move

tandem and hedged
item or

Differences transaction such

critical

terms of the hedging
in

instrument maturities

hedged
or delivery

as differences

notional

amounts

quantity location

dates
Ineffectiveness attributable to also

would
in

result the

if

part

of the change

in

the

fair

value

of

derivative

is

change

counterpartys

creditworthiness

67
both
at

hedge
inception

that

meets the effectiveness on an changes ongoing
in fair

test

specified

in

paragraphs
the

20b

and

28b

that is
at

and

basis the entity expects
values or cash

hedge

to be highly

effective

achieving

offsetting
criteria

flows
If the

also

must meet the other hedge
initially

accounting accounting and
also

to

qualify

for

hedge

accounting
to assess

hedge

qualifies

for

hedge
test

the entity

would

continue

whether
the

the

hedge

meets the effectiveness
If the

would

measure
at

any ineffectiveness
if

during

hedge

period
the

hedge
to

fails

the

effectiveness effective for
at

test

any time that is
offsetting

the entity
in fair

does not expect
or cash

hedge
the

be highly
ceases to qualify
in

achieving

changes

values

flows

hedge
in

hedge

accounting

The

discussions

of measuring hedge

ineffectiveness

the

examples

the

34

Confidential

remainder of hedge

this

section
at

of Appendix

assume

that the

hedge

satisfied

all

of the

criteria

for

accounting

inception

Assuming No 68

Ineffectiveness

in

Hedge

with

an

Interest

Rate Swap

An

assumption of no an interest-bearing
simplifies the

ineffectiveness financial

is

especially

important
interest

in

hedging

relationship
it

involving

instrument necessary

and
to

an

rate

swap because
entries

significantly

computations
in

make
of

the accounting
interest

An

entity

may assume

no

ineffectiveness asset or
liability

hedging

relationship
rate

rate risk involving

an
in

interest-bearing following
list

and

an interest

swap

if all

of the applicable

conditions

the

are

met
to

Conditions

applicable notional

both

fair

value

hedges

and cash

flow hedges amount of the interest-bearing

The
asset or

amount

of the swap

matches

the principal

liability

The

fair

value

of the swap
for

at

its

inception

is

zero
interest

The formula
each
is

computing

net settlements rate the
is

under the

rate the

swap

is

the

same

for rate

net settlement

That
index

is the fixed

the

same throughout
constant

term and

the variable

based on the same

and

includes

same
is

adjustment or no adjustment

The Any
typical

interest-bearing other

asset or

liability

not

prepayable
instruments or
interest

terms

in

the interest-bearing

financial the

rate

swaps

are

of those

instruments
to fair

and

do not invalidate hedges only

assumption of no

ineffectiveness

Conditions

applicable expiration

value

The
liability

date

of the swap

matches

the maturity

date

of the interest-bearing

asset or

There

is

no floor or ceiling on between
repricings that

the variable

interest

rate

of the swap
rate in

The
enough
three
to

interval

of the variable

interest

the

swap

is

frequent

justify an

assumption
or

the variable

payment

or receipt

is at

market rate generally

to six

months

less
to

Conditions
All the

applicable
interest

cash flow hedges only
or

receipts as

payments

on the variable-rate
interest

asset or

liability

during

the

term of

swap

are designated as

hedged and no

payments

beyond

the

term of the swap are

designated

hedged
is

There
asset or
interest

no
has
is

floor or

cap on the variable

interest

rate

of the swap

unless the variable-rate

liability rate

floor or

cap

In that

case

the

swap

must have

floor or

cap

on the variable

that

comparable

to the floor or

cap on the variable-rate

asset or liability
if

For
rate

this is

purpose

comparable and an assets
to 12

does not necessarily
variable percent dates rate
is

mean equal For example
plus

swaps

variable

LIBOR

LIBOR

percent

10

percent

cap on the swap

would

be comparable

cap

on the asset
those rate

The The

repricing

match

of the variable-rate
is

asset or liability the index

index

on which
rate

the variable
is

based matches

on which

the asset or

liabilitys variable

based

69

The

fixed as

rate

on

hedged

item

need

not exactly

match
rate

the fixed rate

on

swap
asset or

designated
liability

fair

value

hedge Nor does
as the variable
its

the variable rate

on an interest-bearing
designated as cash rates

need
fair

to

be the same comes

on The

swap
fixed

flow hedge on

swaps
35

value

from

net settlements

and

variable

swap can be

Confidential

changed

without

affecting

the net settlement

if

both

are

changed

by the same
fixed rate

amount That
percent plus

is

swap same
and

with

payment

based on and
fair

LIBOR
as

and

receipt with

based on payment

of

has the percent

net settlements receipt

value

swap

based on

LIBOR

based on

fixed rate

of

percent

70
even
to

Comparable though
actually
fair

credit risk achieving value

at

inception

is

not

condition require

for

assuming same

no

ineffectiveness rate

perfect

offset

would
the

that the or

discount transaction

be used
justify

determine the
the

of the swap

and

of

hedged
to both value

item

hedged

To

using debtor

same

discount

rate

the credit risk related asset

parties to the

swap

as well

as to the asset

on the hedged
the interest

interest-bearing are

in
cash

fair

hedge

or the variable-rate

on

which

payments

hedged
is

in

flow hedge would of
is

have

to

be the same
risk

However
risk

because
are not to

that complication easily

caused

by the interaction
creditworthiness

interest

rate

and

credit

which

separable comparable
in

not considered

necessary

condition

assume

no ineffectiveness

hedge

of

interest

rate

risk

36

Confidential

Exhibit Materials Considered

In the

forming

my
also

opinions

in this

matter

have

reviewed

number of documents
in

including

SEC

filings

of Fannie

Mae
and
that

and

documents

produced

by the parties

the course

of

discovery documents
in

have and

read

considered relied

relevant for

authoritative

accounting literature
facts

The
are
listed

materials

upon
that

an understanding of the
in

of this case
included

the footnotes

of

this

report

and

those

reviewed

the course

of

my work

the

following

various

Fannie
other

Mae

accounting policy

memoranda and
documents

KPMG

workpapers
cited
in this

various

Fannie

Mae

and

KPMG

as specifically

report
the

2001

and

2003 and

versions

of Fannie

Maes

Derivatives

Accounting

Guidelines
in

Fannie
Fall

Maes

KPMGs

submissions to the

SEC

Office

of Chief Accountant

2004
submitted

the reports

by other experts examinations witnesses testimony

in this

matter

and marked
in

the regulatory

and

civil

including

exhibits

connection

therewith of the following Harry Argires Jonathan Jonathan

SEC

Feb

2005 Feb

2006 2004
2006
16-17

Boyles Boyles

OFHEO
SEC

testimony

testimony Boyles

May 2009

2006

Jonathan

24 2004 Dec Apr 11-132005 Mar 14-16 civil litigation transcript Sept

Aug

Kimberly
Katarina

Stone Skladony

SEC

testimony

Nov

29-30 2005

OFHEO

testimony

Aug

26 2004

Mona

Patel

OFHEO
SEC

testimony testimony testimony testimony

Sept

2004
13

Mary Trzeciak
Ursula Schaefer Donald
Paul Sinclair

Oct

2005

SEC SEC

Sept 29 2005 Sept 22 2005
18

Salfi

SEC

testimony

Oct

2005
27 2005

Mall Johnson

SEC

testimony

Sept

Confidential