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Mark-to-market: Freddie Mac's fourth financial statement.

For a number of years the management of Freddie Mac (the Federal Home Loan Mortgage Corporation) has used mark-to-market (MTM) information to assess corporate performance in its operations and decision making. When our stock began trading without ownership restrictions in 1989, management concluded this internal information should be made available to our shareholders and the broader market so they would be better able to evaluate management's decisions and corporate performance. (See exhibit 1 and on page 79.)

This article describes how Freddie Mac constructed its MTM balance sheet and accompanying footnote disclosures.


Initially, our goal seemed simple. We would create a fourth financial statement to supplement our balance sheet, income statement and statement of cash flows--all of which are prepared according to generally accepted accounting principles. Our fourth financial statement would "simply" aggregate useful market value information and present it to our shareholders.

This goal proved more difficult than we had thought. What management information was relevant to our shareholders? Should a fourth financial statement be an income statement, a balance sheet, neither or both? Should the presentation conform to GAAP standards or was GAAP even relevant? Could readers use the market value information we would provide, given that it's derived from highly technical, state-of-the-art financial models? Clearly, we needed to consider the basics of financial disclosure before proceeding.

Shareholders assess management's performance in many ways. Most commonly they review how reasonable and effective major corporate decisions and strategies are in light of financial disclosures made by the corporation. Corporations use GAAP to determine what these financial disclosures should be. Financial Accounting Standards Board Concepts Statement no. 1, Objectives of Financial Reporting by Business Enterprises, asserts that two primary qualities make accounting information useful--relevance and reliability.

Relevance means financial reporting should provide information that's useful to current and potential investors, creditors and other users in making rational investment, credit and similar decisions. Reliability means the information should be comparable and consistent among companies and over time.

In practice, relevance often is compromised to provide reliability. For example, under GAAP the value of mortgage servicing streams is excluded from the balance sheet unless the streams have been explicitly purchased. This means servicing streams on mortgages originated and held by an entity aren't bookable assets, whereas an identical stream purchased from someone else is. The distinction is not economically rational and could lead uninformed investors to make incorrect decisions about a company's value and performance.

The distinction is understandable, however, because GAAP looks to observable market transactions to establish values, and, in this example, there haven't been any. Without an arm's-length transaction to establish the value of retained servicing stream, different companies could value similar transactions differently. Excluding such entries from the balance sheet preserves reliability,but at the cost of less relevant financial statements.

Whether the cause is off-balance-sheet assets or the failure to recognize current market values, when a company's current economic position is quite different from its financial position reported under GAAP, shareholders unwittingly may be holding either a gold mine or a stick of dynamite. (See exhibit 2 on page 82.)


We concluded that Freddie Mac's fourth financial statement should emphasize relevance over reliability because this would provide the best complement to our standard GAAP financial statements. In particular, the fourth statement would show Freddie Mac's economic condition at a specific time. By using values obtained from observable market transactions wherever possible, we would make it reliable and clear. We also wanted the statement to show how the economic condition had changed over time in response to different business and interest rate environments. A combination of a balance sheet format showing the market value of all assets and liabilities (including items both on and off the GAAP balance sheet) accompanied by supplemental disclosures would meet these goals. The supplemental disclosures would show separately how market values change in response to changes in interest rates and business volume.

We considered, but rejected, an income statement presentation because it didn't meet our goal of providing information on the company's economic condition at a specific time; however, an income statement format seemed to be a logical future addition. More radical possibilities for presentation eventually were dismissed as potentially confusing to the average reader.


By holding the MTM perspective, we gained a sword that cuts through some of the knottiest issues in the construction of a GAAP balance sheet. In particular, the endless debates about what should or should not be "on book" for GAAP became, for the most part, irrelevant. If a corporation has the ownership right to a present or future cash flow, that cash flow contributes to the company's current market value. Similarly, accounting entries that do not reflect changes in present or future cash flows do not affect market values--regardless of whether they're considered on or off book for GAAP.

Participation certificates. The MTM perspective assisted Freddie Mac in several instances because its GAAP balance sheet is quite unusual. As exhibit 3 on page 84 shows, our on-book GAAP assets amount to less than 15% of the off-book items. The latter consist of mortgages purchased and then sold to investors through our mortgage participation certificate (PC) program. Freddie Mac's corporate value is derived primarily from the servicing stream attached to the sold mortgages.

Should this be on book or off book in a market value balance sheet? Although this may be hard to resolve under GAAP, it's easy for market value accounting. The value of the PC servicing streams is no different in kind thant the value of cash flows from an on-book asset. Indeed, the distinction is meaningless. Consequently, we show this item just as we would any other and value it as best we can.

We considered, but rejected, a slight variant, which was to add the value of the mortgages sold in the PC program to the assets and add the value of the liabilities to PC investors to the liabilities section. The net effect would have been the same, but both assets and liabilities would have appeared greater. Given that Freddie Mac actually is entitled to only a very small portion of the total cash flows from sold mortgages, we believed that increasing the value of assets and liabilities shown on the balance sheet would be misleading because it would focus attention on the form rather than on the substance of the balance sheet. Note, however, that we disclose through the loan loss reserve our full exposure to credit risk form our guarantee of the mortgage balance to PC investors.

REMICs. Freddie Mac has sold certain classes of real estate mortgage investment conduits (REMICs) that entitle the holder to exercise a one-time option to put the securities to Freddie Mac, at par, on a specific date. Under FASB Statement no. 77, Reporting by Transferors for Transfers of Receivables with Recourse, and FASB emerging issues task force Issue no. 89-2, Maximum Maturity Guarantees on Transfers of Receivables with Recourse, the potential significance of this put option must [TABULAR DATA OMITTED]

be measured assuming the mortgage-related securities will pay down according to scheduled amortization--no prepayments are considered. In the case of REMICs, the contractual term is usually 30 years, with the vast majority of scheduled principal reduction in the latter part of the 30-year term. Under GAAP, the outstanding REMIC balances would be considered significant at the put option date. Thus, sale treatment is disallowed for these REMICs.

Because Freddie Mac receives no future income from these REMICs, the only effect on the MTM accounting is through the value of the put. Prepayment activity must be considered to estimate the likelihood the put will be exercised. For the REMICs, however, that likelihood (and therefore the cost) is insignificant.

We might have concluded the MTM balance sheet should show neither the REMIC puts, since their value is negligible, nor the REMICs themselves, since Freddie Mac will receive no future cash flows from them. However, in this case, we chose to be consistent with GAAP treatment, and consequently we show the REMICs as offsetting assets and liabilities.

Deferred items. Just as a market value balance sheet will show some items that are off book for GAAP, it won't show other items that are on book for GAAP. The touchstone is the same in each case: Is there value to future cash flows? For Freddie Mac, deferred revenues and costs are items with no impact on future cash flows. These deferred items generally reflect the timing difference between the receipt or payment


of cash and recognition of GAAP income. Any benefit or cost associated with these deferred items is imbedded in the estimated future cash flows of the asset or liability. For example, when mortgage assets are purchased at a discount, their future cash flows will be less than those from assets purchased at par. Consequently, there's no need to evaluate these deferred items separately in the MTM balance sheet; rather, they are part of the valuation of the related asset or liability.


Because the MTM balance sheet isn't a GAAP instrument, there's no GAAP standard for its preparation and disclosure. Our decision to publish it as a fourth financial statement led us to conclude we needed additional disclosures in three main areas:

1. A limitations section describing what the MTM presentation is not and what it does not do.

2. A discussion section explaining how this balance sheet differs from the GAAP balance sheet.

3. A section summarizing the significant valuation methodologies and assumptions used to estimate the market value of the assets and liabilities.

Each of these is included as a footnote to the MTM balance sheet.


Any release of financial information should tell readers the limitations of the information. If readers understand the limitations, they can use the data as they deem appropriate. Obviously, certain information might be unavailable, and this should be mentioned as a limitation. But more important, a limitations section should attempt to lessen the risk the data will be misused.

Comparison to stock price. Freddie Mac believed the single biggest risk was that users would attempt to compare the net market value presented in the MTM balance sheet to the aggregate value of Freddie Mac's publicly traded stock. This would be understandable because the term "market value" is used throughout our MTM disclosures--but the comparison would be inappropriate. The MTM balance sheet displays the estimated market value of all existing assets and liabilities having significant economic value, whether on or off book for GAAP. However, the MTM doesn't attempt to place a value on future business opportunities or franchise potential. The market value of our common stock implicitly includes both of these. As a result, it's impossible to compare the net market value of the MTM balance sheet to the aggregate value of the company's stock. We state this limitation as clearly as possible.

Income Taxes. The MTM treatment of income taxes is a second important limitation. The expected income tax liability is a very significant part of the MTM, presentation. Unfortunately, the tax code's complexity prevents us from precisely modeling taxable income. CPAs who have encountered FASB Statement no. 96, Accounting for Income Taxes, will be familiar with this problem.

Because income taxes are a significant component of future cash flows and of financial reporting, we believed it would be better to include a rough estimate of the impact of income taxes rather than exclude it entirely. If market values are based on the present value of future cash flows and if we assume that cash flows are equal to taxable income, then a conservative estimate of the income tax impact would be the difference between the net market value in the MTM balance sheet and the GAAP stockholder's equity, multiplied by the maximum statutory tax rate.


Our second MTM footnote disclosure concerns valuation techniques. Freddie Mac values four major types of items:

* Mortgage-related retained assets.

* Mortgage-related sold assets (our portfolio of PC servicing).

* Short-term liquid assets and liabilities.

* Long-term unsecured debt.

Market quotations for mortgage-backed securities are used to value the mortgages that Freddie Mac hasn't sold, and debt securities also are valued by comparing them to similar securities.

To value the PC servicing portfolio, we considered three generally practiced valuation techniques:

1. Sales prices for comparable servicing portfolios.

2. Discounted cash flows (DCFs).

3. Market prices for interest-only (IO) securities.

We concluded we couldn't rely on the sales prices of comparable servicing portfolios because finding a truly comparable sale is difficult. Servicing portfolios tend to be very diverse in servicing cost, geographic diversity and credit risk.

DCF is a well-established and generally practiced method of assigning a value to future streams of cash flows. However, the results depend heavily on the discount rate selected. Unless companies use identical discount rates or disclose the rates they use, the DCF method can result in significantly different values for identical future cash flows. We wanted to avoid techniques sensitive to unverifiable assumptions.

Therefore, we chose a method that allows the financial markets to provide an implied discount rate. We do this by using IO prices as the benchmark. A significant part of Freddie Mac's MTM value exists because the interest rate received on the mortgage collateral exceeds the rate paid to investors in our PCs. This excess interest (or spread) is economically the same as an IO strip. Although the IO market at times has been illiquid, we believe under normal circumstances it provides a superior and more objective basis for valuing our PC servicing portfolio than do either sales prices for comparable servicing portfolios or DCFs.

Observed market quotations serve as our benchmarks for estimating market values, but it's necessary to adjust them for any differences between the characteristics of the observed security and our own security. For example, our mortgage security may have a remaining term of 290 months, whereas the market quotation was based on a security with a remaining term of 300 months. Freddie Mac uses an option-adjusted spread (OAS) model to interpolate these market valuations. (See exhibit 4 at left.)

For assets and liabilities that are short term, liquid or relatively insignificant in dollar amount, the market value of each item generally won't be materially different from its book value. Therefore, in these cases we assume the market value is the same as the book value.


The opinion of an independent CPA gives more credence to management's presentation of financial information. To be consistent with our other financial statements, we decided to have the MTM balance sheet audited as well. Such a request can be a significant challenge to a CPA firm because the auditor must rely more on management's representations than in a typical GAAP audit. This is because all valuations are based to some degree on estimate rather than on consummated transactions.


As with any type of unique financial information, the potential value of an MTM balance sheet may not be recognized immediately because users have few, if any, bases for comparison. Few entities now release market-value information, and those that do probably have not used a consistent method. Nevertheless, management has a responsibility to let shareholders know whether the company's current economic position should be cause for celebration or for damage control.

Sometimes, verifiable market values are unobtainable or collecting and reporting the information is excessively expensive. In Freddie Mac's case, however, market value information was readily available, and management already used it internally. Consequently, we found creating an informative and relevant fourth financial statement was possible without incurring significant costs. In the absence of authoritative guidance about presentation format, management used its best judgment about what would be clear and relevant. Some decisions will change as we gain experience and feedback. Nevertheless, management believes that disclosure of MTM information for Freddie Mac was both possible and necessary to provide a complete picture of corporate performance.

JIM B. LEVITES, CPA, CMA, is assistant controller, corporate accounting at Freddie Mac (the Federal Home Loan Mortgage Corporation). He is a member of the American Institute of CPAs and the California Society of CPAs.
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Author:Levites, Jim B.
Publication:Journal of Accountancy
Date:Oct 1, 1990
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