Fannie Mae 2004 Annual Report Download - page 266

Financial Guaranties and Master Servicing
We identified the accounting errors described below related to our financial guaranties and master servicing
that resulted in a pre-tax increase in net income of $175 million and $178 million for the years ended
December 31, 2003 and 2002, respectively.
Recognition, Valuation and Amortization of Guaranties and Master Servicing
We identified seven errors associated with the recognition, valuation and amortization of our guaranty and
master servicing contracts. The most significant errors were that we incorrectly amortized guaranty fee buy-
downs and risk-based pricing adjustments; we incorrectly valued our guaranty assets and guaranty obligations;
we incorrectly accounted for buy-ups; we did not record credit enhancements associated with our guaranties as
separate assets; and we incorrectly recorded adjustments to guaranty assets and guaranty obligations based on
the amount of Fannie Mae mortgage-backed securities (“Fannie Mae MBS”) held in the consolidated balance
sheets. In conjunction with the review of these issues, we identified the following additional errors: we did not
record guaranty assets and guaranty obligations associated with our guaranties to MBS trusts in which we
were the transferor of the trust’s underlying loans and we did not recognize master servicing assets and related
deferred profit, where applicable.
The restatement adjustments associated with these errors resulted in a pre-tax increase in net income of
$1.0 billion and $491 million for the years ended December 31, 2003 and 2002, respectively. These
restatement adjustments also impacted the consolidated balance sheets, resulting in an increase of $144 million
and $246 million in total assets and a decrease in total liabilities of $1.6 billion and $1.2 billion as of
December 31, 2003 and 2002, respectively. Each of the errors that resulted in these adjustments is described
below.
For guaranties entered into before January 1, 2003, the effective date of FIN No. 45, Guarantor’s Accounting
and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others (an
interpretation of FASB Statements No. 5, 57, and 107 and rescission of FASB Interpretation No. 34) (“FIN 45”),
we made errors in applying amortization to up-front cash receipts associated with our guaranties, known as
buy-downs and risk-based pricing adjustments, pursuant to SFAS No. 91, Accounting for Nonrefundable Fees
and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases (an amendment
of FASB Statements No. 13, 60, and 65 and rescission of FASB Statement No. 17) (“SFAS 91”). The errors in
amortization of these items are described in the “Amortization of Cost Basis Adjustments” section below. The
impact of correcting these errors resulted in changes in the periodic recognition of “Guaranty fee income” in
the consolidated statements of income. For guaranties entered into or modified after the adoption of FIN 45,
buy-downs and risk-based pricing adjustments should have been recorded as an additional component of
“Guaranty obligations” and amortized in proportion to the reduction to “Guaranty assets.” The impact of
correcting this error resulted in changes in the carrying amount of “Other liabilities” and “Guaranty
obligations” in the consolidated balance sheets and changes in the periodic recognition of “Guaranty fee
income” in the consolidated statements of income.
We had valuation errors associated with our guaranty assets and guaranty obligations. We incorrectly included
up-front cash payments associated with our guaranties, known as buy-ups, in the basis of our guaranty assets
while also recording these buy-ups as a separate asset included in “Other assets” in the consolidated balance
sheets. We recorded guaranty obligations equal to the recorded guaranty assets, including any buy-ups, when
we should have independently measured guaranty obligations at fair value based on estimates of expected
credit losses and recorded deferred profit associated with these arrangements. The impact of correcting these
errors resulted in decreases in “Other assets” and “Guaranty obligations” in the consolidated balance sheets.
We did not correctly account for buy-ups. Historically, we accounted for buy-ups at amortized cost under the
retrospective effective interest method pursuant to SFAS 91. However, since the recognition of income on a
buy-up is subject to the risk that we may not substantially recover our investment due to prepayments, we
should have subsequently measured the fair value of the buy-ups as if they were debt securities pursuant to
F-15
FANNIE MAE
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)