Recent reports detailing U.S. mortgage financier Freddie Mac's accounting woes have placed too much emphasis on its notional interest-rate derivatives position, which in turn is providing a misleading portrait of the mortgage giant's potential liabilities, according to derivatives professionals. Joseph Suh, partner at Morrison & Foerster in New York, noted that many recent articles have focused on Freddie Mac's supposed USD700 billion (notional) derivatives position but they have not adequately explained that this exposure does not equate to having an aggregate potential liability of the same size. The recently announced investigation into Freddie Mac's accounting practices by the Securities and Exchange Commission has sparked a debate over the role of derivatives as a risk management tool.
Notional amounts are not equal to the actual amount of payment obligations of parties in derivatives contracts, said Suh. The focus on the notional USD700 billion figure also ignores the effect of netting provisions on the company's liabilities under the derivatives contracts, he added. Eric Hiller, chief rates strategist at Bank of America in Chicago, agreed that netting provisions have the potential to greatly impact upon a notional derivatives position. For example, if the agency were to hedge some of a 10-year debt issue with a 10-year swap and a two-year asset with a two-year swap it would not be possible to net the two positions, although they are both risk reducing, and this in turn could confuse the notional figure, he explained.
In spite of the reports, however, Robert Pickel, executive director and ceo of the International Swaps and Derivatives Association, is confident the reports will not influence regulators against derivatives. While the common industry standard for measuring derivatives volumes is by notional outstanding amounts and not by net exposure, which would obviously be meaningful in the appropriate context, we are confident that the regulatory community has an excellent understanding of the difference and is focused accordingly, he said.
