EXPERT REPORT OF TIMOTHY LUCAS

In re Fannie Mae Securities Litigation

United States District CouP District of Columbia

MDL No 1668

Consolidated Civil Action No 04-cv-O1 639 RJL

Submitted November 15 2010

Confidential

Qualifications

have over 35 years experience as Certified Public Accountant CPA For 14

years until my retirement in May of 2002 served as Director of Research and Technical

Activities for the Financial Accounting Standards Board FASB or the Board The

FASB is designated by the accounting profession to define Generally Accepted Accounting

Principles in the United States GAAP As Director was responsible for supervising

the FASBs professional research staff which comprised 50 CPAs PhDs and support staff

also participated in the debates and procedures leading to new accounting standards In

particular was significantly involved in the Boards technical project on accounting for

derivatives and hedging which led to the issuance of FASB Statement 133 Accounting for

Derivative Instruments and Hedging Activities Statement 133 No other project

absorbed as much of the Boards time or my time During that same period 19882002

also served as Chairman of the Emerging Issues Task Force EITF The EITF is

group of senior accounting professionals who meet regularly with the FASB and the Chief

Accountant of the Securities and Exchange Commission SECor his designee to

discuss and resolve financial reporting issues that arise in practice

Before becoming the Director of Research and Technical Activities at the FASB

was Project Manager there from 1979 to 1986 Before joining the FASB in 1979 was

an auditor for Deloitte Haskins Sells Big public accounting firm from 1972 to

1979 When left the firm was an Audit Manager with responsibility for overseeing

public company audits

hold Bachelor of Arts degree in Economics and Bachelor of Science degree in

Accounting as well as Master of Accounting degree all from Rice University in

Houston Texas My resume which includes list of all my publications over the last ten

years and list of all cases in litigation or any administrative proceeding in which served

an expert report or testified at trial or by deposition over the last four years is attached as

Exhibit

Confidential

II Assignment

have been retained by KPMG in this litigation to address certain accounting issues

pertaining to the application of Statement 133 in the time frame from 2001 to 2004 the

relevant time period have also been retained to identi and explain certain relevant

financial accounting concepts and to respond to certain opinions expressed by otherexperts

in this matter have read the expert reports of John Barron and Robert Berliner

submitted in this case In this report offer some comments on the contents of those

reports that are related to Statement 133

In connection with my work on this engagement have called on the knowledge

and experience gained during my professional career My opinions are based on my

experience and expertise in financial accounting For my work in connection with the

preparation of my report have billed KPMG at my regular hourly rate of $650 am

independent of the parties in this litigation have no financial interest in the outcome of

this matter and my fees are in no respect contingent upon the outcome of this case

reserve the right to supplement my opinions based on the opinions expressed by

plaintiffs experts and any additional information that might become available

III Snmmary Overview of Opinions

In my opinion as more fully discussed below Fannie Maes approach to

implementation of Statement 133 was reasonable and appropriate application of GAAP in

the relevant time period Further for certain specific issues that have been raised regarding

Fannie Maes hedging transactions as described below have found that the companys

approach to applying Statement 133 was reasonable and appropriate

Fannie Mae identified 13 transactions that were most significant making up 96% of the hedge transactions

outstanding as of March 31 2004 based on notional amounts FMCIV-05 00700330 at 0390

Confidential

IV Overview of GAAP

GAAP is body of accounting conventions rules and procedures that define

accepted accounting practice at particular point in time and provide standard that

accountants follow when preparing financial statements and related footnotes.2 Financial

statements prepared in accordance with GAAP are way in which companies report their

financial position and the results of operations to current and prospective investors and

creditors and to other interested parties such as regulators The FASB has issued series

of Statements of Financial Accounting Concepts to set out the objectives and qualitative

characteristics that it seeks to achieve in GAAP financial statements Those Concepts

Statements recognize that the objective or purpose of GAAP financial statements is to

provide readers of the statements including investors and creditors with reliable and

understandable information about the economics of company That information is

intended to be useful to people who are making economic decisions such as whether to

buy or sell companys stock or to extend loan to the company The Concepts

Statements also recognize that there is cost to preparing financial statements and that both

the accounting standards and the procedures developed to implement them should meet

practical cost benefit test.3

Over the years GAAP has developed from number of sources primarily within

the private sector4 including the FASB and its staff5 the EITF and the Accounting

AU Section 411 The Meaning of Present Fairly in Conformity With Generally Accepted Accounting

Principles effective March 15 1992 AU Section 411

See FASB Statement of Financial Accounting Concepts No Objectives of Financial Reporting by

Business Enterprises and FASB Statement of Financial Accounting Concepts No Qualitative

Characteristics of Accounting Information

FASB Facts About FASB 2007 at available at http//www.fasb.orglfacts/index.shtml The SEC has

statutory authority to establish financial accounting and reporting standards for publicly held companies

under the Securities Exchange Act of 1934 Throughout its history however the Commissions policy has

been to rely on the private sector for this function to the extent that the private sector demonstrates ability

to fulfill the responsibility in the public interest.

The standards of predecessor standard sellers including Opinions of the Accounting Principles Board and

Accounting Research Bulletins of the AICPAs Committee on Accounting Procedure have been adopted

by the FASE FASB Staff pronouncements that are authoritative include Implementation Guides QAsSee FASB Facts About FASB 2007 at available at http//www.fasb.org/facts/index.shtml Since

1973 the Financial Accounting Standards Board FASB has been the designated organization in the

continued on next page

Confidential

Standards Executive Committee AcSEC There was in the relevant time period

hierarchy of sources within GAAP.6

10 GAAP is not frozen or finished it continues to evolve over time There are

number of areas that are subject to ongoing efforts to improve authoritative guidance

because the existing guidance does not specifically address given type of transaction or is

unclear incomplete conflicting or not effective in communicating the transactions to

which the guidance applies

11 GAAP is not an exact science Courts have recognized that GAAP is term of art

that encompasses wide range of acceptable procedures.7 The United States Supreme

Court for example has observed that GAAP is far from being canonical set of rules that

will ensure identical accounting treatment of identical transactions...

tolerate range of reasonable treatments leaving the choice among altematives to

management..

12 Applying GAAP often requires significant professional judgment on the part of

both company professionals who prepare the companys financial statements and the

professionals who audit them GAAP does not provide unambiguous answers to all the

questions that come up in preparing financial statements for todays corporations and it

never will The accountant who prepares the financial statements is expected to study and

understand the rules and then to exercise professional judgment in applying them to the

continued from previous page

private sector for establishing standards of financial accounting that govern the preparation of financial

reports by nongovernmental entities Those standards are officially recognized as authoritative by the

Securities and Exchange Commission SEC Financial Reporting Release No Section 101 and

reaffirmed in its April 2003 Policy Statement and the American Institute of Certified Public Accountants

Rule 203 Rules of Professional Conduct as amended May 1973 and May 1979 parentheticals in

original

The GAAP Hierarchy in 1999 2004 was set forth in the authoritative auditing literature in particular in

AU Section 411 18 The FASB recently completed project to move the GAAP Hierarchy into its

literature See Statement of Financial Accounting Standards No 162 The Hierarchy of Generally Accepted

Accounting Principles Issue No 302 May 2008

In re IKON Office Solutions Inc Sec Litig 277 F3d 658 675 n.22 Cir 2002 citing Thor Power

Tool Co Connr 439 U.S 522 544 1979

Thor Power Tool 439 U.S at 544

Confidential

companys specific transactions and situations.9 As the companys transactions and

situations change or as accounting guidance evolves it may be appropriate for the

accountant to change policies that are used to apply GAAP Such change however does

not mean that the policies applied in previous periods based on judgments appropriately

made at that time were wrong It is inappropriate to conclude that accounting policies were

wrong just because changes in transactions and situations caused the accountant to change

those policies in later period The nature of the accountants undertaking is such that

conformity with GAAP is reasonableness test rather than an absolute test

13 The use ofjudgrnent is an important and unavoidable part of GAAP Although

financial statements are basically reporting results of operations in past periods GAAP

requires the accountant to make reasonable judgments and estimates based on current

information including judgments of how to interpret GAAP pronouncements and apply

them in practical and cost effective manner Often new interpretations of GAAP

subsequent to the date of the financial report may require change in the judgment for

future reports But that new interpretation does not make the previous financial statements

wrong They were prepared in conformity with GAAP based on the best information

reasonably available at the time

Derivatives Hedging and Hedge Accounting

14 loan contract between lender and borrower may provide for the payment of

interest in various ways Some contracts provide for interest payments at fixed rate e.g

5% for the life of the contract The popular 30-year fixed-rate mortgages are an example

of this contract Alternatively the contract may provide for interest at rate that floats or

varies with specified index Under such contract the rate is reset at specified intervals

See Remarks by chairman Arthur Levitt SEC the Numbers Game New York September 28 1998

Our accounting principles werent meant to be straitjacket Accountants are wise enough to know they

cannot anticipate every business structure or every new and innovative transaction so they develop

principles that allow forflexibility to adapt to changing circumstances.

Confidential

For example there are adjustable rate mortgages referred to as ARMs that reset the rate

every year based on the then current rate on specified U.S Treasury securities

15 Derivatives are contracts that provide for the parties to make payments or transfer

other assets to each other based on formula that incorporates specified underlying

variable such as an interest rate security price or foreign exchange rate common

example of derivative is an interest rate swap in which one party agrees to pay the other

interest on stated notional amount at fixed rate and the other party agrees to pay interest

on the same amount at floating rate So for example party might agreeto pay fixed

rate of 3% on the notional amount of$lO million while party agrees to pay interest on

the same amount at the floating rate LIBOR The notional amount is provided in the

contract only as base for the calculation of periodic payments under the contract that

amount is not paid by either party Typically the contract requires no initial payment from

either party and interest payments are settled net so depending on the level of LIBOR each

period one of the parties makes payment to the other

16 Viewed in isolation an interest rate swap may seem like strange instrument but

there are practical economic uses for such contracts company might enter into an

interest rate swap for example if it had floating rate debt outstanding and was worried that

rates would increase driving up its interest expense In that case it would enter swap

where it agreed to pay fixed rate and receive floating rate often referred to as pay

fixed swap If rates do go up the interest on the debt will increase but the increasing

payments received from the swap counterparty will offset the increase Of course if rates

go down the company will have to make payments under the swap that offset the reduced

interest on the debt that otherwise would have benefited it The company has protected

itself from an undesirable outcome increased interest payments if rates go up but it has

given up the potential upside lower interest payments if rates decrease The decision to

hedge or not to hedge particular risk exposure is an economic decision quite apart from

the accounting for the hedge

LIBOR or the London Interbank Offered Rate is market interest rate that varies with market forces and is

published daily It is often used as reference for variable or floating rate loans

Confidential

VIE History of Statement 133

17 FASB Statement 133 Accounting for Derivatives and Hedging Activities

Statement 133 is the primary GAAP literature for derivative instruments Statement

133 was issued in 1998 after 12 years of development effort by the FASB

18 Increasing innovation including new varieties of derivatives and new uses for them

was one of the reasons the FASB cited when it made the decision in 1986 to add to its

agenda broad project on accounting for financial In the 990s series of

highly publicized losses that involved use of derivatives for speculation or in failed hedges

added to the pressure for the FASB to address accounting for derivatives In many cases

the losses came as surprise because it was not apparent from the financial statements that

the company was using derivatives The FASB recognized however that derivatives were

often used to limit risk The transaction involving the interest rate swap described above is

an example In Statement 133 itself the Board noted Changes in global financial markets

and related financial innovations have led to the development of new derivatives used to

manage exposures to risk including interest rate foreign exchange price and credit risks

Many believe that accounting standards have not kept pace with those changes

Derivatives can be useful risk management tools and some believe that the inadequacy of

financial reporting may have discouraged their use by contributing to an atmosphere of

uncertainty Concem about inadequate financial reporting also was heightened by the

publicity surrounding large derivative losses at few companies.2

19 The accounting for certain types of derivatives had been previously addressed in the

GAAP literature but for many transactions the accountant had to reason by analogy and

practice was diverse.13 Many thought that if derivative was acquired for the purpose of

hedging risk the derivative should be accounted for as part of the hedged transaction

For interest rate swaps the EITF had agreed that if the swap was hedging an outstanding

Statement 133 20712

Statement 133 212

See EITF Issue 84-36 Interest Rate Swap Transactions and FASB Statement 80 Accounting for Futures

Contracts

Confidential

debt it would be appropriate to use an accounting approach called synthetic instrument

accounting.4 Under that approach if the company had floating rate debt and had entered

into pay-fixed swap as in the example above the company would treat the combined

results of the two instruments as if they were one synthetic instrument It would simply

record interest expense at the fixed rate and ignore changes in the fair value of the swap

This is called hedge accounting and is discussed further below The FASB concluded

that developing separate accounting model for each type of derivative was impractical In

Statement 133 the Boards goal was to develop broad accounting model for all types of

derivatives and to define when and how hedge accounting should be used

20 The Boards gestation process for Statement 133 was long difficult and

contentious Between 1986 and the issuance of Statement 133 in June of 1998 the Board

issued six different documents defining the issues and describing proposed accounting

approaches including three exposures of conclusions and drafts with opportunities for

formal comment letters from accountants and companies who followed the process

During that period the Board held 131 public meetings on the subject After that extensive

due process the Board noted in Statement 133 This Statement is an additional step in the

Boards project on financial instruments and is intended to address the immediate problems

about the recognition and measurement of derivatives while the Boards vision of having

all financial instruments measured at fair value in the statement of financial position is

pursued Certain provisions of this Statement will be reconsidered as the Board continues

to address the issues in its broad project on financial instruments.15

21 The process of developing the accounting for derivatives and hedging did not end

with the issuance of the statement Before the ink was dry the FASB anticipating

greater than normal volume of complex implementation issues took the unprecedented step

of establishing group of expert practitioners called the Derivatives Implementation

Group which became known as the DIG That group included people expected to be in

positions to see implementation issues as they arose and to bring them to the Boards

14

See EITF Issue 84-36 Interest Rate Swap Transactions

Statement 133 J2I6

Confidential

attention The DIG met periodically to discuss issues and recommend solutions to the

Board Eventually over 150 DIG statements of guidance referred to 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

Subsequent amendments of number of provisions were contained in Statements 138 in

June 2000 and 149 in April 2003 Throughout this period and for several years thereafter

the SEC staff was active in generating comments to registrants and in frequent public

comments interpreting the standards

23 The end result of all of this well intentioned activity was to build formidable and

growing book of rules Statement 133 implementation became significantly difficult

challenge Several hundred public companies ended up restating financial tatements when

their implementation efforts were deemed inadequate under the standard as it was later

interpreted.16 Subsequent to the relevant time period both the SEC and the FASB have

moved to make the rules less complex and less difficult to comply with.1 Absent those

SEC efforts it is likely there would have been numerous additional restatements

24 In June 2008 the FASB issued an exposure draft proposing to amend Statement

133 yet again The stated objectives of that project were to

Simpliaccounting for hedging activities

Improve the financial reporting of hedging activities to make the accounting

model and associated disclosures more useful and easier to understand for users of

financial statements

Resolve major practice issues related to hedge accounting that have arisen

under Statement 133

Address differences resulting from recognition and measurement anomalies

between the accounting for derivative instruments and the accounting for hedged

items or transactions.8

See e.g http//www.cfo.com/articIe.cfm/6874855/c 2984409/ftarchives see also Audit Analytics 2009

Financial Resiatements Nine Year Comparison at 21 2009

The SEC made an announcement at the EITF meeting on March 15 2007 see infra paragraph 51 and the

FASB issued Exposure Drafts dated June 62008 and May 26 2010

See Accounting for Hedging Activities an Amendment of FA SB Statement 133 at iiavailable at

http//www.fasb.org/drafiled hedgingamendment_st133.pdf

Con fidentiat

25 In the Background and Basis for Conclusions section of the 2008 exposure draft

the Board commented on the reasons for the project as follows

Since the effective date of Statement 133 the FASB has been asked to address

numerous issues on many aspects of hedge accounting including but not limited

to issues related to assessing hedge effectiveness and measuring hedge

ineffectiveness As result in May 2007 the Board agreed to add project to its

agenda to reconsider the hedge accounting guidance in Statement 133 The Board

decided that the accounting for hedging activities should be simplified to make

it easier forpreparers of financial reports to comply with the guidance and the

financial reporting of hedging activities should be improved to make the hedge

accounting results more useful and transparent to investors and other users of

financial information.9

26 In summary the Board concluded that Statement 133 as it has been interpreted and

applied is unduly rigid complex and difficult to comply with The Boards proposed

changes include changing the threshold for hedge accounting from quantitative evaluation

of highly effective to qualitative evaluation of reasonably effective making it easier

to qualify for hedge accounting The proposal would also require reassessment of

effectiveness after the initiation of hedging relationship only if circumstances suggest that

the hedge may no longer be reasonably effective It would eliminate most designation of

specific risks so that generally all changes in the fair values or the cash flows would be

part of the hedge It would also eliminate all of the approaches that assume no

ineffectiveness

27 The FASBs effort to simplify the rules for hedge accounting has not been

completed as of this writing but the Board has announced that it still intends to pursue this

effort as part of broader project on financial instruments rather than as separate

expedited project The Board included many of the provisions of the 2008 exposure draft

in an exposure draft issued on May 26 2010 Accounting for Financial Instruments and

Revision to the Accounting for Derivative Instruments and Hedging Activities

19Id A3

10 Confidential

VII Overview of Statement 133

28 At some level the FASB tried to take principles-based approach to Statement 133

The Board articulated four fundamental decisions to serve as cornerstones of the

standard

all derivatives were to be recognized on the balance sheet

all derivatives were to be measured at fair value

only items meeting the definitions of assets and liabilities were to be shown as such

special hedge accounting was to be available only for qualifying transactions0

With all derivatives on balance sheet and measured at fair value it was necessary to

account for the gains and losses as the values changed Under Statement 133 the

accounting for the gains and losses depends on whether the derivative is designated as and

effective as hedge If the relationship does not qualify for hedge accounting gains and

losses on the derivative are recognized in earnings

29 Statement 133 provides for two different kinds of hedging strategies.2 These are

called fair value hedges and cash flow hedges In some strategies the objective is to

protect against losses in the fair value of an asset or liability For example the holder of

100 shares of XYZ stock currently selling for $100 per share could buy derivative to

protect it from the risk that the price of the stock might decline That derivative would pay

the holder if the share price declined The hedge would require however that the investor

give up at least some of the upside potential for gains if the stock price went up Statement

133 provides for fair value hedge accounting for such strategy For fair value hedge

gains and losses on both the derivative and the hedged asset or liability are recognized in

earnings If the hedge works as expected the gains on one side offset the losses on the

other Fannie Mae made its fair value hedge accounting transparent disclosing the

cumulative adjustment to the value of its debt securities from hedge accounting.22

20Statement 133

21

Arguably Statement 133 provides third strategy for foreign currency hedges but that is not relevant here

222003 Form 10-K at 146

Ill Pa Confidential

30 In other strategies the objective is to protect against adverse changes in an expected

cash flow Paragraphs 15 and 16 above gave the example of the company with floating rate

debt with interest payments thatvary

with market index such as LIBOR If the company

is concerned that rates will go up it might enter into derivative that would effectively

lock in fixed rate Statement 133 provides for cash flow hedge accounting for such

strategies In cash flow hedge gains or losses on the derivative are shown in section of

the balance sheet called other comprehensive income or OCT The gains or losses

remain in OCI until the hedged item affects earnings at which time they are moved out of

the balance sheet and included in earnings as well If the hedge works as anticipated the

gains and losses will offset in the same future period reflecting the economics of the

effective hedge in the income statement cash flow hedge strategy may involve

forecasted future cash flow such as planned issuance of debt rather than an existing asset

or liability Cash flow hedge accounting is transparent The reader of the financial

statements can see in the OCT section of the statement of changes in stockholders equity

and in related table the amount of any gain or loss on derivatives that are held in cash

flow hedge relationships.23

31 In summary if the strategy qualifies for hedge accounting gains and losses are

deferred and recognized when the hedged item affects eamings for cash flow hedges or

offset by currently recognizing gain or loss on the hedged item for fair value hedges

The purpose of hedging activities is to avoid economic losses and volatility The FASB

recognized that accounting needed to reflect the economics of effective hedges and

accordingly provided for hedge accounting in Statement 133 The purpose of hedge

accounting is to avoid volatility of financial statements that would not reflect the

underlying economics Both cash flow hedge accounting and fair value hedge accounting

work to recognize gains and losses on hedging derivatives in the same period as losses and

gains on the related hedged transaction Absent hedge accounting gains and losses on

hedging derivatives would be recognized earlier than losses and gains on the hedged

232003 Form 10-K at 80 table 31 124

12 Confidential

positions generating accounting volatility that would misrepresent the economics of the

transaction

32 Not every derivative transaction can qualify for hedge accounting under Statement

133 One of the conditions for qualifying for hedge accounting is that the hedge is

expected to be highly effective hedge is said to be effective if the losses and

sometimes gains on the hedged item are offset by gains and sometimes losses on the

derivative

33 Statement 133 introduced the idea of measuring ineffectiveness Ineffectiveness is

easy to understand in fair value hedge Simply compare the amount of the change in the

fair value of the derivative to the change in the fair value of the hedged item Assuming

one of those changes is gain and the other is loss the difference is ineffectiveness For

cash flow hedges however including those involving forecasted transactions the objective

is to eliminate or reduce variability in future cash flows If there is ineffectiveness it is

necessary to convert differences in those future cash flows into an amount of gain or loss to

be recognized After Statement 133 was issued it became apparent that there was more

than one supportable way to measure gains or losses from ineffectiveness in cash flow

hedge.24

VIII Assumption of No Ineffectivcness

34 Statement 133 sets forth requirements for assessing and measuring ineffectiveness

in paragraphs 62-70 Those paragraphs are attached as Exhibit The FASB did not

specify methods to be used for that purpose recognizing that appropriateness of

given method of assessing hedge effectiveness can depend on the nature of the risk being

hedged and the type of hedging instrument used.2S The FASB also recognized that there

would be situations in which determining that hedge relationship would qualify as highly

effective would be easy If the critical terms of the hedged item and the hedging derivative

match the entity could assume that the hedge would be sufficiently highly effective that

24See DIG Issue

25Statement 133 62

13 Confidential

measurement of in effectiveness was unnecessary The Board understood that the hedges in

these relationships would not be literally perfect and that ineffectiveness would not be

zero but that the ineffectiveness could be determined to be inconsequential or small

enough to ignore

35 While paragraph 65 clearly contemplates number of relationships that would

qualify for an assumption of no ineffectiveness ANT approach with no computation

being necessary to measure ineffectiveness and no accounting entrymade to recognize any

ineffectiveness the Board did not specify which instruments or relationships would qualify

and did not set forth list of the critical terms except in several examples6 Thus the

accountant who would apply this approach must assess the critical terms based on

understanding the economics of the relationship

36 Paragraph 68 of Statement 133 is special case of the ANI approach In the very

common case of hedging interest rate risk with swap the Board did set out the critical

terms and relieved the accountant of the responsibility of assessing the economics of the

relationship Those relationships became known among practitioners as the shortcut

method

37 It is clear that the Board intended to provide for ANT approaches beyond the

paragraph 68 shortcut method In recent amendment of 133 Statement 161

Disclosures About Derivative Instruments and Hedging Activities the FASB notes that the

assumption of no ineffectiveness encompasses the shortcut method and other methods In

paragraph A65 commenting on its reasons for not requiring disclosure of the extent of such

methods the Board states Those Board members noted that this disclosure might reflect

negatively on entities that appropriately use the shortcut method as well as other methods

that assume zero ineffectiveness

38 Apart from the special case of paragraph 68 to apply an ANT approach under

Statement 133 the entity must identify which terms are critical which requires an

understanding of the economics affecting the hedged item and the derivative To apply the

26

Examples are found in paragraphs 65 155 and 161 of Statement 133

14 Confidential

AN approach it may also be necessary to determine what match means for each critical

term in the context of the particular hedge

39 The Board understood that hedges are rarely if ever perfect in the sense that the

change in the derivative value will equal to the penny the change in the hedged position

Further some terms may be impractical to match exactly For example derivative

might mature on the same day as hedged item but it could be difficult to arrange for the

two transactions to happen at the same instant Even transaction that meets all the criteria

for the paragraph 68 shortcut method will generally have some ineffectiveness but the

amount is minimal and Statement 133 does not require measurement or recognition.27

Statement 133 like all FASB Statements explicitly provides that the provisions of this

Statement need not be applied to immaterial items.28

40 For the ANI approach it should be sufficient for the critical terms to be those That

have the potential to create ineffectiveness that is more than inconsequential and for

match to be difference in those terms smaller than what would have the potential to

create ineffectiveness that is more than inconsequential The SEC staff has explicitly

recognized the validity of this approach The example cited was foreign currency

hedging relationship where the settlements of the hedged item and the derivative occurred

within the same month but on different days9

27

Paragraph 70 of Statement 133 recognizes this Comparable credit risk at inception is not condition for

assuming no ineffectiveness even though actually achieving perfect offset would require that the same

discount rate be used to determine the fair value of the swap and of the hedged item or hedged transaction

To justify using the same discount rate the credit risk related to both parties to the swap as well as to the

debtor on the hedged interest-bearing asset in fair value hedge or the variable-rate asset on which the

interest payments are hedged in cash flow hedge would have to be the same However because that

complication is caused by the interaction of interest rate risk and credit risk which are not easily separable

comparable creditworthiness is not considered necessary condition to assume no ineffectiveness in

hedge of interest rate risk

DIG Issue E-4 notes Statement 133 acknowledges in paragraph 70 that hedging relationship that meets

all of the applicable conditions in paragraph 68 may nevertheless involve some ineffectiveness

notwithstanding the supposed assumption of no ineffectiveness Yet Statement 133 permits application

of the shortcut method which does not recognize such ineffectiveness currently in earnings

28Statement 133 following 56

29See info paragraph 51 Mr Barron takes issue with the use of the terms practical applications and

inconsequential ineffectiveness in Fannie Maes implementation of Statement 133 In my view one of

continued on next page

15 Confidential

41 In my opinion an ANI approach is an appropriate way to apply 133 in cost

effective manner

IX Fannie Maes Use of Derivatives

42 understand that Fannie Mae made extensive use of derivatives in managing

interest rate risk At December 31 2000 Fannie Mae held approximately 1400 derivative

contracts with total notional amount of $324.7 billion.30 Fannie Maes assets consisted

mostly of fixed rate mortgage assets To finance these assets Fannie Mae had liabilities

with various maturities including significant amount of short term discount notes

Although the discount notes had fixed rates they matured and were refunded rolled over

frequently at market rates The basic objective of the hedging program was to structure the

debt cash flows so the interest expense would vary with the interest earned on its assets

locking in positive spread For example if interest rates went up interest on the rolling

discount notes would rise while interest income on the fixed rate mortgage assets remained

constant The result could reduce or even eliminate the positive spread Fannie Mae

entered into derivative contracts including interest rate swaps so that the combined cash

flows of the debt and the derivative would have stable relationship with the cash flows

from its assets Hedging activities were an important part of Fannie Maes business model

which was intended to produce consistent relatively stable profit margins on its portfolio

even as interest rates and mortgage prepayments varied

Fannie Mae Implementation of Statement 133

43 understand that Fannie Mae recognized before Statement 133 was issued that it

would be complex and difficult to apply it to its business Fannie Mae undertook an

extensive effort to plan for transition working with its auditor and regulators as well as

continued from previous page

the FASBs objectives in every Statement is to make sure practical application is possible and cost of the

implementation is reasonable While the words inconsequential ineffectiveness do not appear in

Statement 133 in my view that is perfectly acceptable term for amounts of ineffectiveness small enough

to be not recognized under an ANI approach inconsequential was intended to denote amounts much

smaller than fhose that would be simply immaterial

30See FMCI V-OS 00394376 at 4380

16 Confidential

employees from different parts of the organization result of that effort was the

Derivatives Accounting Guidelines known as the DAG which was sizeable book

setting forth the companys policies for applying Statement 133 The DAG included

diagrams describing pictorially the cash flows to and from the counterparty as well as an

outline form description of the transaction and its accounting.32

44 The volume of transactions the number of hedging strategies the complexity of

Statement 133 and the fact that additional guidance continued to emerge from the DIG and

the SEC combined to make implementation major challenge for Fannie Mae Because of

the volume of transactions computerized approach was an essential part of

implementation Fannie Mae discovered that there was no readily available off the shelf

software available that would meet its needs.33

45 As part of its extensive effort to implement Statement 133 Fannie Mae decided to

define series of relationships that would qualify for an assumption of no ineffectiveness

Under this approach Fannie Mae would generally limit the transactions they entered into

and designated as hedges to those where it would be easy to assess that the hedge was

very highly effective and there would be no ineffectiveness to recognize in eamings

during the term of the hedge because the critical terms of the hedged item and the

derivative matched.34 This approach meant that Fannie Mae would not enter into some

transactions that otherwise would have been economically attractive that would have been

economic hedges and that would have qualified for hedge accounting under Statement 133

but would not have qualified for an ANI approach

46 understand that there were occasional transactions that fell outside the parameters

of the AN guidelines because the critical terms did not match Since these transactions did

not qualify DNQ for the assumption of no ineffectiveness although they did qualify for

hedge accounting ineffectiveness was calculated using long-haul and recorded The

See FMCJ V-OS 00394376 at 4381-82 4385-89

32See KPMG-CIV-00108327 at 8667-801 KPMG-CIV-00285352 at 5767-927

See FM-CIV-0 1-00144228 at 4229 see also Jonathan Boyles civil tr 276-77 September 16 2009

Statement 133 65

17 Confidential

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 Fannie Mae also made extensive use of options and swaptions an option to acquire

swap as hedging instruments As permitted by Statement 133 Fannie Mae designated

the intrinsic value of these instruments as the hedging derivative the time value was not

part of the hedging relationship and changes in the time value were recognized in earnings

as they occurred

48 Tn my opinion Fannie Maes approach to implementation of Statement 133 was

reasonable and appropriate application of GAAP in the relevant time period

XI Issues Raised by Fannie Mae Implementation

49 The following sections discuss certain issues that have been raised specific to

Fannie Maes hedge transactions

Was it reasonable under GAAP in the relevant time period for Fannie Mae as it

described in its letters to the SEC36 to assume no ineffectiveness on the basis of

analysis that showed that minimal variances between the terms of the hedged item

and the hedging instrument would be expected to produce inconsequential amounts of

ineffectiveness

50 As noted above in my opinion an ANI approach is reasonable and appropriate

way to apply Statement 133 and is specifically provided for in paragraph Further to

apply an ANI approach under Statement 133 the entity must identify which terms are

critical based on an understanding of the economics affecting the hedged item and the

derivative To apply the ANI approach it is also necessary to determine what match

KPMO-CIV-00108327 at 8414-15 8642 8489-95 8397 KPMG-CIV-00285352 at 5442-43 57205519-28 see also e.g KPMG-CIV-00009996 FMCIV-03 00126701

36FMCIV-05 00394376 to 4425 FMCI V-OS 00700330 to 0407

31 Mr Barton in his report has chosen to interpret paragraph 65 as narrowly as paragraph 68 requiring that

all terms that could possibly produce ineffectiveness must match exactly Even with such reading of

paragraph 65 one could support the use of an ANI approach for transactions that met criteria calculated to

limit ineffectiveness to inconsequential amounts based on the language provisions of this Statement

need not be applied to immaterial items which appearsin all FASB Statements

18 Confidential

means for each critical term in the context of the particular hedge The critical terms would

be deemed to match when the difference between the critical term of the hedged item and

that of the hedging instrument are small enough that ineffectiveness is inconsequential

That is the approach Fannie Mae used in its adoption of Statement 133

5L As noted above the SEC staff endorsed very similar application of an ANI

approach The minutes of the EITF meeting of March 15 2007 report

An SEC staff member indicated that in situations in which registrants have

applied the critical terms match method when the terms of the hedge and the

hedged item do not exactly match but the other provisions of paragraph 65 have

been satisfied registrants would generally be expected to

Evaluate and support the reasonableness of the original conclusion that

the terms of the hedge and the hedged item matched

Perform quantitative assessment to confirm that the relationship was

highly effective and that any ineffectiveness was de minimis

If the results confirm that there was reasonable basis to assert that the terms

matched that the relationship was highly effective and that any ineffectiveness was

de minimis continued application of hedge accounting may be acceptable.38

The example cited was foreign currency hedging relationship where the settlements of the

hedged item and the derivative occurred within the same month but not on the same day

52 In addition 2001 publication distributed by another Big accounting firm

describes similar approach applied to the repricing dates of an interest rate swap

company may believe that its interest rate risk hedge design is marginally

ineffective perhaps because the repricing dates of the swap and the hedged item do

not exactly match However the company can approximate the maximum amount

of ineffectiveness that could incur as long as market interest rates remain within

reasonable range say between 4% and 8% If this worst case ineffectiveness is

clearly immaterial company might be able to establish policy that no earnings

adjustment will be recorded as long as market conditions remain within certain

38See http//www.fasb.org/jspIFASB/Page/03-1 5-O7mtg_minutes.pdf footnote omitted see also Deloitte

Heads 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 This policy would be solely based on the guidance that the provisions of

the Statement need not be applied to immaterial items.39

53 Another Big accounting firm recognized this approach was widely practiced in

2007 publication

Many registrants have historically evaluated the effectiveness of hedging

relationships for only those provisions that may have reasonable possibility of

creating more than de minimis amount of ineffectiveness Other sources of

potential ineffectiveness i.e those that pose only remote chance of giving rise to

significant amount of ineffectiveness were often evaluated only qualitatively In

practice many entities believed that only the material aspects of hedging

relationship i.e the critical terms need to be quantitatively assessed and

documented to qualif5i for the application of hedge accounting under FAS 133 For

example many in practice believe that if the hedged item and the derivative settle

within the same month the critical terms of the hedging relationship were

sufficiently matched for purposes of applying paragraph 65 of the Standard

Therefore no quantitative assessment was performed and the qualitative

assessment of those de minimis sources of ineffectiveness may not have been

formally documented

Our historical perspective has been that if there were any sources of variability in

hedging relationship that were not perfectly matched an assumption of no

ineffectiveness under paragraph 65 might still have been acceptable if an entity had

reasonably demonstrated an expectation of high effectiveness and that any amounts

of ineffectiveness would be de minimis.40

54 Fannie Mae described its approach in its letter to the SEC in the following terms

Although FAS 133 requires an assessment of effectiveness it does not prescribe

methodology With respect to many of Fannie Maes hedge relationships

assessment of hedge effectiveness is based on matching key terms of the derivative

and hedged item including consideration of the credit worthiness of the derivative

counterparty Based on this method of assessing effectiveness we concluded that

the hedge relationship would have no or inconsequential ineffectiveness We also

concluded that as long as the key matching terms of the hedge relationship were

FMCIV-03 03091796 at 1934 Ernst Young LLP Financial Reporting Developments Accounting for

Derivative Instruments and Hedging Activities Comprehensive Analysis of FASB Statement 133 as

Amended and Interpreted at 4.36 Dec 2001 emphasis in original

40FMCIV-1 0-11169603 at 70007-08 PricewaterhouseCoopers LLP Guide to Accounting for Derivative

instruments and Hedging Activities at 393-94 2007

20 Confidential

maintained there was no need to measure ineffectiveness on individual transactions

on periodicbasis.4

55 In summary Fannie Maes application of an ANI approach using critical terms that

were matched within defined limits calculated to assure that unrecognized

ineffectiveness was inconsequential was reasonable and appropriate and was consistent

with the interpretation of Statement 133 that other knowledgeable accountants adopted

Was it reasonable under GAAP in the relevant time period for Fannie Mae to assume

no ineffectiveness on hedges of discount notes such as DAG transaction number

when the dates on which the swap rates reset were not the same as the dates of

issuance roll over of the discount notes but were within 1- days

56 One of Fannie Maes hedging strategies was hedge of the rollover of its discount

notes Discount notes are short term notes Fannie Mae issues on regular basis on

Wednesday of each week Because the notes issued in the future wilt be priced based on

then-current interest rates the discount note program is effectively floating rate funding

source The interest payments on the thture issuances have cash flow risk To better match

the characteristics of its assets to lock in spread Fannie Mae needed to have funding

source with fixed interest cash flows It could achieve that goal with combination of the

discount note program and derivative such as swap.42 The swap would be pay-fixed-

receive-floating instrument extending for the period of time that Fannie Mae estimated

would match the life of some of its fixed rate assets such as 10 years

57 Fannie Mae applied an ANI approach to these hedges Because the discount notes

were issued only on Wednesdays and with fixed maturities e.g 90 days while available

swaps with 90 day reset intervals might have been issued on any day of the week it was

not practicable to have the maturities of the notes and the reset of the swap occur on the

same day Fannie Mae determined that if the dates were within 1- days the resulting

FMCI V-OS 00394376 at 4391

42KPMG-CJV-00108327 at 8409 8672-73 KPMG-CIV-00285352 at 5436 5772-73

21 Confidential

ineffectiveness would be inconsequential That is one of the critical terms was the

reset/maturity date and 1-7 days was match.43

58 understand that Fannie Mae did quantitative assessment of the amount of

ineffectiveness that could result from the 1-7 day policy prior to adoption and that they

reconfirmed and updated that assessment in 2003 Those analyses concluded and

subsequent analysis has confirmed45 that the amount of ineffectiveness was

inconsequential

59 This is an example of the general application of an ANT approach described in the

previous question The guidance cited in that discussion from Ernst Young in 2001 and

from the SEC and PricewaterhouseCoopers in 2007 uses the example of dates that are

close but not exactly matched.46 In my opinion the approach to the discount note hedging

program described above including the use of the ANT approach and the definition of

match as 1- days was reasonable and appropriate application of Statement 133

Was it reasonable nnder GAAP in the relevant time period for Fannie Mae to assume

no ineffectiveness for termouts DAG transactions number 2-4 13 and 20 when the

fair valne of the initial swap was not zero at the date of the termout

60 Term-outs are variation on the discount note hedge Sometimes because of

market conditions during the term of discount note hedge the 90-day discount notes

would be replaced with medium-term fixed-rate note Fannie Mae would enter into

pay-floating swap so that the combined cash flows of the note and swap are the same as

the original discount notes and the combined cash flows of all three instruments are the

original fixed rate

KPMG-CIV-00108327 at 8410-T3 8472-74 8489-95 8624 KPMG-CIV-00285352 at 5437-38

5501-04 55 19-28 5642

See FMCI V-OS 00394376 at 4393

45See Expert Report of Dwight Grant

46See supra paragraphs 51-53

22 Con fidentia

61 understand that one possible criticism of the application of an ANT approach to

hedge accounting for term-outs is that if one believes the term-out requires redesignation

of swap the fair value of that swap would not be zero at the time of redesignation

62 The paragraph 68 shortcut method requires that the swap have fair value of zero

at designation Regulators and auditors have taken veryliteral rules-based view of this

requirement Paragraph 65 includes no such requirement In my opinion the same rigid

rule is not required to qua1if for the ANI approach under paragraph 65 especially for cash

flow hedges Because paragraph 68 provides mechanical approach reducing the effort

and cost of hedge accounting for very specifically defined transaction that happens to be

frequently encountered the Board defined very specific qualiing tests Because the ANT

approach is potentially applicable to wider range of transactions that the Board did not

attempt to describe specifically except in some examples the approach is different.47

63 note that the termout transactions are similar to and in fact were the inspiration

for example in paragraphs 159-161 of Statement 133 It would also be true in that

example that the fair value of the first swap would not be zero at the date the second swap

was added Nevertheless the Board concluded Together the cash flows from the two

derivatives are effective at offsetting changes in the interest payments on the.three-year

note Changes in fair values of the two swaps are recognized in other comprehensive

income and are reclassified to earnings when the hedged forecasted transactions the

variable interest payments affect earnings as required by paragraph No mention is

made of any recognized ineffectiveness

64 Mr Barron makes reference page 40 to an amendment of example that was

included in Statement 138 He notes that reference to the shortcut method was deleted

Mr Baron recognizes pages 9-1 and 35 that Statement 133 incorporates both the shortcut method

1168 and the matched terms method 1165 His primary conclusion that Fannie Maes accounting did

not comply with Statement 133 page 12 rests on the idea that the accounting could not quali for the

matched terms or ANI approach In reaching that conclusion he incorrectly extends the requirements for

the shortcut method to the matched terms approach As described above the two are more different than he

appreciates In particular there is no requirement under paragraph 65 for zero initial fair value or for

terms to exactly match Mr Berliner makes similar argument page 3-10

48Statement 133 11161 parentheticals in original

23 Confidential

and concludes that the intent of the amendment was to preclude an assumption of no

ineffectiveness He does not make reference to the remaining undeleted portion of the

paragraph quoted above In my opinion the language in fair values of the two

swaps are recognized in other comprehensive income.. contained in the amended

example clearly describes an ANI approach The Statement 138 amendment was

technical correction to delete the reference to paragraph 68 and the short cut from what

should have been an example of paragraph 65 ANI approach all along

65 believe that in the relevant time period when Fannie Maes policies were

developed reasonable people could have had different views on whether term-out should

be thought of as single continuing hedge relationship or new hedge relationship at the

time of the term-out requiring redesignation of the hedge with regard to swap

understand that it was known at the time the original hedge was put on that term-outs could

occur The basic discount note hedge involves discount notes issued rolled over

periodically after the hedge is putin place The medium term note might have been viewed

as part of that rollover process Since the original swap was never out of hedge

relationship and since the cash flows overall achieved the desired fixed rate that was the

objective of the strategy with or without the term-out one might reasonably have reached

the conclusion that there is single hedge relationship and no redesignation is necessary

66 Even if the termout is considered new hedge relationship and redesignation the

fact that swap has non-zero fair value does not preclude use of an ANI approach

understand that Fannie Mae in addition to relying on the guidance in the example in

paragraphs 159-161 also did quantitative assessment to determine that the ineffectiveness

resulting from the non-zero fair value of swap when the term-out occurred was

inconsequential.49

67 The term-out transactions are complex The example in paragraphs 159-161 is

helpful but it does not address all the details of application of 133 to these transactions It

appears that the overall combination of these instruments did achieve the objective of FMs

See FMCI V-OS 00394376 at 4387 FMCIV-0S-00700330 at 0332 0390-96

24 Confidential

cash flow hedge In my opinion the approach to accounting for term-outs described above

was reasonable and appropriate application of Statement 133

Was it reasonable under GAAP ia the relevant time period for Fannie Mac to assume

no ineffectiveness when using swaptions in varions hedge strategies even though the

fair value of the swap at the date of exercise would not be zero DAG transactions 10

11 67 and 71

68 swaption is an instrument that gives the holder the right but not the obligation to

convert it to swap with specified terms at future date As with other option instruments

the buyer pays premium at origination and has one sided protection Statement 133

clearly contemplates that hedge strategy can designate as the hedged item changes in

value or changes in cash flows above or below certain level In such strategy the option

will always be in the money when it is exercised if it was out of the money it would not be

exercised but would expire worthless In my opinion use of an AN approach for such

strategies was reasonable and appropriate application of Statement 133.50

Was it reasonable under GAAP in the relevant time period for Fannie Mae to assume

no ineffectiveness when using dnration as the critical term in hedges of anticipated

debt issuances

69 Anticipatory debt hedges were used when Fannie Mae planned to issue debt to fund

assets it was committed to acquire short time in the future up to 30 days Because the

assets Fannie Mae was committed to acquire had fixed rate and the currently available

funding rate was lower than the rate on the assets Fannie Mae entered into derivative

transactions to lock-in the positive spread over the estimated life of the assets.5

70 Fannie Mae applied an ANI approach to accounting for these hedges In its

duration matching approach Fannie Mae defined the critical term as the product of

Mr Barrons report pages 45-47 objects to these transactions and notes that it is the same issue as the

termout transactions the non-zero fair value at the date ot exercise As noted do not agree that this

should necessarily be viewed as new relationship or that even if it is that precludes application of the

ANJ approach

KPMG-CIV-00108327 at 8402-05 8423-42 8616-21 KPMG-CIV-00285352 at 5429-32

5451-70 5633-39

25 Confidential

duration and notional amount Duration is direct measure of the sensitivity of the value

of fixed-rate instrument to changes in interest rates based on the weighted average present

value of all of the cash flows of the instrument Two instruments with the same duration

will have the same sensitivity to small changes in interest rates and thus will be more

effective hedges than two instruments with the same final maturity Duration is more

sophisticated and exacting measure of how much an instruments fair value will change

with change in interest rates The same duration matching was used for both the business

decision of selecting an economically appropriate hedge relationship and for the

accounting understand that the use of the product of duration and principal/notional

amount is standard approach in finance and economics.52

71 Fannie Mae defined certain ranges of duration as matching closely enough to ensure

inconsequential ineffectiveness understand that Fannie Mae initially did quantitative

assessment of the effect of duration differences within the selected ranges and that they

periodically updated that assessment for selected transactions.53

72 As noted above the FASB did not try to define the critical terms for an ANI

approach It is necessary for the accountant who would apply an ANI approach to

understand the economics of the instruments and to identify based on that understanding

the critical terms and how precisely they must match to ensure inconsequential

ineffectiveness In my opinion use of an ANI approach with the critical term defined in

terms of duration is reasonable and appropriate application of Statement 133

Was it reasonable under GAAP in the relevant time period for Fannie Mae use de

minimis test of ineffectiveness based on changes in target yield between the hedged

item and the hedging instrument as part of dollar offset approach to assessing and

measuring ineffectiveness of hedges of anticipated issuances of longer dated debt

73 understand that Fannie Maes approach provided for occasions when hedge did

not qualify for the assumption of no ineffectiveness ANI If such situation arose the

52understand that if the products match closely and the durations match closely then mathematically the

principal/notional amounts must also be close See Expert Report of Dwight Grant

See FMCIV-05 00394376 at 4400 FMCI V-OS 00700330 at 0372-88

26 Confidential

DAG provided that Fannie Mae would assess effectiveness using dollar offset approach

with de minimis test Under the dollar offset approach the change in the fair value of the

derivative is compared to the change in the hedged item and the hedge is deemed highly

effective if the ratio is between 80-125% This method will predictably fail on many

occasions when the changes in both values are small If the relevant markets were

essentially unchanged the changes in $1000000 hedge might be $l and -$0.50 for

ratio of 50% or even $1 and $O.50 If the dollar offset method is to be used which

was clearly contemplated see DIG E-8 it needs to include provision so that numerical

results outside of the 80-125 range when the absolute change is de minimis do not call into

question the expectation of higheffectiveness.54

74 am aware of 2003 SEC staff speech that some have interpreted to proscribe the

use of de minimis test as part of dollar offset method because that is viewed as two

methods.55 do not agree with that interpretation of Statement 133 believe it would be

an inappropriate amendment to Statement 133 because as discussed above it would make

it impractical to ever use the dollar offset method

75 In my opinion Fannie Maes use of de minimis test as part of dollar offset

approach to assessing ineffectiveness was reasonable and appropriate application of

Statement 133

Was Fannie Maes approach to hedge documentation which viewed the DAG and the

computerized system as parts of that documentation reasonable interpretation of

the requirements of Statement 133 in the relevant time period

76 As spelled out in EITF topic D-102 documentation of hedge should include

identification of

The hedging instrument derivative

54 Mr Barron page 47 and Mr Berliner page 3-18 both assert that Fannie Maes use of de minimis test

as part of the dollar offset method of assessing effectiveness for transactions that did not use an ANI

approach was inappropriate As noted above such test is necessary part of the dollar offset method and

Statement 133 clearly contemplated the use of that method

John James AICPA National Conference on Current SEC Developments Dec 11 2003 available at

http//www.sec.govfnews/speech/spch 1211 O3jmj.htm

27 Confidential

The hedged item or transaction

The nature of the risk being hedged

The method that will be used retrospectively and prospectively to assess effectiveness

The method that will be used to measure ineffectiveness

The extent form and level of precise detail of that documentation was something that

received considerable attention as accountants auditors and regulators worked to

implement Statement 133 In general expectations for documentation increased over the

first years of implementation

77 understand that some of the hedge documentation Fannie Mae relied on was coded

into the computer systems that were developed as part of the implementation of Statement

133 Statement 133 requires documentation and as noted above the interpretation of that

requirement has been increasingly rigid in the years after the Statement was issued but

there is no requirement that all documentation has to be on paper In my opinion the

approach Fannie Mae followed was reasonable and appropriate

Did Fannie Maes use of the terminology shortcut method in the original version of

the DAG when referring to an ANI approach affect the substance of compliance with

Statement 133

78 The term shortcut method has come to be associated only with interest rate swap

transactions discussed in paragraphs 68-70 Early in the life of Statement 133 at Fannie

Mae and elsewhere that usage was not always consistently observed by practitioners

causing some confusion One could also describe the method outlined in paragraph 65 as

shortcut

79 In my opinion the fact that the word shortcut was used in the first edition DAG to

refer to ANT approaches is not substantive problem The DAG includes an

understandable description of the hedging approaches Fannie Mae used for the transactions

reviewed

On Volatility

80 It has been suggested that one of Fannie Maes objectives in its implementation of

Statement 133 was to reduce the volatility of reported earnings Mr Barron notes page

15 that management of Fannie Mae disagreed with certain provisions of Statement 133

28 Confidential

and that one of managements objectives in implementing new GAAP standards was to

reflect the true economics of our business He follows that with the observation that

the true economics without complying with GAAP is unacceptable

note that eliminating volatility is the business objective of any hedging strategy and that

eliminating accounting volatility that does not reasonably representthe economics of

business transaction is always the objective of any hedge accounting In the development

of Statement 133 the FASB recognized that simply marking all derivatives to fair value

with gains and losses to earnings would show volatility not representative of the actual

economics when the derivative is part of an effective hedge and would be inappropriate

accounting That was the reason for the investment of significant efforts over several

years to develop hedge accounting To the extent Fannie Maes hedges were effective

economically hedge accounting provides better more representationally faithful

financial reporting than would the application of Statement 133 without hedge

accounting understand that subsequent analysis has shown that Fannie Maes hedges

were economically effective and that the ineffectiveness not recognized due to the use of

an ANT approach was minor.56

November 2010

Timothy Lucas Date

56See Expert Report of Dwight Grant As noted above Fannie Mae recognized changes in the time value of

its options and swaptions in earnings as they occurred As result the earnings Fannie Mae reported were

quite volatile

29 Confidential

Exhibit

Resume

Timothy Lucas 3863 Attley Drive Louisville TN 37777

865 980 7759 E-mail Tim@LucasFR.com

Experience

LUCAS Financial Reporting May 2002 to Date

Independent Consultant on issues related to Generally Accepted Accounting Principles GAAPEngagements have included consulting with corporate management on problems identified with

past accounting that might require restatement as well as appropriate accounting for prospective

transactions Other engagements involved working with legal counsel as an expertin both

testiFying and consulting roles in various civil and criminal legal proceedings and SEC

investigations

Neenah Paper Inc 2004 to Date

Member of the Board and Chairman of the Audit Committee of this NYSE Company

Financial Accounting Standards Board FASB 1988 to 2002

Director of Research and Technical Activities

Chairman Emerging Issues Task Force EITFAs the leader of the FASBs technical staff the Director position was on the same level as the

seven full time Board Members That role involved active participation in all major FASB

projects including retiree health care costs income taxes not for profit organizations

impairment of assets stock compensation and various financial instruments topics notably

derivatives and hedging- Also served as Chairman of the EITF group of top accounting

professionals that met six times year to debate and resolve financial reporting issues on

timely basis The Chief Accountant of the SEC and FASB Board Members also participated in

those meetings As Director played key role in the FASBs communications program with

regular speeches at major conferences sponsored by the American Institute of CPAs Financial

Executives International the Institute of Management Accountants and numerous others met

quarterly with the SEC staff and with bank regulators to discuss FASB activities and accounting

issues Responsible for all aspects of administration recruiting evaluation training

assignments etc for the FASB technical staff

Previous Experience

Gordon Capital an investment banking and brokerage firm 1986 to 1987

FASB Project Manager leading projects on Pensions and Concepts 1979 to 1985

Deloitte 1-laskins Sells audit manager and staff training director 1972 to 1979

Jesse Jones Graduate School of Business Rice University adjunct 1976 to 1979

LT.j.g U.S Navy Supply Corps Navy Finance Center 1969 to 1972

Education

BA Economics 1968 BS Accounting 1969 Rice University Houston Texas

Master of Accounting 1976 Jesse Jones Graduate School Rice University Houston Texas

30 Confidential

Publications have authored in the preceding ten years

The FASB publishes range of technical documents from formal Statements of Financial

Accounting Standards to research pieces to regular updates on process and agenda All of those

are created by teams of staff and as Director of Research was responsible for that process from

1988 through May of 2002 Most do not identi an author

Cases in litigation or any administrative proceeding in which have served an expert report

or testified at trial or by deposition in the preceding four years

In Court Testimony

United States of America Prabhat Goyal

United States District Court Northern District of California San Francisco Division

Case No CR-04-0201 MJJ

Costa Brava Partnership III L.P Goodman Company LLP

Fairfax County Circuit Court Virginia

Case No CL 2005-7931

Alan Schein and Results Technologies Inc Emst Young LLP

Circuit Court of the Seventeenth Judicial Circuit Broward County Florida

Case No 03-000266 CACE 03

Adeiphia Communications Corporation et al Motorola Inc et al

U.S Bankruptcy Court Adversary Case No 06-01 558-reg

By Deposition

AOL Time Warner Securities Litigation

Superior 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 No O3cvhO7 7932

Schering-Plough Corporation United States

United States District Court District of New Jersey 5-48-19846

Civil Action No 05-257515K

Bank of America Corp ABN AMRO Bank N.VArbitration

Securities And Exchange Commission

Microtune Inc Douglas Bartek and Nancy Richardson

United States District Court Northern District of Texas

Civil Action No 3-O8CV1 105-B

311 Confidential

Alstom SA Securities Litigation

United States District Court Southern District of New York

Civil Action No 03-CV-6595VM

Served an expert report

In addition to reports on the matters listed above in the last four years have served expert

reports in seven other matters that 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 that an entity define at the time it designates hedging

relationship the method it will use to assess the hedges effectiveness in achieving offsetting

changes in fair value or offsetting cash flows attributable to the risk being hedged It also

requires that an entity use that defined method consistently throughout the hedge period to

assess at inception of the hedge and on an ongoing basis whether it expects the hedging

relationship to be highly effective in achieving offset and to measure the ineffective part of

the hedge If the entity identifies an improved method and wants to apply that method

prospectively it must discontinue the existing hedging relationship and designate the relationship

anew using the improved method This Statement does not specify single method for either

assessing whether hedge is expected to be highly effective or measuring hedge ineffectiveness

The appropriateness of given method of assessing hedge effectiveness can depend on the nature

of the risk being hedged and the type of hedging instrument used Ordinarily however an entity

should assess effectiveness for similar hedges in similar manner use of different methods for

similar hedges should be justified

63 In defining how hedge effectiveness will be assessed an entity must specify whether it

will include in that assessment all of the gain or loss on hedging instrument This Statement

permits but does not require an entity to exclude all or part of the hedging instruments time

value from the assessment of hedge effectiveness as follows

If the effectiveness of hedge with an option contract is assessed based on changes in the

options intrinsic value the change in the time value of the contract would be excluded from the

assessment of hedge effectiveness

If the effectiveness of hedge with an option contract is assessed based on changes in the

options minimum value that is its intrinsic value plus the effect of discounting the change in

the volatility value of the contract would be excluded from the assessment of hedge

effectiveness

If the effectiveness of hedge with forward or fUtures contract is assessed based on

changes in fair value attributable to changes in spot prices the change in the fair value of the

contract related to the changes in the difference between the spot price and the forward or futures

price would be excluded from the assessment of hedge effectiveness

In each circumstance above changes in the excluded component would be included currently in

earnings together with any ineffectiveness that results under the defined method of assessing

ineffectiveness As noted in paragraph 62 the effectiveness of similar hedges generally should

be assessed similarly that includes whether component of the gain or loss on derivative is

excluded in assessing effectiveness No other components of gain or loss on the designated

hedging instrument may be excluded from the assessment of hedge effectiveness

64 In assessing the effectiveness of cash flow hedge an entity generally will need to

consider the time value of money if significant in the circumstances Considering the effect of

the time value of money is especially important if the hedging instrument involves periodic cash

33 Confidential

settlements An example of situation in which an entity likely would reflect the time value of

money is tailing strategy with futures contracts When using tailing strategy an entity adjusts

the size or contract amount of futures contracts used in hedge so that earnings or expense

from reinvestment or finding of daily settlement gains or losses on the futures do not distort

the results of the hedge To assess offset of expected cash flows when tailing strategy has been

used an entity could reflect the time value of money perhaps by comparing the presentvalue of

the hedged forecasted cash flow with the results of the hedging instrument

65 Whether hedging relationship qualifies as highly effective sometimes will be easy to

assess and there will be no ineffectiveness to recognize in earnings during the term of the hedge

If the critical terms of the hedging instrument and of the entire hedged asset or liability as

opposed to selected cash flows or hedged forecasted transaction are the same the entity could

conclude that changes in fair value or cash flows attributable to the risk being hedged are

expected to completely offset at inception and on an ongoing basis For example an entity may

assume that hedge of forecasted purchase of commodity with forward contract will be

highly effective and that there will be no ineffectiveness to be recognized in earnings if

The forward contract is for purchase of the same quantity of the same commodity at the

same time and location as the hedged forecasted purchase

The fair value of the forward contract at inception is zero

Either the change in the discount or premium on the forward contract is excluded from

the assessment of effectiveness and included directly in earnings pursuant to paragraph 63 or the

change in expected cash flows on the forecasted transaction is based on the forward price for the

commodity

66 Assessing hedge effectiveness and measuring the ineffective part of the hedge however

can be more complex For example hedge ineffectiveness would resuJt from the following

circumstances among others

difference between the basis of the hedging instrument and the hedged item or hedged

transaction such as Deutsche markbased hedging instrument and Dutch gui Id erbased

hedged item to the extent that those bases do not move in tandem

Differences in critical terms of the hedging instrument and hedged item or hedged

transaction such as differences in notional amounts maturities quantity location or delivery

dates

Ineffectiveness also would result if part of the change in the fair value of derivative is

attributable to change in the counterpartys creditworthiness

67 hedge that meets the effectiveness test specified in paragraphs 20b and 28b that is

both at inception and on an ongoing basis the entity expects the hedge to be highly effective at

achieving offsetting changes in fair values or cash flows also must meet the other hedge

accounting criteria to qualify for hedge accounting If the hedge initially qualifies for hedge

accounting the entity would continue to assess whether the hedge meets the effectiveness test

and also would measure any ineffectiveness during the hedge period If the hedge fails the

effectiveness test at any time that is if the entity does not expectthe hedge to be highly

effective at achieving offsetting changes in fair values or cash flows the hedge ceases to qualify

for hedge accounting The discussions of measuring hedge ineffectiveness in the examples in the

34 Confidential

remainder of this section of Appendix assume that the hedge satisfied all of the criteria for

hedge accounting at inception

Assuming No Ineffectiveness in Hedge with an Interest Rate Swap

68 An assumption of no ineffectiveness is especially important in hedging relationship

involving an interest-bearing financial instrument and an interest rate swap because it

significantly simplifies the computations necessary to make the accounting entries An entity

may assume no ineffectiveness in hedging relationship of interest rate risk involving an

interest-bearing asset or liability and an interest rate swap if all of the applicable conditions in the

following list are met

Conditions applicable to both fair value hedges and cash flow hedges

The notional amount of the swap matches the principal amount of the interest-bearing

asset or liability

The fair value of the swap at its inception is zero

The formula for computing net settlements under the interest rate swap is the same for

each net settlement That is the fixed rate is the same throughout the term and the variable rate

is based on the same index and includes the same constant adjustment or no adjustment

The interest-bearing asset or liability is not prepayable

Any other terms in the interest-bearing financial instruments or interest rate swaps are

typical of those instruments and do not invalidate the assumption of no ineffectiveness

Conditions applicable to fair value hedges only

The expiration date of the swap matches the maturity date of the interest-bearing asset or

liability

There is no floor or ceiling on the variable interest rate of the swapThe interval between repricings of the variable interest rate in the swap is frequent

enough to justify an assumption that the variable payment or receipt is at market rate generally

three to six months or less

Conditions applicable to cash flow hedges only

All interest receipts or payments on the variable-rate asset or liability during the term of

the swap are designated as hedged and no interest payments beyond the term of the swap are

designated as hedged

There is no floor or cap on the variable interest rate of the swap unless the variable-rate

asset or liability has floor or cap In that case the swap must have floor or cap on the variable

interest rate that is comparable to the floor or cap on the variable-rate asset or liability For this

purpose comparable does not necessarily mean equal For example if swaps variable rate is

LIBOR and an assets variable rate is LIBOR plus percent 10 percent cap on the swap would

be comparable to 12 percent cap on the asset

The repricing dates match those of the variable-rate asset or liability

The index on which the variable rate is based matches the index on which the asset or

liabilitys variable rate is based

69 The fixed rate on hedged item need not exactly match the fixed rate on swap

designated as fair value hedge Nor does the variable rate on an interest-bearing asset or

liability need to be the same as the variable rate on swap designated as cash flow hedge

swaps fair value comes from its net settlements The fixed and variable rates on swap can be

35 Confidential

changed without affecting the net settlement if both are changed by the same amount That is

swap with payment based on LIBOR and receipt based on fixed rate of percenthas the

same net settlements and fair value as swap with payment based on LIBOR plus percent

and receipt based on fixed rate of percent

70 Comparable credit risk at inception is not condition for assuming no ineffectiveness

even though actually achieving perfect offset would require that the same discount rate be used

to determine the fair value of the swap and of the hedged item or hedged transaction To justify

using the same discount rate the credit risk related to both parties to the swap as well as to the

debtor on the hedged interest-bearing asset in fair value hedge or the variable-rate asset on

which the interest payments are hedged in cash flow hedge would have to be the same

However because that complication is caused by the interaction of interest rate risk and credit

risk which are not easily separable comparable creditworthiness is not considered necessary

condition to assume no ineffectiveness in hedge of interest rate risk

36 Confidential

Exhibit

Materials Considered

In forming my opinions in this matter have reviewed number of documents including

the SEC filings of Fannie Mae and documents produced by the parties in the course of

discovery have also read and considered relevant authoritative accounting literature The

documents and materials that relied upon for an understanding of the facts of this case are listed

in the footnotes of this report and those that reviewed in the course of my work included the

following

various Fannie Mae accounting policy memoranda and KPMG workpapers

various other Fannie Mae and KPMG documents as specifically cited in this

report

the 2001 and 2003 versions of Fannie Maes Derivatives Accounting Guidelines

Fannie Maes and KPMGs submissions to the SEC Office of Chief Accountant in

Fall 2004

the reports submitted by other experts in this matter and

the regulatory and civil examinations including exhibits marked in connection

therewith of the following witnesses

Harry Argires SEC testimony Feb 2005 Feb 2006

Jonathan Boyles OFHEO testimony Aug 24 2004 Dec 2004Jonathan Boyles SEC testimony Apr 11-132005 Mar 14-16 2006

May 2006 Jonathan Boyles civil litigation transcript Sept 16-17

2009

Kimberly Stone SEC testimony Nov 29-30 2005

Katarina Skladony OFHEO testimony Aug 26 2004

Mona Patel OFHEO testimony Sept 2004

Mary Trzeciak SEC testimony Oct 13 2005

Ursula Schaefer SEC testimony Sept 29 2005

Donald Sinclair SEC testimony Sept 22 2005

Paul Salfi SEC testimony Oct 18 2005

Mall Johnson SEC testimony Sept 27 2005

Confidential