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. A FOURTH FINANCIAL STATEMENT 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.) RELEVANCE OVER RELIABILITY 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. …