So using market prices as its determinant, Freddie Mac is now in negative equity. But rather then let that reflect into the income statements, the company has changed its accounting rules to more appropriately match its business expectations...
Fair Value of Net Assets
The company's attribution of changes in fair value relies on models, assumptions and other measurement techniques that evolve over time.
At March 31, 2008, the fair value of net assets was ($5.2) billion as compared to $12.6 billion at December 31, 2007, reflecting a net after-tax reduction of $17.8 billion. This change in fair value of net assets includes the payment of preferred and common stock dividends during the first quarter of 2008.
The change in fair value of net assets includes a pre-tax reduction in fair value of $28.8 billion as a result of net mortgage-to-debt OAS widening, partially offset by a pre-tax increase in fair value related to core spread income in the first quarter of 2008. In addition, the company estimates that the change in fair value of its credit guarantee activities resulted in a pre-tax reduction of $3.0 billion.
I'm reminded of what Buffett and Munger keep repeating about how two parties are entering into derivative contracts and then both sides are reporting gains. You know the person on the other side of Freddie's transactions aren't discounting their gains to conform with Freddie's models. Some time in the near future, one of them is going to find themselves much poorer than they think they are.