With Freddie Mac, a major mortgage lender (and once my employer) gripped by scandal, it might be useful to go over some basic economics of the mortgage business. In particular, I want so describe how mortgages are a depreciating asset.

To most of us, a mortgage is a liability. It is the money that we borrowed in order to buy a home.

On the other side of the transaction is the lender. On the lender’s balance sheet, the mortgage is an asset.

From the borrower’s standpoint, with respect to inflation, a 30-year fixed-rate mortgage is a “heads I win, tails you lose” proposition. If inflation and interest rates go up, you pay back your mortgage in cheapened dollars. If inflation and interest rates go down, your mortgage payments cost more in real terms–but only if you keep your mortgage. Instead, borrowers typically refinance.

Economists call this the prepayment option. We say the borrower is long the option and the lender is short the option.

The value of the option grows over time, because the more time passes, the greater the chance of an unanticipated change in interest rates. Since the lender is short the option, the fact that the value of the option increases over time means that the mortgage asset can be expected to depreciate over time.

Thus, mortgages depreciate as assets, and they do so in ways that depend on changes in inflation and interest rates. Accordingly, large lenders, such as Freddie Mac and Fannie Mae, engage in hedging. The most important hedge is for the lender, say, Fannie Mae, to fund the mortgage by issuing callable debt. Instead of funding the mortgage by issuing “straight debt” (borrowing money) for 10 years at 5 percent, Fannie will issue “callable debt” for 10 years at, say, 5.4 percent with an option to call the debt (to refinance, in effect) in, say, 3 years.

Because Freddie and Fannie have such large portfolios, and because callable debt does not perfectly address the depreciation of mortgage assets, the agencies also use more exotic financial instruments, known as derivatives, in their hedging. Freddie tends to do so more than Fannie.

While the mortgage assets are depreciating, the callable debt and financial derivatives are appreciating. If the hedging is done correctly, the appreciation matches the depreciation under a wide variety of market conditions and scenarios.

The accounting treatment of all of this is interesting. Generally Accepted Accounting Principles (GAAP) do *not* allow lenders to depreciate their mortgage assets (also known as marking assets to market). They also do not allow lenders to mark their callable debt to market. However, GAAP usually does call for derivatives to be marked to market. Freddie Mac tried to evade the GAAP treatment and treat their derivatives the same way that they would treat mortgages and callable debt. When Freddie Mac had to switch auditors from the Enron-tainted Arthur Andersen, the new auditor challenged Freddie Mac’s stance, producing the scandal.

Being forced to use GAAP treatment for its derivatives means that Freddie Mac must recognize the appreciation of its hedges while not being able to depreciate its mortgages. The result is to create earnings that are front-loaded. In fact, Freddie Mac will soon re-state its earnings for the past several years to be higher than was reported. By the same token, reported earnings in future years will be lower than would have been reported under Freddie Mac’s previous accounting treatment.

For Discussion. The pattern of earnings that Freddie Mac originally reported is close to the pattern that would have been reported if GAAP required all assets and liabilities (not just derivatives) to be marked to market. Economists favor mark-to-market accounting, but many banks complain that it makes earnings too volatile. What are other challenges with mark-to-market accounting?