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SEC investigates Fannie Mae

September 24, 2004

Mortgage giant may have manipulated earnings

By Samantha Peterson
Inman News

Fannie Mae CEO Franklin Raines The Securities and Exchange Commission has launched an informal inquiry into Fannie Mae after a federal report suggested the mortgage giant may have manipulated earnings and used improper accounting techniques.

Fannie's federal regulator, the Office of Federal Housing Enterprise Oversight, publicly released a 211-page report late Wednesday that outlines misapplications of Generally Accepted Accounting Principles, or GAAP for short. Those missteps are not limited occurrences, "but are pervasive and are reinforced by management," according to the report.

The report, presented to Fannie Mae's board of directors earlier this week, found that the company had used improper "cookie jar" reserve accounting – setting aside large cash reserves to reduce revenues in some years so they can be used in other years when the company needs them. That smoothes out a company's earnings, but can give investors an inaccurate view of a company's financial performance.

The housing office found other accounting problems, including at least one instance where the company deferred expenses to meet executive bonus targets. The problems differ in their specifics, but all "have emerged from a culture and environment that made these problems possible."

"The matters detailed in this report are serious and raise concerns regarding the validity of previously reported financial results, the adequacy of regulatory capital, the quality of management supervision, and the overall safety and soundness of the enterprise," the report states.

Ann Korologos, presiding director of Fannie Mae's board of directors, in a statement said, "The board takes the report seriously and is working with OFHEO to resolve these matters." The board has pledged its full cooperation with the regulators, she said.

Fannie's chairman and CEO Franklin Raines said the company's management team supports the board of directors and "will assist them in any way we can as they carry out their duties."

Fannie is a shareholder-owned company chartered by Congress to ensure a constant flow of mortgage funds. OFHEO's ongoing investigation initially stemmed from the accounting scandal at Fannie's corporate cousin, Freddie Mac, which understated profits by about $5 billion for 2000-2002 to smooth earnings and meet Wall Street expectations. Freddie Mac paid a $125 million fine and ousted several top executives.

The two corporations securitize and either resell or own a substantial portion of the outstanding home mortgage debt in the United States. The secondary market helps increase the liquidity of mortgage funds, which makes home loans more easily available to borrowers.

According to OFHEO's report, characteristics of Fannie's culture that gave rise to the problems include:

• Management's desire to portray Fannie Mae as a consistent generator of stable and growing earnings.
  
• A dysfunctional and ineffective process for developing accounting policies.
  
• An operating environment that tolerated weak or non-existent internal controls.
  
• Key person dependencies and poor segregation of duties.
  
• Incomplete and ineffective reviews by the office of auditing.
  
• An inordinate concentration of responsibility vested with the chief financial officer.
  
• An executive compensation structure that rewarded management for meeting goals tied to earnings-per-share, a metric subject to manipulation by management.

"The tenor of earnings management is deeply ingrained at Fannie Mae and has given rise to accounting policies and practices that emphasize effects on earnings volatility, rather than faithfulness to GAAP," the report states.

One of Fannie Mae's key messages to the investor community has been the management's ability generate stable and growing earnings, according to the OFHEO report. The company's annual financial reports show recurring graphs of steadily increasing earnings even as interest rates have been volatile. The management's desire to minimize earnings volatility "was a central organizing principle in the development of key accounting policies."

In light of OFHEO's findings, the Council for Citizens Against Government Waste on Wednesday called for Congress to protect taxpayers by putting in place tough new oversight rules for the nation's housing government-sponsored entities, Fannie, Freddie and the Federal Home Loan Bank Systems.

"This should come as absolutely no surprise to anyone," said CCAGW president Tom Schatz. "The GSEs have been operating in the shadows for years, fighting even the most sensible reforms tooth and nail. Fannie Mae and Freddie Mac have been engaging in increasingly risky hedging activities, pursuing excessive profits at the expense of their congressional mandate to support low and middle income homebuyers, and lining the pockets of their executives, all while putting taxpayers at greater and greater risk for a bailout. Even in the face of an accounting scandal at Freddie Mac last year, most members of Congress have stubbornly turned a blind eye."

Since the Freddie Mac scandal rattled investors last year, Congressional members have talked about passing legislation to strengthen GSE oversight, but nothing has gone through. The latest push came toward the end of March from Sen. Richard Shelby (R-Ala.), chairman of the U.S. Senate's banking committee. Among other provisions, that legislation would have given federal regulators the power to shut down Fannie Mae or Freddie Mac if either was in danger of insolvency.

Fannie Mae's stock (NYSE: FNM) was trading at $67.26 today, down $3.43 from yesterday's close of $70.69.

Copyright 2004 Inman News