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Fannie Mae: What's The Damage?


For years, Fannie Mae has stood like a colossus astride global financial markets. With $1 trillion in assets, it owns or guarantees more than one-quarter of all residential mortgages in America. Its debt, long considered rock solid, is held as reserves by foreign central banks, as capital by thousands of commercial banks. Its stock, and the pools of mortgages it packages and sells, are held by legions of mutual and pension funds. It inspires envy among banks that would like a piece of its lucrative business and have campaigned for years to strip it of its special status as a government-chartered financier.

Today, though, the colossus is hobbled. A searing, 211-page report of a Special Examination of Fannie Mae released on Sept. 22 by the Office of Federal Housing Enterprise Oversight paints an ugly picture of a company tottering under the weight of the sort of baleful misdeeds that marked the corporate scandals of the past three years: dishonest accounting, lax internal controls, insufficient capital, and me-first managers who only care that earnings are high enough to get fat bonuses and stock options. The once-obscure regulatory agency lays out in mind-numbing detail dozens of Fannie's alleged accounting errors and management mistakes. Worse, it hints that Fannie's earnings as far back as 1998 may have been much lower than those in its financial statements. If OFHEO is right, Fannie may be undercapitalized and, disturbingly, not as financially solid as it appears.

Fannie's initial reaction did little to assuage such worries. Within five days -- possibly the quickest resolution of a major corporate crisis in modern times -- directors waved the white flag and agreed to a sweeping settlement on OFHEO's draconian terms. The pact requires Fannie to boost capital by 30%, improve its accounting, and impose stronger internal controls. Fannie must get OFHEO's approval for a wide array of policy decisions, including any dividend increases or accounting chain-of-command changes. The board also named former New Hampshire GOP Senator Warren Rudman to oversee an investigation into whether Fannie's officers deliberately made end runs around accounting rules or committed other malfeasance.

With its board on the run and Chief Executive Officer Franklin D. Raines's job on the line, Fannie looks to be in a tight spot. But before a legion of critics -- rivals, short-sellers, Republican lawmakers, and economists -- celebrate the end of its dominance in the mortgage-finance market, they might consider the powerful defense it could mount.

Fannie's defense against OFHEO's charges could be formidable. A spokeswoman said neither Raines nor anyone else at the company would comment. But in interviews with former employees, securities and legal experts, accountants familiar with Fannie's books, other financial regulators, and outside advisers to Fannie, a picture emerges that differs from the one OFHEO has painted: Raines & Co. could argue that Fannie itself brought many of the issues cited in the report to the attention of OFHEO. Fannie's management even vetted the complaints of a whistle-blower to the board's audit committee, and then told OFHEO as well. And Fannie's outside auditor, KPMG, certified its results knowing OFHEO's concerns.

More important, the Securities & Exchange Commission will have the final word over whether Fannie must restate past earnings -- and the SEC may disagree with OFHEO's two most damaging allegations, over accounting for derivatives and delayed recognition of expenses. If so, the SEC could blunt, if not wipe out, the financial impact of the alleged misdeeds.

Even so, the SEC may well concur on one serious charge: that Fannie violated generally accepted accounting principles (GAAP) when it deferred $200 million in expenses in 1998. OFHEO says that the move helped Fannie hit an earnings target that triggered $27 million in bonuses for top execs. But even here, the SEC could undermine OFHEO by concluding that the incident occurred too long ago for the SEC to demand a restatement. The commission could bring enforcement actions if it concludes Fannie purposely deferred expenses to trigger the bonuses, or created "cookie jar" reserves to meet other earnings targets -- another of OFHEO's allegations. But accounting and legal experts who have read the report say it contains no evidence of illicit intent, nor does it give other examples beyond 1998 where execs were rewarded as a result of managing earnings.

Deciding whether OFHEO's accounting charges are valid could come down to a war between accountants over the nuances of two key accounting standards, one of them 800 pages long. "My sense is OFHEO has gone overboard," says Edwin Walczak, who manages the Vontobel U.S. Value Fund, a long-time holder of Fannie stock.

Even if the SEC takes Fannie's side, the lender will come out of this donnybrook bloodied. Much of what OFHEO has uncovered is disturbing. OFHEO alleges that the smoothing of swings in earnings "was a central organizing principle" in its accounting policies. Chief Financial Officer J. Timothy Howard has "inordinate responsibilities," OFHEO says, as chief risk officer, controller, and overseer of Fannie's vast investment portfolio. He also sets the salary of Fannie's chief internal auditor, which undermines his independence. Howard would not comment. Fannie's board has pledged to review Howard's duties.

FORGIVING MARKET

Not surprisingly, the OFHEO report tripped alarm bells around the globe. If worries about Fannie's soundness had gathered momentum, they could have cost Fannie dearly by pushing up its borrowing costs. Credit-rating agencies placed Fannie's subordinated debt and its preferred stock on credit-watch, but kept a triple-A rating on most of Fannie's other debt.

Faced with a major crisis, Fannie's board teleconferenced over the Sept. 25-26 weekend and agreed to settle. That helped keep the bond market calm. But equity investors have taken a hit -- Fannie's stock closed at $66.25 on Sept. 29, down 12.4% since the day before the report's release. Equity investors, accustomed to Fannie's stellar growth, fear the reforms agreed to with OFHEO could cut its earnings growth. Despite all the bad news, says Bernie Schaeffer, chairman and CEO of Schaeffer's Investment Research Inc.: "The market has been forgiving."

Indeed, Fannie may be able to weather the turbulence with relative ease. It began conserving capital during OFHEO's eight-month exam. Already it has an 18% surplus over the minimum capital required by regulators. That means it needs only about $5 billion more to reach the 30% cushion OFHEO now requires -- and has nine months to get there. Fannie has many options: It could reduce borrowings, cut or trim its dividend, sell preferred stock, postpone plans to repurchase shares, shed assets, or do some combination. Says Marshall B. Front, whose Front Barnett Associates LLC manages $1.4 billion, including $33 million of Fannie stock: "It appears that Fannie Mae is going to be able to accomplish the higher capital without any more than a negligible economic impact."

Fannie, infamous for its muscular lobbying presence in Washington, may not escape so lightly on Capitol Hill. Nebraska GOP Senator Chuck Hagel, who sought to transfer Fannie's regulation to the Treasury Dept. from the Housing & Urban Development Dept., says he plans to push his legislation forward next year. Longtime Fannie critic Representative Richard H. Baker (R-La.), is expected to match Hagel's moves in the financial services subcommittee he chairs. Their efforts stalled this year, despite an accounting scandal at smaller rival Freddie Mac (FRE) in 2003, because Congress feared upsetting the housing sector in an election year. "But now you're talking about the big boy," says Hagel. "If that doesn't shake some [lawmakers], they've been living between Pluto and Saturn."

The political momentum was intentionally generated by OFHEO. The regulator's strategy: take its report first to Fannie's board on Sept. 20, and not give management a chance to see -- let alone rebut -- its findings. That's a far cry from the give-and-take that most regulators' exams entail. A former bank regulator, who considers OFHEO Director Armando Falcon Jr. a friend, faults him for making the report public before giving Fannie a chance to respond: "If you're really worried about safety and soundness and contagion effects in the market, most prudential supervisors would have dealt with this in private and slowed down the report's release." Through a Fannie spokesman, a director says the board didn't object when OFHEO asked to release the report.

"SIN NO MORE"

The SEC plans to handle its probe of the OFHEO allegations differently. One SEC official says the agency will give Fannie a chance to make its best case. And it could differ with what may be OFHEO's most damaging charge -- that Fannie's hedge accounting is improper. Fannie uses nearly $1 trillion in options and other derivatives to offset interest-rate and prepayment risk in the pools of mortgages it finances. Standard accounting would require it to record gains or losses in their value in earnings each quarter -- making reported profits volatile. Fannie instead uses hedge accounting to keep the swings in asset value out of its earnings.

But to do so, Fannie must routinely test whether the derivatives are properly matched to the assets they're hedging. OFHEO alleges that Fannie failed to do those tests. "Their approach is so complicated and so large that they lost track," says James Midanek, an investment manager at Walnut Creek (Calif.)-based Midanek/Pak Advisors. OFHEO says that Fannie misapplied the rules since 2001 -- and wants the SEC to order it to stop using hedge accounting. As a result, some $7 billion in net losses in the derivatives portfolio must be subtracted from income. That's quite a hit: Fannie's net income was $7.9 billion last year. But the SEC could give Fannie a chance to adopt procedures to make sure its hedging is done properly. "We could say 'go and sin no more,"' says the SEC official.

The second most serious charge is that Fannie delayed recognizing certain expenses -- largely prepaid interest -- if they were below a threshold. OFHEO says that is inconsistent with GAAP. But the SEC may beg to differ: Other companies often make similar judgments based on whether a dollar amount is material. The SEC could wave off the charge, unless Fannie intended to manage earnings or create a cookie jar reserve. "It gets into a whole lot of judgment between the auditor and the [company]," says one SEC official. "You wouldn't necessarily do your accounting down to the last dollar."

Fannie's intentions will surely be the focus of the SEC's review of the $27 million in 1998 bonuses. If OFHEO, whose examination continues, uncovers more cases where earnings management helped execs hit performance goals in order to get bonuses and stock options, the SEC may bring an enforcement case.

Washington is abuzz over Falcon's chutzpah and the merits of his case. Says Stanley Sporkin, a retired federal judge and ex-SEC enforcement director now advising OFHEO: "More than any other case I've seen, it's all there." But OFHEO isn't taking any chances. After all, it hired Sporkin for his deep connections within the SEC. And on Sept. 29, he and Falcon met with SEC Enforcement Director Stephen M. Cutler. With the forces massing on both sides, it could be a long and bitter battle.

By Paula Dwyer and Amy Borrus in Washington, with Mara DerHovanesian in New York and bureau reports


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