The Fall of Fannie

The accounting scandal at Fannie Mae (FNM) is certainly one of the saddest. Few companies had the corporate image of FNM. People don’t expect much from companies like Enron, but Fannie was supposed to be different. Now we learn that it was all a charade.

Fannie Mae’s regular quarterly reports of smooth profit growth in recent years were “illusions deliberately and systematically created” by senior executives through improper accounting and manipulation of earnings, the company’s regulator said in a report issued Tuesday.
The report from the Office of Federal Housing Enterprise Oversight, or Ofheo, came as the mortgage-finance company prepared to announce a settlement with Ofheo and the Securities and Exchange Commission under which Fannie will pay a fine of $400 million.
“We are glad to resolve these matters. We have all learned some powerful lessons here about getting things right and about hubris and humility,” said Fannie Mae President and Chief Executive Daniel H. Mudd in a statement. “We are a much different company than before. But we also recognize that we have a long road ahead of us.”
Ofheo’s 340-page report blamed both the board and management for a corporate culture that allowed managers to disregard accounting standards when they got in the way of achieving earnings targets. The company then rewarded executives with huge bonuses for hitting those targets, the report said. (Read the full report.)
For the six years through 2003, the report said, $52 million of the $90 million of compensation for Franklin D. Raines, the chief executive officer, was directly tied to meeting targets for earnings per share. Mr. Raines was forced out of the company in December 2004 when regulators confirmed that Fannie had violated accounting rules. Lawyers for Mr. Raines couldn’t be reached immediately for comment.

The report showed that Raines systematically misled the public:

In the summer of 2002, interest rates fell 100 basis points in 60 days to a 40 year low, and mortgage prepayments accelerated dramatically. That acceleration caused Fannie Mae’s duration gap, the only published measure of the Enterprise’s interest rate risk exposure, to move well outside of Board-approved limits. In Fannie Mae’s 2002 Annual Report, Mr. Raines described the Enterprise’s response:
“Even though we took actions to rebalance our portfolio, the actions were routine … and had no material impact on our business or core business earnings. In fact, our core business earnings per share increased by 21 percent during 2002.”
Mr. Raines’ statements failed to mention several important facts. First, the change in the duration gap occurred because Fannie Mae had not fully hedged its exposure to mortgage prepayments — in other words, senior management had taken significant interest rate risk. Second, the decline in rates had had a multi-billion dollar economic impact — the market value of the Enterprise’s assets had risen much less than the market value of its liabilities, so that its net asset value had declined. The rebalancing required to address Fannie Mae’s duration mismatch in 2002 — accomplished through the repurchase of high-coupon long-term debt and the cancellation of pay-fixed swaps — was quite costly. Mr. Raines failed to mention that core business earnings did not reflect that cost.
Failing to Acknowledge Deficiencies
Another example of that behavior occurred during a press briefing on July 30, 2003. During that briefing Mr. Raines attempted to reassure the participants that Fannie Mae did not have the types of accounting problems then plaguing Freddie Mac. His statements about the quality of Fannie Mae’s internal control system were categorical and sweeping:
“So it is possible to run these things properly, but you’ve got to make the investments. You’ve got to say that this has got to stand scrutiny internal and external. You can’t just go get [sic] by saying, Well, let’s do the cheapest or easiest thing to do. So Fannie Mae had always made the investments. We made the investments over Y2K. We’ve made the investments in our accounting systems. We’ve centralized our accounting so we don’t have to go all over the company to find out what the facts are you can to one place….
Management does matter, and a management that cares a lot about internal control does matter. I think that’s really the important difference. It would not take 500 people for us to go back, even if we had made the same mistakes, because we have these systems automated and we can go back and quickly adjust them.”

Raines served as Director of OMB from 1996 to 1998.

Posted by on May 23rd, 2006 at 2:01 pm


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