Fannie Mae wanted to look very safe, but to do that it cut accounting corners, two regulatory agencies have concluded. And that has severely damaged the image of the company and its management.
The management of Fannie Mae had agreed to change its accounting as a result of harsh criticism levied in September by the Office of Federal Housing Enterprise Oversight, its regulator. But the company, in a highly unusual move, asked Donald T. Nicolaisen, chief accountant of the Securities and Exchange Commission, to rule that it had acted reasonably in the past.
On Wednesday night, he instead concluded that the accounting was wrong, making it all but certain that Fannie Mae will have to restate its financial reports for recent years, reducing its profits by billions. Yesterday, Fannie Mae stock fell $1.39, to $69.30, amid speculation that Franklin D. Raines, the chief executive, would be forced to resign.
At the heart of Fannie Mae's problem is that it is in a very volatile business. That volatility is produced by the fact that mortgages in the United States usually come with an option that benefits the borrower. The option allows the borrower to repay the loan, often without penalty, at any time.
That means that prepayments of mortgages are likely to accelerate when interest rates fall, as borrowers refinance, and to slow sharply when rates rise. (Some loans will be paid early in any case, because mortgages normally are paid when a homeowner sells the home.)
That volatility does not mean that the mortgage business is a bad one. But Fannie Mae believed that it needed to report steady earnings increases to persuade investors that it was a safe enterprise that deserved a low cost of capital. The Office of Federal Housing Enterprise Oversight report concluded that it violated accounting rules to produce the desired smooth numbers.
Armando Falcon Jr., director of OFHEO, testified before Congress that Fannie Mae engaged in a "pervasive and willful misapplication of generally accepted accounting principles."
The accounting issues at Fannie Mae concerned two accounting rules. Neither is simple, and results from both can be changed if the company changes its assumptions. But the fact that a range of numbers might be appropriate did not give the company the right to pick numbers based on what figure would look best on its financial statements. Still, that is what the OFHEO report concluded happened.
The first rule was Statement of Financial Accounting Standard 91, which took effect in 1988. Under that rule, when Fannie Mae purchased a loan it was to estimate the amount of expected prepayments and then treat the loan as having a constant yield over its expected life.
But Fannie Mae was also expected to review those assumptions periodically and change them to reflect experience. Such changes could indicate that the company had reported too much or too little income in the past, and in such cases the extra income or expense was to be recognized immediately.
In 1998, American interest rates plunged abruptly after Russia defaulted on some debts and investors sought safety. Mortgage prepayments soared, and that meant that Fannie had recorded too much interest income in the past, since it had assumed mortgages would remain outstanding for longer than they did. Fannie Mae should have taken a $400 million hit to profits, but instead it deferred half of it. That meant executives qualified for bonuses that would not have been paid had the full impact been taken.
That was not an isolated occurrence, although it was the most dramatic, Falcon later said. "Fannie Mae improperly delayed the recognition of income to create a cookie jar reserve that it could dip into whenever it best served the interests of senior management," he testified in a congressional hearing in October. "Those interests included smoothing earnings and meeting earnings-per-share targets linked to executive bonuses."
Much but not all of the accounting was approved by KPMG, Fannie Mae's auditor. It signed off on all the financial statements the company produced, but Falcon testified that KPMG recorded the 1998 dispute as "an audit difference, a term which means KPMG disagreed with Fannie Mae." Presumably the auditor was persuaded that the $200 million difference was not material.
The other rule important in the Fannie Mae case is Statement of Financial Accounting Standard 133, the rule on derivatives. That rule, which took effect in 2001, required that companies report changes in values of the derivatives they owned, and add or subtract them from profits.
The rule provided a way to avoid that, called hedge accounting. If the company documented exactly what asset was being hedged by a derivative, then it could keep the change in value of the derivative off the income statement. That is what Fannie Mae said it did, but both OFHEO and the SEC concluded it had not complied with the rules. And if the rules were not met, that meant the changes in income should have been reported. For Fannie Mae, that is expected to produce losses of more than $7 billion when profits are restated.
It is not clear how much of that could have been avoided had Fannie Mae followed the rules.