Fannie Mae Execs Defend Accounting

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In an highly charged political showdown just before the end of the congressional calendar, top executives at Fannie Mae last week refuted charges brought by federal regulators that they engaged in multi-billion-dollar accounting improprieties.

The top Fannie brass, including CEO Franklin Raines, CRO Timothy Howard, and Chairman Ann Korologos, all testified that they disagree with findings by the Office of Federal Housing Enterprise Oversight that the company manipulated its earnings over the past six years to meet Wall Street expectations and to qualify top executives for multi-million dollar bonuses.

The OFHEO findings, they insisted, amount to a disagreement over arcane accounting rules governing the valuation of derivatives and the recognition of gains and losses, and are still open to debate. "We can discuss forever, but the (Securities and Exchange Commission) is going to decide," said Raines, during heated four-hour testimony before the House Financial Services Subcommittee on Government Sponsored Enterprises.

The hearing, the final one of the year for the panel, served as a bookend to the committee's first hearing this year, which surrounded similar allegations concerning Freddie Mac, Fannie Mae's sister company.

Committee Was Misled

Several members of the committee suggested they were mislead by Raines who made public statements during the Freddie Mac controversy that Fannie Mae did not engage in such accounting sleight-of-hand. "It's unfortunate that we are here today," said Rep. Michael Oxley, chairman of the full Financial Services Committee. "After earnings smoothing at Freddie Mac was discovered, the public and the markets and the members of the committee were assured that there were no similar issues at Fannie Mae."

Rep. Richard Baker of Louisiana, Republican chairman of the subcommittee and a long-time critic of Fannie Mae and Freddie Mac, was particularly angered. "For the record, I am not pleased and certainly not happy about these revelations," said Baker. "I am saddened by the disclosures. In all my years of inquiry in this matter, I was only in pursuit of appropriate oversight. Never did I question whether the GSEs were professionally managed to the highest standards of business conduct. Now I do."

The hearing, called within days after OFHEO issued a scathing report about accounting practices at Fannie, will serve as a backdrop for efforts next year to reform oversight of the secondary mortgage market, efforts that were buried this year by teams of Fannie and Freddie lobbyists, the most powerful lobby on Capitol Hill. The two government sponsored enterprises and their allies were successful in beating back minimal efforts at reform which would have simply moved their regulator out from under the Department of Housing and Urban Development (HUD) and into the Treasury Department.

But lawmakers last week indicated the reform bid will be much broader in the next Congress, encompassing initiatives opposed by the two companies to set new capital standards, closely limit new products and services the two companies may offer, and even the potential for full privatization of the quasi-governmental agencies.

The debate has enormous consequences for credit unions, which sell about a third of all their mortgages to one of the two secondary mortgage market giants, and own as much as $100 billion of bonds issued by one of the two companies.

The OFHEO report found that annual bonuses for top Fannie Mae executives, which amounted to $249 million over the past six years, were closely tied to earnings per share performance of the company. This caused executives to manipulate financials to meet the earnings targets and qualify for bonuses, according to OFHEO. In one instance in 1998, the company allegedly deferred the recognition of $200 million in expenses, enabling the company to report earnings of $3.2309 a share, just meeting the $3.23 per share target, and entitling six top executives to $5.9 million in bonuses.

Armando Falcon, director of OFHEO, testified last week that Fannie used the arcane accounting rules FAS 91 and FAS 133 to manipulate the books.

With FAS 91, which governs the amortization of balances related to mortgages and mortgage-backed securities, the company would improperly delay the recognition of income in order to create a "cookie jar" reserve it could use whenever management wanted to add or subtract from earnings, according to Falcon.

With FAS 133, which requires that derivatives be marked to market, OFHEO found that Fannie implemented the rule for its multi-billion dollar derivatives portfolio in a way to minimize earnings volatility.

But Raines insisted the accounting treatment underwent rigorous review both inside and outside the company with its independent auditor, KPMG, signing off on the treatment. "Fannie Mae has not withdrawn those financial statements and KPMG has not withdrawn its opinion that those financial statements were prepared consistent with (generally accepted accounting principles) in all material aspects," he said. "Rather, the issues that have been raised by OFHEO will be taken up directly with the staff of the SEC, which ultimately has the final authority over GAAP."

Last week's hearing had a decidedly partisan edge, with Republican members of the committee critical of Fannie Mae and its executives, and Democrats supportive and dismissive of the OFHEO findings. Credit union champion Paul Kanjorski of Pennsylvania, the ranking Democrat on the subcommittee, asked Falcon why the report, labeled as partially complete, had been released to the public and why it took the federal regulator six years to uncover alleged wrongdoing in the company's 1998 financials. "It took you six years to figure it out," said Kanjorski, best known among credit unions for his sponsorship of HR 1151, the 1998 CU Membership Access Act.

Front Group?

Maxine Waters, the California Democrat, suggested the federal regulator was fronting for a group of Fannie Mae and Freddie Mac competitors known as FM Watch, which as been lobbying to rein in the powers of the two mortgage giants. "I feel like I'm in the middle of another battle between FM watch and Fannie Mae and Freddie Mac," said Waters.

But Republican members who control the committee and the Congress made it clear that the debate will rage anew over a regulatory oversight scheme when a new Congress is seated next January. Noting that Fannie and Freddie enjoy certain advantages form their government charters, like exemption from local taxes, exemption from SEC registration and a guaranteed line of credit with the U.S. Treasury, California Republican Ed Royce, said he wants to see creation of a strong regulator for both Fannie and Freddie, which would also have oversight over the Federal Home Loan Bank system.

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