Fannie Mae's Accounting Leads To Drama In DC

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The brewing drama-can we call it a scandal yet?-over accounting at Fannie Mae was brought to center stage in the Capitol earlier this month when Republican advocates of secondary market reform decided they couldn't wait till next year.

In its final hearing of the year the House Financial Services Subcommittee on Government Sponsored Enterprises decided to air a highly spurious report by an ineffective regulator that has been targeted for elimination, the Office of Federal Housing Enterprise Oversight, which purports to monitor the activities of Fannie Mae and Freddie Mac.

The dramatic hearing pitted Republicans who control the committee, against Democrats, who were obviously briefed by Fannie Mae on what questions to ask. Democratic supporters of Fannie Mae used highly charged terms, calling the hearing a "witch hunt," and a "political lynching," of Fannie Mae CEO Franklin Raines. This succeeded in evoking emotional moments in American history, like the McCarthy hearings aimed at ferreting out perceived communist infiltration in the U.S. government, and even worse, the lynching of black Americans in the south in an earlier era (Raines is African-American).

At issue were dubious claims by the regulator, which both Republicans and Democrats agree should be replaced with a more effective oversight scheme, that Fannie Mae executives effectively cooked the books to please Wall Street investors and to qualify its executives for multi-million dollar bonuses. The main evidence in the report surrounded financial statements the secondary mortgage market giant issued in 1998. That's right, six years ago!

What lawmakers on both sides of the aisle wanted to know during the hearing was, among other things, if the alleged accounting improprieties were so bad, why did it take the federal regulator six years to find them? After all, they noted, the regulator, a part of the Department of Housing and Urban Development, examines just two companies-Fannie Mae and Freddie Mac.

The hearing took on the feel of farce from the start when OFHEO Director Armando Falcon told lawmakers his agency did not even read Fannie Mae's outside auditor's report from 1998.

The dispute boils down to the interpretation by Fannie Mae of two rules that govern its accounting for mortgage assets (FAS 91) and for financial derivatives, hedges, and the requirement to account for them at market value (FAS 133). The market value accounting of such large portfolios of derivatives was predicted to cause havoc on the books of companies like Fannie Mae and Freddie Mac when the new rule (FAS 133) was passed in the early 1990s. And that's just what has happened, with net income under GAAP taking huge swings from quarter to quarter, along with changes in interest rates, for companies like Fannie, Freddie and others that hold large hedging positions.

Timothy Howard, chief financial officer for Fannie and one of the targets of the critical OFHEO report, acknowledged the huge swings and the distortions on GAAP statements caused by FAS 133. That's why Fannie created a new measure of its finances it believes is a more accurate portrayal of the company's activities, called "core cash," which is akin to operating financials. The core cash finances are always provided along with the traditional GAAP finances, giving investors another view of the company's operations, Howard noted.

The Real Purpose

But the purpose of the hearings seemed clear, according to many in the audience. That is to expand the debate on reforming the secondary market beyond the humble proposals that were easily defeated this year, much because of heavy lobbying by both Fannie and Freddie. That proposal would have simply eliminated OFHEO and created a new oversight agency for the two companies in the Treasury Department, with a little bit more authority. The Democrats at the hearing wrongly charged it was the Bush Administration that killed the reform bid this year. That is not so. It was the lobbying by the two companies, which are widely believed to have the most powerful lobbying teams in Washington.

The next Congress, however, is likely to seek even greater reforms, such as strict restrictions on what the two companies may do and even the possibility of a full privatization of the government chartered enterprises.

That is what the hearing was all about.

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