Fannie Mae Execs Face the Music

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Expect Fannie Mae's notorious propaganda machine to be unleashed Wednesday -- to little effect.

The mortgage giant's two top executives are scheduled to appear before a congressional committee to answer questions arising from a scathing report by Fannie's regulator on the company's accounting and management culture.

All indications are that Fannie and its supporters on Wall Street and in Washington have been waging a behind-the-scenes campaign to discredit the report, which was released Sept. 22 by Fannie's regulator, the Office of Housing Enterprise Oversight, or OFHEO. Before the House Committee on Financial Services on Wednesday, Fannie CEO Franklin Raines and CFO Timothy Howard are expected to mount an aggressive and highly polished self-defense. When challenged in the past, Raines has shown himself to be particularly good at building smokescreens around Fannie's accounting.

On the face of it, OFHEO's allegations are extremely serious, and that forces Raines and Howard into a position where they simply have to make a last ditch, all-out counterattack if they are to stand any chance of emerging untarnished by OFHEO's allegations. Using findings in the report, it appears that Fannie may have excluded nearly $12 billion of derivatives losses from earnings, making Fannie look as bad as Enron or WorldCom.

Fannie's stock, shellacked since the OFHEO report came out, rose fractionally to $66 Tuesday. Fannie didn't respond to a request for comment.

Firing Line

So what line of defense might Raines and Howard take Wednesday?

Many of the questions will center on the section of the OFHEO report that claims Fannie's failed to properly apply an accounting rule known as SFAS 133, which guides companies on how to account for the value of financial instruments called derivatives. Fannie uses the $1 trillion worth of derivatives on its books to insure itself against adverse interest rate movements. In its report, OFHEO suggests that Fannie didn't meet SFAS 133 requirements and, as a result, billions of dollars of derivatives losses may have been kept out of earnings and out of an important measure of Fannie's financial strength called core capital.

The word from a well-connected Washington source Tuesday night was that Raines and Howard won't even set out to vigorously defend Fannie's derivatives accounting and its application of SFAS 133. Instead, the source says the Fannie execs will argue that, since the derivatives did their job by supposedly protecting the company against adverse movements in interest rates, the way they were accounted for is of little concern from an economic perspective.

It's hard to conceive of Fannie arguing this line, since it is tacit admission that their derivatives accounting can't be defended. In addition, the very fact that Fannie had huge losses on its derivatives -- the losses on SFAS 133 derivatives totaled nearly $17 billion in the middle of last year -- is a stark indication that they didn't in fact protect the company well against movements in interest rates.

Given that this argument is so weak, it's hard to see it being the main tenet of the company's defense. Don't be surprised, then, if Fannie honchos also decide to advance some of the other pro-Fannie arguments that have been circulating since the OFHEO report came out.

Raines and Howard may also claim that SFAS 133 is very complex and that different interpretations of the rule are possible. The execs may contend, as others have, that Fannie and OFHEO merely differ in how they think SFAS 133 should be applied, and that no clear infraction of generally accepted accounting principles has been made. To them, this means OFHEO is on very shaky ground in alleging that Fannie used its application to manipulate earnings. Indeed, Fannie's defenders are already suggesting that the Securities and Exchange Commission, the main stock market cop, feels that OFHEO has overstepped the mark in its arguments concerning SFAS 133.