Fannie Mess: One for the Books

Fannie Mae (FNM - commentary - Cramer's Take), the government-sponsored mortgage company whose financial statements were strongly criticized in a report by its regulator last week, looks set to join Enron and WorldCom in the hall of accounting infamy.

Lining up Fannie alongside two of America's worst corporate fraud offenders may seem a stretch to some. But a close reading of the report suggests that Fannie could have kept billions of dollars of losses out of earnings -- as well as out of an important capital number that is used by its regulator to determine the company's financial strength.

WorldCom is thought to have hidden around $11 billion of expenses to boost its earnings. But it's possible that Fannie, which provides huge support to the U.S. housing market through billions of dollars of mortgage purchases each year, overstated the capital number by more than that. For example, at the end of last year, the capital number in question may have excluded as much as $11.6 billion in pretax net losses.

If Fannie did fail to include those losses in earnings and capital, it would have drastic ramifications for the company, investors and the structure of the U.S. housing industry. Fannie may have to raise far more new capital than Wall Street currently is estimating, leading to a further decline in Fannie's stock. The Office of Federal Housing Enterprise Oversight and Fannie announced Monday that Fannie must immediately go about raising its capital to 30% above its required level, but the final amount may be far higher.

Any evidence of large-scale fraud would almost certainly cause politicians to much more aggressively regulate Fannie and rival Freddie Mac (FRE - commentary - Cramer's Take), which revealed accounting irregularities of its own last year, though they appear to be of a less serious nature than Fannie's.

Fannie declined to comment, and its regulator, the OFHEO, didn't respond to a request for comment.

The OFHEO decided at the end of last year to carry out a probe of Fannie's accounting after the accounting chicanery at Freddie surfaced. The probe isn't yet completed, which means there could be more unpleasant findings at Fannie.

The OFHEO hasn't detailed the scale of any restatement that Fannie may need to make. Instead, the regulator has asked the company to conduct a thorough review to quantify by how much its financial statements may be off.

Well before Freddie's accounting issues came out, this column had been raising questions about Fannie's accounting and its management team, led by CEO Franklin Raines, an extremely influential Washington insider.

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In keeping with TSC's editorial policy, Peter Eavis doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He welcomes your feedback and invites you to send any to [e-mail].