Fannie Mess Could Get Worse

Is the Fannie Mae (FNM - commentary - Cramer's Take) scandal about to get markedly worse?

That's the question investors must ask after the revelation last week by Fannie that its regulator is looking at the way the company accounts for $1.4 trillion of mortgage assets that are currently classified as being "off balance sheet." If Fannie were forced to bring even a quarter of these assets on balance sheet, the company would be severely undercapitalized.

The regulator, the Office of Federal Housing Enterprise Oversight, and the Securities and Exchange Commission have already said Fannie has misapplied two important accounting rules. Since 2001, the company failed to record more than $9 billion of losses in its earnings statements, because of a failure to properly apply a derivatives accounting rule. Fannie is expected to reduce past earnings by close to that amount in what will be a highly damaging restatement. Its stock has plunged, and its CEO and CFO have left the company. Investors may not see up-to-date financials from Fannie for another two years.

Can it get any worse? Possibly. On Tuesday, Fannie's shares rose $1.11 to $59.57.

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In its Feb. 23 release, government-sponsored Fannie said that OFHEO has identified additional accounting policies that may not be in compliance with generally accepted accounting principles, or GAAP.

In the list of additional policies, Fannie mentioned FIN 46, a relatively new accounting rule that governs how companies treat special entities set up to hold assets off balance sheet. The rule is designed to keep companies from setting up entities to wrongfully shift assets and liabilities off their books. A company may want to do this to avoid booking losses, to hold less capital or to shield its financial results from volatility. FIN 46 came out mainly in response to abuses by Enron, which improperly shifted losses from its balance sheet with dubious "special purpose entities."

How might Fannie have misapplied this rule? Fannie buys billions of dollars of residential mortgages each year and then does one of two things with them. It keeps a large portion on its balance sheet and earns interest from them. The others it bundles up into bonds called mortgage-backed securities. Fannie guarantees the mortgages in these MBS deals. To issue MBS, Fannie uses so-called qualified special purpose entities, or QSPEs. As of Jan. 31 there were a massive $1.42 trillion of mortgages in these off-balance-sheet pools of guaranteed assets.

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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].