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Fannie Mae Execs Face the Music

Peter Eavis

Editor's note: This is a special bonus column for TheStreet.com readers. Peter Eavis' commentary regularly appears on RealMoney.com. To sign up for RealMoney, where you can read his commentary every day, please click here for a free trial.

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.

All nonsense. Anyone who argues along these lines clearly hasn't read the report, or understood it. In the report, OFHEO has gone out of its way to show that when it comes to SFAS 133, this is not a mere disagreement between accountants. OFHEO also shows that the complexity argument is a canard when it comes to SFAS 133. To do that, it cites the 2003 remarks of a senior SEC accountant.

The rule does become burdensome to implement when companies try to use it to keep losses out of earnings. The reason SFAS 133 is burdensome in this respect is that it requires companies to clearly show why gains and losses on derivatives should be excluded from earnings. In that sense, it is a sound rule. Companies shouldn't be allowed to just keep losses and gains out of earnings at their own subjective discretion. That would be an accounting free-for-all.

And, critically, OFHEO's report indicates that Fannie failed in most cases to show why its derivatives losses should be kept out of earnings. The company appears to have used the provision in SFAS 133 that allows it to keep losses out of earnings, but for the most part it seems to have failed to fulfill the requirements for taking advantage of that aspect of SFAS 133.

But why? Another utterly silly theory going around is that OFHEO hasn't shown motive for the alleged abuse of SFAS 133. But the regulator has suggested motive in several parts of its report. OFHEO even quotes a senior Fannie accountant, Jonathan Boyles, saying what motivated Fannie when it was implementing SFAS 133, which companies had to abide by from 2001 on. In March 2003, Boyles wrote a memo describing what drove the implementation of SFAS 133. First on the list was that "earnings volatility was to be minimized."

Rickety Table

This is no surprise to Fannie watchers. Right from when the rule was first proposed, Fannie never hid its dislike for SFAS 133, chiefly because it would cause volatility in earnings. Despite intensive lobbying, Fannie failed to stop SFAS 133. What seems to have happened is that the company gave the appearance of properly applying the rule, but actually implemented it in such a way that volatility was excluded from earnings. That alleged approach became very useful when huge losses started to accumulate on derivatives from the end of 2001 on. The system that was possibly set up to avoid earnings volatility may suddenly have become very convenient for keeping the gargantuan derivatives losses out of earnings.

OFHEO has been extremely clever in its approach. Not only has it anticipated possible Fannie defenses, it also appears to be trying to get insiders over to its side. From the report, a chief culprit seems to be the Fannie accountant Boyles. But if higher-ups helped formulate dodgy accounting policies, Boyles is now very unlikely to take all the blame on his own shoulders, especially if the Justice Department is readying an investigation, as has been reported.

It is also wise to ignore any reports that the SEC has doubts about OFHEO's allegations. The SEC officials who will be working on the agencies probe of Fannie told congressional staffers that they are taking OFHEO's findings very seriously, according to Michael DiResto, press spokesman for Rep. Richard Baker, (R., La.), who is on the House Financial Services Committee and is a longtime critic of Fannie.

Josh Rosner, an analyst with Medley Global Advisors, points out another good reason why the SEC is unlikely to defend Fannie's accounting against OFHEO: Fannie's board has entered a consent agreement with OFHEO to review its books and restate past earnings and change accounting policies, if the need arises. In other words, it's hard to see the SEC rushing to the defense of a company that may soon have to restate its books.

Rosner also notes that OFHEO isn't only making allegations about Fannie's accounting. Much of its report alleges that controls at Fannie are poor, and that the possible safety and soundness deficiencies could be enough to justify the increase in capital that OFHEO has already demanded, says Rosner. (Medley Global Advisors doesn't do any investment banking, and Rosner has no positions in Fannie stock.)

Fannie really doesn't have a leg to stand on. People expect Raines to make a convincing effort in Congress to overcome the skeptics. But the evidence stacked against Fannie is so weighty that Raines may just flame out like former Enron CEO Jeff Skilling did when he tried to defend himself before Congress.