Fannie's Hedging Deals Look Thorny

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.

Fannie Mae (FNM), fending off serious accounting allegations by its regulator, said Tuesday that it is now the subject of a Justice Department investigation.

The question everyone's going to be asking is this: What might end up in any criminal complaint against Fannie, the nation's largest mortgage buyer?

In fact, thanks to some serious digging by Fannie's regulator, the Office of Federal Housing Enterprise Oversight, there now appears to be enough material in the public domain to assemble a strong hypothetical case against Fannie, whose management team is led by CEO Franklin Raines and finance chief Tim Howard.

Raines and Howard, as well as some Fannie supporters, have made broad-brush criticisms of the findings contained in OFHEO's Sept. 22 report on Fannie's accounting. But no one in the Fannie camp has so far made a convincing effort to defend the company against the particular allegations of the OFHEO report. At congressional hearings last week on OFHEO's report, Howard had to answer detailed accounting questions, but often tied himself in self-contradictory knots.

Using what is known so far, a prosecutor could make a simple and serious case against Fannie. There's much in the OFHEO report to suggest that Fannie misapplied accounting rules to make both its earnings and regulatory capital look a lot stronger than they actually were. According to some estimates, Fannie may have excluded as much as $12 billion of losses from its income statement.

Fannie's defenders have every interest in making the issues seem as complex as possible. First, so that people get lost in the details and switch off. And second, to make it look like the accounting rules are so open to interpretation that there is no one right approach and that Fannie and OFHEO merely had a difference of opinion.

But a prosecutor would have no problems drawing out simple and clear-cut abuses. As with nearly all accounting scandals, Fannie's alleged abuses aimed to do one thing: Make the books look better than they really were. Enron's ruses were sometimes complex, but after a long gestation period, the Justice Department hasn't had any real trouble putting together a convincing case against ex-Enron employees. Don't expect it to be any different when it comes to Fannie.

Timeline

Fannie appears to have committed its most serious abuses when accounting for the changes in the value of derivatives, which are financial instruments used to hedge the company against adverse interest rate movements.

Any theoretical case against Fannie would simply argue that Fannie kept losses on those derivatives out of earnings by misapplying the provisions of an accounting rule known as FAS 133. To see how that may well have happened, it helps to approach the issue chronologically. The Fannie mess didn't come out of nowhere.

First, we have to understand Fannie's basic business. Though Fannie is a private company, it is also known as a government-sponsored enterprise because it operates under special advantages granted by Congress. It was set up to provide support to the housing market by buying mortgages from lenders like banks and thrifts. Because of Fannie's so-called GSE status, the market has come to treat the company almost like a government institution, assuming that the debt Fannie issues carries a government guarantee. This implicit government guarantee allows Fannie to borrow more cheaply than other financial institutions.

Fannie then uses those cheap funds to buy billions of dollars of mortgages each year. If the payments on the mortgages bought by Fannie are higher than the payments on the debt it borrows, the company makes money. A drop in profitability can occur, however, when borrowers decide to prepay their mortgages.

Why can that hurt profits? If Fannie borrowed at 5% to pay for 30-year mortgages yielding 6%, the 1 percentage-point difference is its profit. But if rates come down and mortgages start to yield 5%, Fannie has to be borrowing at 4% to make the same profit. It's not that easy to get debt costs down quickly simply by issuing new debt, so Fannie has to find a way of cutting its borrowing costs quickly. It uses billions of dollars of derivatives to do that.

And the accounting for these derivatives are central to the anti-Fannie case.

Hedge Clippers

The use of derivatives has ballooned over the past 20 years, especially in the financial sector of the economy. There is nothing inherently wrong with derivatives, just as there is nothing inherently wrong with stocks or bonds. It makes much sense for Fannie, as well as other mortgage holders, to use them to hedge against the big losses that changes in interest rates can cause in the mortgage buying business.

Because derivatives use became widespread so quickly, especially in the '80s and '90s, accounting rulemakers found it hard to keep up, and an utterly intolerable situation developed: Companies were holding huge amounts of derivatives, but their books barely reflected their presence. Losses could pile up on them and this wouldn't be properly reflected in financial statements.

After some very nasty derivatives-related scandals, the Securities and Exchange Commission, as well as the Financial Accounting Standards Board, the U.S. body that formulates accounting rules, started in the late '90s to draw up a rule that would make companies reflect the change in value of derivatives much more accurately and fully on their income statements and balance sheets.

That rule came to be known as FAS 133 -- and Fannie fought it harder than any other company in America, often leading the lobbying effort against it. FASB, quite understandably, wanted to have companies' income statements reflect the changes in the value of derivatives each quarter. That caused howls of protest, from Fannie and others.

In December 2000, just before the rule became effective on Jan. 1, 2001, Fannie CFO Howard gave a presentation to investors about FAS 133. In it, he noted that FASB wanted to "put all derivatives on the balance sheet, and to reflect changes in their market values either in the income statement or the equity account."

An alternative method, Howard wrote, was to "require supplemental disclosure of a company's use of derivatives while leaving the income statement and balance sheet alone." Howard announced: "Fannie Mae was in favor of the second alternative."

In the end, a compromise was reached: Companies didn't have to include gains and losses on derivatives that had a very close hedging relationship with a real asset, like a mortgage, or a real liability, for example, a bond. If a company could very clearly and rigorously prove that a derivative's decline in value was closely offset by a rise in the value of an asset or liability, that derivative loss would not have to flow through earnings in the period the value change took place.

Once it had failed to get all derivatives onto the income statement, FASB wanted to avoid the situation in which a company would have a loss on some derivatives and then, after the fact, pretend that it was offset by some increase in the value of an asset. That's why FAS 133 demands very detailed and contemporaneous documentation of derivatives that a company elects to keep out of earnings calculations.

The OFHEO report on Fannie makes a simple, but chilling, allegation: Fannie has claimed close hedging relationships for most of its derivatives and thus kept losses on them out of earnings, but it appears to OFHEO that most of those derivatives don't in fact qualify for exclusion. In other words, it appears that Fannie has done what FASB always feared, which is wrongfully claiming that loss-making derivatives deserve to be kept out of earnings to make the company look stronger than it really is.

Forked Road

What might be the reasons for Fannie choosing this possible path? The best likely explanation so far is that Fannie hated FAS 133 so much that it never seriously set out to implement it. Maybe it thought it was too big to have to use FAS 133 properly.

After all, Fannie may never have set out to specifically hide losses. The OFHEO report has a memo that shows that the chief guiding principle for FAS 133 implementation was to limit volatility in earnings, i.e., to protect earnings against both gains and losses on derivatives. Most accounting-abuse cases start out at the top of a slippery slope. The first infraction might seem rather inconsequential, like "limiting volatility."

But this possibly deliberate misapplication of FAS 133 could have come in handy when losses, and not gains, started to pile up on Fannie's derivatives after the Federal Reserve slashed interest rates following the Sept. 11, 2001, attacks. Fannie, unlike GSE sibling Freddie Mac(FRE), was inadequately hedged for lower rates, and failed to get proper protection for the new low-rate environment. As a result, derivatives losses continued to balloon, and losses on FAS 133-related derivatives climbed to dangerous levels in 2002 and 2003.

Did earnings get hurt in the period when the huge losses were sustained? Nope, because of the way Fannie applied FAS 133.

And FAS 133 wasn't the only area in which Fannie appears to have made grave missteps. OFHEO has shown in scrupulous detail how another rule, called FAS 91, was allegedly misapplied to smooth out earnings. An ex-Fannie employee named Roger Barnes aided that segment of the OFHEO report. And in testimony before the House committee hearing last week, Barnes described what he saw as the culture within key accounting units at Fannie.

"The atmosphere and culture ... is one of intimidation, restraint of dissenting opinions, and pressure to be part of the 'Team,' giving Chairman Franklin Raines and Vice Chairman Tim Howard the numbers the Office of the Chairman desired to please the markets," according to Barnes.

If the office of the chairman did in fact misuse FAS 91 to help earnings, there is every reason to suppose that it could have done the same with FAS 133.

Fannie said Tuesday that the Justice Department told the company "to preserve certain documents, including documents relating to the matters discussed in the OFHEO report." No doubt the feds are heading straight for the FAS 133 file.

---