The Wheels of Justice Flatten Fannie Mae

Can the Fannie Mae (FNM Quote) scandal now take its place as the Enron-sized debacle it long has been shaping up as?

Up till Wednesday, many on Wall Street and in Washington were quite willing to downplay a detailed report by Fannie's regulator that showed the company had used faulty accounting in a way that allowed it to keep billions of dollars of losses out of its income statement.

But Wednesday evening, the Securities and Exchange Commission, the stock market's main cop, gave Fannie's regulator its backing by saying that Fannie had violated accounting rules. The agency took particular issue with the way Fannie accounts for derivatives, which are financial instruments the company uses to insure itself against adverse movements in interest rates.

The SEC, speaking through its chief accountant, also told the government-sponsored mortgage giant to restate its financial reports. That's a deeply humiliating demand for Fannie CEO Franklin Raines, because he had fought the accounting charges and staunchly defended the integrity of Fannie's books before Congress in October.

The fact is, Fannie's dubious accounting allowed it to keep a stunning $9 billion worth of losses out of earnings, making a closely watched measure of regulatory capital look much stronger than it actually was.

Fannie will now face the prospect of having to quickly raise as much as $11 billion in fresh capital. It could do that by liquidating over $300 billion of mortgages or by issuing new stock. Neither option is good for Fannie's stock, which has stubbornly remained in the high $60s since the scathing Sept. 20 report from Fannie's regulator, the Office of Federal Housing Enterprise Oversight, or OFHEO. It slipped 5% early Thursday on news of the setback.

Turmoil

The $9 billion in losses that will need to be recognized are equivalent to over one-fourth of Fannie's core capital, and they far exceed the $7.9 billion Fannie earned last year. Any other financial company that incorrectly treated a similar level of losses could easily find itself under the control of regulators.

However, the reason for the market has so far been ready to shrug off Fannie's problems is the widespread belief that Fannie's government-sponsored status amounts to a government commitment to bail the company out if it gets into trouble. That implicit guarantee certainly exists, but it won't protect investors now that the SEC has so clearly damned Fannie's accounting.