The Wheels of Justice Flatten Fannie Mae

Like Enron and WorldCom, Fannie was able to keep billions of dollars out of its income statement by failing to properly apply clear and easy-to-understand accounting rules. Fannie failed to comply with a derivatives accounting rule called FAS 133. That rules says that to keep losses on derivatives out of earnings (and instead store them on the balance sheet), a company must meet all sorts of stringent requirements to show the losses are more or less offset by gains elsewhere on the balance sheet. Fannie simply failed to show that its derivatives losses were offset by particular gains, according to OFHEO.

Just Like Enron

How on earth did a company with a triple-A credit rating (for how much longer?) and a solid reputation come to that level of alleged accounting abuse? The most likely answer is that Fannie never set out to properly apply FAS 133, which became effective in 2001. Fannie never hid its dislike of the rule and led a massive, and somewhat successful, corporate lobbying effort to modify it in the late '90s. Like Enron, Fannie appears to have thought it was above the rules.

In OFHEO's report, Fannie's chief accountant said: "We have several known departures from GAAP in our adoption of FAS 133. We have cleared those with our auditors." (GAAP stands for generally accepted accounting principles, which are the accounting rules that the SEC expects public companies to follow.) The executive, Jonathan Boyles, appears to be saying that Fannie knew it didn't apply FAS 133 properly and was OK with that. Enron took the same dismissive view of accounting guidelines, in its case for all sorts of off-balance sheet structures.

And it appears Fannie execs sat down and worked out how to avoid faithful interpretation of FAS 133. The SEC said that Fannie "internally developed its own unique methodology" for assessing whether derivatives losses could be kept out of earnings in the period they occurred. It will now be up to the Justice Department, probing Fannie, to determine who set up and implemented this "unique methodology," and whether it was established with the specific intention of keeping losses out of earnings.