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Fannie Mae's Trust Fund Troubles

There's no disputing anymore that Fannie Mae (FNM) will have to recognize huge losses that were previously kept out of earnings and that its financial statements are a terrible mess.

But there are indications that the mortgage giant's bookkeeping was so badly done that it could end up having to bring huge amounts of assets onto its balance sheet as part of a cleanup of its financial statements.

And any large-scale transferal of assets onto its balance sheet would be a nightmare for Fannie, because it could be extremely expensive to carry out, take many months to execute and, in a worst-case scenario, leave the government-sponsored company severely undercapitalized.

Detox first looked at the off-balance-sheet assets in question -- $1.42 trillion of mortgages contained in so-called mortgage-backed securities held by bond investors -- in early March. That was after Fannie said that its regulator, the Office of Federal Housing Enterprise Oversight, was looking into how these securities were accounted for.

Trying to gauge what exactly might be wrong with Fannie's accounting for these securities has been tough, since Fannie didn't describe why the off-balance-sheet accounting might be an issue. A Wall Street Journal article Monday quoted OFHEO director Armando Falcon as saying that the agency was "still trying to quantify the potential problem."

Separately, Falcon sent a letter of resignation Tuesday to President Bush, saying he aimed to leave OFHEO on May 20. Falcon's allotted term ended in October, but after an array of serious accounting problems were discovered at Fannie by an OFHEO-sponsored probe, Falcon, a Clinton appointee, stayed on with the blessing of the Bush administration, which has been very keen to rein in and reform Fannie Mae and Freddie Mac (FRE).

The chances of introducing far-reaching reform through legislation got a big boost last year when the OFHEO probe showed that Fannie had kept over $9 billion of losses out of earnings by misapplying accounting for derivatives. Last month, Fannie said that it might have to recognize an extra $2.4 billion of losses. Stephen Blumenthal, OFHEO's deputy director, will be acting director of OFHEO.

Fannie stock rose 82 cents to $52.28 Tuesday. Fannie declined to comment on its accounting for off-balance-sheet assets.

Potential Pitfalls

Ever since Fannie mentioned that OFHEO was looking at the off-balance-sheet assets, investors were forced to look for ways in which Fannie's accounting for the assets might be wrong. And there are a number of ways in which it might have been misapplied.

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 and aims to make profits from the guarantee fees over time.

To issue MBS, Fannie uses so-called qualified special-purpose entities, or QSPEs. But it appears that Fannie may have failed to take the necessary steps to gain QSPE status for its off-balance-sheet assets. If the entities don't qualify, Fannie would have to bring all the assets they contain onto its balance sheet.

FANNIETOX

Last year, when discussing an amendment to FAS 140, the accounting rule that partly governs QSPEs, former Fannie accounting officer Jonathan Boyles said that consolidating off-balance-sheet entities "would substantially increase Fannie Mae's minimum capital requirements." In a previous column, Detox estimated that if a fourth of the $1.42 trillion of assets came on balance sheet, it would mean Fannie raising its minimum capital by a range of $7.3 billion to $9.9 billion.

Control Freaks

The first big problem is that Fannie appears to continue to have too much control over the loans in the QSPEs, which are supposed to be almost totally independent of Fannie. In the disclosures for its MBS entities, Fannie says that it has the "right and the option, without obligation and in its discretion, to withdraw" certain delinquent loans from the pools of MBSs. But FAS 140 says that a company that runs a QSPE can't have ad hoc discretion over what assets go in and out of the trust. Any additions or removals have to happen according to preset "automatic" guidelines.

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