Sept. 2, 2004: "Fannie Probe Turns to Derivatives"
Did mortgage giant
Fannie Mae cook its
books in order to exclude large derivatives losses
from its income statement?
Finding an answer to that question is one of the
main aims of a probe being conducted by Fannie's
regulator, the Office of Federal Housing Enterprise
Oversight, or OFHEO. And according to a person
familiar with the investigation, one of the reasons
that OFHEO has sent subpoenas to Fannie is to obtain
information that would help it decide whether the
company misapplied generally accepted accounting rules
to keep losses on derivatives out of earnings.
As this column
has
often reported, Fannie has suffered gargantuan
losses on derivatives under CEO Franklin Raines. The
losses, which ballooned to nearly $17 billion in 2003,
appeared to be the result of a risky interest rate
hedging strategy that backfired badly. The derivatives
losses in question are amortized into earnings over
time. The OFHEO investigation aims to determine
whether Fannie was amortizing too few losses into its
income statement and thus artificially boosting
earnings, according to the person familiar with the
probe, which began in February and is expected to end
by the end of this month.
Fannie has strived hard to give Wall Street
earnings that grow at a strong and steady rate. If it
was able to do that only because it was abusing its
accounts to keep derivatives losses out of earnings,
Fannie's reputation would be hurt badly and CEO Raines
would come under fire.
Fannie didn't comment. Its stock dropped 60 cents
to $73.85 Wednesday.
OFHEO declined to comment on any aspect of its
investigation, which the regulator launched soon after
its probe of accounting missteps at
Freddie Mac
(FRE Quote),
Fannie's rival mortgage buyer. Having seen some of the
tricks Freddie played, OFHEO said right from the start
that its probe of Fannie would look at how earnings
were calculated. Back in December, OFHEO said that one
of the things it would do in its Fannie probe was to
"focus on transactions that significantly accelerate
or defer the pattern of income recognition."
With that being one of its main aims, it made perfect sense for OFHEO to look at how Fannie's billions of dollars of derivatives losses were
treated. In theory, the accounting rule that covers
derivatives -- known as FAS 133 -- could be abused to
keep a portion of derivatives losses out of earnings. In a November 2003 letter from OFHEO director Armando Falcon to Raines obtained by
TheStreet.com, OFHEO asked for documents pertaining to a range of subjects, but specifically requested documents "related to FAS 133."
Preparations for FAS 133 were started under former
Fannie chief James Johnson, now a private equity
investor and adviser to John Kerry. Johnson didn't
return a call seeking comment.
However, Fannie may be doing all it can to avoid
scrutiny of its derivatives accounting. At a
congressional hearing in July, OFHEO director Armando
Falcon has said that Fannie's cooperation with the
probe has been "spotty." According to an AP report, he
also said, "We've had some instances where deadlines
have been missed without explanation, submissions in
response to requests for information that weren't
complete -- even though there were assertions that
they were complete."
The lack of cooperation may have been the reason
for the issuance of subpoenas, a development reported
by
The Wall Street Journal on Aug. 20.
According to the person familiar with the
investigation, the subpoenas are aimed at getting
documents that would show whether certain accounting
treatments were implemented as part of willful
attempts to artificially smooth earnings.
Of course, while the derivatives losses don't all go into earnings when they occur, they have all been reflected in the balance sheet -- in the equity number. However, to the bemusement of many investors, Fannie has asked market participants to look at equity numbers that leave out the FAS 133-related derivatives losses when assessing the strength of the company's capital.
At the end of June, there were $8.5 billion of
unrecoverable derivatives losses in Fannie's equity
that had yet to be amortized into earnings. If, as makes sense, that sum were subtracted from the capital numbers Fannie asks investors to concentrate on, the company would look weakly capitalized. Since Fannie was betting on a drop in bond prices at the end of the second quarter, the recent rally in bonds may have created more derivatives losses, and the company's true capital base may be even weaker than it was at the end of the second quarter.
OFHEO's ongoing probe has scored a couple of
successes. It led to Fannie changing its accounting
for some impaired bonds, an issue this column was
first to flag.
Fannie ended up having to book heavier losses on the
bonds.
Also, it would appear that OFHEO is leaning on
Fannie to make some changes in its corporate structure
to improve risk management. Last week, Fannie said it
was going to "move transactional risk management
responsibilities to its business units while
strengthening the integration of its financial risk
assessment capabilities at the corporate level." Why
the changes? Well, in the press release containing the
news on the organization change, Fannie CFO Timothy
Howard implied the impetus for changes in risk
management were coming from OFHEO.
Howard said that "because OFHEO's proposed corporate
governance rule addresses issues related to the
organization of risk management activities, the
company anticipates making further changes to its risk-management structure once the final rule is in place."
Falcon's term at OFHEO is due to come to an end at
the beginning of October, but an OFHEO spokeswoman
said Falcon wants to ensure a smooth changeover and,
if necessary, he would stay through the transition to
the new director.
A Bush victory in November would be a disaster for
Fannie, which has resisted reforms proposed by the
White House to tighten regulation of Fannie and
Freddie. The two companies have been told by the White
House that a second Bush administration's stance would
be tougher, according to a person familiar with
relations between the administration and the
government-sponsored entities, or GSEs.
However, Fannie management could find it hard to
resist reform calls even under a possible Kerry
presidency if OFHEO finds it did keep derivatives
losses out of earnings.
One of the big corporate tricks of the '90s was to
find ways to manipulate accounting to defer or bury
losses. There would be few supporters left in Congress
if Fannie were discovered to have had engaged in
Enronesque practices and ethics.
