Peter Eavis Digs Into Fannie Mae

Nov. 16, 2004. "Fannie Mae: Day Late, Many Dollars Short"

Mortgage giant Fannie Mae (FNM), with its government-sponsored status and its perfect credit rating, has long been seen as one of the bluest blue chips in the stock market.

But Monday, Washington-based Fannie became one of market's biggest delinquents, by failing to file results for its third quarter with the Securities and Exchange Commission on time and by announcing that it may have to book a staggering $9 billion of losses after its regulator questioned the way it accounts for financial instruments called derivatives.

A charge of $9 billion would rank among the biggest ever outside of the telecom industry meltdown and would almost certainly lead to the departure of Fannie's management team, led by CEO Franklin Raines. It also would give the White House and certain forces in Congress the ammunition they need to press forward with far-reaching reforms of Fannie Mae and its rival Freddie Mac (FRE). Both companies have been hit by accounting scandals, and both operate under special advantages granted by congressional charter.

In September, Fannie's regulator, the Office of Federal Housing Enterprise Oversight, or OFHEO, published a report that argued that Fannie had not properly applied a derivatives accounting rule known as FAS 133. As a result, OFHEO contended, Fannie's earnings and a key measure of capital may have been substantially overstated.

Monday, Fannie said that if the SEC finds that Fannie didn't apply FAS 133 correctly, the company will have to record a $9 billion after-tax cumulative loss in earnings. By definition, that sum would also have to come out of capital, almost certainly pushing Fannie's capital below the level required by regulators and by congressional statute.

Detox estimates Fannie would be undercapitalized to the tune of $11 billion if Fannie has to book a $9 billion charge.

That $9 billion net loss figure is large enough, but even that number doesn't adequately show the full losses that Fannie may have kept out of earnings by allegedly misapplying FAS 133. It is important to understand that the $9 billion is a net figure, made up of after-tax derivative losses of $13.5 billion and after-tax gains of $4.5 billion. The before-tax number for those losses is actually $20 billion. If it is found that FAS 133 was incorrectly applied at Fannie, the talk will soon turn to motive. Clearly, with derivatives losses of that scale, Fannie execs may have deliberately decided to misapply FAS 133 to keep its stock up, and keep regulators and its political opponents off its back.

Indeed, there is every reason to believe that any misapplication of FAS 133 was not a mistake. In its report on Fannie's accounting, OFHEO included a quote from Fannie accounting chief Jonathan Boyles that suggests the company knew it wasn't applying FAS 133 correctly. In an interview in August as part of OFHEO's probe of Fannie's accounting, OFHEO says Boyles said the following: "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.)

Monday, Fannie didn't say when it would file its third-quarter results, but said it failed to do so on time -- Monday was the deadline -- because it was "advised by its independent auditor that it is unable to complete its review" of Fannie's third-quarter results. Last week, this column predicted that Fannie's auditor, KPMG, would be unlikely to give its approval of the numbers.

Fannie said that it believes that its applications of FAS 133 and FAS 91 -- another rule OFHEO thinks Fannie incorrectly applied -- are "consistent with" GAAP. Fannie said that it has made its case to the SEC on both rules, with KPMG concurrence. However, Fannie also said that it will "modify its accounting, if necessary, to comply with the SEC's views."

Clearly, Fannie hopes the SEC will come down on its side. But, as Detox argued last week, the chances of that happening are slim. The SEC understands FAS 133 extremely well and is fully aware of the ways in which companies try to misapply it to make their earnings look better than they really are.

Some Fannie supporters have argued that the SEC may just tell Fannie to change its FAS 133 accounting, but allow it to avoid a costly and damaging restatement of past results. But if $9 billion of losses have been left out of earnings, the sum is so large that anyone in the SEC would have a very hard taking the "go-and-sin-no-more" line.

The nub of the issue is whether Fannie should have given nearly all its derivatives a special treatment that allows companies to keep losses on them out of earnings in the period they occurred. Instead, they accumulate on the balance sheet -- in a special equity account -- where they are amortized into earnings over time. For derivatives to qualify for this special treatment to stay out of earnings, companies have to show very carefully why they qualify -- and this requires careful measurement of the derivatives' value and extensive documentation.

If a company can prove that a derivative possesses "hedge effectiveness" -- i.e., changes in its value closely offset the change of a value of the asset or liability being hedged -- any losses (or gains) stay out of earnings in the period they occur and go onto the balance sheet.

OFHEO charges that Fannie has failed to show why its derivatives qualify for hedge effectiveness in the vast majority of cases.

The SEC has made a point of looking out for ways in which companies abuse FAS 133 to obtain hedge effectiveness for their derivatives. In a speech last December, an official from the SEC's Office of the Chief Accountant said that the SEC had "recently observed situations of 'sloppy' documentation and aggressive interpretations of Statement 133's hedge accounting guidance." OFHEO alleges that this is what happened at Fannie.

Fannie lobbied hard to prevent the implementation of FAS 133. It forced some changes, but the rule that became effective in 2001 was still not to Fannie's liking. It is therefore believed that Fannie, which has never been afraid to use its huge influence in Washington, never really tried to implement a rule it didn't like.

The key concern for the market is how much capital Fannie now has to raise. In the midst of its accounting problems, Fannie agreed with OFHEO in September that it would increase its minimum capital requirement by 30%. That means that Fannie's new capital requirement is around $41 billion. At the end of September, Fannie likely had so-called core capital of $38.5 billion. Subtracting $9 billion of net losses would take that down to $29.5 billion, which is $11.5 billion below the minimum requirement.

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