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Franklin Raines' fanny-covering has already begun.

The ousted

Fannie Mae


CEO began his self-defense as soon as he stepped downfrom the company Tuesday evening, with a statement reiterating hisview that, under him, Fannie had "always made good faith efforts toget its accounting right."

Raines' assertion comes in the face of criticism of Fannie'saccounting by the company's regulator and the

Securities and ExchangeCommission

. He, along with plenty of supporters, has strongly arguedthat Fannie doesn't have accounting issues, even after its regulatorsaid that billions of dollars of losses had been kept out of thecompany's earnings.

Given how many politicians were in Fannie's pocket, there will be noshortage of people trying to shore up Raines' reputation. Inanticipation of this revisionist propaganda, and in the interest ofholding Fannie's future bosses accountable, it is necessary to firmlygrasp why the financial statements issued under Raines are sodangerously unrepresentative of Fannie's true health.

Creative Destruction

Raines' departure, coming after the Fannie board met this weekend toconsider his fate, is completely justified. The accounting misstepsare both clear-cut and dangerous to the health of Fannie, which holdssome $1 trillion of assets and supports the U.S. housing market withbillions of dollars of mortgage purchases each year.

The more investors understand the Raines-era abuses, the betterpositioned they will be to properly assess Fannie's future CEOs,starting with interim CEO Daniel Mudd, the chief operating officer appointed Tuesday by the company's board.

Fannie CFO Tim Howard also left Tuesday, and will be replaced byinterim finance chief Robert Levin, another Fannie insider.

Fannie's audit committee also dismissed the company's independentauditor, KPMG, and has started to look for a replacement.

Raines is leaving a company that now has to restate its earnings toincorporate $9 billion of derivatives losses, and likely won't fileup-to-date financial statements for months. Its accounting is alsobeing investigated by the SEC, the Justice Department and its regulator,the Office of Federal Housing Enterprise Oversight, or OFHEO. And whoknows what other problems the new auditor will find once it starts to goover Fannie's books.

Despite the obvious gravity of the situation and the size of thelosses left out of earnings, Raines seems keen to avoid blame, judgingby a statement he put out after his "retirement" Tuesday night.

Raines said: "Although, to my knowledge, the company has always madegood faith efforts to get its accounting right, the SEC has determinedthat mistakes were made. By my early retirement, I have held myselfaccountable."

The strong implication is that he always thought Fannie's accountingwas correct. This complaint is echoed by those in the market who arguethat the main accounting rule Fannie allegedly broke was overlycomplex and open to a variety of possibly valid interpretations.

Echoes of WorldCom

To help close the door on the Raines-and-Howard era at Fannie, let'ssee once and for all why this defense is utter bunkum.

To do this, we first have to go back to basics and grasp the two maintreatments that accounting has for a company's expenses. One method isto put an expense on the income statement, where it is subtracted fromrevenue to arrive at earnings. The other method is to put an expenseon the balance sheet. Then, that expense is bled gradually into theincome and statement earnings in future accounting periods.

This second method is known as capitalization. All companies practiceit. If a widget-manufacturer wants to buy a new widget-making plant,the cost of that plant will be placed on the balance sheet. Then, overtime that cost will be "amortized" into earnings through thedepreciation expense on the income statement.

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This system is theoretically sound, but it has often been abused byexecs who want to make earnings look stronger than they actually are.Clearly, a manager can take an expense that should be on the incomestatement and capitalize it onto the balance sheet. This is exactlywhat happened at


, where billions of dollars of expenses wereimproperly capitalized. In WorldCom's case, no one had any troublegrasping the accounting. With Fannie, people seem to be finding it alot harder. But what we know so far strongly suggests that Fanniecarried out a very similar ruse.

Fannie's main way of making profits is to borrow money and then usethose funds to buy and hold mortgages that have a higher interestrate. The difference is Fannie's profit. (Its cost of debt isparticularly low because creditors perceive it to be operating under agovernment guarantee.)

It would be a very easy business if it weren't for movements ininterest rates. For example, declines in interest rates lead tomassive amounts of mortgage prepayments, which forces Fannie toreplace higher-yielding mortgages with lower-yielding ones. Thispotentially crushes profits, since Fannie's borrowing costs don'treprice downward as quickly. To try and hedge against thishappening, Fannie buys financial instruments called derivatives, whichmove in relation to interest rate moves.

At Fannie, extremely large losses have built up on its derivatives, asit bet the wrong way on interest rates. In 2001, an accounting rulecalled FAS 133 became effective, and it required that some derivativeslosses be placed immediately in earnings and some be capitalized onthe balance sheet to be amortized into earnings over time. If acompany wants to pretend earnings are higher than they are, it couldput income-statement derivatives expenses on the balance sheet, in thesame way that WorldCom put its telecom maintenance expenses on itsbalance sheet when it shouldn't have.

Naive Son

Regulator OFHEO alleges that Fannie capitalized all sorts ofderivatives losses that it shouldn't have. If it reversed thattreatment, it would mean restating earnings to include $9.2 billion oflosses that never made it onto the income statement. That sumrepresents over one-third of the company's earnings since 2001. The pro-Raines argument is that it was easy to mistakenly place these losses on the balance sheet instead of the income statement. That is extremely naive. Gaining the right to capitalize losses is like gaining the right for exemptions on a tax return -- both require that stringent and clear conditions be met to gain the advantageous treatment. And FAS 133 lays down some very clear conditions that have to be met for derivatives losses to be capitalized. OFHEO says Fannie simply didn't fulfill them. This column has argued repeatedly that Fannie

never intended to implement FAS 133 because it hated it from the get-go.

These large derivatives losses were clearly a source of greatembarrassment to Fannie for several years. Detox repeatedly askedFannie to break out how much of these capitalized losses wereunrecoupable because the derivatives had been closed out. At a pressconference in summer 2003, this columnist asked Raines himself todistinguish between losses on closed-out derivatives and open ones.Raines

declined to break out the losses by type.

The distinction is actually bogus, because an open derivative canstill be effectively unrecoupable. But the fact that Raines and Fanniedidn't give more detail on the losses showed that they were extremelysensitive about their existence. And maybe Raines and Howard werealways so loath to discuss the derivatives losses because they didn'twant anyone asking why they were on the balance sheet and not theincome statement.

Finally, Raines supporters may also point to the fact that whileFannie is now "significantly undercapitalized" on one capital measure,it appears adequately capitalized on something called risk-basedcapital. There are two problems with that defense. First, the $9.2billion of unrecognized losses weren't included in the calculation.Second, OFHEO's measurement of risk-based capital is deeply flawed,since it compares apples with oranges in a way that benefits Fannie.

In other words, the market's Wednesday morning rally notwithstanding, there is no defending Raines on the basis of Fannie's accounting. And that will likely become increasingly obvious as we learn more of what went on under his rule.

In keeping with TSC's editorial policy, Peter Eavis doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He welcomes your feedback and invites you to send any to