Feds Fine 'Arrogant and Unethical' Fannie Mae

A report details the company's accounting games.
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Updated from 12:24 p.m.

Fannie Mae

agreed Tuesday to pay $400 million to end a nearly three-year investigation into its accounting missteps. Regulators blasted the mortgage finance firm for fostering an "arrogant and unethical corporate culture."

The settlement marks the latest attempt by Fannie's new management team to close the book on a sordid chapter in the government-sponsored company's history. But a 348-page report by regulators, outlining years of accounting games at Fannie, will only provide more ammunition for the firm's many critics on Capitol Hill.

The settlement with the Office of Federal Housing Enterprise Oversight and the Securities and Exchange Commission requires Fannie to strengthen its accounting systems and corporate governance.

Shares of Fannie, which had not traded as of early Tuesday afternoon, closed Monday at $50.27. In January 2004, around the time investigation was beginning to pick up steam, the stock traded around $80.

The picture painted by regulators at OFHEO is one of an out-of-control company that manipulated earnings for years in order to make sure that top managers got hefty annual bonuses. The report rips to shreds Fannie's carefully crafted image as a sober, well-run institution that once boasted a triple-A credit rating -- the gold standard for corporations. Many of the accounting games at Fannie were

first reported by

TheStreet.com's

Peter Eavis.

"The image of Fannie Mae as one of the lowest-risk and 'best in class' institutions was a facade," says James Lockhard, OFHEO's acting director. "Senior management manipulated accounting; reaped maximum, undeserved bonuses; and prevented the rest of the world from knowing."

The regulators say former CEO Franklin Raines personally benefited from the accounting manipulation at Fannie because he earned more money every time the firm hit its earning targets.

Regulators didn't charge Raines with any wrongdoing. But the settlement does call on Fannie "to undertake a review of current and separated employees for remedial actions."

The settlement and the scathing OFHEO report could set the stage for Fannie to bring legal action to recoup the bonuses paid to Raines and his former loyal deputies. At this time, there's no indication the firm is planning to do that, but some investors may push Fannie in that direction.

Fannie Chairman Stephen Ashley issued a statement Tuesday saying the settlement will "bring these matters to a conclusion'' and permit the company "to restore the confidence of our shareholders.''

The main allegations at Fannie have been long known to investors. From 1998 through 2004, the company overstated its earnings by $10.6 billion. Most of the accounting shenanigans at Fannie revolved around the use of improper accounting treatment for derivatives, sophisticated financial instruments the firm used to hedge its gargantuan mortgage portfolio against interest rate fluctuations.

The scandal at Fannie led to a management shake-up, including the resignation of Raines, a former director of the federal Office of Management and Budget in the Clinton administration. The company is still bracing for a massive earnings restatement, which has already cost shareholders hundreds of millions of dollars in fees paid to professional advisers.

One of those advisers is former Sen. Warren Rudman of New Hampshire, who issued his own report in February about the accounting fraud at Fannie. Many on Wall Street and Capitol Hill viewed the Rudman report as a "whitewash" because it absolved Raines and Fannie's board of any serious blame for the accounting woes.

Rudman, a partner in the big New York law firm Paul Weiss Rifkind Wharton & Garrison, attributed most of the wrongdoing at Fannie on Raines' underlings. And in a stark contrast with OFHEO, Rudman concluded that, with only one exception in 1998, there's no evidence that Fannie Mae's accounting shenanigans "were motivated by a desire to maximize bonuses."

In fact, OFHEO says that earnings management at Fannie "made a significant contribution" to Raines' compensation, which totaled more than $90 million from 1998 through 2003. Raines stepped down in December 2004. Regulators say $52 million of his compensation was tied to Fannie meeting earnings targets.

The regulators said Raines set the tone for much of the accounting abuses at Fannie by demanding the firm hit earnings targets. The OFHEO says Raines' message to his staff was a clear one: "EPS results mattered, not how they were achieved.''

The regulators also found that Fannie's board contributed to the accounting manipulation by not acting independently of Raines and other former senior executives.

"Mr. Raines has repeatedly stated that he never authorized, encouraged, or was aware of violations of Generally Accepted Accounting Principles ("GAAP") at Fannie Mae for the purpose of smoothing earnings, reaching bonus targets, or for any other improper reason. The facts on the record and conclusions from previous reports support this statement," Raines' lawyer said late Tuesday.

The federal government established Fannie and its sister company,

Freddie Mac

, to create a secondary market for buying and selling home mortgages and provide lenders with a guarantee on those loans in the even to a default. But over the years, critics say Fannie and Freddie have strayed from their original by taking on too much debt and risk.

Two years ago, Freddie paid a $125 million fine to settle a regulatory investigation involving its own allegations of earnings manipulation. Like Fannie, officials at Freddie also manipulated the accounting treatment the firm used to value its derivatives. But unlike Fannie, Freddie deliberately understated its earnings in order to avoid the kind of quarter-to-quarter volatility in earnings that Wall Street analysts and investors abhor.

OFEHO began investigating Fannie shortly after the accounting irregularities at Freddie came to light in 2003. The investigations of both government-sponsored companies were begun by former OFEHO director Armando Falcon, whose term expired in 2005.

Falcon issued a statement blaming Congress for allowing the fraud at Fannie to fester, noting that the mortgage firm long boasted one of the most-effective lobbying operations on Capitol Hill. He called Fannie Mae a "government sponsored Enron.''

Falcon is trying to get back at his critics in Congress, many of whom derided OFHEO as an ineffective regulator. Ever since the scandals at Freddie and Fannie erupted, some in Congress have been trying to enact a measure that would replace OFHEO with another regulatory agency.

A bill to create a new regulator for Fannie and Freddie has been put on hold because of political debate over how much power the agency should have in forcing Fannie and Freddie to reduce the size of their mortage portfolios.