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.
Second, it appears that Fannie may not have made its off-balance-sheet entities sufficiently remote. FAS 140 suggests strict guidelines for this. Companies transferring assets to the QSPEs are supposed to execute a legally clear-cut sale of the assets, but since Fannie doesn't typically book gains on the assets it transfers, the legal requirements many not have been fulfilled. In addition to possible accounting problems, Fannie may also have failed to properly document the assets held in off-balance-sheet trusts. That could mean that the yield on Fannie's MBS may not exactly match the underlying loans that are supposed to be in the MBS, since Fannie may have failed to classify which loans go with which securities. Of course, if Fannie's QSPE accounting isn't correct, it could in theory transfer the assets back on balance sheet and immediately reissue them with the correct accounting. But it wouldn't be as easy as that. Investors would probably demand some fee for participation in an exchange offer. Moreover, it might be extremely difficult to do because the documentation may be too slipshod to do an organized reissue. In that case, OFHEO would be best advised to demand the assets come on balance sheet until an orderly solution is found. It would have to demand sharply higher capital during that period. And since Fannie is already undercapitalized, a demand for more capital could result in Fannie being classified as severely undercapitalized and put it on an extremely shaky footing. While this may seem outlandish, it's hard to think of any alternatives. In theory, OFHEO could just order the assets on balance sheet but demand only a small capital hike. But that would be extremely risky, as it's not clear how long the assets may have to stay on balance sheet. For example, if the value of the once-off-balance-sheet assets slid in an economic downturn and Fannie was holding less capital than it should against them, the company would be horribly exposed. Clearly, the Fannie mess is nowhere close to being cleared up.