Editor's note: On Monday night, TSC's Peter Eavis received the 2005 Gerald Loeb Award for Commentary, recognizing his outstanding work uncovering and explaining accounting problems at Fannie Mae. Judges in the country's top annual awards for business journalism said Eavis "spelled out the accounting troubles at Fannie Mae long before any findings of wrongdoing were raised and dug into Fannie's financial statements finding numerous areas of concern, even going so far as to tell federal regulators where to look." Below, in chronological order, are five key columns Eavis wrote on Fannie last year.
Jan. 30, 2004: "Freddie Flap Highlights Fannie Flaw"It became sorely apparent Thursday that there is no way that Fannie Mae ( FNM) could survive the ordeal that its sibling Freddie Mac ( FRE) is going through. Freddie has fessed up to a range of accounting missteps over the past six months but still hasn't released financial statements for any period in 2003. Because of the failure to provide 2003 numbers, Freddie's regulator told the company Thursday that it must hold capital that is 30% in excess of its statutory minimum capital requirement. Freddie almost certainly already has enough capital on its books to meet the extra 30% requirement. But if Fannie were forced to do the same, it would be in dire straits, because it wouldn't have enough capital. In fact, it would have to issue at least $7 billion in stock to pad out its capital number, which, at current levels, looks precariously low. Defenders of Fannie would argue that Fannie isn't going to find itself in trouble with its regulator, the Office of Federal Housing Enterprise Oversight, because it hasn't got into any trouble over its accounting. But in the midst of the Freddie revelations, OFHEO decided it might be a good idea to conduct a probe of Fannie's accounts to see whether it was also up to no good. The investigation has only just begun. There are plenty of areas where
Capital IdeaHow do we sort our way through the numbers to show that Fannie would be reeling if OFHEO forced it to do what Freddie did? Let's start with what capital actually is. At financial institutions, capital measurements involve subtracting liabilities from assets to see how much "cushion" against shocks the balance sheet has. For government-sponsored entities such as Fannie and Freddie, there are a number of complex capital yardsticks. One key measurement OFHEO looks at is called the minimum capital requirement. This is a statutory requirement arrived at by mandating that capital must be equivalent to at least 2.5% of assets on Fannie's or Freddie's books, plus 0.45% of the mortgages they have guaranteed but don't own. In order to pass the minimum capital requirement test, Fannie and Freddie's so-called core capital has to be in excess of the minimum capital requirement. And core capital is basically assets minus liabilities, but excluding gains or losses on certain types of derivatives, which are financial instruments used to hedge against interest rate moves. So how do Fannie and Freddie's numbers stack up when it comes to these capital measures? As of Nov. 30, Freddie had a minimum capital requirement of $25.1 billion, but its core capital was well in excess of that at $33.2 billion. If we increase the minimum capital for Freddie by 30%, as OFHEO demands, the new hurdle that Freddie must meet is $32.6 billion. In other words, its core capital is over $500 million in excess of the harsher requirement. In contrast, Fannie fares very badly under this exercise. At the end of last year, Fannie said I had an estimated minimum capital requirement of $31.5 billion, exceeded by its core capital of $34.4 billion. However, if we add 30% to the minimum requirement, we get $41 billion. That is $6.6 billion over Fannie's core capital. Clearly, if Fannie finds itself in Freddie's shoes, the stock would be hammered, as investors would fear a large dilutive equity issuance to boost capital. Of course, any whiff of accounting chicanery at Fannie would already have sent the stock skidding, but fear of dilution would add to the slide.
Derivative DealingsIndeed, if both companies are found to have accounting issues, the regulators would almost certainly consider introducing new capital rules. If, as is sensible, the authorities started to require that the companies include net derivatives gains or losses in their capital reporting, Fannie would be in the ICU in minutes. Freddie might be OK, though. If we include the derivatives losses at Fannie, we arrive at a capital number that is equal to shareholders' equity, as measured under generally accepted accounting principles. At the end of last year, Fannie's shareholders' equity was $22.4 billion, a mere faction of its $1 trillion in assets. The real shocker is that Fannie would have to almost double its shareholders' equity for it to meet the $41 billion minimum capital requirement (increased by 30%). That would mean issuing over $20 billion in stock, which is over a fourth of its market value. Some defenders of Fannie might think that using shareholders' equity is unfair, because they contend that the vast majority of derivatives losses included in that capital measure will be made back in the future. Not so. First, most of the net $12 billion in net derivatives losses are
April 1, 2004. "A New Reason to Fret About Fannie"An unusual remark from Fannie Mae's ( FNM) regulator Wednesday suggests that the nation's second-largest financial institution could soon become the latest company to face accusations of accounting irregularities. The Office of Federal Housing Enterprise Oversight, which regulates government-sponsored Fannie and its smaller rival Freddie Mac ( FRE), said that a special accounting review that it is conducting of Fannie's books "may result in a restatement of prior period results and a revision of the respective capital calculations." It is extremely rare for a regulator to raise the possibility of accounting adjustments at a company if there are no grounds for suspecting restatements will have to be made. In a prepared statement, Fannie commented: "The language in the letter with respect to the OFHEO special examination straightforwardly states the fact that it is ongoing. As previously announced, OFHEO has recently retained a national accounting firm to supplement the agency's efforts and obviously has not reached any conclusions. We look forward to continuing to work with OFHEO on the examination." Last year, Freddie got into trouble for abusing its accounting to understate earnings. The scandal would have been far worse if Freddie had been overstating past numbers, because the company would've been fooling outsiders into believing that it was stronger than it really was. OFHEO has not said whether Fannie has been overstating or understating earnings, but there are several ways in which Fannie may have been
April 6, 2004 "Fannie Flap Points to Options Grants"When a regulator raises questions about a company's accounting, the stock usually gets crushed. Mysteriously, this hasn't happened to Fannie Mae ( FNM) in the wake of last week's flap over its books. But with all the worries swirling around the mortgage giant, bullish investors could be showing a bit too much confidence in management. Last Thursday, the Office for Federal Housing Enterprise Oversight (OFHEO) surprised Wall Street by saying Fannie "may not have applied the proper accounting guidance" when writing down the value of certain assets. Though the remarks were highly unusual, the market has since shrugged them off: On Monday, Fannie's stock closed at $75.05 -- which is 1% above Wednesday's closing price. Even so, it's worth noting that Wall Street often ignores the first whiff of scandal (recall Enron). And when it comes to Fannie, there is enough material in the public domain to suggest that OFHEO is right to have big doubts about the company's bookkeeping. Fannie, which throws its weight around in Washington with its lobbying efforts, is unlikely to win this battle. Fannie's numbers strongly suggest that the company wanted to avoid taking losses on certain assets. The motive may have been to ensure that 2003's per-share earnings exceeded $6.46, the level at which senior execs, including CEO Franklin Raines, get to cash in a lush options grant. The company may also have feared a big writedown in assets would strengthen the hand of politicians who want to strengthen regulation of Fannie and also Freddie Mac ( FRE), which was at the center of an accounting scandal last year for understating its earnings. At the same time, OFHEO, criticized in the past for being ineffectual and uninquisitive, is showing that it is not afraid of Fannie. Washington chatter says that the battle between Fannie and OFHEO has gotten so highly charged that it could result in Raines losing his job if Fannie is seen to be at fault. If OFHEO doesn't come up with any real dirt on Fannie after its review, OFHEO Chief Armando Falcon would be the one resigning. Investors must care because proof of accounting missteps could trigger a drawn-out process of accounting restatement at Fannie similar to the one that is occurring at Freddie, which has yet to release 2003 financials. Fannie, which holds one dollar of capital for every $45 of assets, is much more weakly capitalized than other financial institutions, which means it is much more vulnerable to shocks. If Fannie had to hold more capital during a restatement process, it would have to raise as much as $15 billion to get leverage to a reassuring level. A capital repair job of that size could involve issuing billions of dollars in stock, which would dilute existing shareholders. And regulators would almost certainly impose limits on future growth. So what is OFHEO looking at? Its review is giving Fannie's books a broad sweep, but the agency appears to have found something it doesn't like about how Fannie has valued bonds that are backed by mobile home loans, as well as other assets. Detox
Sept. 2, 2004: "Fannie Probe Turns to Derivatives"Did mortgage giant Fannie Mae ( FNM) 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