How profitable was Fannie Mae?

September 24, 2004
MARKET PLACE
A Possible Case of Fudging Profit to Match Desires
By FLOYD NORRIS
Source

How profitable was Fannie Mae?

The answer, according to a report by its newly invigorated regulator, is that it was as profitable as it wanted to be.

The report, released late Wednesday, essentially argues that the accounting policies at Fannie Mae, the giant mortgage company, violated generally accepted accounting principles and gave it far too much flexibility in choosing how much it would report in earnings.

It is unclear whether that led Fannie Mae to overstate its profits regularly, although the report does say that happened in 1998. Instead, the report says that the agency sought improperly to eliminate volatility from its earnings. In at least some cases, that meant finding ways to hide earnings so they could be used later.

Management, the report said, "wanted to portray Fannie Mae as a consistent generator of stable and growing earnings" and did so even though there was really a lot of volatility in its business.

It said the company had a "dysfunctional and ineffective process" for setting accounting policies and that internal auditors performed "incomplete and ineffective reviews."

The report said that management had wide latitude in estimates of crucial factors in computing its earnings, which it could use "to hit an earnings number."

Because those same manipulated numbers were used to analyze Fannie Mae's sensitivity to changes in interest rates, the report said, "this practice has unfavorable safety and soundness implications that go beyond financial reporting."

The report by the Office of Federal Housing Enterprise Oversight, prepared with the help of Deloitte & Touche, is far from the last word, even though it led the agency yesterday to demand that Fannie Mae take immediate steps to address concerns about safety and soundness.

The company had told analysts that its accounting decisions were supported by KPMG, which certified the company's books, and some analysts voiced hope that the argument would be seen as an arcane one between accounting firms.

A spokesman for KPMG declined to comment.

At the heart of the dispute is perhaps the most complex accounting rule in existence, known as SFAS 133, a statement of the Financial Accounting Standards Board. That rule requires companies to account for derivative securities at market value but allows them to keep those changes from affecting earnings if the derivatives are used to hedge specified exposures.

The report concluded that Fannie Mae rode roughshod over the rules, certifying that some hedges were "perfect hedges" when they were not, and in other cases treated as hedges investments that did not qualify for the treatment.

In some cases, Fannie Mae's documentation of hedges was not adequate, and in other cases the documents were created retroactively, the report said.

"This lack of documentation and the ability to create such documentation retroactively is not only an SFAS 133 violation, but is evidence of a poor control framework and is a significant safety and soundness problem," the report said.

The accounting rule at issue is similar to Statement 39 of the International Accounting Standards Board, which is now the subject of a dispute in Europe. The European Commission, under pressure from banks who fear it would cause earnings to be too volatile, is expected to allow companies to ignore significant parts of the rule. The international board changed several parts of its rule to make it easier to use hedge accounting without the extensive documentation that caused part of the problem at Fannie Mae.

For Fannie Mae, the controversy may leave it more vulnerable to political opponents who want to reduce the benefits it receives from the lower interest rates it commands because it could call on the Treasury for some help if it ran into problems. The amount of such help is relatively small, but many investors have assumed more would be available if needed, and thus have been willing to lend money at low rates to Fannie Mae.

It may be that in making itself more attractive to stock market investors by reporting steadily growing earnings, Fannie Mae took steps that will damage the most important advantage it had.

Copyright 2004 The New York Times Company