September 26, 2004
Reading Fannie Mae's Scary Cookbook
By GRETCHEN MORGENSON
SourceA SHOCKING exposé hit the Street last week about one of the best-loved, all-American companies: Fannie Mae, the mortgage and financial services giant. The report, written by the company's regulator, the Office of Federal Housing Enterprise Oversight, offered a litany of accounting improprieties at the company. You might call it "In the Kitchen With Fannie: How to Cook the Books for Fun and Profit."
In other words, the report cuts through all the smoke and fog the company's powerful publicity and myth machine has generated lo, these many years. Fannie Mae, the ultimate story stock, was not just a mortgage company, after all. It was the glorious institution with a mission of making the American dream of homeownership come true for millions. (Bring up the violins.)
Now, however, investors know the truth about Fannie Mae: that it is just another scheming corporation run by me-first managers. And this is only an interim report, meaning that there is more to come.
As is so often the case, the truth hurts. Fannie Mae's stock plummeted 15 percent last week, and its debt traded in a way that reflected possible rising risk at the company. Investors have clearly begun to realize that they were betrayed by the company and that an earnings restatement may be in the offing.
A Fannie Mae spokesman, Chuck Greener, said on Friday that the company's board was in discussions with the oversight office, but he declined to comment further.
While the report is a scathing rebuke to Fannie Mae, its conclusions could probably be applied to many other companies. The question is, can investors handle these truths, given how unlovely they are?
For example, will investors finally realize that no matter what management says, companies cannot produce smooth and steady earnings growth from their operations, quarter after quarter? We live in a volatile world with highs and lows, peaks and valleys. Any company that claims to produce predictable growth - and so many still do - can watch its nose grow.
INVESTORS also learned from the report that when bonuses are at risk, executives will think nothing of manipulating numbers to remove the threat. In 1998, for example, Fannie Mae was facing the possibility of having to record an expense of $400 million. Sure, the company's earnings would have been reduced if it took the expense, but more important, its executives' bonuses would be diminished. So, the company took only $200 million, and put off expensing the rest.
Abracadabra! Franklin D. Raines, the company's current chief executive, and his predecessor, James Johnson, got their bonuses.
Then there is the revelation that companies like Fannie Mae think that following accounting rules is for girlie men. The report said that when accounting arbiters changed the rules to require Fannie Mae to mark its portfolio to market - running gains and losses through its income statement except in cases where the holdings were hedged - the company had a better idea. It used less onerous hedge accounting, shifting losses to a line on its balance sheet known as "other comprehensive income." Never mind that it could not justify the move in many cases. Its goal of smooth and steady earnings growth was achieved.
Fannie Mae's regulator did not quantify how much of the company's hedges were accounted for improperly. But it did note that as of December 2003, the company recorded $12.2 billion in deferred losses relating to cash-flow hedges. If Fannie Mae has to record some or all of this against its retained earnings, which were $24.5 billion at the end of last year, its regulatory capital will suffer, the report noted dryly.
Which leads to another revelation that Fannie Mae's fans must now face: that the company is grossly undercapitalized. Its equity capital of roughly 2 percent is much lower than the 8 percent required of "A"-rated banks, according to Sean Egan of the Egan-Jones Ratings Company. "In the past Fannie has made the argument that it was very familiar with the mortgage market and therefore needs less equity," Mr. Egan said. "Our view is the lack of diversification argues for a greater level of equity."
Raising capital in this environment will be difficult, to say the least. But Fannie Mae's regulator may force the issue, said Josh Rosner, a financial services analyst at Medley Global Advisors, a policy and regulatory research firm in New York. "If a company is deemed to be unsafe or unsound, the regulator may require it to hold capital in excess of statutory required capital until the problems have been addressed on a remedial basis," Mr. Rosner said. "We don't even know how much they'd have to raise, because the alleged accounting problems mean current capital may be misstated. But they will have a significant restraint on their ability to grow for some time. That is unquantifiable."
The report's description of Fannie Mae's accounting practices raises doubts about the company's claims to efficiency and profitability, according to Bert Ely, a financial consultant at Ely & Company in Alexandria, Va. "To what extent has Fannie underestimated its cost of doing business by rolling those losses into other comprehensive income?" Mr. Ely asked. "Is this going to lead to higher costs that reduce their profitability or will they try to pass that through to homeowners as higher interest rates, which would argue against their existence?"
Another lesson from the report is that employees who speak out about misconduct at their companies are often ignored. Roger Barnes, a former employee in the controller's department at Fannie Mae, who left in November 2003, raised questions about the company's accounting. The company pooh-poohed the allegations, but regulators later found them to be "substantive.''
Also troubling is the fact that Fannie Mae's problems have implications for the entire mortgage market. One of the regulatory findings was that the company's risk controls and accounting systems were exceedingly weak and lax. Are its other systems similarly weak?
That is no small question. Most of the mortgages underwritten in the nation today use automated programs designed by Fannie Mae. "If allegations that they engineered systems for growth without regard to safety and soundness are correct, other systems, including underwriting, appraisal and loss mitigation systems should be called into question as well,'' Mr. Rosner said.
As the report makes clear, executive bonuses and smooth earnings were viewed by Fannie Mae as far more important than accurate financial statements. The report cited an internal memo written in 1999 extolling the benefits of a brand of software Fannie Mae used when trying to assess how much income or expense should be recognized on securities and loans.
The software, the memo said, allowed a user "to manipulate factors to produce an array of recognition streams," which "strengthens the earnings management that is necessary when dealing with a volatile book of business."
This nugget means that Fannie Mae is probably not alone in playing fast and loose with financial reality. That there is software out there designed to let corporate users manipulate figures to get whatever answer they desire certainly indicates that other companies want to obfuscate, too.
INDEED, that is the larger and most dispiriting lesson to be gleaned from this debacle. Sure, Fannie Mae was more arrogant than most companies; it lobbied more aggressively, slapped around its regulators and threatened any politician who had the temerity to question its favored status as a government-sponsored enterprise. But the company that comes through in the regulatory report is probably not an anomaly.
In other words, Fannie Mae is not the only cook in the kitchen. She has lots of company. And they're spoiling the broth.
Copyright 2004 The New York Times Company