Week 4 Discussion Questions 1 & 2 - Jamie Acker

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Case 5- 9 Fannie Mae The Government’s Enron (Mintz & Morris 2011)

Background

The Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan

Mortgage Corporation (Freddie Mac) are government-sponsored entities (GSEs) that

operate under congressional charters to “help lower- and middle-income Americans buy

homes.” Both entities receive special treatment aimed at increasing home ownership by

decreasing the cost for homeowners to borrow money. They do this by purchasing home

mortgages from banks, guaranteeing them, and then reselling them to investors. This

helps the banks eliminate the credit and interest rate risk as well as lengthening the

mortgage period. Fannie Mae and Freddie Mac receive advantages over commercial

banks including (1) the U.S. Treasury can buy $2.25 billion of each company’s debt; (2)

Fannie Mae and Freddie Mac receive exemption from state and local taxes; and (3) the

implied government backing gives them the ability to take on large amounts of home

loans without increasing their low cost of capital.

Fannie Mae makes money either by buying, guaranteeing, and then reselling home

mortgages for a fee or by buying mortgages, holding them, and then taking on the risk.

By selling the mortgages, Fannie Mae eliminates the interest rate risk. There is less profit

from this conservative approach than by holding the mortgages they buy. By holding the

mortgages, Fannie Mae can make money on the spread because it has such a low cost of

capital. In 1998, Fannie Mae’s holdings hit a peak of $375 billion of mortgages and

mortgage-backed securities on its own books, not to mention the more than $1 trillion of

mortgages it guaranteed. This process of holding mortgages on its books helped Fannie

Mae expand rapidly. It also stimulated unprecedented profit growth because there was

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more profit to be made by keeping the mortgages than by guaranteeing and then reselling

them to other investors.

The reasons for growth in the telecommunications sector in the 1990s were, in part, the

building of overcapacity in telecommunications equipment inventory based on the belief

the economic growth bubble of the early 1990s would never end. Fannie Mae was

similarly affected by the bubble in making and holding home mortgage loans. Just as

telecommunication companies such as Global Crossing and Qwest were motivated to

keep revenue and net income increasing quarter after quarter, the pressure also was on the

top management of Fannie Mae to keep up the pace of growth. Fannie Mae’s CEO,

Franklin Raines, was so optimistic that at an investor conference in May 1999 he

claimed, “The future is so bright that I am willing to set as a goal that our earnings per

share will double over the next five years.”

As growth pressures continued, Fannie Mae began to use more derivatives to hedge

interest rate risk. Critics looked at Fannie Mae’s portfolio and expressed concern that

with the risk involved in using derivatives, it may be at risk of defaulting. They pointed

out that unlike federally guaranteed commercial bank deposits and the partial government

guarantee of pension obligations through the Pension -Benefit Guaranty Corporation

(PBGC), there was no federal guarantee of Fannie Mae. Behind the scenes Fannie Mae

encouraged the concept that if it did default, the government would back it. This belief in

the government as a back-stop if Fannie Mae got into financial trouble raised the specter

of “moral hazard.” Moral hazard is the idea that a party that is protected in some way

from risk will act differently than if they didn’t’ have that protection. This “too big to

fail” philosophy turned out to be true later on, after the initial crisis in the 1990s, when

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the government bailed out Fannie Mae during the 2007–2008 financial crisis.

In the 1990s, Fannie Mae was growing and the market loved it. Top executives were

receiving large bonuses for the growing profits. The growth was due to increased risk but

people believed that, at the end of the day, the government would come to the rescue of

Fannie Mae if that became necessary.

The Accounting Scandal

The discovery of Fannie Mae’s accounting scandal began in 2001 when Freddie Mac

fired its auditor, (Arthur) Andersen, right after Enron’s scandal exploded and the firm’s

existence seemed untenable. Freddie Mac then hired PwC.

PwC looked very closely at Freddie Mac’s books and found it had understated its

profits in an attempt to smooth earnings. Freddie Mac agreed to a $5 billion restatement

and fired many of its top executives. Meanwhile, Fannie Mae continued on its course and

accused Freddie Mac of causing “collateral damage.” The Fannie Mae Web site even

included the statement, “Fannie Mae’s reported financial results follow [GAAP] to the

letter. There should be no question about our accounting.” To a cynic, that statement may

have had the unintended consequence of raising suspicion about Fannie Mae’s

accounting. After all, the markets had already been through it with Enron.

The government agency that regulated Fannie Mae and Freddie Mac at the time, the

Office of Federal Housing Enterprise Oversight (OFHEO), had stated days before

Freddie Mac’s restatement that its internal controls were “accurate and reliable.” Once

the restatement was made public, OFHEO had no choice but to look deeper into -

Fannie Mae’s accounting to make sure such a serious misjudgment did not happen again.

OFHEO was much weaker than most regulatory agencies such as the SEC and Justice

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Department that went after Enron in the obstruction of justice case. Fannie Mae

essentially established OFHEO in 1992 as the regulatory agency that oversaw its

operations and accounting. Fannie Mae was able to control its own regulator because it

had enough influence in Congress to have OFHEO’s budget cut. Fannie Mae had political

influence because of its connections with realtors, homebuilders, and trade groups.

Fannie Mae also made large contributions to various organizations and gained political

clout.

After the Enron debacle, the White House wanted to make sure to avoid another

scandal. The government provided the funding needed to bring in an independent

investigator, Deloitte & Touche, that uncovered massive accounting irregularities. In

September 2004, OFHEO released results of its investigation and “accused Fannie of

both willfully breaking accounting rules and fostering an environment of ‘weak or

nonexistent’ internal controls.”

The investigation focused on the use of derivatives and Fannie Mae’s deferring

derivative losses on the balance sheet, thus inflating profits. OFHEO and Deloitte

believed that the derivative losses should be recorded on the income statement. The

dispute involved the application of FAS No. 133, Accounting for Derivative Instruments

and Hedging Activities. The SEC’s chief accountant determined that Fannie Mae failed to

comply with the requirements for hedge accounting—-including FAS 133’s rigorous

documentation requirements. Fannie Mae was required by law to document its derivative

use and file with the SEC. But, “Fannie Mae’s application of FAS 133 (and its

predecessor standards, FAS 91) did not comply in material respects with the accounting

requirements” of GAAP. In particular, Fannie Mae’s practice of putting losses on the

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balance sheet rather than on the income statement resulted in overstated earnings and

excess executive compensation.

OFHEO issued a report charging that in 1998 Fannie Mae recognized only $200

million in expenses when it was supposed to recognize $400 million. The underreporting

of expenses led to earnings of $3.23 per share and a total of $27 million in executive

bonuses. These charges prompted investigations by the SEC and the Justice Department.

Two weeks after the OFHEO report and charges against Fannie Mae, the House of

Representatives Subcommittee on Capital Markets called a hearing. Raines initially

deflected criticisms by saying, “These accounting standards are highly complex and

require determinations on which experts often disagree.” Raines was quite convincing in

defense of OFHEO charges that Fannie Mae executives had manipulated earnings in an

attempt to increase bonuses. In the end, Raines won because the tone of the OFHEO

reports made it seem as though the regulator was out to get Fannie Mae.

Perhaps feeling his oats after the victory in the House, Raines demanded that the SEC

review OFHEO’s findings. On December 15, 2004, the SEC announced that “Fannie did

not comply ‘in material respects’ with accounting rules, and that as a result, Fannie would

have to restate its results by more than $9 billion.” Other than the $11 - $13 billion

WorldCom fraud, the Fannie Mae fraud has the “dubious” honor of being the next largest

fraud during the dark days of the late 1990s and early 2000s.

The OHFEO had been vindicated. The Fannie Mae board was told that both Raines and

CFO Tim Howard had to be fired. Soon after, both resigned and Fannie Mae fired KPMG

and appointed Deloitte & Touche as the new auditor. Deloitte was asked to audit the 2004

statements of Fannie Mae and reaudit previous statements from 2001.

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OFHEO Report May 23, 2006

On May 23, 2006, OFHEO issued a more extensive report of a comprehensive three-year

investigation that officially charged senior executives at Fannie Mae with manipulating

accounting to collect millions of dollars in undeserved bonuses and to deceive investors.

The fraud led to a $400 million civil penalty against Fannie Mae, more than three times

the $125 million penalty imposed on Freddie Mac for understating its earnings by about

$5 billion from 2000 to 2002 to minimize large profit swings. The $400 million is one of

the largest penalties ever in an accounting fraud case. Of this amount, $350 million will

be returned to investors damaged by the alleged violations as required by the Fair Funds

for Investors provision of SOX.

The OFHEO review involves nearly 8 million pages of documents and details what the

agency calls an arrogant and unethical corporate culture. The report, which concluded an

18-month investigation led by former senator Warren Rudman, was commissioned by

Fannie Mae’s board of directors. The final 2,600-page report charges Fannie Mae

executives with perpetrating an $11 billion accounting fraud in order to meet earnings

targets that would trigger $25 million in bonuses for top executives. The report charged

former CFO J. Timothy Howard and former controller Leanne G. Spencer as the chief

culprits. Along with former chair and CEO Franklin Raines, who earned $20 million

(including $3 million in stock options) in 2003 and $17.7 million in 2002, these

executives created a “culture that improperly stressed stable earnings growth.” Rudman

told reporters that the management team Raines hired was “inadequate and in some

respects not competent.”

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Criticisms of Internal Environment

From 1998 to mid-2004, the smooth growths in profits and precisely hit earnings targets

each quarter reported by Fannie Mae were illusions deliberately created by senior

management using faulty accounting. The report shows that Fannie Mae’s faults were not

limited to violating accounting standards but included inadequate corporate governance

systems that failed to identify excessive risk-taking and poor risk management. Randal

Quarles, U.S. Treasury undersecretary for domestic finance at the time, said in a

statement, “OFHEO’s findings are a clear warning about the very real risk the improperly

managed investment portfolios of [Fannie Mae and Freddie Mac] posed to the greater

financial system.”

Fannie Mae agreed to make these changes in its operations:

• Limit the growth of its multibillion-dollar mortgage holdings, capping them at

$727 billion.

• Make top-to-bottom changes in its corporate culture, accounting procedures, and

ways of managing risk.

• Replace the chair of the board’s audit committee. The board named accounting

professor Dennis Beresford to replace audit committee chair Thomas Gerrity.

The report also faulted Fannie Mae’s board of directors for failing to discover “a wide

variety of unsafe and unsound practices” at the largest buyer and guarantor of home

mortgages in the country. It signaled out senior management for failing to make

investments in accounting systems, computer systems, other infrastructure, and staffing

needed to support a sound internal control system, proper accounting, and GAAP-

consistent financial reporting.

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KPMG’s Audits

As for the role of KPMG as Fannie Mae’s auditors, the report alleges that external audits

performed by the firm failed to include an adequate review of Fannie Mae’s significant

accounting policies for GAAP compliance. KPMG also improperly provided unqualified

opinions on financial statements even though they contained significant departures from

GAAP. The failure of KPMG to detect and disclose the serious weaknesses in policies,

procedures, systems, and controls in Fannie Mae’s financial accounting and reporting,

coupled with the failure of the board of directors to oversee KPMG properly, contributed

to the unsafe and unsound conditions at Fannie Mae.

SEC Civil Action

The SEC filed a civil action against Fannie Mae on May 23, 2006, charging that it

engaged in a financial fraud involving multiple violations of GAAP in connection with

the preparation of its annual and quarterly financial statements. These violations enabled

Fannie Mae to show a stable earnings growth and reduced income statement volatility,

and—for the year ended 1998—Fannie Mae was able to maximize bonuses and meet

forecasted earnings. The SEC action thoroughly details a variety of deficiencies in

accounting and financial reporting. Four of the more serious situations are described

below.

Improper Accounting for Loan Fees, Premiums, and Discounts

FFAS No. 91 requires companies to recognize loan fees, premiums, and discounts as an

adjustment over the life of the applicable loans, to generate a “constant effective yield”

on the loans. Because of the possibility of loan prepayments, the estimated life of the

loans may change with changing market conditions. FAS 91 requires that any changes to

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the amortization of fees, premiums, and discounts caused by changes in estimated

prepayments be recognized as a gain or loss in its entirety in the current period’s income

statement. Fannie Mae referred to this amount as the “catch-up adjustment.” In the fourth

quarter of 1998, Fannie Mae’s accounting models calculated an approximate $439

million catch-up adjustment, in the form of a decrease to net interest income. Rather than

book this amount consistent with FAS 91, senior management of Fannie Mae directed

employees to record only $240 million of the catch-up amount in that year’s income

statement. By not recording the full catch-up adjustment, Fannie Mae understated its

expenses and overstated its income by a pretax amount of $199 million. The unrecorded

catch-up amount represented 4.3 percent of the 1998 earnings before taxes and 4.9

percent of 1998 net interest income for the fiscal year 1998.

Improper Hedge Accounting

Fannie Mae used debt to finance the acquisition of mortgages and mortgage securities

and it turned to derivative instruments to hedge against the effect of fluctuations in

interest rates on its debt costs. Application of FAS 133 required that Fannie Mae adjust

the value of its derivatives to changing market values. Critics contended that this standard

opened the door to earnings volatility, and it would appear that Fannie’s desires to create

earnings stability was used as the motivation for the application of the standards in

FAS 133.

Accounting for Loan Loss Reserve

During the period 1997 through 2003, management failed to provide any quantitative

estimate of losses in their loan portfolio, instead relying on a qualitative judgment. The

failure to establish and implement an appropriate model for determining the size of the

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loan loss reserve was a violation of the GAAP rules in FAS 5.

Fannie Mae maintained an unjustifiably high level of loan loss reserve in case it was

needed to compensate for possible future changes in the economic environment. This

violates the GAAP requirement that the estimate of loss reserves should be based on

losses currently inherent in the loan portfolio. At year-end 2002, Fannie Mae’s reserve

was overstated by at least $100 million. This overstatement resulted in a $100 million

understatement of earnings before tax, which represented 1.6 percent of the earnings

before tax and $.08 of additional earnings per share on the year-end 2002 figure of $4.52.

Classifications of Securities Held in Portfolio

FAS 115 requires the classification of securities acquired as either trading, available-for-

sale, or held-to-maturity at the time of acquisition. Rather than follow the FAS 115 rules,

Fannie Mae initially classified the securities it acquired as held-to-maturity and then, at

the end of the month of acquisition, decided on the ultimate classification.

GAAP requires that the accounting classification be made at the time of acquisition.

Once a security is classified, it can be reclassified only in narrow circumstances. Both

trading and available-for-sale securities are valued at current market value, with any

declines over time (or recaptures) in trading securities reported as a loss (or gain) in the

income statement and as other comprehensive income in the equity section of the balance

sheet for available-for-sale securities.

Postscript

On October 27, 2008, Congress formed the Federal Housing Finance Agency (FHFA) by

a legislative merger of OFHEO, the Federal Housing Finance Board (FHFB), and the

U.S. Department of Housing and Urban Development (HUD) government-sponsored

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enterprise mission team. FHFA now regulates Fannie Mae, Freddie Mac, and the 12

Federal Home Loan Banks.

The meltdown in the mortgage-backed securities market that occurred during the

financial crisis of 2007–2008 took place after the facts of this case. One can only wonder

how bad things would have been for Fannie Mae had the entity been exposed to huge

market losses in the mortgages it held in addition to the financial fraud discussed in the

case.

During the financial crisis, the market prices of many securities, particularly those

backed by subprime home mortgages, had plunged to fractions of their original prices.

That forced banks to report hundreds of billions of dollars in losses during 2008. The

business community turned its attention to the accounting standards established by FASB

for some relief. Bankers bitterly complained that the current market prices were the result

of distressed sales and that they should be allowed to ignore those prices and value the

securities instead at their value in a normal market.

At first, FASB resisted making changes, but that changed within a few days of a

congressional hearing at which legislators from both parties demanded that the board act.

FASB approved three changes to the rules, one of which would allow banks to keep some

declines in asset values off their income statements. Reluctant FASB board members

rationalized going along with this change by stating that improved disclosures would help

investors. The American Bankers Association, which pushed legislators to demand the

board make changes, praised the board stating that the “decision should improve

information for investors by providing more accurate estimates of market values.” The

change that met with the most dissent was to allow banks to write down these

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investments to market value only if they conclude that the decline is “other than

temporary.” This change will now enable banks to keep many losses off the income

statements, although the declines will still show up in the institutions’ balance sheets.

A class-action lawsuit was filed in 2005 on behalf of approximately one million Fannie

Mae shareholders who incurred losses after regulators identified pervasive accounting

irregularities at the company. Between 1998 and 2004, government investigators found,

senior executives at Fannie had manipulated its results to hit earnings targets and

generate $115 million in bonus compensation. The company had to restate its earnings,

reducing them by $6.3 billion.

In 2006, the government sued three former executives, seeking $100 million in fines

and $115 million in restitution from bonuses it maintained they had not earned. Without

admitting wrongdoing, former CEO Franklin Raines and two other members of top

management paid $31.4 million to settle the matter in 2008. In September of that year,

the federal government stepped in to rescue Fannie Mae, which was struggling under a

mountain of bad mortgages.

Costs spent defending the three former executives against the shareholder suit recently

totaled almost $100 million, according to a report in February 2012 by the inspector

general of the FHFA. Since Fannie was taken over by the government in September

2008, the inspector general said, taxpayers have borne $37 million in legal outlays on

behalf of the three executives.

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On September 21, 2012, the federal judge overseeing the class action against Fannie

Mae and its management ruled that the investors’ lawyers had not proved that former

CEO Franklin Raines knowingly misled shareholders about the company’s accounting

and internal controls, a necessary hurdle for the case against him to continue. The judge

ruled at best, evidence submitted by the shareholders showed that Raines “acted

negligently in his role as the company’s chief executive and negligently in his

representations about the company’s accounting and earnings management practices.”