Washington Post business columnist Steven Pearlstein was online to talk about the investigation into accounting practices at Fannie Mae.
A transcript follows.
Steven Pearlstein writes about business and the economy for The Washington Post. His columns on the economy appear every Wednesday and Friday.
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After reading the report much of the accusations about FNM sound like they should are indeed in a complex area where audit experts argue over and should have been handled by the SEC. Is this election year politics to hurt Raines and reward commercial banks?
Steven Pearlstein: In Washington, there is a political angle to most things, unfortunately. I'd say the agency realizes that the White House and the Congress and the Federal Reserve are all in the hands of people who want to reign in Fannie and Freddie, if not privatize them completely. And the agency knows that its very existence is on the line. How that affects their decision I'll leave to your judgment, and that of the SEC.
Republicans in general and this administration specifically have not tried to hide their contempt for Fannie and Freddie. Is it possible that OFHEO is pursuing a pure political agenda, one where the ultimate outcome is dissolution of the two mortgage giants?
Steven Pearlstein: Possible, yes. Not because they are Republican, however. Because any bureaucracy practices the art of self preservation.
According to the testimony of the CFO , Controller, VP of Financial Accounting, etc. KPMG was the final arbiter of Fannie Mae's compliance with GAAP, what is their liability? Also, how could a major American corporation employ such a group of unqualified officers in the accounting area and it not show up in a footnote in the annual report?
Steven Pearlstein: KPMG has a lot on the line here. You got that right.
As you note in your piece this morning the smoke and mirrors of Enron and Worldcom's accounting projected a vision of strong growth that was really a house of cards. Given the tremendous housing market of the past five years, I would have to imagine their situation is the opposite--you would expect double-digit growth.
Given the relatively small amounts mentioned in the OFHEO report, is it likely that this level of differences re: earning would have affected executive bonuses or not?
Steven Pearlstein: I am loathe to say what I'm about to say, but I think it is true. Unfortunately, the pay packages at the top of this and other big corporations are so obscenely large that, in fact, the $1.7 million bonus for former chairman Jim Johnson that supposedly propelled him to cook the books was simply not large enough to explain taking the kind of risk that could ruin his professional reputation. These guys deal in tens of millions, unfortunately. That said, I should be clearer about something than I was in this morning's column: The accounting rules give the management some wide latitude in accounting for things like the market value of derivatives. And I'm sure they make their decisions with an eye toward smoothing earnings or even making a bonus target. But that doesn't mean that the decisions are illegal or outside the hash marks of acceptability under the accounting rules. There is some room for perfectly legal games playing, which goes under the euphemism of earnings management. And then there is earnings management that is clearly deceitful and fraudulent. So it depends.
Column: What Fannie Needs Is a Strong Federal Guardian (Sept. 29, 2004)
You know it's really sad these companies are always caught after the fact.
I am certain there's a large number of people who benefited well financially of these suddenly noticed errors with the company finances.
It just amazes me how the most highly intelligent people run these companies (Harvard, Yale etc.), but yet no one discovers the money is being handled right until after the fact (suddenly intelligence comes).
They should really make these people pay....take everything from them house, car, etc., and pay back the monies with interest. Just like they would a king pin...they take everything and lock you up and when you do get out, you have to start all over again.
But, I've seen these people get compensation.(Enron people are still doing well)
No matter how you look at it...it's corruption and greed.
Steven Pearlstein: Sorry, Mr. Washington, but I think you assume that which is still to be proved, namely that they manipulated the books in an effort to disguise the true financial condition of the company. Ofheo and its contract auditors at Deloitte think so. But Fannie and its auditors seem to disagree. It will be up to the SEC to decide in the end.
I know corporate officers are tracked for insider trading. Is there any way to determine and who, if any, of the regulators traded on this "damning" information prior to it becoming public?
Steven Pearlstein: Yes, if you go to the SEC website and look under the filings made by Fannie Mae, they include notices of sales of stock or exercise of options by top executives.
I worked at Fannie Mae for three years until May of this year. With all this in the news about Fannie Mae, I remember a meeting I was in about a year ago there. In the meeting, a very senior manager was explaining our derivative strategy. I remember him stating that they were making so much money using a particular hedging strategy and that word from above (Tim Howard, CFO and person under scrutiny) wanted to maintain "smoother" earnings so as not to surprise Wall St. with unexpected increased earnings. After that, there was a sudden falloff in the use of that particular hedge. With that said, are Frank and Tim Howard likely to be goners when this is all over? The mere fact they are making tens of millions of dollars in a quasi government job seems to be too much for them to overcome.
Steven Pearlstein: Not sure they will be goners, although there will be pressure on Fannie to get this behind them by paying a fine, making some structural changes and changing some folks at the top. The big question I have is whether the board feels Mr. Howard was as thorough and candid with them as he needed to be. In talking with some folks, I wasn't able to get a clear answer on that. If he wasn't, he would have to resign. If he was and the board feels it has a defensible position on the accounting issues, then there would be no reason to throw folks overboard. The board and the top officers have already shown its good faith in that matter, however, by changing the employment contracts to make it easier to dismiss them.
Two years ago, didn't the OFHEO inform Congress that Fannie's method for implementing the new rules on derivative accounting was "reliable?" Now they're says they're all wrong.
Currently, OFHEO has hired Deloitte Touche and Tohmatsu as outside auditors while Fannie Mae has KPMG. How can no-one agree what is the General Accounting Standard? These are the Big 4 Accounting Firms... Formerly 5 while Andersen was still in existence.
Face it, Armando Falcon should just step down and resign. He's already stuck his foot in his mouth in front of Congress and succeeded in pinning the blame on Fannie Mae. He's caused the domino effect on the economy.
Steven Pearlstein: I agree this is mostly an accounting dispute in an area that is murky at best and allows for all sorts of discretion on the part of the company and its auditors. I simply cannot believe that KPMG would risk its reputation, and maybe its very existence, cow towing to Fannie Mae executives if it thought its accounting treatment of derivative instruments and mortgage premiums were way out of line. As for Ofheo and Armando, I'm not sure there is any reason for him to resign but there is a need to put a new agency in charge of regulating fannie and freddie, with more resources, sophistication and powers. Armando would certainly be one candidate to head it, but there's no reason not to open it up to others.
Former Fannie Mae employee Barnes is scheduled to testify at the October 4 hearing. From the information in the Post, it is unclear to me how he is a noteworthy witness. It appears he brought up an accounting concern that found its way to the Board--which sounds like Fannie did things right. Two days before the Board met, Barnes agreed with senior accountants that the accounting was sound and that the aberration only appeared on the micro-level, no bigger than a rounding error. When the Board met, they agreed to change to alter the accounting so that aberrations would not appear on the micro or macro level. So, from what I have read, it seems all of Barnes gripes were addressed quickly. Am I missing something? Is there something else for which he is being called to testify or is this it? If this is it, what's the problem?
Steven Pearlstein: I can't say I know any more than was in the report on that, which you have summarized a bit selectively. But even based on the information in the report, I think we can say that this was not an Enron-type situation in which the employee's complaint was shoved under the rug and the person harassed. The matter got sent up the chain and people considered it and took what they thought was the appropriate action. Now the question is whether they made the right judgment.
If the decision is to remove the top three officials at Fannie Mae and replace them with individuals outside the company, would the change in management and culture over a short period of time have a negative impact on Fannies ability to provide adequate liquidity to the mortgage market? Do you think one of the three positions should be filled by someone inside Fannie Mae? Is there anyone internally you think could handle it?
Steven Pearlstein: This is a pretty complicated business, so you need people who know what it is about. I'm not sure bringing in a whole new team at the top with no Fannie experience is a very smart idea. But you could certainly change the CEO or the vice chairman, although I'm not suggesting that. The problem with an outsider would come with the more technically oriented jobs of CFO and Chief Operating Officer. It might be that someone with alot of mortgage backed securities background from Wall Street, or even Freddie, could do it. I just don't know enough about those jobs to say.
The existence of Fannie Mae and Freddie Mac is the reason Americans enjoy 30-year mortgages with no prepayment penalties. The interest rate spread between a short-term mortgage and a government bond is about 2 points. 30-year mortgages hold about the same rates as riskless securities because Fannie and Freddie essentially turn mortgages into government bonds.
Americans celebrate this as an overall good thing, and maybe it is, but the downside is that by pushing the price of financing down the price of housing goes up. After home owners have paid as much as they can afford to buy their homes, they don't want a lot more housing built in their community that would simultaneously lower the quality of life there and reduce the value of their own home.
The lack of affordable housing is one of America's most important economic problems, and government-supported mortgages is ultimately one of its chief causes.
Steven Pearlstein: Well, you deal with a number of controversial issues. Let me try to address them.
There is a hot academic debate about how much Fannie and Freddie lower the cost of mortgages. The answer is likely something between 10 basis points and 25. That said, I'm not sure that makes a big difference in housing affordability, nor should we expect it to. Nor do I think we have a problem in the U.S. now with too little home ownership. In fact, we may have too much home ownership, due largely to the tax code, not Fannie and Freddie. In fact, the tax breaks tend to get capitalized and bid up the price of housing, which tends to make it less affordable to lower income people. So there is a perverse effect there.
The other point I'd like to make is that having Fannie and Freddie, however, does more than simply lower the interest rates on conforming loans. They have also provided a degree of standardization that has made the market more efficient. And by providing a buyer of last resort for mortgages when banks suddenly decide they don't want to hold them any more (which happens from time to time), they insure a steady supply of mortgages at interest rates that are less volatile, while at the same time making the banking system more flexible and efficient and sound. That's why I find it so odd that Alan Greenspan has waged this war on Fannie and Freddie, because without them the bank holding companies he regulates would not be safe bets as they are having this mortgage backstop available to them. But he's such a free market ideologue he simply can't stand the idea that a government-sponsored enterprise (other than the Fed) might actually improve the efficiency of markets. Its against his religion.
What are the implications of the Fannie Mae accounting issues with regard to the market value of the billions of bonds and related debt being held by municipalities and others?
Steven Pearlstein: That's a good question. One thing all the regulators involved in this need to understand is that the market for Freddie and Fannie paper is huge, with much of it held by investors around the world who, in effect, are helping to finance the U.S. current account deficit. It would not be good for anyone to unnecessarily roil that market. So far that hasn't happened, although Fannie and Freddie are paying a bit more to borrow, which we can handle.
You seem to have minimized the accounting scandal at Fannie. However, Gretchen Morgenson of the NYTimes reports "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." Isn't that rather serious?
Steven Pearlstein: No, frankly, I don't think it is. Those losses you refer to, as I understand it, aren't the kind of losses most people think when that term is used, such as operating losses. They are losses required by new accounting rules reflecting the changes in the market value of hedging instruments held by Fannie as a result of changes in interest rates and other facts. If this was a company that was actively trading those hedges all the time, the market value would be of keen interest. The fact that they hold these derivative instruments to reduce and hedge risk, with no intention of selling, makes it largely an academic exercise calculating the market values every quarter. Now having said that, I agree with those who think Fannie and Freddie should be required to hold a bigger capital cushion. That's what I'd hope a strong new regulator would do. But as I wrote today, this is not the house of cards that Ms. Morgenson and others are quick to suggest. Furthermore, I note in Ms. Morgenson's column that she quotes prominently an "expert" who is under contract withFM Watch, the organization funded by Fannie competitors that want to drive it out of business. And another analyst quotes in her column has been telling its clients to dump Fannie stock for years, and may also not be the most objective source on this.
You claim that, "Rather, they center on complex new rules that require the company to constantly re-estimate the market value of financial derivatives used to hedge its interest rate risks -- instruments for which there is no ready market and which they have no intention of selling."
Most of the deferred losses at Fannie deal with closed derivative transactions that Fannie had ALREADY SOLD AT A LOSS. What is so hard about recording the loss as incurred rather than pretending it didn't happen?
Steven Pearlstein: Nothing.
I think it might also be worthwhile to look at the broader issue of the subsidizing of home ownership that this represents. While I understand the intuitive appeal of this, I am not sure if it would stand up to proper analysis. For example, do Fannie and Freddie really help lower income people or mainly the middle class? Could not the private sector provide a similar service? Why discriminate against those who rent?
Steven Pearlstein: Those are good questions. There is some reason to encourage home ownership, subsidize if you will, in that it leads to stronger communities and allows people to build up net worth on which they can borrow in tough times. But you're right, this is mostly a middle class subsidy. Fannie and Freddie do help, however, in making mortgages more available to lower income people that most banks have traditionally shunned in the past, both by agreeing to buying those mortgages and designing credit scoring mechanisms that allow everyone to distinguish the good credit risks from the bad ones among those with limited incomes. As for discrimination against renters, you are right: whether it be Fannie and Freddie or the tax code, our system does essentially ask renters (generally a lower income group) to subsidize homeowners (a higher income group). They also force lower income homeowners to subsidize higher income homeowners, which also isn't exactly a worthy public policy goal.
You said, "it is inconceivable they could have watched what happened at Enron and WorldCom and Freddie Mac without making damn sure that the company's accounting policies were sound."
Their regulator has already said that this is bigger than what happened at Freddie. Also, you point to Fannie's board, but you did not mention that Anne Mulcahy, "the chief executive of a corporation that barely survived its own accounting scandal," has resigned from the board.
Steven Pearlstein: Sorry, no gotcha there. My point was that Ms. Mulcahy was on the board during the period in question. She only sent in her letter of resignation in the last couple of weeks, and technically, I am told, her resignation has not taken effect yet.
Silver Spring, Md.:
It seems that Fannie Mae has an effective monopoly - I don't have a sense of what the financial markets think of this situation? Would they want some tweaks to fix up the accounting or would the industry like for Fannie Mae and all of its build-in advantages broken up and given lots of competition.
As a lowly mortgage holder, it seems the current system is fairly efficient and transparent (compared to what my dad faced decade ago) but it just might be those fuzzy focus Fannie Mae advertisements.
Well, I would like them to pay taxes to DC (and a pony. I'd really like a pony)
Steven Pearlstein: Ponies are over-rated, but I think you make lots of good points.
As usual, a great column.
How do you reconcile your less-than-vitriolic take on the whole scandal with the press's numerous articles and OFHEO's scathing report?
Steven Pearlstein: Thanks. I don't have any inside knowledge here, or any great understanding of the arcane rules of accounting. Logic simply tells me that the folks at Fannie, who aren't stupid, wouldn't have been so stupid in the post-Enron era, at a time when they were literally under a political microscope, of playing fraudulent games with their accounting. These are people who like money but they value their reputations as much or more.
You said, "And don't kid yourself -- it's not just Fannie Mae. If regulators were to use the same criteria in evaluating every accounting decision at Citigroup or J.P. Morgan or GE Capital in the past six years, they surely would have found exactly the same game-playing. That doesn't excuse it, but it does put this so-called scandal in a different light."
In the OFHEO report, it is made clear that one man, Jonathan Boyles, sets the accounting policy at Fannie Mae. There are excerpts with interview with Boyles where he openly admits that some of Fannie's accounting policies did not comport with GAAP and he knew it. Do you believe that at Citigroup, JPMorgan, or GE Capital that one person sets the accounting policy and that this one person also knows that some of those policies are not in accordance with GAAP?
Steven Pearlstein: Not sure about that, Mr. Boston. But I am sure that when it comes to earnings management, Citi, Morgan and GE are in the major leagues. I think you are mixing two points.
A portion of the Fannie Mae Board accepted the OFHEO report, negotiated the Agreement and forced the senior officers to amend their compensation agreements. Has the Board now taken effective control of Fannie Mae?
Steven Pearlstein: They've ratcheted up their involvement in the company, that's for sure. Its a big place, lots going on each day, however.
The big difference between Freddie's accounting errors and Fannie's is that Freddie smoothed earnings and UNDERSTATED their value for stability. Fannie apparently cooked the books to ensure that (in 1998, I believe) top execs would get bonuses. Had they not done that, NO bonuses would have been paid to Johnson, et al.
Steven Pearlstein: All true. But please also understand that Freddie engaged in sham transactions to smooth its earnings. Nothing like that has been alleged so far with Fannie.
You say that FNMA needs stronger federal regulation to keep it from managing earnings reports. However, in the early 1980s, HUD attempted to impose a strong oversight authority over FNMA, approving every program decision. It became clear that HUD's aims were political, ie, every program change had to have a political quid pro quo (new projects in Chicago, higher minority approvals, less Congressional lobbying, etc.) This greatly impeded FNMA's earnings, and was subsequently dropped by a new administration. My question, how do you prevent political grandstanding by a federal regulator?
Steven Pearlstein: You prevent it by setting up a culture such that politicians don't screw around with it because they know there would be serious economic consequences. The Federal Reserve has done that in large part, despite Mr. Greenspan's playing footsie with the White House. The Comptroller has done it in large part. It is possible.
It seems like FNM has two battles here--the accounting difference between Deloitte/Ofheo and KPMG/Fannie and one in the court of public opinion. A NYT piece today editorial piece portrayed FNM as just another corrupt company that has been cooking the books. What are FNM's chances in the court of public opinion in this scandal ridden environment of the past few years?
Steven Pearlstein: It's chances are particularly good in the court of public opinion, because these are complicated issues and if some regulator says it smells, most people are going to assume the regulator is right. That's why I think you'll see a quick settlement here. There is probably no way Fannie can convince the public that it is right and the regulator is wrong, even if it were true.
Steven Pearlstein: Thanks, folks. See you next week, I hope.