Report Finds Accounting Practices That Start at the Bottom Line

By David S. Hilzenrath
Washington Post Staff Writer
Friday, February 24, 2006

It begins with a number -- say, $6.46.

That's the figure Fannie Mae was shooting for after the company set a goal in 1999 of doubling annual earnings per share by the end of 2003. For employees, incentive pay was on the line.

In another time, or another company, success might have been riding on the basics. Making and selling widgets. Or, in Fannie's case, turning mortgages into mortgage-backed securities.

But in the modern corporation, the core mission of delivering products or services can seem like a sideshow to the accounting machinations that ultimately determine the bottom line. Success or failure can come down to such financial esoterica as "back-end credit enhancements," "deferred price adjustments" and the accounting for derivatives in hedge transactions. Not to mention the way accountants interpret the phrase "at acquisition."

U.S. financial markets are supposed to be the most transparent and heavily regulated, with numbers you can trust. But as a 2,652-page report released yesterday shows, government-chartered Fannie Mae, one of the nation's largest and most scrutinized financial companies, was able to create the numbers it wanted.

"For Joe Investor, there's no way sitting here in Berkeley, California, I know whether any company is cooking the books," said Dwight Jaffee, a professor of finance and real estate at the University of California at Berkeley. Investors must rely on the auditors and the board of directors, Jaffee said.

The report, commissioned by members of Fannie's board, says the board was essentially in the dark while improper accounting was inflating Fannie's earnings by billions of dollars.

After 17 months of work, even the lawyers and accountants who labored to produce the report aren't entirely sure what happened.

But some things came across loud and clear -- like the number $6.46.

"You must be able to say it in your sleep, you must be able to recite it forwards and backwards, you must have a raging fire in your belly that burns away all doubts," the former head of Fannie Mae's internal audit unit, Sam Rajappa, said in a pep talk for internal auditors six years ago.

According to the report, Fannie Mae managers wanted to deliver the steady earnings growth that Wall Street favored. The enemy was volatility -- unpredictable fluctuations in the company's financial performance. Those could unsettle investors and force Fannie to hold more money in reserve, thereby eating into profit.

In internal memos and e-mails cited in the report, Fannie insiders refer to the "smoothing" of the numbers and the availability of an "earnings piggy bank" that can "get us to" that year's targeted number. One employee mentions that "Janet's looking for income" and later says, "If Janet needs income, looks like we might have some here."

Sometimes, the objective was to delay income until it would better serve the cause, the report indicates. Fannie wasn't another Enron Corp., trying to hide massive losses incurred by unsuccessful ventures. Its underlying business was sound but volatile. Its executives usually were looking to keep growth predictable.

Echoing earlier findings by regulators, the report describes a variety of levers managers used to help Fannie meet its targets.

First, there's the way the company handled calculations of the rate at which borrowers would prepay their mortgages, a key variable affecting the value of loans the company has on its books. Through a policy of its own creation, Fannie established a "precision threshold," a sort of margin of error within which executives allegedly gave themselves the discretion to not make required adjustments over time, the report said.

Then there's the way the company accounted for derivatives, complex financial instruments that can be used to speculate on interest rates or to hedge against sudden swings in rates. To avoid booking changes in the value of the derivatives, Fannie took a shortcut that it wasn't entitled to take, the report said. Beyond avoiding earnings volatility, the company sought to avoid substantial changes to its business or the need to develop complex new accounting systems, the report said.

Sometimes Fannie engaged in transactions to manage earnings, the report said.

For example, to depress income in 2001 through 2003, the company bought back some of its own debt, though it properly accounted for the transactions, according to the report. One executive told investigators that the then-chief executive, Franklin D. Raines, and J. Timothy Howard, then chief financial officer, determined a "budget" for buyback losses based on internal earnings forecasts, the report said.

Another example involved the company's use of mortgage insurance. Fannie Mae buys the insurance for a valid business purpose: to protect itself against losses when people default on their mortgages. But the investigation, led by Warren B. Rudman, a Republican who represented New Hampshire in the Senate, concluded that management began looking at insurance products "as a method for accomplishing earnings-related goals."

One such transaction in January 2002 was entered primarily to shift profit from 2002 into 2003 and 2004, the report said.

A Fannie executive objected that the insurance deal paid benefits on only foreclosure and therefore gave the company an incentive to foreclose on poor borrowers, the report said.

"Should we be exposing Fannie Mae to this type of political risk to 'move' $40 million of income?" the executive asked in an e-mail.

As early as 1998, the company and its outside auditor recognized that Fannie was not following the accounting rules in determining how much money to set aside as an allowance for losses on loans it held. But it didn't address the issue until 2002, the report said. Managers viewed the excess allowance as a "war chest" that could be drawn from as needed, the report said.

There's no indication that Fannie tapped the surplus to boost earnings; simply leaving it there helped the company, the report said. Reducing the allowance when the company first realized it was overstated would have boosted income -- in effect raising the bar and making it harder to meet subsequent earnings goals, the report said.

Fannie Mae said in early 2004 that it had met its five-year goal of doubling earnings. That triggered a windfall for employees who had been granted stock options that would vest if the company hit the target.