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Fannie Report Details a Calculated 'Catch-Up'

By David S. Hilzenrath
Washington Post Staff Writer
Tuesday, February 28, 2006

As a vacationing Franklin D. Raines was preparing to take the helm of Fannie Mae in the summer of 1998, one of the company's top executives spelled out some stark realities for him to contemplate while "lying on the beach, jogging, looking for your ball in the rough."

The company had finished crunching profit forecasts, and it appeared that earnings per share for 1998 would fall short of two important targets: the $3.21 that Wall Street was expecting and the $3.23 that would trigger maximum funding of management bonuses, Lawrence M. Small wrote.

What happened in the next few months made headlines last week when a 2,652-page investigative study of the company's accounting problems was released. But the episode also demonstrated some of the broader problems that allowed Fannie Mae's problems to fester, according to the document. Not only did Fannie managers break accounting rules to unlock bonus payments, the report concluded, but the effectiveness of key controls also broke down.

By early 1999, Fannie had delayed booking almost $200 million of expenses, counted two years of tax credits in a single year and, on the day it closed its books for 1998, pulled $3.9 million of "miscellaneous income" from what investigators suspect was a "bucket account." It was just enough to deliver the maximum payout of $27.1 million in management bonuses.

Fannie's outside auditor, KPMG LLP, flagged the almost $200 million of delayed expenses as an "audit difference" but certified the company's books nonetheless, the report said. KPMG spokesman George Ledwith declined to comment.

The investigation, performed by former senator Warren B. Rudman and other lawyers at the firm Paul, Weiss, Rifkind, Wharton & Garrison LLP, concluded that management's disclosures to the board about the 1998 accounting maneuvers were "incomplete and misleading."

The audit committee of Fannie's board was told in 2000 that KPMG had identified delayed expenses as an "audit difference," the report said. The report, commissioned by a special committee of Fannie's board, does not say how the directors reacted to that information.

Despite the challenges Fannie Mae faces, Small was optimistic.

"For 1998, I'm reasonably confident there's enough in the 'non-recurring earnings piggy-bank' to get us to $3.21," he wrote. "Since we have generally been successful at dealing with this sort of challenge, I'm confident we'll be able to do so once again," he added.

Looking ahead to 1999, there was talk that the company might "offload" expenses to "an unconsolidated subsidiary," Small wrote.

Small, now secretary of the Smithsonian Institution, did not return calls seeking comment.

Small told investigators that his mention of a "non-recurring earnings piggy bank" was an unfortunate choice of words and probably referred to the possibility of unexpected or one-time revenue sources, such as the gain on a sale of property, the report said.

A central figure in the report's narrative of the 1998 episode is Leanne G. Spencer, Fannie's controller at the time.

Spencer and her attorney, David Krakoff, "vigorously dispute the speculative allegations" in the report, Krakoff said last week.

Spencer appears to have confronted earlier gaps in Fannie's income. Discussing the outlook for 1996 in an undated memo to then-Chief Financial Officer J. Timothy Howard, she asked rhetorically, "What do I have up my sleeve?," then went on to describe $996,000 of income that colleagues would not add to the company's books "until we told them to." The same document referred to a "bucket account" to be drawn on as an earnings "cushion."

In preparation for a September 1998 meeting with Howard, the report says, Spencer drafted a plan to reach Wall Street's number.

"Establish as priority one the goal of making $3.21 per share in 1998," Spencer's notes said. "Manage earnings to that target," the notes said.

At the heart of Spencer's proposal was an item Fannie insiders referred to as "the catch-up." As with many companies, Fannie's reported profits were largely a function of complex estimates that could be squeezed or stretched. The catch-up -- which related to changes in the value of loans Fannie owned -- was among the most important of those figures.

Although accounting rules required the company to make periodic adjustments for changing loan values, it had not done so, the report said. By the end of 1998, Fannie was more than a decade behind on the catch-up and had accumulated an unrecorded expense of $439.7 million, the report said.

KPMG had flagged the problem year after year, Spencer told investigators. In 1996, KPMG, which might not have known the full magnitude of the problem, put the figure at $103 million, the report said.

Taking the $439.7 million hit at the end of 1998 would have left Fannie's earnings far below Wall Street's estimates and wiped out annual bonuses under a company incentive plan. Instead, Spencer and Howard decided to record only $240 million of the catch-up in 1998 and to deduct the remaining $199 million from profits in future periods, the report said.

Spencer told investigators that she and Howard became "comfortable" that $240 million was the "best estimate" to record.

The investigation concluded that they arrived at the $240 million figure by working backward from Wall Street's target. The report cited a set of three "Earnings Alternatives Schedules" drafted by one of Spencer's subordinates on Jan. 7, 1999 -- after the close of the 1998 fiscal year -- showing combinations of accounting maneuvers that would enable Fannie to reach the target. One of the scenarios included $240 million of catch-up.

Raines's calendar for Jan. 8, 1999, includes an 8 a.m. "earnings alternative meeting." Spencer told investigators that the attendees included Raines, Small, Howard, and Jamie S. Gorelick, who was then vice chairman of the company and who has also served in senior positions in the Clinton administration and on the commission that investigated the 2001 terrorist attacks.

With the exception of Howard, who declined to be interviewed by the board's investigators, none of the attendees recalled seeing or discussing the "Earnings Alternatives Schedules," the report said. No one but Spencer recalled the meeting, the report said.

Spencer told investigators that at the meeting, she and Howard presented their plan to count only $240 million of catch-up. In explaining why they would leave out more than $199 million, they said the estimates were imprecise, Spencer told investigators.

Raines insisted that the company should book everything that needed to be booked, according to Spencer's account. If there were any other "elephants under the table," as Spencer put it, Raines said it was time to bring them out and clean them up.

However, Raines ultimately became comfortable with the plan to record only the $240 million, Spencer told investigators.

To further narrow the profit gap, management had another tactic, the report said. Fannie Mae had been using improper accounting for tax credits related to investments in low-income housing, and correcting that error would produce a one-time earnings boost, the report said.

As of November 1998, managers were saving the boost for 1999. In a memo, Spencer and a colleague urged Small not to tell colleagues too much about the subject because they didn't want KPMG to force them to make the change in 1998. "Technically, if you 'know' about a[n] accounting change you are supposed to book it," they wrote.

In January 1999, management decided to apply the windfall to the 1998 financial results, the report said.

That increased Fannie Mae's 1998 profit to $3.2285 per share -- enough to meet Wall Street's revised expectations of $3.22 but just short of the $3.23 needed to trigger the maximum bonuses.

Then, Fannie turned to an account containing balances that KPMG had been advising management to liquidate since 1994. Investigators suspected that this was the "bucket account" Spencer had previously cited as a "cushion."

On Jan. 9, 1999, as Fannie was closing the books on 1998, $3.9 million was moved out of the account and booked as "miscellaneous income," the report said. There was no documentation justifying the action, the report said. But it increased earnings per share to $3.2309, crossing the threshold for maximum bonuses.

In the years that followed, misuse of the catch-up became a running theme at Fannie, contributing to the billions of dollars of accounting errors that the company must now correct, investigations have found.

Howard's lawyer, Steve Salky, said last week that he and Howard "reject the report's mischaracterization of Mr. Howard's motives and conduct." In a written statement, a lawyer for Raines, Robert B. Barnett, said the former chief executive "strongly believes that, as the leader of Fannie Mae, he should be accountable for what happened within the organization, regardless of his personal involvement or fault." The investigation did not find that Raines knew Fannie's accounting departed from the rules in significant ways, the report said.

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