Watching Fannie Mae

Wednesday, March 1, 2006

THE COMPANY'S accounting systems were "grossly inadequate." Its practices weren't consistent with accounting principles -- and, "in many instances, management was aware of the departure." Employees in critical financial jobs "were either unqualified for their positions, did not understand their roles, or failed to carry out their roles properly." The information given to the board about all this "was incomplete and, at times, misleading."

Sound like some two-bit, fly-by-night company? Yes, but the company in question is Fannie Mae, the mortgage giant that helps finance one in every five home loans in the United States. And this unsparing assessment isn't from an irate whistle-blower or even an unhappy bureaucrat -- it's from an outside review commissioned by Fannie Mae's own board and headed by former senator Warren B. Rudman (R-N.H.). Fannie Mae's financial shenanigans don't come as a huge surprise. Indeed, it's a measure of how much was already known about the company's woes that financial markets reacted positively when the report was released last week, relieved that the Rudman team hadn't turned up even worse news. Still, it was bad enough. For example, the report finds that company executives improperly manipulated earnings in 1998, deliberately delaying taking nearly $200 million in expenses, to preserve executives' ability to collect millions in bonuses.

It's possible to see a silver lining in the report. It finds a "dramatic shift in both the 'tone at the top' and the Company's internal organization." And it said that "our suggestions for changes in corporate governance either have been implemented or are underway."

But the report also underscores the importance of having an aggressive and empowered regulator to keep an eye on Fannie Mae -- and the degree to which the current regulator, the Office of Federal Housing Enterprise Oversight (OFHEO), is not up to that job. True, OFHEO eventually found serious deficiencies in the company's operations. But it was inert for a long time while the company's accounting systems were, as the Rudman report found, "grossly inadequate." Instead, as the report described it, Fannie Mae's improper method of accounting for its huge derivatives portfolio was well known to its regulators, who didn't see the problem: "As late as June 2002 . . . OFHEO reported that the Company's implementation of [the derivatives accounting rule] had a sound basis."

Fannie Mae and its cousin, Freddie Mac, may be too big to fail, but they're also too big to be regulated this laxly. The continuing congressional failure to fix this situation is intolerable. It is "strong but good medicine," Fannie Mae chief executive Daniel H. Mudd said in a statement responding to the report. That's fine, but a tough new regulator is needed to make sure the patient keeps taking the medicine after Dr. Rudman has moved on.

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