Fannie Mae Warnings Documented

The Rudman report provides a glimpse of some of the discussions within the company before its accounting problems became public in late 2004.

In the November 2003 audit committee meeting, Spencer briefed directors on what she identified as a "critical accounting policy" involving how the company adjusted for changes in estimated interest income.

Regulators have since asserted that, under the policy, Fannie Mae improperly gave itself a sort of margin of error for key accounting adjustments. Though Fannie Mae considered the margin to be "the functional equivalent of zero," it sometimes exceeded $100 million and provided a way to make earnings appear less volatile, regulators said.

Four months before Spencer's briefing, an investigation of accounting violations at Freddie Mac found similar issues.

Minutes of Fannie Mae's November 2003 audit committee meeting list Raines and Mudd as attending with directors such as committee Chairman Thomas P. Gerrity, a professor of management and former dean of the Wharton School; Frederic V. Malek, chairman of Thayer Capital Partners; and Anne M. Mulcahy, chairman and chief executive of Xerox Corp. They or their representatives either declined to comment or did not respond to requests for comment for this report.

Spencer's presentation "should have at least raised red flags," said Armando Falcon Jr., former director of the Office of Federal Housing Enterprise Oversight, which regulates Fannie Mae. "An attentive audit committee should have said, 'Well, wait a minute, what does this functional equivalent of zero really mean?' "

The Rudman report says Mulcahy asked a question reflecting concern about the degree of discretion the policy gave management. Spencer's reply, Rudman concluded, is one of the instances in which the board was misled.

"Obviously, they were never told that it was a departure" from generally accepted accounting principles, Rudman said in an interview. "It's not like these issues weren't presented to management and to the board. It's that they were presented as being proper accounting practices."

Many companies have taken the position that they could let accounting errors slide as long as they did not exceed some quantitative measure. The Securities and Exchange Commission staff was so concerned about abuses of that reasoning that it issued a bulletin on the subject.

"Investors presumably . . . would regard as significant an accounting practice that, in essence, rendered all earnings figures subject to a management-directed margin of misstatement," the 1999 bulletin said.

A lawyer for Spencer, David S. Krakoff, said management made full disclosure to the company's outside auditor, which gave unqualified approval to Fannie Mae's financial statements.

On July 9, 2003, another warning came in a report by Fannie Mae's internal audit unit, the distribution list for which included Raines, Mudd and other managers.

The document said inconsistencies among various accounting systems at the company required that they be periodically "realigned," resulting in "adjustments" of as much as $45 million, and that certain assets were being misclassified, leading to a $155 million mistake.

"Controls need strengthening," the document said. It concluded that management "demonstrated a good level of awareness about control issues and has initiated timely actions to resolve these issues."

Three weeks after the internal report, Raines held a news conference to address fallout from Freddie Mac's accounting scandal and gave assurances that Fannie Mae had invested in its systems. "We have centralized our accounting, so we don't have to go all over the company to find out what the facts are," Raines said, according to a transcript.

Another hint of trouble involved Fannie Mae's accounting for financial hedges. After Freddie Mac was accused of trying to smooth earnings and get around a rule on hedge accounting called FAS 133, Raines drew a sharp contrast.

"Our two companies' approach to the earnings volatility created by FAS 133 was radically different: They tried to reduce volatility. We reported and explained the volatility," Raines said in an August 2003 statement on Fannie Mae's Web site.

However, the Rudman report quotes a slide from a presentation to the Office of the Chair three months earlier that said a goal in implementing the rule was to "Minimize earnings volatility." The report doesn't name the people who received the briefing, but at the time the Office of the Chair included Raines and Mudd.

Fannie Mae remains under investigation by the SEC, the Justice Department and OFHEO, and it is defending itself in shareholder litigation.