Fannie Mae Warnings Documented

By David S. Hilzenrath
Washington Post Staff Writer
Monday, March 13, 2006

A recently released investigative report attributed Fannie Mae's accounting problems in large part to two executives, but documents within the study indicate that the board and former chief executive were informed about some of the policies and practices that got the company into trouble.

In a November 2003 meeting of the board's audit committee, attended by chief executive Franklin D. Raines and his successor, Daniel H. Mudd, the company's controller spelled out a policy related to interest income that regulators have since declared invalid.

In May 2003, a presentation for the company's Office of the Chair, an executive group that included Raines and Mudd, said one of Fannie Mae's goal in implementing a new accounting rule was to "Minimize earnings volatility."

In July 2003, an internal audit report, which included Raines and Mudd on its distribution list, cited problems with Fannie Mae's accounting controls that may have affected its books by as much as $155 million.

Those warning signs came against the backdrop of an accounting scandal at Fannie Mae's direct competitor in the mortgage industry, Freddie Mac, a company with a virtually identical business model and a similar government charter to keep the housing markets supplied with money. The problems at Freddie Mac had raised widespread concerns about Fannie Mae's accounting -- concerns that Raines sought to dispel.

When a House committee convenes tomorrow to review the recent investigative study of Fannie Mae, one of the company's congressional overseers plans to ask about the conduct of the board and Raines. The company's accounting problems set in motion one of the largest ever financial restatements and an overhaul of the company's top management.

The board "perhaps did not discharge their duties sufficiently well to protect the corporation's or the shareholders' interests," said Rep. Richard H. Baker (R-La.), chairman of the subcommittee that oversees Fannie Mae and a longtime critic of the company. "I am at a loss as to how the report didn't conclude that Mr. Raines was more directly involved."

The recent investigation was conducted by a team of outside lawyers and accountants led by former senator Warren B. Rudman. It found a variety of errors and manipulations presided over by members of Fannie Mae's management -- including one instance in which the company refrained from booking nearly $200 million in estimated expenses, allegedly to maximize management bonuses. That decision was a major focus of Rudman's report and another case in which directors received information about possible accounting trouble: The audit committee was told in February 2000 that outside auditor KPMG LLP had logged an "audit difference" related to the expenses.

Robert P. Parker, a lawyer who worked on the Rudman report, said board members were told that the matter was "immaterial."

Overall, the Rudman report cited former company controller Leanne G. Spencer and former chief financial officer J. Timothy Howard as "primarily responsible" for accounting violations at the company -- a contention that both deny.

In contrast, the report, commissioned by board members at a cost of up to $70 million, said the board "endeavored" to meet its obligations but was not alerted to problems by Fannie Mae's management.

As for Raines, "we did not find that he knew" that the company's accounting departed from the rules "in significant ways," the report said.

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.