Study Finds 'Extensive' Fraud at Fannie Mae

By Kathleen Day
Washington Post Staff Writer
Wednesday, May 24, 2006; A01

Fannie Mae engaged in "extensive financial fraud" over six years by doctoring earnings so executives could collect hundreds of millions of dollars in bonuses, federal officials said yesterday in a report that portrayed a company determined to play by its own rules.

Regulators at the Securities and Exchange Commission and the Office of Federal Housing Enterprise Oversight, in announcing a settlement with Fannie Mae that includes $400 million in penalties, provided the most detailed picture yet of what went wrong at the congressionally chartered firm.

They portray the District-based mortgage funding giant -- a linchpin of the nation's housing market -- as governed by a weak board of directors, which failed to install basic internal controls and instead let itself be dominated and left uninformed by chief executive Franklin Raines and Chief Financial Officer J. Timothy Howard, who both were later ousted.

The result was a company whose managers engaged in one questionable maneuver after another, including two transactions with investment banking firm Goldman Sachs Group Inc. that improperly pushed $107 million of Fannie Mae earnings into future years. The aim, OFHEO said, was always the same: To shape the company's books, not in response to accepted accounting rules but in a way that made it appear that the company had reached earnings targets, thus triggering the maximum possible payout for executives including Raines, Howard and others.

The settlement closes regulators' civil probe into Fannie Mae's accounting scandal, the result of the company's misstating earnings by about $10.6 billion from 1998 through 2004.

SEC Chairman Christopher Cox and acting OFHEO director James B. Lockhart III said they now will turn their focus to individuals, including Raines and Howard, to determine what role former and current executives played in the accounting fraud and if they should be forced to forfeit millions of dollars in what the regulators called "ill-gotten" compensation. They said the Justice Department is continuing a criminal probe.

"Fraudulent financial reporting cheats investors of their savings," Cox said. "Those whose actions led to the accounting fraud you've heard described today will be vigorously pursued."

Lockhart agreed. "You could argue none of it was deserved," he said in response to a question on how much of $52.8 million in bonuses Raines received during the six years might have been linked to improper accounting manipulation. As the settlement was announced, OFHEO released a 340-page report summarizing what it found in its nearly three-year probe of the company.

"The conduct of Mr. Raines, CFO Timothy Howard, and other members of the inner circle of senior executives at Fannie Mae was inconsistent with the values of responsibility, accountability, and integrity," the report said. "Those individuals engaged in improper earnings management in order to generate unjustified levels of compensation for themselves and other executives."

Raines's lawyer Robert Barnett said in a prepared statement that Raines "has repeatedly stated that he never authorized, encouraged, or was aware of violations" of accounting rules. Even so, Raines "strongly believes that, as the leader of Fannie Mae, he should be accountable for what happened within the organization, regardless of personal involvement or fault."

Howard's lawyer had no comment.

Fannie Mae agreed to the settlement with the SEC and OFHEO without admitting or denying guilt. The company is in the midst of trying to create accurate accounting records for the years in question, an undertaking that is costing it hundreds of millions of dollars.

The agreement requires the company to invest in up-to-date computer technology and human expertise. It bars the company from growing one of its most profitable but risky business lines, that of buying and holding home loans for its own investment portfolio.

It also requires Fannie Mae to review the conduct of former and current executives. That includes its current chief executive, Daniel H. Mudd, and current Chairman Stephen B. Ashley. Both were on the board of the company during the six years when the accounting problems occurred.

And the company must specifically consider retroactively firing Raines and Howard, a change in status that would deprive them of millions of dollars in compensation. At the end of 2004, in the wake of an embarrassing SEC ruling that Fannie Mae's accounting was wrong, the board pressured Raines and Howard to leave. Raines was allowed to retire and Howard to resign, preserving severance packages for the two.

The OFHEO report is the second in recent months to criticize the company's management, but it goes substantially beyond the first study, which was commissioned by the board of directors, which hired Warren B. Rudman, a former Republican senator from New Hampshire, to write it. Where Rudman, applying a stricter legal standard, found only one year in which earnings were manipulated to trigger bonuses, OFHEO, using a looser burden of proof, concluded that the company consistently arranged its books to hit earnings-per-share targets almost to the penny.

The company's consistent performance was not an "uncanny coincidence," investigators wrote, but a product of executives willing to dip into "cookie jar" reserves to make up a shortfall, then push excess earnings off into the future as a cushion for the next bonus cycle.

The Rudman report essentially absolved the board from blame, saying most directors relied on lawyers and accountants who misled them. In contrast, OFHEO's report says the board was responsible for creating a system that allowed them to be misled by giving Raines and Howard too much power.

Rudman said OFHEO's report and his agree on the facts. "Their comments on the tone at the top, the arrogance of the corporation, tracks with what we said," Rudman said. "The two reports don't disagree that the board was at times misled, either intentionally or unintentionally, and was given bad information."

OFHEO concludes that the board actually helped create the problems by failing to act independently of Raines and Howard and by failing to correct accounting and internal control problems even after similar problems emerged in 2003 at Freddie Mac, which eventually paid $125 million in penalties to OFHEO to settle charges of accounting fraud.

The report cites example after example of transactions that it says Fannie Mae made solely to push earnings up or down to meet profit targets expected by Wall Street. The two transactions with Goldman Sachs in 2001 and 2002, for example, had no economic purpose beyond manipulating earnings and that purpose was not clearly articulated to investors, the report said. In a prepared statement, a Goldman Sachs spokesman disagreed with that conclusion.

Mudd said yesterday that in retrospect he should have done some things differently but that in general he felt he acted appropriately. Ashley, in a conference call with investment banking analysts, said the board supports Mudd.

Thomas P. Gerrity, a Fannie Mae director and chairman of its audit committee for the past seven years, last week said he would step down from the board at year's end.

The OFHEO report also included a new, detailed account of the actions taken by Raines and other insiders, including current chief executive Mudd, to thwart OFHEO's investigation. For example, Fannie Mae tried to insert language into an appropriations bill to cut the agency's budget until then-OFHEO Director Armando Falcon Jr. was replaced, it said.

Mudd, who was promoted to chief executive after Raines resigned in 2004, was criticized in the report for not taking more steps to address internal control problems when he became aware of them.

"This report . . . is strong medicine," Mudd said yesterday. "It is what Fannie Mae needed, and strong medicine is certainly what we received today."

Staff writers Annys Shin and Terence O'Hara contributed to this report.

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