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Fannie Correction: 'What If?'

By David S. Hilzenrath
Washington Post Staff Writer
Thursday, December 14, 2006

Three years ago, Fannie Mae assured lawmakers that it had the required capital to cope with a broad variety of business setbacks.

Since 1992, "Fannie Mae has met or exceeded our capital requirements in every year," Franklin D. Raines, then its chief executive, testified in September 2003. "Indeed, we are one of the best-capitalized financial institutions in the world, when compared to the risk of our business."

As it turns out, the assurance was false.

Last week, when the giant mortgage funding company corrected years of flawed financial reports, the new numbers showed that it fell short of a key capital requirement by billions of dollars in 2002 and 2003.

Had it been apparent at the time, the $7.3 billion shortfall at the end of 2002 could have put Fannie Mae on a different trajectory. Regulators might have intervened -- as they did later, when accounting problems came to light. Wall Street might have reevaluated Fannie Mae's vaunted management, not to mention the value of its stock. And Fannie Mae might have been forced to raise additional capital or liquidate investments, sacrificing profits.

Instead, based on Fannie Mae's financial reports, the Office of Federal Housing Enterprise Oversight, which monitors Fannie Mae's financial safety and soundness, gave the company a passing grade.

"Fannie Mae's core capital of $28.079 billion exceeded the minimum capital requirement by $877 million," the agency said in early 2003.

The accounting correction Fannie Mae filed with the Securities and Exchange Commission last week offers an alternative version of history, inviting investors to roll back the tape and play it forward again without the illusions. Like all adventures in time travel, it's a matter of conjecture. The very act of traveling back in time equipped with better information might have altered the reality.

Ed Groshans, a stock analyst at Fox-Pitt, Kelton, speculated that Fannie Mae would not have allowed itself to be declared undercapitalized. If Fannie Mae executives had been forced to keep their books properly, they would have taken steps to avert a shortfall, Groshans said.

One option would have been to reduce Fannie Mae's investment portfolio, a major source of profit. In that case, investors could have seen Fannie Mae's earnings "come down fairly significantly," Groshans said. "People would have been a little bit concerned as to what was going on internally," he said.

A Fannie Mae spokesman declined to comment.

Chartered by the federal government, Fannie Mae plays a major role in the nation's housing finance system. It buys mortgages from lenders and helps lenders replenish their funds by packaging mortgages into securities for sale to investors.

Unlike some other companies caught up in accounting scandals, Fannie Mae never defaulted on its obligations. What's more, the government uses two standards to determine whether the company is adequately capitalized. Fannie Mae is required to meet both tests, and while it failed one of them, the restatement shows that it passed the other.

The test Fannie Mae failed is meant to protect "against broad categories of business risk," according to the OFHEO.

Although the company fell short, the restatement showed that Fannie Mae's financial condition improved significantly based on another measure. Total stockholders' equity rose by $15.6 billion, to $31.9 billion, as of the end of 2002 and by $9.9 billion, to $32.3 billion, as of the end of 2003. There were two main reasons. First, when it corrected its accounting, Fannie Mae showed increases in the value of financial instruments known as derivatives that were previously obscured. Second, in the restatement, Fannie Mae recorded gains on mortgage-related investments that would not have shown up unless it sold the assets.

The SEC earlier this year accused Fannie Mae of fraud. Without admitting or denying wrongdoing, the company paid a $400 million settlement. Raines and other executives who presided over the problems were replaced.

Fannie Mae still faces litigation from shareholders, and the OFHEO has threatened to sue former executives to recoup some of their compensation.

Fannie Mae's accounting corrections, which involved a multitude of additions to and subtractions from profits it had previously claimed, had the net effect of reducing the company's past earnings by $6.3 billion.

Of all the numbers Fannie Mae corrected, the capital cushion is one of the most consequential. It is meant to assure that the company can withstand a sharp financial reversal. Some policymakers fear that if Fannie Mae became insolvent, it could send shock waves through the financial system and trigger a taxpayer bailout. Raines's 2003 testimony about the company's capital position served as a counterpoint to such warnings. It came as lawmakers were considering stepping up regulation of Fannie Mae and its rival Freddie Mac.

That debate will continue when the new Congress convenes next year, lawmakers say.

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