Fannie Mae, the giant mortgage finance company, yesterday agreed to stop using accounting methods that its regulator criticized last week and to raise billions of dollars of additional capital as a cushion against potential losses.
The agreement with the Office of Federal Housing Enterprise Oversight also calls for Fannie Mae to begin addressing management problems, including reviewing the role of its chief financial officer, J. Timothy Howard. His multiple responsibilities put him in a position to set financial targets and influence the way the company met them, regulators said in a report last week.
Yesterday's agreement said Fannie would appoint an independent chief risk officer, a post now held by Howard, and assure the independence of the internal auditor, whose performance is now reviewed by Howard.
Fannie, based in the District, neither admitted nor denied wrongdoing in the agreement, which was negotiated by and will be monitored by independent board members. OFHEO's report accused the company of manipulating accounting to achieve desired financial results, tolerating weak financial controls, ignoring a whistle-blower and permitting a culture that made the problems possible.
The agreement left the fate of company management, headed by chairman and chief executive Franklin D. Raines, under review. In a letter to Fannie Mae directors last week, OFHEO Director Armando Falcon Jr. said that he doubted management's ability to bring about the "broad cultural and operational changes" needed at the company and that he was "prepared to act if the Board does not."
The company and its smaller, McLean-based rival, Freddie Mac, play a major role in the mortgage business, borrowing money from investors to buy mortgages from lenders such as banks and savings and loans. The companies, chartered by the government to assure ready availability of funds for home buyers, also package mortgages as securities for sale to investors.
Under yesterday's agreement, Fannie Mae agreed to change the way it deals with two accounting issues. Fannie will change the way it accounts for derivatives, complex financial instruments used to hedge against shifts in interest rates. The company also agreed to discontinue what regulators described as a financial cookie jar that the company kept on hand to dip into as needed and smooth over fluctuations in results.
While committing to correct its accounting methods in future financial reports, the company also agreed to calculate the impact such changes would have on previously issued financial statements. Corinne Russell, an OFHEO spokeswoman, said the Securities and Exchange Commission will decide whether past financial statements must be corrected.
The agreement "doesn't mean that the company is at all out of the woods," said Charles M. Elson, who heads a corporate governance program at the University of Delaware. "This is just really the beginning of a long inquiry into what happened," Elson said.
The company faces an ongoing review by OFHEO into additional accounting issues, a probe by the SEC, an Oct. 6 congressional hearing, and an investigation by a committee of outside board members who hired former senator Warren B. Rudman. Rudman helped lead the Senate's investigation of the Iran-contra affair in the 1980s and has since conducted a number of corporate investigations.
Investors reacted positively to the agreement yesterday, sending Fannie Mae's stock up 99 cents, or 1.5 percent, to $66.50. Last week, investors drove Fannie's stock down 15.2 percent to a 52-week low of $65.51.
Michael Yarian, senior government agency bond trader at Barclays Capital in New York, said the bond market's initial concerns over Fannie's future appear to have eased. "There is no sense of impending doom in the market," Yarian said. "Fannie Mae has been very above board and gone out of their way to cooperate" with regulators. "No one believes that Fannie is going into any sort of liquidity crisis."
Some Wall Street stock analysts were less positive, however. Prudential Equity Group LLC downgraded Fannie's stock to a "neutral" rating, saying the requirement that Fannie set aside more capital could slow the firm's growth. Morgan Stanley downgraded Fannie from "overweight" to "equal weight."
One of the key elements of the agreement calls for Fannie to increase the amount of capital it keeps on hand within nine months to 30 percent more than the minimum it has been required to maintain. As of March 31, Fannie was required to hold $31.354 billion of capital, which it exceeded by $4.347 billion, or 13.9 percent, OFHEO reported. Based on the March numbers, Fannie would have to increase its capital by about $5.1 billion.
Correcting Fannie's derivatives accounting for past years could alter reported earnings by billions of dollars, the OFHEO report said.
Wall Street analysts who follow Fannie Mae said they did not believe the firm would have trouble raising the capital. To do so, Fannie Mae could issue new stock, reduce its dividend, sell current assets from its portfolio of mortgages, or slow growth by reducing the rate at which it purchases mortgages from lenders.
Several analysts said Fannie Mae would probably choose to sell assets or reduce growth, in part because selling stock would require the firm to warn investors that its current financial statements are under review and may have to be restated. Issuing more stock could also further harm Fannie's share price.
Standard & Poor's analyst Michael T. DeStefano said in an interview that Fannie Mae could also reduce the amount of stock it buys back from investors. "Their financial flexibility is very strong," he said. "This is a very manageable thing for them to achieve."
Regulators began a special review of Fannie's accounting late last year after an investigation of Freddie Mac concluded that Freddie had used elaborate maneuvers to circumvent accounting rules and make its earnings appear smoother than they really were. The scandal at Freddie cost several top executives their jobs, including two chief executives forced out in rapid succession.
Since the disclosures about Freddie Mac, Raines had assured investors that Fannie Mae followed accounting rules.
But OFHEO's examination concluded otherwise. In 1998, regulators allege, Fannie improperly postponed booking $200 million of expenses, enabling Raines and other top executives to receive millions of dollars of bonuses that were pegged to the company's financial performance.