The Securities and Exchange Commission is months away from deciding whether Washington mortgage giant Fannie Mae will need to restate its earnings in the aftermath of a sharply critical report on its accounting practices, according to government and company officials.
Since February, the SEC's enforcement division has been probing whether Fannie Mae employed complex financial instruments called derivatives to smooth out earnings volatility, which can upset investors and affect a company's stock price. Fannie is cooperating with the informal investigation, forestalling the need for regulators to issue subpoenas. The SEC probe includes, but is not limited to, issues raised in last week's accounting report, board member Ann McLaughlin Korologos said in a statement last week.
The SEC has the power to crack down on securities fraud and to police the accuracy of financial reports that publicly traded companies file with the agency. Fannie Mae, a government-sponsored entity, voluntarily files quarterly financial statements with the SEC under a 2002 pact.
Such investigations easily can take months if not years. The SEC opened a probe of Fannie competitor Freddie Mac in June 2003. Only last month it issued a so-called Wells notice indicating the agency staff intends to pursue civil charges related to Freddie's alleged smoothing of earnings using derivatives and other methods.
In recent years, the SEC has alleged energy companies, including Dynegy Inc. and Reliant Resources Inc., manipulated earnings in part by improperly accounting for derivatives. Both companies ultimately restated earnings and settled with the SEC. Dynegy agreed to pay a $3 million civil penalty. Reliant did not pay a civil fine because it uncovered the bad conduct itself and reported the problems to the SEC.
Sources familiar with the SEC's Fannie Mae probe said it was too early to tell how serious the investigation could become. They spoke only on condition of anonymity because the review is far from complete.
But regulators and outside experts cited several, possibly substantial, violations of accounting rules highlighted in a report issued last week by the Office of Federal Housing Enterprise Oversight, which monitors the safety and soundness of Fannie and Freddie.
Manyof the problems cited by OFHEO stem from the way Fannie handled an accounting standard known as FAS 133, on accounting for derivatives. The complex standard involves more than 800 pages of guidance and it has sometimes been difficult to put into practice, said Auburn University accounting professor Arlette Wilson.
FAS 133 itself is the product of a political compromise by standards-setters, who were lobbied heavily in the late 1990s by investment banks and other companies that feared a tough standard could increase the volatility of their earnings by forcing them to report changes in the value of their derivative contracts. As a result, standards setters allowed companies under certain circumstances to avoid directly booking the fair value of derivatives on their income statements.
Fannie Mae, which makes heavy use of derivatives to guard against shifts in interest rates, allegedly did not take the proper steps to document the accounting shortcuts it took. To win the benefit of the shortcuts, experts said, companies need to fully document their accounting treatment and to consistently apply the same treatment for the lifespan of the derivative. OFHEO officials contend that Fannie did not have the required paper trail to back up many of its accounting moves.
Stephen G. Ryan, an accounting professor at New York University and the author of a book on derivatives, said that if it is accurate, OFHEO's report describes a company that was operating "outside the letter and the spirit" of accounting standards.
"To get hedge accounting, you've got to earn it," Ryan said. "Fannie Mae wanted hedge accounting but it wasn't really interested in earning it in the way FAS 133 requires, undoubtedly because it's very expensive and requires complex systems."
OFHEO also describes an alleged misuse of reserve accounts that helped release tens of millions of dollars in bonuses for Fannie officials in 1998. Accounting experts said that allegation amounts to something more serious than derivatives recordkeeping. In the past several years, the SEC has brought scores of cases related to the selective use of reserves without proper disclosure to investors.