Fannie Mae, the giant mortgage finance company, has used improper accounting methods that raise serious questions about the quality of its management and the validity of its financial reports, government regulators reported yesterday.
Though it didn't quantify the effect of what it called pervasive misapplication of accounting rules on the company's books, the report by the Office of Federal Housing Enterprise Oversight cited one instance in 1998 where the company inappropriately deferred $200 million of estimated expenses, which enabled management to receive full annual bonuses. Had Fannie recorded the expenses in 1998, no bonus would have been paid, the report said.
The report also detailed numerous transactions over several years where it said Fannie Mae management intentionally smoothed out gyrations in its earnings to show investors it was a low-risk company. Fannie "maintained a corporate culture that emphasized stable earnings at the expense of accurate financial disclosures," regulators said in a letter to the company.
Chief executive Franklin D. Raines and the board of directors were not singled out for blame, but the report criticized "a culture and environment that made these problems possible." It did name J. Timothy Howard, the company's vice chairman and chief financial officer, saying he "failed to provide adequate oversight" of key control and reporting functions and had jobs in which he both set earnings targets and then the accounting policies that could be used to meet them.
The report said company management didn't adequately investigate allegations of irregularities by a former employee, Roger Barnes, who couldn't be reached for comment last night. It said his concerns were "substantive" and his cooperation with regulators important to their examination.
The findings echo those made last year about Freddie Mac, the other large government-chartered mortgage finance company. Regulators, who launched their Fannie Mae inquiry after the Freddie Mac problems came to light, found that Fannie failed to follow the rules in accounting for complex financial instruments known as derivatives, which the company uses to hedge against movements in interest rates. Much of rival Freddie Mac's accounting problems involved accounting for derivatives.
That probe resulted in a $125 million fine and a management shake-up at Freddie Mac.
The two companies were chartered by the government to provide a steady flow of funds for home mortgages. To do that, they borrow money from investors and buy mortgages from banks and other lenders. They also package mortgages into securities for sale to investors. Together they help finance half the home mortgages in the country.
The report's findings that Fannie lacks sufficient internal controls and that its accounting policymaking is "dysfunctional" added to the regulators' concern about the company's safety and soundness.
Federal Reserve Chairman Alan Greenspan and Treasury Secretary John W. Snow have called for tougher oversight of Fannie and Freddie because they worry that, given the huge scale of their operations, serious financial troubles at the companies could put nation's financial system at risk. Though the government disavows any responsibility for the companies' debts, public and private analysts say the government could be called upon to bail them out in a crunch.
Fannie's stock price fell 6.6 percent yesterday, after the company released a statement summarizing the agency's findings, but before the agency made its 198-page report public. Shares closed at $70.69, down $4.96. The price of the company's mortgage-backed securities weakened slightly.
In response to the OFHEO findings, Fannie announced yesterday that it was setting up a panel of independent directors and hired former senator Warren B. Rudman. "The board takes the report seriously and is working with OFHEO to resolve these matters," Ann McLaughlin Korologos, the presiding director, said in a written statement. She also said the Securities and Exchange Commission has been conducting an informal inquiry "that includes issues raised in the OFHEO report."
Last year, amid the scandal at Freddie Mac, Raines said Fannie had not done anything to circumvent accounting rules. "If we had, I would have violated the law in certifying our financial results," he said.
In a brief statement yesterday, Raines did not address the substance of the regulators' findings. Instead, he pledged that Fannie's management will assist the company's outside directors in responding to the regulators "in any way we can."
"The matters detailed in this report are serious and raise concerns regarding the validity of previously reported financial results, the adequacy of regulatory capital, the quality of management supervision, and the overall safety and soundness of the Enterprise," the regulators' report said. Regulatory capital is a financial cushion the company is required to maintain against potential losses.
The report added fresh fuel to a long-running debate over the way the government regulates Fannie and Freddie. The Bush administration and some members of Congress have been pushing for legislation to tighten regulation of Fannie Mae, but those efforts stalled this year amid policy disagreements and resistance from the companies.
"Investors have been fooled, homebuyers have been cheated, and taxpayers are at risk," said Rep. Richard H. Baker (R-La.), chairman of the House subcommittee on capital markets, calling on Congress to follow through on plans to establish a stronger regulator for Fannie Mae. "Fool us once, shame on you. Fool us twice, shame on us," Baker said.
The agency, which some lawmakers have criticized as ineffective and which has long complained that it was underfunded, had historically vouched for Fannie's safety and soundness. The findings released yesterday were the product of a special review by OFHEO, which in February hired the accounting firm Deloitte & Touche LLP to assist it.
Accounting rules can be subject to different interpretations, and some stock analysts predicted yesterday, in reports to their clients, that the examination at Fannie Mae could turn into a battle of accounting experts. Fannie is audited by KPMG LLP, which declined comment yesterday.
The report said that when Fannie didn't agree with accounting standards-setters, it disregarded their guidance "and accounted for the transactions the way they had originally proposed. This sheds some light on the culture and attitude within Fannie Mae -- a determination to do things 'their way.' "
The regulators said the company will need to devote considerable resources to determine the full magnitude of the accounting errors.
In the 1998 incident questioned in the report, Fannie reported paying bonuses to the following executives: chairman and chief executive James A. Johnson, who received $1.932 million; Raines, who then was chairman-designate, received $1.110 million; Chief Operating Officer Lawrence M. Small received $1.108 million; Vice Chairman Jamie Gorelick received $779,625; Howard received $493,750; and Robert J. Levin, who was executive vice president for housing and community development, also received $493,750. The executives either could not be reached or declined comment last night.
In 1999, Raines set a goal of doubling Fannie's earnings in five years. Last year, Fannie met that goal. Employees were rewarded through special stock options pegged to the five-year goal.
Financial performance has also influenced executive compensation in other ways. For example, the size of a bonus pool for Fannie executives in 2002 was based on "an aggressive earnings per share ('EPS') growth measure that Fannie exceeded," the company said in a report filed with the SEC.
Raines received $17.1 million of compensation in 2003, plus stock options the company estimated were worth $3 million when granted. Staff writers Kathleen Day, Terence O'Hara, David A. Vise and Albert B. Crenshaw and staff researcher Richard Drezen contributed to this article.