ow profitable was Fannie Mae?
The answer, according to a report by its newly invigorated regulator,
is that it was as profitable as it wanted to be.
The report, released late Wednesday, essentially argues that the
accounting policies at Fannie Mae, the giant mortgage company, violated
generally accepted accounting principles and gave it far too much
flexibility in choosing how much it would report in earnings.
It is unclear whether that led Fannie Mae to overstate its profits
regularly, although the report does say that happened in 1998. Instead,
the report says that the agency sought improperly to eliminate volatility
from its earnings. In at least some cases, that meant finding ways to hide
earnings so they could be used later.
Management, the report said, "wanted to portray Fannie Mae as a
consistent generator of stable and growing earnings" and did so even
though there was really a lot of volatility in its business.
It said the company had a "dysfunctional and ineffective process" for
setting accounting policies and that internal auditors performed
"incomplete and ineffective reviews."
The report said that management had wide latitude in estimates of
crucial factors in computing its earnings, which it could use "to hit an
earnings number."
Because those same manipulated numbers were used to analyze Fannie
Mae's sensitivity to changes in interest rates, the report said, "this
practice has unfavorable safety and soundness implications that go beyond
financial reporting."
The report by the Office of Federal Housing Enterprise Oversight,
prepared with the help of Deloitte & Touche, is far from the last
word, even though it led the agency yesterday to demand that Fannie Mae
take immediate steps to address concerns about safety and soundness.
The company had told analysts that its accounting decisions were
supported by KPMG, which certified the company's books, and some analysts
voiced hope that the argument would be seen as an arcane one between
accounting firms.
A spokesman for KPMG declined to comment.
At the heart of the dispute is perhaps the most complex accounting rule
in existence, known as SFAS 133, a statement of the Financial Accounting
Standards Board. That rule requires companies to account for derivative
securities at market value but allows them to keep those changes from
affecting earnings if the derivatives are used to hedge specified
exposures.
The report concluded that Fannie Mae rode roughshod over the rules,
certifying that some hedges were "perfect hedges" when they were not, and
in other cases treated as hedges investments that did not qualify for the
treatment.
In some cases, Fannie Mae's documentation of hedges was not adequate,
and in other cases the documents were created retroactively, the report
said.
"This lack of documentation and the ability to create such
documentation retroactively is not only an SFAS 133 violation, but is
evidence of a poor control framework and is a significant safety and
soundness problem," the report said.
The accounting rule at issue is similar to Statement 39 of the
International Accounting Standards Board, which is now the subject of a
dispute in Europe. The European Commission, under pressure from banks who
fear it would cause earnings to be too volatile, is expected to allow
companies to ignore significant parts of the rule. The international board
changed several parts of its rule to make it easier to use hedge
accounting without the extensive documentation that caused part of the
problem at Fannie Mae.
For Fannie Mae, the controversy may leave it more vulnerable to
political opponents who want to reduce the benefits it receives from the
lower interest rates it commands because it could call on the Treasury for
some help if it ran into problems. The amount of such help is relatively
small, but many investors have assumed more would be available if needed,
and thus have been willing to lend money at low rates to Fannie Mae.
It may be that in making itself more attractive to stock market
investors by reporting steadily growing earnings, Fannie Mae took steps
that will damage the most important advantage it had.