Q 15Q 15
Fannie Mae: The Government's Enron
The Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) are government-sponsored entities (GSEs) that operate under congressional charters to "help lower- and middle- income Americans buy homes." Both entities receive special treatment aimed at increasing home ownership by decreasing the cost for homeowners to borrow money. They do this by purchasing home mortgages from banks, guaranteeing them, and then reselling them to investors. This helps the banks eliminate the credit and interest rate risk, as well as lengthen the mortgage period. Fannie Mae and Freddie Mac receive advantages over commercial banks, including the following:
(1) the U.S. Treasury can buy $2.25 billion of each company's debt; (2) Fannie Mae and Freddie Mac receive exemption from state and local taxes; and (3) the implied government backing gives them the ability to take on large amounts of home loans without increasing their low cost of capital.
Fannie Mae makes money either by buying, guaranteeing, and then reselling home mortgages for a fee or by buying mortgages, holding them, and then taking on the risk. By selling the mortgages, Fannie Mae eliminates the interest rate risk. There is less profit from this conservative approach than by holding the mortgages they buy. By holding the mortgages, Fannie Mae can make money on the spread because it has such a low cost of capital. In 1998, Fannie Mae's holdings hit a peak of $375 billion of mortgages and mortgage-backed securities on its own books, not to mention the more than $1 trillion of mortgages that it guaranteed. This process of holding mortgages on its books helped Fannie Mae expand rapidly. It also stimulated unprecedented profit growth because there was more profit to be made by keeping the mortgages than by guaranteeing them and then reselling them to other investors.
The reasons for growth in the telecommunications sector in the 1990s were, in part, the building of overcapacity in telecommunications equipment inventory based on the belief the economic growth bubble of the early 1990s would never end. Fannie Mae was similarly affected by the bubble in making and holding home mortgage loans. Just as telecommunication companies such as Global Crossing and Qwest were motivated to keep revenue and net income increasing quarter after quarter, the pressure also was on the top management of Fannie Mae to keep up the pace of growth. Fannie Mae's CEO, Franklin Raines, was so optimistic that he claimed at an investor conference in May 1999, "The future is so bright that I am willing to set as a goal that our earnings per share will double over the next five years." 1
As growth pressures continued, Fannie Mae began to use more derivatives to hedge interest rate risk. Critics looked at Fannie Mae's portfolio and expressed concern that with the risk involved in using derivatives, it may be at risk of defaulting. They pointed out that unlike federally guaranteed commercial bank deposits and the partial government guarantee of pension obligations through the Pension Benefit Guaranty Corporation (PBGC), there was no federal guarantee of Fannie Mae. Behind the scenes, Fannie Mae encouraged the concept that if it did default, the government would back it. This belief in the government as a back-stop if Fannie Mae got into financial trouble raised the specter of "moral hazard." Moral hazard is the idea that a party that is protected in some way from risk will act differently than if they didn't have that protection. This "too big to fail" philosophy turned out to be true later on, after the initial crisis in the 1990s, when the government bailed out Fannie Mae during the 2007-2008 financial crisis. 2
In the 1990s, Fannie Mae was growing, and the market loved it. Top executives were receiving large bonuses for the growing profits. The growth was due to increased risk but people believed that, at the end of the day, the government would come to the rescue of Fannie Mae if that became necessary.
The Accounting Scandal
The discovery of Fannie Mae's accounting scandal began in 2001, when Freddie Mac fired its auditor, (Arthur) Andersen, right after Enron's scandal exploded and the firm's existence seemed untenable. Freddie Mac then hired PwC.
PwC looked very closely at Freddie Mac's books and found that it had understated its profits in an attempt to smooth earnings. Freddie Mac agreed to a $5 billion restatement and fired many of its top executives. Meanwhile, Fannie Mae continued on its course and accused Freddie Mac of causing "collateral damage." The Fannie Mae Web site even included the statement, "Fannie Mae's reported financial results follow [GAAP] to the letter. There should be no question about our accounting." To a cynic, that statement may have had the unintended consequence of raising suspicion about Fannie Mae's accounting. After all, the markets had already been through it with Enron.
The government agency that regulated Fannie Mae and Freddie Mac at the time, the Office of Federal Housing Enterprise Oversight (OFHEO), had stated days before Freddie Mac's restatement that its internal controls were "accurate and reliable." Once the restatement was made public, OFHEO had no choice but to look deeper into Fannie Mae's accounting to make sure that such a serious misjudgment did not happen again.
OFHEO was much weaker than most regulatory agencies such as the SEC and Justice Department that went after Enron in the obstruction of justice case. Fannie Mae essentially established OFHEO in 1992 as the regulatory agency that oversaw its operations and accounting. Fannie Mae was able to control its own regulator because it had enough influence in Congress to have OFHEO's budget cut. Fannie Mae had political influence because of its connections with realtors, homebuilders, and trade groups. Fannie Mae also made large contributions to various organizations and gained political clout.
After the Enron debacle, the White House wanted to make sure to avoid another scandal. The government provided the funding needed to bring in an independent investigator, Deloitte Touche, that uncovered massive accounting irregularities. In September 2004, OFHEO released results of its investigation and "accused Fannie of both willfully breaking accounting rules and fostering an environment of 'weak or nonexistent' internal controls."
The investigation focused on the use of derivatives and Fannie Mae's deferring derivative losses on the balance sheet, thus inflating profits. OFHEO and Deloitte believed that the derivative losses should be recorded on the income statement. The dispute involved the application of FAS 133, Accounting for Derivative Instruments and Hedging Activities. The SEC's chief accountant determined that Fannie Mae failed to comply with the requirements for hedge accounting-including FAS 133's rigorous documentation requirements. Fannie Mae was required by law to document its derivative use and file with the SEC. But "Fannie Mae's application of FAS 133 (and its predecessor standards, FAS 91) did not comply in material respects with the accounting requirements" of GAAP. In particular, Fannie Mae's practice of putting losses on the balance sheet rather than on the income statement resulted in overstated earnings and excess executive compensation. 3
OFHEO issued a report charging that in 1998, Fannie Mae recognized only $200 million in expenses when it was supposed to recognize $400 million. The underreporting of expenses led to an earnings per share (EPS) value of $3.23 and a total of $27 million in executive bonuses. These charges prompted investigations by the SEC and the Justice Department. 4
Two weeks after the OFHEO report and charges against Fannie Mae, the House of Representatives Subcommittee on Capital Markets called a hearing. Raines initially deflected criticisms by saying, "These accounting standards are highly complex and require determinations on which experts often disagree." Raines was quite convincing in his defense of OFHEO charges that Fannie Mae executives had manipulated earnings in an attempt to increase bonuses. In the end, Raines won because the tone of the OFHEO reports made it seem as though the regulator was out to get Fannie Mae.
Perhaps feeling his oats after the victory in the House, Raines demanded that the SEC review OFHEO's findings. On December 15, 2004, the SEC announced that "Fannie did not comply 'in material respects' with accounting rules, and that as a result, Fannie would have to restate its results by more than $9 billion." Other than the $11-13 billion WorldCom fraud, the Fannie Mae fraud has the "dubious" honor of being the next largest fraud during the dark days of the late 1990s and early 2000s.
The OHFEO had been vindicated. The Fannie Mae board was told that both Raines and CFO Tim Howard had to be fired. Soon after, both resigned, and Fannie Mae fired KPMG and appointed Deloitte Touche as the new auditor. Deloitte was asked to audit the 2004 statements of Fannie Mae and reaudit previous statements from 2001.
OFHEO Report of May 23, 2006
On May 23, 2006, OFHEO issued a more extensive report of a comprehensive three-year investigation that officially charged senior executives at Fannie Mae with manipulating accounting to collect millions of dollars in undeserved bonuses and to deceive investors. The fraud led to a $400 million civil penalty against Fannie Mae, more than three times the $125 million penalty imposed on Freddie Mac for understating its earnings by about $5 billion from 2000 to 2002 to minimize large profit swings. The $400 million is one of the largest penalties ever in an accounting fraud case. Of this amount, $350 million will be returned to investors damaged by the alleged violations as required by the Fair Funds for Investors provision of SOX. 5
The OFHEO review involves nearly 8 million pages of documents and details what the agency calls an arrogant and unethical corporate culture. The report, which concluded an 18-month investigation led by former senator Warren Rudman, was commissioned by Fannie Mae's board of directors. The final 2,600 page report charges Fannie Mae executives with perpetrating an $11 billion accounting fraud in order to meet earnings targets that would trigger $25 million in bonuses for top executives. The report charged former CFO Tim Howard and former controller Leanne G. Spencer as the chief culprits. Along with former chair and CEO Franklin Raines, who earned $20 million (including $3 million in stock options) in 2003 and $17.7 million in 2002, these executives created a "culture that improperly stressed stable earnings growth." Rudman told reporters that the management team Raines hired was "inadequate and in some respects not competent." 6
Criticisms of Internal Environment
From 1998 to mid-2004, the smooth growths in profits and precisely hit earnings targets each quarter reported by Fannie Mae were illusions deliberately created by senior management using faulty accounting. The report shows that Fannie Mae's faults were not limited to violating accounting standards but included inadequate corporate governance systems that failed to identify excessive risk taking and poor risk management. Randal Quarles, U.S. Treasury undersecretary for domestic finance at the time, said in a statement, "OFHEO's findings are a clear warning about the very real risk the improperly managed investment portfolios of [Fannie Mae and Freddie Mac] posed to the greater financial system." 7
Fannie Mae agreed to make these changes in its operations:
• Limit the growth of its multibillion-dollar mortgage holdings, capping them at $727 billion.
• Make top-to-bottom changes in its corporate culture, accounting procedures, and ways of managing risk.
• Replace the chair of the board's audit committee. The board named accounting professor Dennis Beresford to replace audit committee chair Thomas Gerrity.
The report also faulted Fannie Mae's board of directors for failing to discover "a wide variety of unsafe and unsound practices" at the largest buyer and guarantor of home mortgages in the country. It signaled out senior management for failing to make investments in accounting systems, computer systems, other infrastructure, and staffing needed to support a sound internal control system, proper accounting, and GAAP-consistent financial reporting.
As for the role of KPMG as Fannie Mae's auditors, the report alleges that external audits performed by the firm failed to include an adequate review of Fannie Mae's significant accounting policies for GAAP compliance. KPMG also improperly provided unqualified opinions on financial statements even though they contained significant departures from GAAP. The failure of KPMG to detect and disclose the serious weaknesses in policies, procedures, systems, and controls in Fannie Mae's financial accounting and reporting, coupled with the failure of the board of directors to oversee KPMG properly, contributed to the unsafe and unsound conditions at Fannie Mae.
SEC Civil Action
The SEC filed a civil action against Fannie Mae on May 23, 2006, charging that it engaged in a financial fraud involving multiple violations of GAAP in connection with the preparation of its annual and quarterly financial statements. These violations enabled Fannie Mae to show a stable earnings growth and reduced income statement volatility, and-as of year-end 1998-Fannie Mae was able to maximize bonuses and meet forecasted earnings. The SEC action thoroughly details a variety of deficiencies in accounting and financial reporting. Four of the more serious situations are described below. 8
Improper Accounting for Loan Fees, Premiums, and Discounts
FAS 91 requires companies to recognize loan fees, premiums, and discounts as an adjustment over the life of the applicable loans, to generate a "constant effective yield" on the loans. Because of the possibility of loan prepayments, the estimated life of the loans may change with changing market conditions. FAS 91 requires that any changes to the amortization of fees, premiums, and discounts caused by changes in estimated prepayments be recognized as a gain or loss in its entirety in the current period's income statement. Fannie Mae referred to this amount as the "catch-up adjustment." In the fourth quarter of 1998, Fannie Mae's accounting models calculated an approximate $439 million catch-up adjustment, in the form of a decrease to net interest income. Rather than book this amount consistent with FAS 91 , senior management of Fannie Mae directed employees to record only $240 million of the catch-up amount in that year's income statement. By not recording the full catch-up adjustment, Fannie Mae understated its expenses and overstated its income by a pretax amount of $199 million. The unrecorded catch-up amount represented 4.3 percent of the 1998 earnings before taxes and 4.9 percent of 1998 net interest income for the fiscal year 1998. 9
Improper Hedge Accounting
Fannie Mae used debt to finance the acquisition of mortgages and mortgage securities and it turned to derivative instruments to hedge against the effect of fluctuations in interest rates on its debt costs. Application of FAS 133 required that Fannie Mae adjust the value of its derivatives to changing market values. Critics contended that this standard opened the door to earnings volatility, and it would appear that Fannie's desire to create earnings stability was used as the motivation for the application of the standards in FAS 133. 10
Accounting for Loan Loss Reserve
During the period 1997 through 2003, management failed to provide any quantitative estimate of losses in their loan portfolio, instead relying on a qualitative judgment. The failure to establish and implement an appropriate model for determining the size of the loan loss reserve was a violation of the GAAP rules in FAS 5. 11
Fannie Mae maintained an unjustifiably high level of loan loss reserve in case it was needed to compensate for possible future changes in the economic environment. This violates the GAAP requirement that the estimate of loss reserves should be based on losses currently inherent in the loan portfolio. At year-end 2002, Fannie Mae's reserve was overstated by at least $100 million. This overstatement resulted in a $100 million understatement of earnings before tax, which represented 1.6 percent of the earnings before tax and $.08 of additional EPS on the year-end 2002 figure of $4.52.
Classifications of Securities Held in Portfolio
FAS 115 requires the classification of securities acquired as either trading, available for sale, or held to maturity at the time of acquisition. Rather than follow the FAS 115 rules, Fannie Mae initially classified the securities that it acquired as held to maturity and then, at the end of the month of acquisition, decided on the ultimate classification. 12
GAAP requires that the accounting classification be made at the time of acquisition. Once a security is classified, it can be reclassified only in narrow circumstances. Both trading and available-for-sale securities are valued at current market value, with any declines over time (or recaptures) in trading securities reported as a loss (or gain) in the income statement and as other comprehensive income in the equity section of the balance sheet for available-for-sale securities.
On October 27, 2008, Congress formed the Federal Housing Finance Agency (FHFA) by a legislative merger of OFHEO, the Federal Housing Finance Board (FHFB), and the U.S. Department of Housing and Urban Development (HUD) government-sponsored enterprise mission team. FHFA now regulates Fannie Mae, Freddie Mac, and the 12 Federal Home Loan Banks.
The meltdown in the mortgage-backed securities market that occurred during the financial crisis of 2007-2008 took place after the facts of this case. One can only wonder how bad things would have been for Fannie Mae had the entity been exposed to huge market losses in the mortgages that it held in addition to the financial fraud discussed in the case.
During the financial crisis, the market prices of many securities, particularly those backed by subprime home mortgages, had plunged to fractions of their original prices. That forced banks to report hundreds of billions of dollars in losses during 2008. The business community turned its attention to the accounting standards established by FASB for some relief. Bankers bitterly complained that the current market prices were the result of distressed sales and that they should be allowed to ignore those prices and value the securities instead at their value in a normal market.
At first, FASB resisted making changes, but that changed within a few days of a congressional hearing at which legislators from both parties demanded that the board act. FASB approved three changes to the rules, one of which would allow banks to keep some declines in asset values off their income statements. Reluctant FASB board members rationalized going along with this change by stating that improved disclosures would help investors. The American Bankers Association, which pushed legislators to demand the board make changes, praised the board stating that the "decision should improve information for investors by providing more accurate estimates of market values." The change that met with the most dissent was to allow banks to write down these investments to market value only if they conclude that the decline is "other than temporary." This change will now enable banks to keep many losses off the income statements, although the declines will still show up in the institutions' balance sheets.
A class action lawsuit was filed in 2005 on behalf of approximately 1 million Fannie Mae shareholders who incurred losses after regulators identified pervasive accounting irregularities at the company. Government investigators found that between 1998 and 2004, senior executives at Fannie had manipulated its results to hit earnings targets and generate $115 million in bonus compensation. The company had to restate its earnings, reducing them by $6.3 billion.
In 2006, the government sued three former executives, seeking $100 million in fines and $115 million in restitution from bonuses that it maintained they had not earned. Without admitting wrongdoing, former CEO Franklin Raines and two other members of top management paid $31.4 million to settle the matter in 2008. In September of that year, the federal government stepped in to rescue Fannie Mae, which was struggling under a mountain of bad mortgages.
Costs spent defending the three former executives against the shareholder suit recently totaled almost $100 million, according to a report in February 2012 by the inspector general of the FHFA. Since Fannie was taken over by the government in September 2008, the inspector general said, taxpayers have borne $37 million in legal outlays on behalf of the three executives.
On September 21, 2012, the federal judge overseeing the class action against Fannie Mae and its management ruled that the investors' lawyers had not proved that Raines knowingly misled shareholders about the company's accounting and internal controls, a necessary hurdle for the case against him to continue. The judge ruled that at best, evidence submitted by the shareholders showed that Raines "acted negligently in his role as the company's chief executive and negligently in his representations about the company's accounting and earnings management practices."
1. An eight-month investigation by OFHEO concluded that slack standards at Fannie Mae created a corporate culture "that emphasized stable earnings at the expense of accurate financial disclosures." What is wrong with having stable earnings over time? Answer this question with respect to stakeholder interests.
2. Fannie Mae's corporate governance system failed to identify excessive risk taking. Describe those risks and the mechanisms that should have been used by Fannie Mae and KPMG to enhance risk assessment. To what extent do you think the risk taking at Fannie Mae was due to moral hazard?
3. According to the case, KPMG failed to review Fannie Mae's significant accounting policies for GAAP compliance. One item in particular was the failure of Fannie Mae to make a quantitative estimate of losses on its loan portfolio. In the end, KPMG gave an unqualified (now unmodified) opinion even though the financial statements contained significant departures from GAAP. What ethical and professional standards did KPMG violate in taking that position?
1 Bethany McLean, "Fannie Mae: The Fall of Fannie Mae," Fortune , January 10, 2005.
2 With a growing sense of crisis in U.S. financial markets, Fannie Mae and Freddie Mac were placed into conservatorship and the U.S. government committed to backstop the two-government-sponsored enterprises (GSEs) with up to $200 billion in additional capital.
3 Securities and Exchange Commission, SEC Form 8-K for Federal National Mortgage Association (Fannie Mae), December 28, 2004.
4 Office of the Federal Housing Oversight, Report of the Findings to Date: Special Examination of Fannie Mae, September 17, 2004, www.ofheo.gov/media/pdf/FNMfindingstodate17septo4.pdf.
5 OFHEO, Report of the Findings to Date: Special Examination of Fannie Mae , September 17, 2004, www.fanniemae.com/media/pdf/newsreleases/FNMSPECIALEXAM.pdf.
6 Stephen Labaton and Eric Dash, "Report on Fannie Mae Cites Manipulation to Secure Bonus," New York Times , February 23, 2006, www.nytimes.com/2006/02/23/business/23cnd-fannie.htm.
7 Under Secretary Randal K. Quarles Statement on Treasury Reaction to OFHEO Report , May 23, 2006, www.ustreas.gov/press/releases/js4278.htm.
8 Securities and Exchange Commission, Case Number 1:06CV00959, Securities and Exchange Commission v. Federal National Mortgage Association , May 23, 2006.
9 Financial Accounting Standards Board, Statement of Financial Accounting Standards (FAS) No. 91 , Accounting for Non- refundable Fees and Costs Associated with Origination or Acquiring Loans and Initial Direct Costs of Leases (Norwalk, CT: FASB, 1982).
10 Financial Accounting Standards Board, Statement of Financial Accounting Standards (FAS) No. 133 , Accounting for Derivatives Instruments and Hedging Activities (Norwalk, CT: FASB, 1998).
11 Financial Accounting Standards Board, Statement of Financial Accounting Standards (FAS) No. 5 , Accounting for Contingencies (Norwalk, CT: FASB, 1975).
12 Financial Accounting Standards Board, Statement of Financial Accounting Standards (FAS) No. 115 , Accounting for Certain Investments in Debt and Equity Securities (Norwalk, CT: FASB, 1993).