Fannie Mae accounting shenanigans could spur more oversight.

As Fannie Mae officials reel from a series of negative headlines and brace for the possibility of long-threatened legislation aimed at putting tough curbs on its activities, published reports are pointing to serious accounting irregularities that suggest systemic problems with controls and procedures.

On September 28, the Office of Federal Housing Enterprise Oversight (Ofheo), an agency within the Department of Housing and Urban Development (HUD), published an examination report highlighting numerous problems with Fannie Mae's accounting policies, internal controls and financial reporting processes.

While HUD has not completed its investigation, its interim findings generated sufficient concern to publish the report and to bring the matter to the attention of both the Administration and Congress. The report generated numerous newspaper articles and op-ed pieces, and persuaded the House Financial Services Committee to hold hearings.

The report focuses specifically on four broad areas: a) Fannie Mae's treatment of deferred price adjustments and attempts to smooth earnings; b) its accounting treatment of derivative instruments and hedging transactions; c) the way in which it develops its accounting policies; and d) its internal controls over accounting policies and issues.

The report cited numerous examples of earnings "smoothing." HUD found that Fannie Mae management had deliberately developed and adopted accounting policies to spread estimated income or expense that exceeded predetermined thresholds over multiple reporting periods. HUD also found that Fannie Mae management had made discretionary adjustments to financial statements for the sole purpose of minimizing volatility and achieving desired financial results.

HUD found that management in 1998 had deferred recognition of a $200 million expense for multiple periods so senior management and staff could receive full performance bonuses. It also found that Fannie Mae was improperly classifying certain derivatives, enabling it to spread out losses over many years instead of recognizing them immediately. Financial accounting standards require that derivatives be carried on the balance sheet at fair value.

Changes in a derivative's fair value are required to be included in earnings, which give rise to earnings volatility. One way to address this volatility is by engaging in hedging transactions, with each derivative offset by a designated hedge. If a hedge qualifies as "perfectly effective," the potential earnings volatility disappears.

HUD found, however, that Fannie Mae engaged in countless hedging relationships that failed to qualify as "perfectly effective." Consequently, the fair value changes for those derivatives should have been recorded in its earnings. HUD further discovered that the company had applied a shortcut method for a broad range of hedge relationships where such shortcuts were inappropriate.

Policies Tied to Image?

The report also found that Fannie Mae made a concerted effort to develop accounting policies designed to provide earnings flexibility and to minimize earnings volatility. HUD believes these policies were developed to help Fannie Mae reinforce its public image as a low-risk company, and to enable senior management to meet performance expectations and therefore earn full performance bonuses.

Another criticism in the HUD report was that management failed to properly implement critical accounting policies in part due to the lack of a sound policy development framework. Fannie Mae, it concluded, relies on a few individuals to make key decisions on critical accounting policies and practices. The report also concluded that Fannie Mae relies on its external auditor, KPMG LLP, as the final arbiter of compliance with generally accepted accounting principles (GAAP). HUD believes it is Fannie Mae's responsibility to determine sound accounting policies for the organization, but the organization--specifically the Controller's Department--lacks the skills required to accomplish this.

Rep. Richard Baker (R-La.), Chairman of the Capital Markets Subcommittee of the House Financial Services Committee, has already introduced legislation aimed at tightening control over both Fannie Mae and its mortgage competitor, Freddie Mac. The "Secondary Mortgage Market Enterprises Regulatory Improvement Act" (HR. 2575) would transfer supervisory and regulatory authority over Fannie Mae and Freddie Mac from HUD to the Treasury Department.

Baker's bill would require Treasury to ensure that the enterprises operate in a financially safe manner and remain adequately capitalized. The legislation also includes operating, administrative and regulatory provisions that would: a) require public disclosure of information; b) establish an assessment authority; c) limit "non-mission" related assets; and d) establish minimum and critical capital levels.

The legislation had 20 co-sponsors by early October and could move through the House Financial Services Committee sometime early next year.

Mark Prysock ([e-mail]) is FEI's Director of Public Affairs and General Counsel in FEI's Washington, D.C., office.