Fannie Mae Made
$1.1 Billion Error
In Its Accounting
Understatement of Equity Renews Calls
For Oversight of Two Mortgage Giants
By PATRICK BARTA and JOHN D. MCKINNON
Staff Reporters of THE WALL STREET JOURNAL
Fannie Mae, the mortgage-financing giant already facing a crescendo of criticism about its financial oversight, said it miscalculated the value of its mortgage commitments, forcing it to make a $1.1 billion restatement of its stockholder equity.
The government-chartered company, which bills itself as the world's largest nonbank financial institution, released a revised third-quarter financial statement Wednesday correcting what it called "computational errors" that appeared when the results were first reported earlier this month. The restated figures were higher and didn't alter the company's profit, which was $2.67 billion in the third quarter, up 168% from a year earlier.
But the episode instantly reinforced fears that Fannie Mae and its smaller sibling Freddie Mac lack the necessary skills to operate their massive and complex businesses, which some investors, rivals and political critics worry could pose risk to the nation's financial system if not properly managed. Though the companies are not formally backed by a government guarantee, investors generally assume the government would step in to bail the companies out in an emergency, given their critical importance to the housing and broader financial markets.
Spreads between most Fannie Mae debt issues and comparable Treasury securities widened Wednesday. Investors pummeled the stock after the news was announced, though the stock recovered some ground by the end of the day. In 4 p.m. New York Stock exchange composite trading, Fannie Mae's shares were down 2.4% at $73.10.
Lawmakers and Treasury officials were already debating whether to tighten oversight of Fannie and Freddie after Freddie Mac disclosed its own accounting problems earlier this year. Freddie Mac's problems, which involved understating income by at least $4.5 billion, led to a major management shake-up, including the ouster of two chief executive officers. Freddie Mac used financial transactions to shift excess earnings into the future and mask the company's volatility.
Both companies "have a credibility problem, and this only makes it worse," said James Bianco, president of Bianco Research LLC, a Chicago-based investment-research firm who has been critical of the two companies. He said it highlights how too few people have a firm grasp on Fannie Mae's arcane accounting and overall financial position, even as Wall Street analysts continue to tout the company's stock. "Investors look at this stuff, throw their arms up in the air [and say], 'We don't understand this stuff, you don't understand this stuff, and the companies don't understand this stuff, but it doesn't matter, because the government is going to back it anyway.' "
Fannie Mae had previously argued that it had a far better lock on its accounting than Freddie Mac, hoping to cast itself as a more responsible and sophisticated operation that didn't need much more scrutiny. Fannie Mae went so far as to hold an accounting "tutorial" earlier this month to explain derivatives accounting to investors, analysts and reporters. Yet it was in derivatives accounting that its stumble came.
Company officials asserted Wednesday that the errors didn't portend any deeper financial troubles at the company but were simply mistakes made while implementing a complicated new accounting rule that took effect for the third quarter. Fannie Mae spokeswoman Janis Smith said the company had not yet developed computer systems to implement the rule, which in this quarter involved calculating the value of some 170,000 mortgage commitments. As a result, she said the company had to do the calculations by hand. "It was literally just human error in doing the calculations," she said. The calculations were off by about $1.3 billion, but the total effect on stockholder equity was just over $1.1 billion.
The company said it found the mistakes while reviewing its public financial statements for the third quarter before filing them with the Securities and Exchange Commission.
Fannie Mae's announcement underscores the increasing complexity of its business and the accounting rules that apply to it. Created by the government in the 1930s to boost the U.S. mortgage market, Fannie Mae today is a publicly traded, government-sponsored institution with a $900 billion portfolio of mortgages bought from lenders so they can make more loans. As Fannie Mae has sought to boost its returns for shareholders, and as the business has rapidly grown, so too have the concerns about complexity and risk.
Among other things, Fannie Mae -- like Freddie Mac -- must now rely on billions of dollars of financial contracts known as derivatives to hedge the risks associated with its mushrooming portfolio. Such hedges are necessary to guard against sudden swings in interest rates, which can dramatically alter the profitability of the companies' mortgages. But the derivatives can introduce risks of their own, adding volatility to the companies' earnings.
The company's regulator, the Office of Federal Housing Enterprise Oversight, released a terse statement from Director Armando Falcon Jr., saying that Fannie Mae's error underscored the need for a closer examination of the company's overall accounting practices that OFHEO is "about to begin." Some observers suggested that the overloaded agency would have to speed up that review, on top of its investigation into Freddie Mac's problems.
Fannie and Freddie critics were quick to seize on the latest snafu to push for legislation to stiffen the government's oversight.
"Here we go again," said Rep. Richard Baker, a Louisiana Republican and longtime critic of the two companies. "Here's Fannie, just like Freddie, after announcing a bigger than $1 billion accounting error, asking us to believe it's no big deal. Nevertheless, I hope they'll excuse me if I'm more than just a little bit concerned about this. ... Before something calamitous occurs, Congress must demand professional oversight to give us the straight facts about these companies' books."
Sen. Richard Shelby, an Alabama Republican and chairman of the Senate Banking Committee, was also critical. "It is always a concern when a public company's accounting function breaks down and the public receives incorrect information," he said, adding that the committee is seeking "a full briefing" from OFHEO and vowing to continue work on "legislation to create a stronger" oversight body.
That legislation ran aground after the politically powerful companies and their allies persuaded Congress to resist the Bush administration's demand that the Treasury Department be given broad new authority over the companies' new ventures and their financial safety and soundness. The administration responded by blasting the proposal Congress was considering. Negotiations appear to have stalled, and action remains unlikely this year. OFHEO is currently part of the Department of Housing and Urban Development.
Fannie and Freddie critics suggested that the new disclosures could improve the bill's chances, if not this year then next. Pressure on the securities of both Fannie and Freddie had appeared to help bring them to the table to negotiate on legislation this fall, according to many observers.
"This is going to give new ammunition to the people who want to pass legislation, and they don't need a whole lot of additional ammunition," said David John, a fellow at the conservative Heritage Foundation in Washington. "They're really nervous about what any shaking of confidence in Fannie and Freddie will mean to the housing market. If housing runs into problem then the whole recovery is brought into question. There is some level of urgency."
Others were more skeptical, however. "I still think Congress is going to get out without doing anything this year," said Guy Cecala, publisher of Inside Mortgage Finance. "Will this blow over by next year? Probably unless they find more problems."
Fannie Mae insisted that its problem did not bespeak any serious failings of its internal controls. The problem was tied in part to an obscure accounting provision, known as Financial Accounting Standard 149, that supplemented a previous and highly controversial rule requiring companies to record quarterly changes in the value of their derivatives.
As part of its normal business, Fannie Mae makes commitments to buy mortgages from lenders, who deliver the loans some 60 or 90 days later. This process is what allows consumers to lock in interest rates long before they actually close a loan. But under FAS 149, Fannie Mae must treat its mortgage commitments as derivatives, and hence record any unrealized changes in value of those commitments despite whatever price the company agreed to pay for the loans. Those values count toward the company's stockholder equity -- defined as the total value of a company once its liabilities are subtracted from its assets, making it an important metric used by some investors to determine the worth of a company.
Ms. Smith, the Fannie Mae spokeswoman, said the error was discovered after the company went back through the numbers before filing statements with the SEC. "We have an obligation to disclose errors as they become known, and that's what we've done today," she said.
The way Fannie Mae disclosed its problems Wednesday drew some criticism, however. Investors got their first inkling of trouble at around 12:40 p.m., when the press-release wire service Business Wire sent out a notice indicating that Fannie Mae intended to restate its mid-October earnings release. Within an hour and a half, investors began to sell the stock in droves. At around 2:20 p.m., Fannie Mae issued a more-detailed press release that reassured investors that the company wasn't about to dramatically alter its third-quarter profits, instead changing its stockholder equity, and the stock began to recover.
Some complained that the lag between the first statement and the later one caused mass confusion in the marketplace, and possibly even created buying opportunities for people who knew the full extent of the company's troubles. A Fannie Mae spokesman said the initial statement was released by mistake by Business Wire, which didn't respond to a request for comment.
Write to Patrick Barta at patrick.barta@wsj.com1 and John D. McKinnon at john.mckinnon@wsj.com2
URL for this article:
online.wsj.com |
