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Watch out for the hurricane named Fannie
The Street.com
The Fannie Mae mess is one for the books
By Peter Eavis 9/30/2004
Fannie Mae, the government-sponsored mortgage company whose financial statements were strongly criticized in a report by its regulator last week, looks set to join Enron and WorldCom in the hall of accounting infamy.
Lining up Fannie Mae (FNM, news, msgs) alongside two of America's worst corporate fraud offenders may seem a stretch to some. But a close reading of the report suggests that Fannie could have kept billions of dollars of losses out of earnings -- as well as out of an important capital number that is used by its regulator to determine the company's financial strength.
WorldCom is thought to have hidden around $11 billion of expenses to boost its earnings. But it's possible that Fannie, which provides huge support to the U.S. housing market through billions of dollars of mortgage purchases each year, overstated the capital number by more than that. For example, at the end of last year, the capital number in question may have excluded as much as $11.6 billion in pretax net losses.
Implications for the housing industry
If Fannie did fail to include those losses in earnings and capital, it would have drastic ramifications for the company, investors and the structure of the U.S. housing industry. Fannie may have to raise far more new capital than Wall Street currently is estimating, leading to a further decline in Fannie's stock. The Office of Federal Housing Enterprise Oversight (OFHEO) and Fannie announced Monday that Fannie must immediately go about raising its capital to 30% above its required level, but the final amount may be far higher. Check out your options.
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Any evidence of large-scale fraud would almost certainly cause politicians to much more aggressively regulate Fannie and rival Freddie Mac (FRE, news, msgs), which revealed accounting irregularities of its own last year, though they appear to be of a less serious nature than Fannie's.
Fannie declined to comment, and its regulator, the OFHEO, didn't respond to a request for comment.
The OFHEO decided at the end of last year to carry out a probe of Fannie's accounting after the accounting chicanery at Freddie surfaced. The probe isn't yet completed, which means there could be more unpleasant findings at Fannie.
The OFHEO hasn't detailed the scale of any restatement that Fannie may need to make. Instead, the regulator has asked the company to conduct a thorough review to quantify how much its financial statements may be off.
Well before Freddie's accounting issues came out, this column had been raising questions about Fannie's accounting and its management team, led by CEO Franklin Raines, an extremely influential Washington insider.
Billions in losses on derivatives
The OFHEO report mainly alleges that Fannie didn't apply two accounting rules correctly. The real bombshell to come out of the probe, conducted in conjunction with accountants at Deloitte & Touche, is the assertion that Fannie incorrectly accounted for large amounts of derivatives, which are financial instruments that Fannie uses to insure, or "hedge," against adverse interest rate movements.
Potentially billions of dollars of losses on these derivatives may not have been properly factored into its earnings or core capital, which is a specially calculated measurement of financial strength.
Here's the alleged irregularity. The OFHEO says that Fannie incorrectly excluded changes in the value of certain derivatives from earnings and core capital. Changes in the value of derivatives can be excluded from both numbers only if certain conditions are met.
The OFHEO says that Fannie's derivatives often failed to meet those conditions. If a derivative doesn't meet those conditions, its change in value, or at least a portion of its change in value, gets recorded in a balance sheet account called other comprehensive income, or OCI.
There is no sure way for an outsider to concretely determine the dollar total for the derivatives that Fannie allegedly should not have excluded. However, given that the OFHEO's report suggests that Fannie's derivatives accounting was endemically bad, analysts have taken the step of factoring into core capital all the derivatives losses stored up in OCI, and offsetting those with some gains that would occur if Fannie did that.
At the end of last year, there were $18.8 billion of pretax derivatives losses in OCI, offset by an estimated $7.2 billion of gains, producing estimated pretax net losses of $11.6 billion, or $7.5 billion after tax.
Given the sharp drop in interest rates in recent days, the net after-tax losses could be even higher now. When interest rates were close to current levels at the end of March, Fannie's net losses stood at around $10 billion after-tax, or a staggering $15 billion before tax.
So how much capital should Fannie raise?
This calculation has three steps. First we subtract the $10 billion of estimated net losses from the end-June core capital number of $36.2 billion to get a new "cleaned up" core capital of $26.2 billion.
Second, we have to calculate Fannie's new minimum capital requirement with the 30% increase. It was $31.2 billion at the end of June, but would be $40.6 billion with the 30% addition.
Third, we need to subtract our new "cleaned up" core capital number of $26.2 billion from the $40.6 billion, because that will show how much capital Fannie is theoretically undercapitalized, and would have to raise to meet OFHEO's new minimum capital requirement. That shortfall comes to a bruising $14.4 billion.
So, bearing those numbers in mind, how serious is the Fannie mess? Much more serious than many Wall Streeters think.
Most seriously, there may have been times in the past three years when Fannie's core capital number, if it wrongfully excluded the OCI losses, was so far below its minimum capital requirement that Fannie probably would have been shut down by the OFHEO.
In the third quarter of 2002, when plunging interest rates drove up derivatives losses at Fannie, the company easily could have been nearly 40% undercapitalized, if it was incorrectly excluding OCI losses from core capital.
There is absolutely no way that any banking regulator would allow a bank to continue normal business if it were that much undercapitalized. If Citigroup's (C, news, msgs) regulator were to come out tomorrow and say it was 40% undercapitalized, sell-side analysts would be quick to slap a sell recommendation on the bank.
But when Fannie's regulator comes out and produces strong evidence that the company may have been similarly undercapitalized, Wall Street strangely rushes to Fannie's defense.
Hints of deep management problems
OFHEO's report also gives hints of deep arrogance within Fannie's management, suggesting the current top execs soon will be gone, possibly leaving the company effectively without direction for months.
The regulator suggests Fannie's derivatives accounting has been erroneous since it became subject to a new rule called SFAS 133 in 2001. Fannie has never really hidden its dislike for SFAS 133. And if it is revealed that Fannie didn't apply SFAS 133, the reason may turn out to be that it never felt it really had to, simply because it was so big and exerted so much influence around Washington and Wall Street.
Fannie's stock actually moved up Tuesday, suggesting that investors see the capital-raising agreement with OFHEO to be the worst Fannie has to endure. But the company's problems are not over, says Josh Rosner, an analyst at research company Medley Global Advisors. Rosner says it'll be extremely difficult to go back and recalculate some numbers, and he says that a true core capital number is "unquantifiable at this point."
Rosner adds that it could be several quarters before Fannie is able to file financial statements with the Securities and Exchange Commission.
CEO Raines and CFO Timothy Howard, both of whom have vigorously defended Fannie's accounting in the past, almost certainly won't want to sign off on financials that may need to be restated in the future. As a result, there could be a long delay before Fannie files SEC-registered financials again. And that may severely curtail Fannie's ability to issue debt to fund its business.
Unlike Enron and WorldCom, Fannie isn't going to plunge into bankruptcy. But it already has descended to their level in other ways.
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