Fannie Mae redux

I normally don't agree with much that appears on the editorial page of the WSJ, but in this case I do. Fannie Mae execs are guilty of fraud and mismanagement, as discussed in previous posts here and here.

Will Franklin Raines keep his $40M+ in compensation awarded during years when Fannie was violating the law and deliberately misleading investors and the public? I watched the hearings on CSPAN over a year ago and heard Raines and his CFO lying directly to Congress. Will there be consequences?

(Why is a physicist interested in this at all? Because the problem of hedging a portfolio of mortgages is theoretically interesting. Fannie was claiming to have smooth, predictable earnings from a business notorious for causing blow ups for the most sophisticated banks and hedge funds. How were they doing it? Or were they just gambling with taxpayer dollars?)

Fannie's Funny Business

The stock market seemed relieved yesterday when Warren Rudman's 2,652-page report into Fannie Mae's accounting troubles didn't report major new discrepancies in the mortgage giant's books. That news was enough to put the stock up about 2% on the day after a nearly 4% rise Wednesday ahead of the report's release.

And we suppose it is good news of a sort that Fannie Mae's accounting restatement, for which the world has been waiting for more than a year, won't grow from the $10.8 billion figure already estimated. But $10.8 billion is big enough as it is; WorldCom's fraud came to "only" $11 billion. The report's main findings paint the picture of a company that routinely flouted both the rules and law. Some conclusions from the executive summary give a flavor:

• "[M]anagement's accounting practices in virtually all of the areas that we reviewed were not consistent with GAAP, and, in many areas, management was aware of the departures from GAAP" (emphasis added).

• "[E]mployees who occupied critical accounting, financial reporting, and audit functions at the Company were either unqualified for their positions, did not understand their roles, or failed to carry out their roles properly."

• "[T]he information that management provided to the Board of Directors with respect to accounting, financial reporting, and internal audit issues generally was incomplete and, at times, misleading."

• "[T]he Company's accounting systems were grossly inadequate."

The report also identified one case, in 1998, where earnings were manipulated specifically to meet a bonus target. That one instance was a doozy, however; a $199 million amortization expense that went unreported in order to make sure management got its lush payday.

If Fannie Mae were a normal private company, it would be tarred and feathered faster than you can say "Enron." But Fannie Mae is not just another private company. It has a federal charter and an implicit guarantee from the government (read: taxpayers) of its debt. Which makes it all the more vital that Congress reduce the risk that Fannie Mae and Freddie Mac pose to our financial system and the federal fisc.

One of the Rudman report's more worrisome findings was that Fannie's derivatives accounting was wrong because Fannie claimed that its hedges exactly matched its risk exposure when it did not. Fannie has long claimed it is capable of perfectly hedging the interest-rate and prepayment risks in its $800 billion portfolio of mortgage-backed securities. The Rudman report found that that often was not true. But the report only looked at the accounting issues posed by derivatives and hedging, so the public still knows precious little about the extent of the portfolio risk.

The report lets former CEO Franklin Raines off lightly, blaming him mainly for a "culture" that tolerated the accounting abuses. But the core of that culture was a belief that critics -- including us -- could be dismissed and assailed because the company knew it had Congress bought and paid for. And judging by the laughably weak reform that Financial Services Chairman Mike Oxley passed through the House, it still does. If Republicans on Capitol Hill want to know why voters think they've gone native, the failure to rein in Fannie even after a $10.8 billion accounting scandal is Exhibit A.