Fannie Mae: the implied story, Part 1

June 26, 2006 | Fannie Mae, GSEs, Risk, Taxation

“I know it’s a scandal,” scowled the managing editor over his reading glasses, “but where’s the story?


“Is there a part in it for a crusading editor?”

[Disclaimer: Fannie Mae conspicuously declined to comment at all on the OFHEO report, presumably instead reserving its defense for later litigation or other trials. In high school debate, assertions not rebutted are considered proven, so we will treat everything in the Fannie Mae report as solid-gold truth. Should Fannie Mae later substantively dispute or refute these allegations, I will be pleased to update, revise, or retract these conclusions.]

[Quotes in green are from the OFHEO report (full document, .pdf), on which Fannie Mae declined to comment. Sentences are occasionally reformatted (bullets, boldface emphasis, inconsequential brief elisions) for clarity.]

For that is the challenge of translating the OFHEO report.


OFHEO’s knowledgeable authors chronicle a series of contextually dastardly deeds performed by supremely knowledgeable insiders, and describes them for an audience of knowledgeable specialists. OFHEO’s report thus takes for granted that of course everybody knows why otherwise-purposeless earnings management is a red flag, why matching only 50-60% of the prepayment optionality is incredibly risky to US taxpayers, and why tying incentive compensation to a single metric invites destructive gaming.


Makes my brain hurt.

In short, OFHEO expects its recitation of acts to provoke knowledgeable outrage, which it has done among knowledgeable observers like Congressman Baker and Senator Shelby. But research reports seldom make the best-seller lists, thus as a public service, herewith we offer a multi-part series:

The OFHEO report, reorganized sin by alleged sin.


“To be …or what?

Those of you who just arrived might want AHI’s refresher course, consisting of the following:

  1. Fannie Mae, the OFHEO report
  2. Fannie Mae, the story so far
  3. Primary and secondary markets
  4. GSE’s: the earnings engine
  5. Balance sheet turbocharging

There are five main themes, all of which link together.


Five points in a pentagram too …

1. Maximizing executive bonuses. Fannie Mae’s senior management sought to maximize their personal bonuses through a deliberate strategy that permeated all aspects of the company’s operations.

This chapter reviews the emergence of Fannie Mae’s corporate culture, improper earnings management under Franklin Raines, the business strategy senior management developed to meet earnings targets, how senior executives defended Fannie Mae’s image, and the inappropriate “tone at the top” set by the Board of Directors and the highest level of senior management. Page 34.


2. Gaming the bonus formula. Management selected a bonus metric, Earnings Per Share, that could be gamed (manipulated for favorable effect) and was gamed.

Under the Fannie Mae executive compensation program, senior management reaped financial rewards when the Enterprise met earnings per share (EPS) growth targets established, measured, and set by senior management itself. Page 55.

While companies typically link the compensation of their executives to firm performance, relying heavily on one accounting-based measure such as earnings per share is problematic. Academic literature and practical experience suggests that when such a linkage exists executives can and do act aggressively to maximize their compensation by making accounting adjustments. Page 5.


Just a little tinkering with the formula, nothing to worry about.

3. Turbocharging the balance sheet. Earnings were boosted by a strategy of expanding the balance sheet through three means: (a) penetrating business areas already being well served for affordable housing, (b) trimming affordability benefits (subsidy passthrough) to customers, and (c) turbocharging the balance sheet by lending long and borrowing short, taking advantage of a favorable yield curve.

[Actually, OFHEO’s report deals mainly with the balance sheet turbocharging; movement into already-served markets and erosion of affordability benefits are possibilities outside OFHEO’s scope but consistently leveled by other Fannie Mae critics. Nevertheless, while those claims are not the focus of these posts, to overlook them entirely would be an oversight.]

Fannie Mae’s executive compensation program gave senior executives the message to focus on increasing earnings rather than controlling risk. Page 5.

Fannie Mae’s strategy for managing the retained mortgage portfolio involved taking a significant amount of interest rate risk, as members of the Board should have been aware. Page 46.


See, the needle’s not moving. No danger here of running it into the red!

4. Buffing the image by smoothing earnings in covert ways. To downplay balance sheet turbocharging, management smoothed out earnings using a variety of winkles, gimmicks, and tricks, all with the goal of giving the image of a flawlessly performing engine comfortably under control.

Fannie Mae senior management achieved those earning targets by regularly manipulating earnings. They did so by, among other things:

1. Manipulating accounts and accounting rules,

2. Calibrating repurchase of shares and debt to achieve EPS targets,

3. Entering into questionable transactions, and

4. Misallocating resources.

Page 5.


5. Squelching criticism. Management maintained a multiple-front campaign to conceal, cow, coerce, contain, or undercut analysts, critics, and regulators that might otherwise spotlight the earnings smoothing and balance sheet turbocharging.

The illusory nature of Fannie Mae’s public image and senior management’s efforts at concealment were the two essential features of the Enterprise’s corporate culture. Those features, which were both supported by repeated improper manipulation of earnings, are a major theme of this report. Page 34.


Senior management systematically withheld information about the Enterprise’s operations and financial condition from the Board of Directors, its committees, its external auditors, OFHEO, the Congress, and the public—or disclosed information that was incomplete, inaccurate, or misleading. Systematically withholding information prevented others from becoming aware of Fannie Mae’s earning management strategies, the fact that Enterprise’s accounting polices did not comply with GAAP, the pervasive weaknesses of its internal control system, and related safety and soundness issues. Page 9.

OFHEO has published quite an indictment — if true, it’s appalling and beyond appalling. Is it true?


Give us a moment, we’re still reading it …

Is it convincingly documented?

Let’s examine the claims one by one.

[Continued tomorrow in Part 2.]