Affordable Housing Institute : US

[For the introduction, see Part 1.]

[For previous installments, see Parts 2, 3, and 4.]

[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.]

 

If the turbocharged earnings engine starts to rattle more than hum, what must one do? Clap a silencer on it.

During the period covered by this report, the corporate culture of Fannie Mae encouraged a perception of the Enterprise as a low-risk financial institution that was so well managed that it could hit announced profit targets on the nose every year, regardless of the state of the economy, and that compensated its senior executives appropriately for its extraordinary performance. Page 2.

 

What, me worry?

Only extraordinary marksmen should be trusted to wield weapons of such potency:

 

The highest levels of senior management wanted Fannie Mae to be viewed as “one of the lowest risk financial institutions in the world” and as “best in class” in terms of risk management, financial reporting, corporate governance, and internal control. Chairman and CEO Franklin Raines, CFO Timothy Howard, and other members of the inner circle of senior Enterprise executives sought to convey that image to the public, employees, the Board of Directors, and investors. Page 2.

 

Hey, man, it’s groovy in the inner circle!

Indeed, it takes the best in the world, as Mr. Raines modestly acknowledged:

 

In the 2000 Annual Report Mr. Raines stated:

Indeed our 14 years of steady earnings growth demonstrates that Fannie Mae defies the conventional wisdom that financial company earnings are always sensitive to changes in the economy or interest rates. Fannie Mae’s management of credit and interest rate risk contributes stability to the global financial system. Page 33.

 

 

Everything’s fine!

But like many a dagger-thrower’s magic trick, says OFHEO, it was all in fool-the-eye:

 

The image of Fannie Mae communicated by Mr. Raines and his inner circle and promoted by the Enterprise’s corporate culture was false. In the words of one current member of Fannie Mae’s Board of Directors, the picture of the Enterprise as a “best-in-class” financial institution was a “facade.” To maintain that facade, senior executives worked strenuously to hide Fannie Mae’s operational deficiencies and significant risk exposures from outside observers—the Board of Directors, its external auditor, OFHEO, the Congress, and the public. Page 2.

The illusory nature of the Enterprise’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 the report. Page 2.

If one wants to be that precise with so many dimensions of optionality, one needs many tools. OFHEO identifies at least four:

 

“Must be an earnings smoother in here somewhere.”

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.

The goal was consistent: oscillation dampening while maintaining a facade of steadily rising EPS. To create the perception executives wanted:

· EPS has to rise, and

· EPS has to rise smoothly

 

There, it’s running much smoother now.

Management routinely shifted earning to future years when the EPS target for the maximum bonus payout for the current year appeared likely.

In addition, Enterprise executives purposely obscured their official disclosures of executive compensation and failed to provide complete information on the post-employment compensation awarded to former CEOs. Page 5.

 

Mr. Raines’ predecessor, James A. Johnson, preceded him not just in role but also in compensation received. As a very useful Washington Post piece puts it:

Good numbers kept Wall Street happy. They paid the light bills for more than 50 partnership offices that represented Fannie Mae around the country. And they made top executives multimillionaires. Johnson received $21 million in his last year as chief executive and a consulting contract worth $600,000 a year.

To understand OFHEO’s claimed value of obscuring the true picture, let’s start with the accountings standards manipulation, evasion, or simple denial:

 

 

Senior management of Fannie Mae contravened accounting standards and regulatory requirements in a number of ways to manipulate its financial results to achieve earning objectives between the fall of 1998 and 2004. By using a variety of improper accounting techniques and financial transactions, senior executives eliminated or deferred, as needed, current period expenses and income. As a result, they simultaneously created the appearance of stable double-digit earnings growth and generally met, but only once substantially exceeded, the EPS goals that would yield the highest bonus payments. Page 6.

What about those pesky FAS guidelines?

 

“Oh, be real.”

 

When faced with new accounting standards that might increase earnings volatility as reported under GAAP, senior management neither initiated the development of a formal, written GAAP-compliant accounting policy nor invested in the new accounting systems needed to implement them properly. Instead, they patched existing systems and ways of doing business to accommodate their preferred interpretations of the new standards. Page 6.

 

“Encore une fois: I interpret this not to apply to me.”

 

The most significant examples discussed in the report are Fannie Mae’s implementation of FAS 115, Accounting for Certain Investments in Debt and Equity Services, in a manner that allowed for controlling earnings volatility and minimized investment in accounting infrastructure over GAAP compliance, and the improper implementation of derivative accounting under FAS 133, Accounting for Derivative Instruments and Hedging Activities.

 

Management’s disregard for GAAP compliance when GAAP numbers were likely to be volatile and their reliance on obsolete systems were not limited to those two areas. Those priorities characterized the implementation of many accounting policies and practices at the Enterprise, including FIN 46, accounting for dollar roll transactions, and accounting for real estate owned. Page 6.

For instance, relative to FAS 91 (Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases):

 

OFHEO concluded that FAS 91 accounting used by Fannie Mae for amortizing purchase premiums and discounts on securities and loans as well as amortizing other deferred charges was not in accordance with GAAP. Management intentionally developed accounting policies and selected and applied accounting methods to inappropriately reduce earnings volatility and to provide themselves inordinate flexibility in determining the amount of income and expense recognized in any accounting period. In that regard, the amortization policies that management developed and the methods the applied created a “cookie jar” reserve. Page 15.

 

FAS 91’s jaw-breaker title makes the subject sound arcane, but the principle is straightforward. Let’s say a particular bond carries an interest rate above current market. (Remember, even if the bond’s rate is fixed, market rates go up and down.) We buy it for, say, $110 instead of $100. That gives us an “unamortized premium” of $10. We have to write that off (amortize it) over a period. What period? How about the period that we think we will hold the loan — say, ten years?

 

 

In Year 1, we write off $1. In Year 2, another $1. We’ve got $8 of ‘unamortized premium’ left. Now let’s say an order comes down to find some losses!

 

“Cap’n, the earnings canna take it any morr! “

 

We go back to our amortization gnomes, who decide, based on impeccable logic and new information, that these loans are going to pay off faster, and will instead last an average of five years. That means we should have written off $2 in Year 1, and another $2 in Year 2. We now have $2 ($2+$2-$1-$1) that we have to write off now.

 

According to Roger Barnes, Manager for Premium Discount Amortization …

 

Premium Discount Amortization means “writing off the loss we have to take when we pay more for a bond or loan than its face amount”. Sounds like the go-to guy for ginning up losses, doesn’t it?

I think we can squeeze out some more losses here

… whose allegations of earnings management are discussed in Chapters VII and VIII, by 2002 it was clearly Fannie Mae policy to use such instruments as REMICs to reduce short-term income an to push out income to future years. In a May 2002 e-mail, Mr. Barnes noted:

Top management is creating the structured transactions to take losses now. Per Janet, Frank and Tim feel there is enough income locked in for 2002 that we do not need to worry about meeting this year’s goals. Further, she indicated the amortization of deferred items provides a vehicle to manage to “Plan.” Page 93.

 

Want to go the other way? Find a premium pool you’ve been amortizing over 5 years and decide it will last longer, so it’ll be 10. Presto — $2 of earnings!

Further, consistent with its vision of being the only referees able to appreciate its sophistication, Fannie Mae executives overrode dissenting outside and inside views:

 

Additionally, in periods in which EPS targets were hit, adjustments were not made that should have been made. For example, Fannie Mae refused to lower its Allowance for Loan Losses even in the face of historical experience showing the Enterprise actually and consistently recovered more monies that predicted on foreclosures. Faced with a clamor from his staff that accounting standards required an adjustment, Mr. Howard, the Chief Financial Officer, writing in a personal evaluation, set everyone straight that the lack of earnings volatility trumped GAAP. Mr. Howard complained of one of his subordinate’s failure to perceive Fannie Mae’s true priorities. Mr. Howard noted that he was concerned about being able to “rely on [Janet Pennewell’s] business judgment” because of how she had handled the purchase premium and discount amortization and loss reserve policy issues. Page 43.

 

Apply these techniques across a multi-trillion-dollar portfolio, and pretty soon you can find anything you want, especially if you are relying on judgment because you lack precise infrastructure:

Fannie Mae senior executives engaged in a number of unsafe and unsound practices:

· To smooth reported earnings

· To hit the EPS targets that determined their compensation

· To achieve rapid growth while keeping administrative and other infrastructure-related expenses as low as possible, and

· To limit internal and external criticism of the Enterprise. Page 9.

 

“Hey, look at our great grades!”

Those practices include:

· Failing to establish a sound internal control system

· Failing to maintain the independence and objectivity of Fannie Mae’s internal auditor

· Failing to disclose to external parties accurate information about the Enterprise’s financial condition and operations

· Failing to investigate employee allegations and concerns

· Failing to allow the Board of Directors unrestricted access to members of management, and

· Making efforts to interfere with OFHEO’s special examination. Page 9.

What F?

Some inside Fannie Mae allegedly viewed these maneuvers with alarm:

 

Mr. Barnes also expressed concern with the lack of detailed discourse regarding REMICs. Mr. Barnes wrote:

Investors and analysts are clamoring for the data but the company is refusing to provide it because of the uproar it would cause if Wall Street know [sic] we were so heavily “managing income” as to take losses needlessly. There is more concern about maintaining a desired level of income than maximizing income. It is unbelievable. People are buying the stock thinking that every effort is being made to maximize earnings but that is not the case. Pages 94.

With all this going on, why wasn’t there a clamor?

 

[Continued tomorrow in Part 6.]

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