Affordable Housing Institute : US

[For the introduction, see Part 1.]

 

[For previous installments, see Parts 2, 3, 4, and 5.]

 

[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 all these maneuvers and hijinks to turbocharge earnings and them to manage earnings vibration were taking place, why didn’t anybody say anything?

To begin with, there was Fannie Mae’s spectacular confidence:

 

In the summer of 2002, interest rates fell 100 basis points in 60 days to a 40 year low, and mortgage prepayments accelerated dramatically. That acceleration caused Fannie Mae’s duration gap, the only published measure of the Enterprise’s interest rate risk exposure, to move well outside of Board-approved limits. In Fannie Mae’s 2002 Annual Report, Mr. Raines described the Enterprise’s response:

 

Even though we took actions to rebalance our portfolio, the actions were routine … and had no material impact on our business or core business earnings. In fact, our core business earnings per share increased by 21 percent during 2002.

Page 50.

Prepayments? What prepayments?

 

Reality, according to OFHEO, was quite different than the serenely graceful rebalancing described by Mr. Raines:

 

Mr. Raines’ statements failed to mention several important facts.

 

 

First, the change in the duration gap occurred because Fannie Mae had not fully hedged its exposure to mortgage prepayments — in other words, senior management had taken significant interest rate risk.

Second, the decline in rates had had a multi-billion dollar economic impact—the market value of the Enterprise’s assets had risen much less than the market value of its liabilities, so that its net asset value had declined. The rebalancing required to address Fannie Mae’s duration mismatch in 2002—accomplished through the repurchase of high-coupon long-term debt and the cancellation of pay-fixed swaps—was quite costly.

 

Mr. Raines failed to mention that core business earnings did not reflect that cost. Page 50.

 

There’s nothing under the rug. Nothing, I tell you!

There’s that handy, customized, game-able “core business Earnings-Per-Share” measure (see Part 3) coming through when needed.

 

Thus, the steadiness of core business earnings conveyed a false image, promoted by senior management, of the Enterprise as a company that took little risk. Page 50.

 

The Board did nothing:

Fannie Mae’s Board of Directors contributed to those problems by failing to be sufficiently informed and to act independently of its chairman, Franklin Raines, and senior management, and by failing to exercise the requisite oversight over the Enterprise’s operations. Page 1.

 

Indeed, the whole system appears to have been reverse-engineered to promote high core business EPS, and hence maximum executive bonuses:

 

Senior management expected to be able to write the rules that applied to Fannie Mae and to thwart efforts to regulate the Enterprise. As Mr. Mudd remarked in the memorandum to Mr. Raines mentioned above, “We used to, by virtue of our peculiarity, be able to write, or have written, rules that worked for us.” Page 2.

 

“Hey, who’s in charge, me or you?”

Writing their own rules included:

· Deciding when to comply with GAAP

· Engaging in and concealing earnings management

· Failing to cooperate with and trying to interfere with OFHEO’s special examination.

Fannie Mae senior management also skillfully promoted an image of the Enterprise as a private firm whose corporate objectives were essentially identical to the federal government’s public policy of objectives. The message was: what is good for Fannie Mae is good for housing and the nation. Senior executives used that image and their political influence to try to ensure that Fannie Mae operated under rules that differed from those that applied to other corporations. Page 2.

 

To hear OFHEO tell it, from even before there was an OFHEO, Fannie Mae sought to hobble it:

 

“That’s all the freedom of movement you need, dear Ofheo.”

A key political victory for Fannie Mae senior management was the inclusion in the Federal Housing Enterprises Financial Safety and Soundness Act of 1992 (“the 1992 act”) of provisions that weakened OFHEO’s authorities and subjected the agency to the appropriations process. Page 35.

 

FIRREA (rhymes with why-via) was enacted in the aftermath of the S&L bailout, and inferentially because Congress realized that the GSEs were the biggest financial institutions on the planet. Acting to weaken the regulator, if that indeed is what Fannie Mae did, is therefore ominous.

 

Those provisions helped Fannie Mae and Freddie Mac grow their retained mortgage portfolios without impediment beginning in 1993. Page 35.

 

Apparently balance sheet turbocharging was revving up even then.

 

Fannie Mae needed portfolio growth in order to sustain double digit EPS growth in the 1990s, since the mortgage market as a whole was growing much more slowly than it had in the 1980s. Slower growth in that market limited the ability of the Enterprises to expand its outstanding MBS—and the associated guarantee fee income—at the previous torrid pace. Page 35.

 

OFHEO says it was opposed from the beginning, or imperiously ignored:

 

The existence of a federal agency with the ability to regulate the Enterprise represented a direct challenge to senior management. To deal with that challenge, Fannie Mae took the extreme position that OFHEO simply had little authority over the Enterprise, while Fannie Mae’s lobbyists worked to insure that agency was poorly funded and its budget remained subject to approval in the annual appropriations process.

 

The goal of senior management was straightforward: to force OFHEO to rely on the Enterprise for information and expertise to such a degree that Fannie Mae would essentially regulate itself. Page 35.

 

“Please, Fannie Mae, may I have more data?”

OFHEO provides specifics for these remarkable charges:

 

Soon after OFHEO opened its doors a pattern developed in which Fannie Mae’s Office of General Council routinely alleged that the agency had no authority for whatever regulatory action was proposed. The Enterprise maintained that OFHEO employees were acting improperly, perhaps even criminally, in releasing information about Fannie Mae. Page 35.

Over the years, the Enterprise made allegations of impropriety against OFHEO employees publishing research and, more specifically, that OFHEO could not do so without Fannie Mae’s prior review. Those objections were not limited to research, but included many types of disclosures, including those made to and at the request of Congress.

 

The next charge is particularly piquant since the salaries paid to members of Congress are (a) many multiples lower than Fannie Mae’s, and (b) public:

 

Most recently, the Enterprise objected to OFHEO providing Congress with executive compensation information, suggesting that members of Congress might face criminal sanctions if they made the information public. In another context, an attorney in Fannie Mae’s Office of General Council recommended suing OFHEO because it was seeking congressional action. Similarly, the Enterprise repeatedly objected to OFHEO hiring outside consultants to assist it in conducting examinations and otherwise meeting its responsibilities, on the theory they would be seeing confidential information. Pages 35-36.

Over time, the strategy of opposing, circumscribing, and constraining OFHEO became a firmly established corporate policy of Fannie Mae. Page 36.

 

“It is indubitably so, Socrates.”

Despite these obstructive tactics (remember, this is OFHEO telling the story, and everyone is the hero of his own life), there was more to come:

 

Fannie Mae’s resistance to OFHEO’s regulatory efforts intensified after the agency initiated its special examination of the Enterprise in 2003. Senior management made efforts to interfere with the examination by directing Fannie Mae’s lobbyists to use their ties to Congressional staff:

· To generate a Congressional request for the Inspector General of the Department of Housing and Urban Development (HUD) to investigate OFHEO’s conduct of that examination, and

· To insert into an appropriations bill language that would reduce the agency’s appropriations until Director Armando Falcon, who had initiated that examination, was replaced.

Page 3.

A useful historical tidbit: HUD’s Office of Inspector General has a decade-long reputation (whether deserved or not is a discussion for another day) for chastising the government — HUD program staff, housing authority or finance agency partners — to the conspicuous exclusion of private program participants (”calling in an air strike on our own position,” as someone once described it to me). Again presuming OFHEO’s truthfulness and completeness, both of these tactics amount to intimidation.

 

 

In OFHEO’s telling, intimidation of potential critics was not limited to outsiders, it extended within Fannie Mae itself. Start with the corporate governance theory of internal controls:

 

Fannie Mae’s internal control system contravened OFHEO’s supervisory standards. Senior management failed:

· To ensure appropriate segregation of duties

· To invest adequate resources in accounting and financial reporting

· To avoid key person dependencies

· To implement sound accounting policy development and oversight, and

· To prevent conflicts of interest.

Those and other deficiencies in Fannie Mae’s internal control system resulted from decisions, actions, or inactions of Enterprise senior management that failed to meet OFHEO standards and constituted unsafe and unsound practices. Page 9.

 

If one had an independent office, how might one undercut it? Let OFHEO count the ways:

 

Senior management systematically undercut the independence of Fannie Mae’s Office of Internal Auditing in three important ways:

· They required the Office to report to the CFO and barred unfettered communications with the Audit Committee of the Board of Directors.

“You just try to get information out of us.”

 

· They tied the compensation of senior management of the Office of Auditing to earning per share, a metric based on financial statements that the Office audited.

· They appointed the Enterprise’s Controller to head the internal audit unit, effectively allowing him to audit his own work for a year. Page 9.

Nothing to see here.

Beyond encouraging a referee to conclude everything is fine, how about stepping on his eyeglasses?

 

In addition, Fannie Mae did not devote sufficient and appropriate resources to the Office of Auditing, resulting in serious weaknesses, including insufficient staff and insufficient expertise. By undercutting the independence and objectivity of the Enterprise’s internal controls and internal auditors, senior management made it much less likely that they would be challenged to address Fannie Mae’s control deficiencies. Page 9.

“Looks okay to me.”

Even if the internal auditors know nothing, for full deniability everyone else must be deluded too:

 

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.

We’re trying to shine a light on these matters.

To hear OFHEO tell it, the board was at best somnolent:

 

The Board of Directors and its committees failed to meet the safety and soundness obligations set forth in OFHEO corporate governance regulations and other applicable standards for corporate governance. The members of the Board were all knowledgeable and qualified individuals, fully capable of understanding the business and corporate governance duties with which they were charged. The sophisticated and prestigious members of the Board failed:

· To stay appropriately informed of corporate strategy

· To assure appropriate delegations of authority

· To ensure that Board committees functioned effectively

· To provide an appropriate check on Chairman and CEO Raines

· To hire and retain a qualified senior executive officer to manage the internal audit function

· To initiate independent investigations of Fannie Mae, and

· To ensure timely and accurate reports to federal regulators.

Page 10.

Everything’s on the up and up, right?

Nor did the board’s inactivity stop there:

 

In addition to the failures of the Audit and Compensation Committees, Fannie Mae’s full Board of Directors failed in a number of ways that put the safety and soundness of the Enterprise at risk. The Board failed to stay informed of Fannie Mae corporate strategy, major plans of action, and risk policy. Page 11.

· Having approved an executive compensation system that created incentives to manipulate earnings, members of the Board failed to monitor against such manipulations.

· The Board failed to provide delegations of authority to management that reflected the current size and complexity of the Enterprise.

· The Board failed to initiate an independent inquiry into Fannie Mae’s accounting following:

o The announcement of Freddie Mac’s restatement and subsequent investigations, or

o The allegations by Roger Barnes,

both of which involved earnings management.

Page 11.

We encountered Mr. Barnes in Part 5, in an email in which he called the culture “unbelievable; people are buying the stock thinking that every effort is being made to maximize earnings but that is not the case.” (Page 94.)

· The Board failed to assure itself that the Enterprise’s regulators were properly informed of Mr. Barnes’ allegations. The Board also failed to ensure timely and accurate reports to Federal regulators. Page 11.

 

Here endeth the indictment. At least, this concludes the five major pillars of OFHEO’s case. In compiling this enumeration of the charges, I haven’t included anywhere near all the evidence OFHEO has marshaled, cited, or referenced; there’s plenty more.

What has been done?

 

Aside from the departures of Messrs. Raines and Howard, and a sudden change in Fannie Mae’s compensation system, not too much.

True, OFHEO has administered some discipline, probably as much as it can:

 

In addition to the capital requirements, OFHEO directed the Board of Directors of Fannie Mae to make significant changes to its corporate governance structure. Those changes include, but are not limited to:

· Separating the Chairman of the Board and Chief Executive Officer positions

· Creating a new