Cherry-Picking Fannie

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You know, given that we're talking about a government-sponsored enterprise that is also driven, at its core, by the demand for returns by shareholders, I suppose that this oughtn't be much of a shock.

At a hearing before the House Financial Services Subcommittee yesterday, the director of Fannie Mae's (NYSE: FNM) regulating body, the Office of Federal Housing Enterprise Oversight (OFHEO), said his agency had found evidence that Fannie Mae had engaged in "cherry-picking" its best mortgage-backed securities. Doing so runs counter to the rules of accounting, and it is also at odds with denials from Fannie Mae in the past that it had engaged in such practices.

OFHEO Director Armando Falcon didn't describe the potential impact on Fannie Mae's accounting, nor did he detail the level of the problem for mortgage-backed securities investors. But the problem is that under generally accepted accounting principles (GAAP), companies are supposed to identify their classification for securities at the time of acquisition as being "available for sale" or "held to maturity," the identification of which gets different treatment on income statements.

Falcon claims that Fannie Mae had been acquiring the loans underlying these securities (Fannie Mae is the company doing the securitization, so it packages loans into security tranches), determining which would perform best in terms of prepayment and default rates, and keeping them in its own inventory. So rather than determining at the time it acquires the loans how Fannie intended to account for them, it would wait until the end of the month, by which time it could compare the security with all of the others it had also acquired in that month.

Prepayment and default rates (also known as loan mortality rates) are extremely important in determining a mortgage security's market value. By leaving itself the choice of keeping or selling loans, Fannie gave itself the best opportunity to maintain the most profitable loans for itself, while meeting its securitization obligations as part of its federal charter.

Falcon further accused Fannie Mae of having "sloppy internal controls" and said that its interpretation of GAAP had been extremely aggressive. Anyone surprised by this particular interpretation by Falcon and OFHEO at this point in time has not been paying attention.

The biggest issue here is not that Fannie Mae might have to restate past earnings. Rather, if this allegation is true, it is just another of Fannie Mae's past ways of doing business that it will have to change. One may assume that the practice of cherry-picking the most profitable securities has been at least somewhat profitable for the company.

Bill Mann owns none of the companies mentioned in this story. He is the guest analyst for the next four months in the Motley Fool Hidden Gems newsletter.