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Fannie's Sweater Has a Loose Thread

"If you want to destroy my sweater, hold this thread as I walk away." -- Weezer

It is with no overt sense of hyperbole or irony that Bill Fleckenstein from Fleckenstein Capital has taken to calling Fannie Mae (NYSE: FNM  ) "Fanron." Case in point: yesterday's disclosure that its primary regulator had found evidence of more financial statement violations at the government-sponsored mortgage finance company.

Yesterday the mellifluously named Office of Federal Housing Enterprise Oversight (abbreviated as the just-as-mellifluous OFHEO) raised questions about Fannie Mae's method for accounting the value-certain components of its mortgage-backed security portfolio. Should Fannie Mae have to classify these as "available for sale" as opposed to "held-to-maturity," the company would have to mark their value on the balance sheet to market each quarter, which could cause wild swings in Fannie's equity levels.

In addition, OFHEO identified certain variable interest entities (what used to be called "SPEs," again, made famous by the fine folks at Enron), which Fannie used to issue mortgage-backed securities. OFHEO cast doubt on whether these VIEs have any purpose other than to groom Fannie Mae's financial statements. Further, OFHEO questioned Fannie Mae's treatment of interest costs and income and whether they were recorded in such a way as to lower the volatility of earnings.

As I've said in the past, my best take on Fannie Mae is that its financial statements and business are so complicated that they can't even be analyzed. The problem, of course, is that Fannie Mae and its cousin Freddie Mac (NYSE: FRE  ) are both now on record as having broken accounting rules. What else is there that might be found? I don't know, but I do know this: The fact that Congress is looking at all suggests that there is something extremely wrong. Even Rep. Richard Baker (R-LA), a critic of the company and champion of greater oversight, said in an interview that Congress is wary of undermining the ongoing housing boom. What does that tell you?

It tells me that politicians have enough sense that they understand that taking Fannie down could prove disastrous, and yet they feel they have no choice but to clamp down anyway. Even politicians who are anti-GSE in nature, or ones who want to put a few kinks in Fannie's chain after its shabby treatment of its own regulator, don't want to take the company down. But things are not going to be the same for Fannie Mae after this, and no one pontificating on whether the stock is cheap or expensive has a definitive answer to this question: Is this the last of the bombshells?

Bill Mannowns none of the companies mentioned in this article. Fannie Mae is a past recommendation of Philip Durell'sInside Valuenewsletter -- a free trial is but a click away.

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