Fannie Mae's Institutional Arrogance

Pity that Fannie's management decided to test the limits of an implied Federal guarantee.

Bill Mann
Bill Mann
Dec 17, 2004 at 12:00AM

One would think that the news that the Securities and Exchange Commission had ordered mortgage giantFannie Mae (NYSE:FNM) to restate earnings downward by more than $9 billion would have caused investors to think very, very carefully about their faith in the company and its accounting. Instead, the stock drifted a little lower this morning, about 4%, and has since proceeded to recover.

Then again, it's not like the fact that the SEC was looking at Fannie Mae in the first place was some kind of surprise. The amount of the loss is big from a notional standpoint, but it's just that: notional. We're talking about valuing the derivatives that Fannie used to hedge its risk from owning interest rate-sensitive mortgage securities, not some bombshell that the company has dramatically overstated the value of its entire portfolio. Maybe the stock isn't falling today on the news that 38% of its earnings from 2001 to the present have gone up in smoke for the very reason that the ongoing investigations and an outcome of this sort have already been priced in.

Regulators up and down the line have been looking at Fannie Mae's accounting, so perhaps what we have here is some kind of "closure." Fannie treats its derivative restatement as a big bath loss in its September quarter, it might face a managerial change or two, and the loss could cause Fannie to dip below some capital requirement minimums.

What was that last part again? Minimum capital requirements? That sort of sounds important. It's actually amazing to me that Fannie might be at that point, since its leverage ratios to capital far outstrip anything that one would ever see at a bank. Essentially, Fannie Mae is a tiny, tiny slice of equity strapped onto trillions of dollars of debts -- which investors believe are backed by the full faith and credit of the U.S. government. This, despite the fact that the government has insinuated -- as have Fannie Mae and Freddie Mac (NYSE:FRE) -- that this is not the case. So accounting issues like this are just that: disagreements as to the ephemera, not a risk to the core.

But this is wrong. Fannie Mae and Freddie Mac are not bulletproof, and even if some disaster did strike, even if the government did step in and back Fannie and Freddie paper, there's not a snowflake's chance in hell that it'd back the equity.

And this is the problem: Fannie Mae knew for years that it was not in compliance with accounting guidance for valuation of its derivative portfolio, and opted to disregard the rules. This wasn't a misunderstanding -- there may be no more sophisticated organization in the world when it comes to derivatives than Fannie Mae. It knew the benefit of using its method over the one prescribed under FAS 133, and simply ignored the fact that the FASB had rejected that method. According to the Office of Federal Housing Enterprise Oversight's report on the matter, Fannie Mae's top accountant said, "We have several known departures from GAAP in our adoption of FAS 133. We have cleared those with our auditors."

This doesn't put the company's mortgage portfolio at risk, except to the extent that such problems in accounting with Fannie might cause the markets for its paper (mainly foreign central banks) to lose faith in the company. But it makes me wonder about the seemingly blind faith in Fannie's equity. The company already missed a deadline for quarterly results because KPMG refused to add its signature to company financial statements, and now we can add on top of this a $9 billion restatement and a potential violation of minimum capital covenants.

If the company's financial performance were in any way otherwise discernable, I'd understand the sanguine nature of investors. But Fannie's a big black box, and some of what it's putting out has been labeled "toxic." This isn't a little thing -- what we have on our hands is a scandal brewing that could wipe out Fannie's sliver of equity. The company now faces the prospect of having to get back into regulatory capital compliance -- it could do so by liquidating hundreds of millions of mortgage notes, or it could issue several billion in new stock.

The absolute brazenness of Fannie's actions dumbfounds me. It asked regulators for permission to account for its derivatives using its own method, was told no, and did it anyway. How did management possibly think it could get away with this?

I think the answer is arrogance, and the fact that Fannie Mae has such a powerful lobbying force in Washington. Politicians are terrified of the potential economic upset wrought by hitting Fannie Mae's credibility -- there may be no more important financial institution in the country save the Federal Reserve. But it wasn't the politicians or even the regulators who have pushed Fannie Mae down the path of making its capital situation appear better than it actually was.

The best case for Fannie Mae at this point would be a management sweep (board meetings are already in progress), a capital raise, and some fierce new oversight and strictures on the company. The worst is almost too awful to contemplate. What's clear is that the folks running Fannie have taken the faith of shareholders, the public, and even that of taxpayers, and stomped the life out of it. I can't imagine wanting to own such an equity until a little more institutional control is restored.

See also:

Bill Mann owns no shares of any company mentioned in this article.