"Fraud" might be a harsh word, but then again, where federal mortgage guarantor Fannie Mae (NYSE:FNM) is concerned, perhaps we've been too lenient.
Investigators looking into the accounting practices of the government-sponsored entity, which bundles mortgages into securities for sale to investors, have allegedly found "pervasive accounting violations" above and beyond those already disclosed. It's alleged that the company overvalued assets, underreported credit losses, and exploited tax credits. Then, to cover up the losses incurred, it purchased finite insurance policies to help smooth out earnings.
Finite insurance policies have previously gotten various insurance companies like Berkshire Hathaway's (NYSE:BRKa) (NYSE:BRKb) General Re and American International Group (NYSE:AIG) into trouble. When used properly to transfer risk, they are a legitimate transaction; when used to smooth earnings, conceal losses, and mislead investors, they attract the interest of prosecutors and the Securities and Exchange Commission.
No wonder Bill Fleckenstein of Fleckenstein Capital has coined a new name for Fannie Mae: "Fanron."
While internal investigations into Fannie Mae's books have thus far revealed some $10.8 billion in cumulative after-tax losses that may have to be restated for the years 2001 to 2004, investigators haven't been updating the tally as they've gone along. The new revelations suggest that the number will be much higher and the losses far greater than previously disclosed.
Considering that Fannie Mae is a selection of the Motley Fool Inside Value newsletter, it's an area of concern that we Fools will continue to watch closely.
The company has admitted that it violated GAAP in recording derivative transactions, and it has cautioned investors not to rely upon the fiscal 2004 numbers it used to calculate the restatement charges. In an understatement, Fannie Mae advised investors that given the "magnitude of the material weaknesses that currently exist," it was hampered by poor internal controls, leading management to conclude its financial reporting would be "ineffective" in 2005 as well.
The breadth of the financial shenanigans has belatedly led Congress to call for greater oversight of Fannie Mae and its related mortgage backer Freddie Mac (NYSE:FRE). Interestingly, Freddie's condition is considered less dire. Investigators looking into its accounting irregularities found that it had underreported profits by some $5 billion, whereas Fannie covered up its losses by inflating the value of the assets in its $768 billion portfolio, thus trying to hide them altogether.
Upon release of the new allegations by the Dow Jones newswires, Fannie Mae's stock plunged nearly $5 a share -- or 11% -- to a low of $41.71, a level not seen since 1997. In addition to the share price's declining value, investors need to be concerned about what these new revelations portend for the restatements. If protracted investigations delay Fannie from filing revised financial statements with the SEC, its stock could be delisted.
Investors often try to get ahead of the curve, leaping into a situation before all the facts are entirely known or settled. I did this with Fannie Mae, believing that the worst of the news had already come out, new management was in place, and a turnaround was in effect. But where fraud is involved, the more prudent course is often wait until all the investigations are complete. You might not catch the exact bottom of the stock price that way, but you also don't slice your hands by grabbing hold of a falling knife.
Slice your way through these related Foolish articles:
- Fannie and Freddie Face New Rules
- Cherry-Picking Fannie
- The Fannie Mae Mad Lib
- Fannie's Sweater Has a Loose Thread
Even with Fannie Mae as a selection, Motley Fool Inside Value lead analyst Philip Durell is beating the market by better than 2-to-1. A 30-day free trial gives you access to all of his top value picks.
Fool contributor Rich Duprey owns shares of Fannie Mae but does not own any of the other stocks mentioned in this article. The Motley Fool has a disclosure policy.
