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Case 5- 8
Fannie Mae: The Government’s Enron
Background
The Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage
Corporation (Freddie Mac) are government-sponsored entities (GSEs) that operate under congressional
charters to “help lower- and middle-income Americans buy homes.” Both entities receive special treatment
aimed at increasing home ownership by decreasing the cost for homeowners to borrow money. They do this
by purchasing home mortgages from banks, guaranteeing them, and then reselling them to investors. This
helps the banks eliminate the credit and interest rate risk as well as lengthening the mortgage period. Fannie
Mae and Freddie Mac receive advantages over commercial banks including (1) the U.S. Treasury can buy
$2.25 billion of each company’s debt; (2) Fannie Mae and Freddie Mac receive exemption from state and
local taxes; and (3) the implied government backing gives them the ability to take on large amounts of
home loans without increasing their low cost of capital.
Fannie Mae makes money either by buying, guaranteeing, and then reselling home mortgages for a fee or
by buying mortgages, holding them, and then taking on the risk. By selling the mortgages, Fannie Mae
eliminates the interest rate risk. There is less profit from this conservative approach than by holding the
mortgages they buy. By holding the mortgages, Fannie Mae can make money on the spread because it has
such a low cost of capital. In 1998, Fannie Mae’s holdings hit a peak of $375 billion of mortgages and
mortgage-backed securities on its own books, not to mention the more than $1 trillion of mortgages it
guaranteed. This process of holding mortgages on its books helped Fannie Mae expand rapidly. It also
stimulated unprecedented profit growth because there was more profit to be made by keeping the
mortgages than by guaranteeing and then reselling them to other investors.
The reasons for growth in the telecommunications sector in the 1990s were, in part, the building of
overcapacity in telecommunications equipment inventory based on the belief the economic growth bubble
of the early 1990s would never end. Fannie Mae was similarly affected by the bubble in making and
holding home mortgage loans. Just as telecommunication companies such as Global Crossing and Qwest
were motivated to keep revenue and net income increasing quarter after quarter, the pressure also was on
the top management of Fannie Mae to keep up the pace of growth. Fannie Mae’s CEO, Franklin Raines,
was so optimistic that at an investor conference in May 1999 he claimed, “The future is so bright that I am
willing to set as a goal that our earnings per share will double over the next five years.”
As growth pressures continued, Fannie Mae began to use more derivatives to hedge interest rate risk.
Critics looked at Fannie Mae’s portfolio and expressed concern that with the risk involved in using
derivatives, it may be at risk of defaulting. They pointed out that unlike federally guaranteed commercial
bank deposits and the partial government guarantee of pension obligations through the Pension -Benefit
Guaranty Corporation (PBGC), there was no federal guarantee of Fannie Mae. Behind the scenes Fannie
Mae encouraged the concept that if it did default, the government would back it. This belief in the
government as a back-stop if Fannie Mae got into financial trouble raised the specter of “moral hazard.”
Moral hazard is the idea that a party that is protected in some way from risk will act differently than if they
didn’t’ have that protection. This “too big to fail” philosophy turned out to be true later on, after the initial
crisis in the 1990s, when the government bailed out Fannie Mae during the 2007–2008 financial crisis.
In the 1990s, Fannie Mae was growing and the market loved it. Top executives were receiving large
bonuses for the growing profits. The growth was due to increased risk but people believed that, at the end
of the day, the government would come to the rescue of Fannie Mae if that became necessary.
The Accounting Scandal
The discovery of Fannie Mae’s accounting scandal began in 2001 when Freddie Mac fired its auditor,
(Arthur) Andersen, right after Enron’s scandal exploded and the firm’s existence seemed untenable. Freddie
Mac then hired PwC.
PwC looked very closely at Freddie Mac’s books and found it had understated its profits in an attempt to
smooth earnings. Freddie Mac agreed to a $5 billion restatement and fired many of its top executives.
Meanwhile, Fannie Mae continued on its course and accused Freddie Mac of causing “collateral damage.”
The Fannie Mae Web site even included the statement, “Fannie Mae’s reported financial results follow
[GAAP] to the letter. There should be no question about our accounting.” To a cynic, that statement may
have had the unintended consequence of raising suspicion about Fannie Mae’s accounting. After all, the
markets had already been through it with Enron.
The government agency that regulated Fannie Mae and Freddie Mac at the time, the Office of Federal
Housing Enterprise Oversight (OFHEO), had stated days before Freddie Mac’s restatement that its internal
controls were “accurate and reliable.” Once the restatement was made public, OFHEO had no choice but to
look deeper into -Fannie Mae’s accounting to make sure such a serious misjudgment did not happen again.
OFHEO was much weaker than most regulatory agencies such as the SEC and Justice Department that
went after Enron in the obstruction of justice case. Fannie Mae essentially established OFHEO in 1992 as
the regulatory agency that oversaw its operations and accounting. Fannie Mae was able to control its own
regulator because it had enough influence in Congress to have OFHEO’s budget cut. Fannie Mae had
political influence because of its connections with realtors, homebuilders, and trade groups. Fannie Mae
also made large contributions to various organizations and gained political clout.
After the Enron debacle, the White House wanted to make sure to avoid another scandal. The
government provided the funding needed to bring in an independent investigator, Deloitte & Touche, that
uncovered massive accounting irregularities. In September 2004, OFHEO released results of its
investigation and “accused Fannie of both willfully breaking accounting rules and fostering an environment
of ‘weak or nonexistent’ internal controls.”
The investigation focused on the use of derivatives and Fannie Mae’s deferring derivative losses on the
balance sheet, thus inflating profits. OFHEO and Deloitte believed that the derivative losses should be
recorded on the income statement. The dispute involved the application of FAS No. 133, Accounting for
Derivative Instruments and Hedging Activities. The SEC’s chief accountant determined that Fannie Mae
failed to comply with the requirements for hedge accounting—-including FAS 133’s rigorous
documentation requirements. Fannie Mae was required by law to document its derivative use and file with
the SEC. But, “Fannie Mae’s application of FAS 133 (and its predecessor standards, FAS 91) did not comply
in material respects with the accounting requirements” of GAAP. In particular, Fannie Mae’s practice of
putting losses on the balance sheet rather than on the income statement resulted in overstated earnings and
excess executive compensation.
OFHEO issued a report charging that in 1998 Fannie Mae recognized only $200 million in expenses
when it was supposed to recognize $400 million. The underreporting of expenses led to earnings of $3.23
per share and a total of $27 million in executive bonuses. These charges prompted investigations by the
SEC and the Justice Department.
Two weeks after the OFHEO report and charges against Fannie Mae, the House of Representatives
Subcommittee on Capital Markets called a hearing. Raines initially deflected criticisms by saying, “These
accounting standards are highly complex and require determinations on which experts often disagree.”
Raines was quite convincing in defense of OFHEO charges that Fannie Mae executives had manipulated
earnings in an attempt to increase bonuses. In the end, Raines won because the tone of the OFHEO reports
made it seem as though the regulator was out to get Fannie Mae.
Perhaps feeling his oats after the victory in the House, Raines demanded that the SEC review OFHEO’s
findings. On December 15, 2004, the SEC announced that “Fannie did not comply ‘in material respects’
with accounting rules, and that as a result, Fannie would have to restate its results by more than $9 billion.”
Other than the $11 - $13 billion WorldCom fraud, the Fannie Mae fraud has the “dubious” honor of being
the next largest fraud during the dark days of the late 1990s and early 2000s.
The OHFEO had been vindicated. The Fannie Mae board was told that both Raines and CFO Tim
Howard had to be fired. Soon after, both resigned and Fannie Mae fired KPMG and appointed Deloitte &
Touche as the new auditor. Deloitte was asked to audit the 2004 statements of Fannie Mae and reaudit
previous statements from 2001.
OFHEO Report May 23, 2006
On May 23, 2006, OFHEO issued a more extensive report of a comprehensive three-year investigation that
officially charged senior executives at Fannie Mae with manipulating accounting to collect millions of
dollars in undeserved bonuses and to deceive investors. The fraud led to a $400 million civil penalty against
Fannie Mae, more than three times the $125 million penalty imposed on Freddie Mac for understating its
earnings by about $5 billion from 2000 to 2002 to minimize large profit swings. The $400 million is one of
the largest penalties ever in an accounting fraud case. Of this amount, $350 million will be returned to
investors damaged by the alleged violations as required by the Fair Funds for Investors provision of SOX.
The OFHEO review involves nearly 8 million pages of documents and details what the agency calls an
arrogant and unethical corporate culture. The report, which concluded an 18-month investigation led by
former senator Warren Rudman, was commissioned by Fannie Mae’s board of directors. The final 2,600
page report charges Fannie Mae executives with perpetrating an $11 billion accounting fraud in order to
meet earnings targets that would trigger $25 million in bonuses for top executives. The report charged
former CFO J. Timothy Howard and former controller Leanne G. Spencer as the chief culprits. Along with
former chair and CEO Franklin Raines, who earned $20 million (including $3 million in stock options) in
2003 and $17.7 million in 2002, these executives created a “culture that improperly stressed stable earnings
growth.” Rudman told reporters that the management team Raines hired was “inadequate and in some
respects not competent.”
Criticisms of Internal Environment
From 1998 to mid-2004, the smooth growths in profits and precisely hit earnings targets each quarter
reported by Fannie Mae were illusions deliberately created by senior management using faulty accounting.
The report shows that Fannie Mae’s faults were not limited to violating accounting standards but included
inadequate corporate governance systems that failed to identify excessive risk-taking and poor risk
management. Randal Quarles, U.S. Treasury undersecretary for domestic finance at the time, said in a
statement, “OFHEO’s findings are a clear warning about the very real risk the improperly managed
investment portfolios of [Fannie Mae and Freddie Mac] posed to the greater financial system.”
Fannie Mae agreed to make these changes in its operations:
Limit the growth of its multibillion-dollar mortgage holdings, capping them at $727 billion.
Make top-to-bottom changes in its corporate culture, accounting procedures, and ways of
managing risk.
Replace the chair of the board’s audit committee. The board named accounting professor Dennis
Beresford to replace audit committee chair Thomas Gerrity.
The report also faulted Fannie Mae’s board of directors for failing to discover “a wide variety of unsafe
and unsound practices” at the largest buyer and guarantor of home mortgages in the country. It signaled out
senior management for failing to make investments in accounting systems, computer systems, other
infrastructure, and staffing needed to support a sound internal control system, proper accounting, and
GAAP-consistent financial reporting.
KPMG’s Audits
As for the role of KPMG as Fannie Mae’s auditors, the report alleges that external audits performed by the
firm failed to include an adequate review of Fannie Mae’s significant accounting policies for GAAP
compliance. KPMG also improperly provided unqualified opinions on financial statements even though
they contained significant departures from GAAP. The failure of KPMG to detect and disclose the serious
weaknesses in policies, procedures, systems, and controls in Fannie Mae’s financial accounting and
reporting, coupled with the failure of the board of directors to oversee KPMG properly, contributed to the
unsafe and unsound conditions at Fannie Mae.
SEC Civil Action
The SEC filed a civil action against Fannie Mae on May 23, 2006, charging that it engaged in a financial
fraud involving multiple violations of GAAP in connection with the preparation of its annual and quarterly
financial statements. These violations enabled Fannie Mae to show a stable earnings growth and reduced
income statement volatility, and—for the year ended 1998—Fannie Mae was able to maximize bonuses and
meet forecasted earnings. The SEC action thoroughly details a variety of deficiencies in accounting and
financial reporting. Four of the more serious situations are described below.
Improper Accounting for Loan Fees, Premiums, and Discounts
FFAS No. 91 requires companies to recognize loan fees, premiums, and discounts as an adjustment over the
life of the applicable loans, to generate a “constant effective yield” on the loans. Because of the possibility
of loan prepayments, the estimated life of the loans may change with changing market conditions. FAS 91
requires that any changes to the amortization of fees, premiums, and discounts caused by changes in
estimated prepayments be recognized as a gain or loss in its entirety in the current period’s income
statement. Fannie Mae referred to this amount as the “catch-up adjustment.” In the fourth quarter of 1998,
Fannie Mae’s accounting models calculated an approximate $439 million catch-up adjustment, in the form
of a decrease to net interest income. Rather than book this amount consistent with FAS 91, senior
management of Fannie Mae directed employees to record only $240 million of the catch-up amount in that
year’s income statement. By not recording the full catch-up adjustment, Fannie Mae understated its
expenses and overstated its income by a pretax amount of $199 million. The unrecorded catch-up amount
represented 4.3 percent of the 1998 earnings before taxes and 4.9 percent of 1998 net interest income for
the fiscal year 1998.
Improper Hedge Accounting
Fannie Mae used debt to finance the acquisition of mortgages and mortgage securities and it turned to
derivative instruments to hedge against the effect of fluctuations in interest rates on its debt costs.
Application of FAS 133 required that Fannie Mae adjust the value of its derivatives to changing market
values. Critics contended that this standard opened the door to earnings volatility, and it would appear that
Fannie’s desires to create earnings stability was used as the motivation for the application of the standards
in FAS 133.
Accounting for Loan Loss Reserve
During the period 1997 through 2003, management failed to provide any quantitative estimate of losses in
their loan portfolio, instead relying on a qualitative judgment. The failure to establish and implement an
appropriate model for determining the size of the loan loss reserve was a violation of the GAAP rules in
FAS 5.
Fannie Mae maintained an unjustifiably high level of loan loss reserve in case it was needed to
compensate for possible future changes in the economic environment. This violates the GAAP requirement
that the estimate of loss reserves should be based on losses currently inherent in the loan portfolio. At year-
end 2002, Fannie Mae’s reserve was overstated by at least $100 million. This overstatement resulted in a
$100 million understatement of earnings before tax, which represented 1.6 percent of the earnings before
tax and $.08 of additional earnings per share on the year-end 2002 figure of $4.52.
Classifications of Securities Held in Portfolio
FAS 115 requires the classification of securities acquired as either trading, available-for-sale, or held-to-
maturity at the time of acquisition. Rather than follow the FAS 115 rules, Fannie Mae initially classified the
securities it acquired as held-to-maturity and then, at the end of the month of acquisition, decided on the
ultimate classification.
GAAP requires that the accounting classification be made at the time of acquisition. Once a security is
classified, it can be reclassified only in narrow circumstances. Both trading and available-for-sale securities
are valued at current market value, with any declines over time (or recaptures) in trading securities reported
as a loss (or gain) in the income statement and as other comprehensive income in the equity section of the
balance sheet for available-for-sale securities.
Postscript
On October 27, 2008, Congress formed the Federal Housing Finance Agency (FHFA) by a legislative
merger of OFHEO, the Federal Housing Finance Board (FHFB), and the U.S. Department of Housing and
Urban Development (HUD) government-sponsored enterprise mission team. FHFA now regulates Fannie
Mae, Freddie Mac, and the 12 Federal Home Loan Banks.
The meltdown in the mortgage-backed securities market that occurred during the financial crisis of
2007–2008 took place after the facts of this case. One can only wonder how bad things would have been
for Fannie Mae had the entity been exposed to huge market losses in the mortgages it held in addition to the
financial fraud discussed in the case.
During the financial crisis, the market prices of many securities, particularly those backed by subprime
home mortgages, had plunged to fractions of their original prices. That forced banks to report hundreds of
billions of dollars in losses during 2008. The business community turned its attention to the accounting
standards established by FASB for some relief. Bankers bitterly complained that the current market prices
were the result of distressed sales and that they should be allowed to ignore those prices and value the
securities instead at their value in a normal market.
At first, FASB resisted making changes, but that changed within a few days of a congressional hearing at
which legislators from both parties demanded that the board act. FASB approved three changes to the rules,
one of which would allow banks to keep some declines in asset values off their income statements.
Reluctant FASB board members rationalized going along with this change by stating that improved
disclosures would help investors. The American Bankers Association, which pushed legislators to demand
the board make changes, praised the board stating that the “decision should improve information for
investors by providing more accurate estimates of market values.” The change that met with the most
dissent was to allow banks to write down these investments to market value only if they conclude that the
decline is “other than temporary.” This change will now enable banks to keep many losses off the income
statements, although the declines will still show up in the institutions’ balance sheets.
A class-action lawsuit was filed in 2005 on behalf of approximately one million Fannie Mae shareholders
who incurred losses after regulators identified pervasive accounting irregularities at the company. Between
1998 and 2004, government investigators found, senior executives at Fannie had manipulated its results to
hit earnings targets and generate $115 million in bonus compensation. The company had to restate its
earnings, reducing them by $6.3 billion.
In 2006, the government sued three former executives, seeking $100 million in fines and $115 million in
restitution from bonuses it maintained they had not earned. Without admitting wrongdoing, former CEO
Franklin Raines and two other members of top management paid $31.4 million to settle the matter in 2008.
In September of that year, the federal government stepped in to rescue Fannie Mae, which was struggling
under a mountain of bad mortgages.
Costs spent defending the three former executives against the shareholder suit recently totaled almost
$100 million, according to a report in February 2012 by the inspector general of the FHFA. Since Fannie
was taken over by the government in September 2008, the inspector general said, taxpayers have borne $37
million in legal outlays on behalf of the three executives.
On September 21, 2012, the federal judge overseeing the class action against Fannie Mae and its
management ruled that the investors’ lawyers had not proved that former CEO Franklin Raines knowingly
misled shareholders about the company’s accounting and internal controls, a necessary hurdle for the case
against him to continue. The judge ruled at best, evidence submitted by the shareholders showed that
Raines “acted negligently in his role as the company’s chief executive and negligently in his representations
about the company’s accounting and earnings management practices.”
Questions
1. An eight-month investigation by OFHEO concluded that slack standards at Fannie Mae created a
corporate culture “that emphasized stable earnings at the expense of accurate financial disclosures.”
What is wrong with having stable earnings over time? Answer this question with respect to
stakeholder interests.
The first problem with having stable earnings over time is that it is dishonest un less warranted by the facts
and circumstances. Reporting stable earnings solely for the sake of stability is unethical because it misleads
shareholders and other stakeholders into thinking the entity does well each year and not affected by the
normal fluctuations in earnings due to market conditions. Is the user to conclude that management
somehow can make the decisions that navigate these normal fluctuations? The fact is revenues and
2. Fannie Mae’s corporate governance system failed to identify excessive risk-taking. Describe those
risks and the mechanisms that should have been used by Fannie Mae and KPMG to enhance risk
assessment. To what extent do you think the risk-taking at Fannie Mae was due to “moral hazard?”
The excessive risk-taking includes:
The investment in derivatives and deferring derivatives losses on the balance sheet, and improper
Fannie Mae significantly and consistently underreported expenses. Internal auditors, external
Fannie Mae paid excessive bonuses to its executive based upon performance incentives that
Uncontrolled growth in mortgage holdings, improper accounting for loan fees, premiums and
discounts, underestimating loan loss reserves, and misclassification of investments are all
Corporate culture and internal environment are business risks and should have been addressed
KPMG audits failed to include due care review of accounting policies, sufficient evidential corroboration
of controls, systems, procedures and departures from GAAP. The audit committee should have discussed
Moral hazard is highly likely to be part of the risk taking. The management planned on the government
backing up Fannie Mae if it got into financial trouble. This belief may also have encouraged the
management to take even greater risks and to feel invincible like they could do no wrong. Fannie Mae may
3. According to the case, KPMG failed to review Fannie Mae’s significant accounting policies for
GAAP compliance. One item in particular was the failure of Fannie Mae to make a quantitative
estimate of losses on its loan portfolio. In the end, KPMG gave an unqualified (now unmodified)
opinion even though the financial statements contained significant departures from GAAP. What
ethical and professional standards did KPMG violate in taking that position?
KPMG violated objectivity and integrity (Rule 102), due care standard (Rule 201), following GAAS (Rule
202) and the GAAP accounting principles requirement (Rule 203) in giving an unqualified opinion when
the financial statements contained significant departures from GAAP. One issue to raise with students is
KPMG had pressures and incentives to go along with Fannie Mae’s estimate of loan losses. Going along
