Accounting Problems at Fannie Mae

Accounting Problems at Fannie Mae
Mark Jickling
Specialist in Public Finance
Government and Finance Division
Summary
On September 22, 2004, the Office of Federal Housing Enterprise Supervision
(OFHEO) made public a report that charged Fannie Mae, the government-sponsored
enterprise that plays a leading role in the secondary mortgage market, with not following
generally accepted accounting practices in several critical areas, which allowed Fannie
Mae to conceal losses, reduce volatility in reported earnings, present investors with an
artificial picture of steadily growing profits, and meet financial performance targets that
triggered the payment of large bonuses to company executives. Fannie Mae’s initial
response was to argue that OFHEO’s charges involved not improprieties, but merely
differing interpretations of highly complex accounting standards. However, on
December 15, 2004, the Securities and Exchange Commission (SEC), after finding
inadequacies in Fannie’s accounting policies and methodologies, supported OFHEO and
directed Fannie Mae to restate its accounting results since 2001. Shortly thereafter, the
company’s CEO and CFO resigned. In May 2006, Fannie Mae reached a settlement
with OFHEO and the SEC, agreeing to pay $400 million in civil penalties, undertake a
number of remedial steps related to internal controls and oversight of accounting
systems, not increase the size of its mortgage portfolio without OFHEO’s approval, and
be enjoined from future violations of securities laws. In December 2006, Fannie issued
the restatement, which reduced reported earnings for 2001-2004 by $6.3 billion. This
report will be updated as events warrant.
Background
Fannie Mae and Freddie Mac, the two government-sponsored enterprises (GSEs) that
dominate the secondary mortgage market, are huge and complex financial institutions that
play a key role in the financial system. Most home mortgage loans made each year are
purchased by one or the other of the GSEs and either held in portfolio or repackaged and
sold as mortgage-backed securities (MBS). Large quantities of GSE bonds are held by
insured banks, pension funds, and investors of all types. Although GSE debt is not
guaranteed by the government, the “government sponsored” status of Fannie and Freddie
leads market participants to put faith in an “implicit” guarantee, a belief that the Treasury
will never allow either GSE to default on its obligations.

The savings and loan crisis of the 1980s was a painful demonstration of the risks
inherent in mortgage markets. Over a thousand S&Ls failed because their long-term
revenues (from mortgage loans) fell below their cost of funds (the interest they paid to
savers). When interest rates are volatile, holders of mortgages and MBS face a variety of
financial risks, and these risks are now concentrated in the two GSEs. Although both
institutions manage risk with sophisticated financial techniques far beyond the capacity
of any S&L, the accounting problems at Fannie Mae, and at Freddie Mac in 2003,¹ raise
serious questions. The accounting irregularities to date have been portrayed as a
byproduct of management’s wish to persuade investors that, despite the volatile nature of
the mortgage market, the firms’ earnings are steady, predictable, and insulated from
sudden changes. (Other things equal, higher volatility in earnings will drive investors to
demand higher interest rates to compensate for the risk of holding GSE debt, which would
lower the profitability of the mortgage portfolios both GSEs hold.) There has been no
indication that accounting has been manipulated to conceal fundamental financial
problems in the two firms, as was the case at failing firms like Enron and WorldCom.
However, given the size of the GSEs and their importance to the financial system, there
is clearly a public interest in improving accounting transparency and rigor.
Why Fannie Mae’s Financial Statements Were Manipulated
In May 2006, OFHEO published its final report on its special examination of Fannie
Mae.² A major finding is that improper accounting practices were largely driven by
management’s desire to achieve profit targets (expressed as earnings per share, or EPS)
that would trigger maximum bonuses. Fannie Mae had three compensation plans linked
to EPS figures: two affected only a small group of top executives, but another, called the
Annual Incentive Plan, had over 800 beneficiaries.
Achieving the targeted EPS numbers became an overriding goal at Fannie Mae.
Accounting personnel received explicit instructions (as well as constant exhortations)
regarding the importance of the figures. The OFHEO report presents numerous internal
communications that discuss which particular manipulation would be best suited to hit
the target in a particular quarter or year. (It was also important not to exceed the target,
because bonuses were capped. If earnings appeared likely to exceed the target figure,
ways were found to defer recognition of current earnings to future periods.)
In summary, Fannie Mae’s accounting systems and policies were designed to
produce the results that management wanted, and not to provide investors with an
accurate picture of the firm’s financial condition. The image management tried to project
— of a firm whose financial results were predictable and stable — was false. In 2002
and 2003, when interest rates dropped to very low levels, Fannie Mae incurred large
losses due to an increased rate of mortgage prepayments. “The magnitude of those losses,
although not large enough to threaten the safety and soundness of Fannie Mae, provides
evidence that the Enterprise’s interest rate risk exposure during the period was significant

¹ See CRS Report RS21567, Accounting and Management Problems at Freddie Mac, by Mark
Jickling.
² Report of the Special Examination of Fannie Mae, May 2006, 340 p. (Available on the OFHEO
and Fannie Mae websites.)

and is inconsistent with the image of Fannie Mae as a very low-risk institution promoted
by senior management.”³
The Accounting Issues
The 2004 OFHEO report⁴ identified (and the Rudman⁵ and May 2006 OFHEO
reports confirmed) a number of major accounting problems at Fannie Mae. Several dealt
with the failure to comply with specific accounting rules, and a more general critique
focused on weaknesses in the firm’s accounting processes, corporate culture, the “tone
at the top,” and failure of the board of governors to provide effective oversight. These
issues are summarized below.
Derivatives Accounting (SFAS 133). Derivatives — including futures
contracts, options, forwards, swaps, and caps — are financial instruments whose value
is linked to changes in some economic variable, most often interest rates. Fannie Mae
uses derivatives extensively to manage interest rate risk. Derivatives accounting is
governed by SFAS 133.⁶ Under SFAS 133, the fair value of all financial derivatives must
be calculated (“marked-to-market”) at the end of each accounting period. Changes in fair
value from the previous accounting period must be reported as current income, unless the
derivatives are used for hedging. If a derivative is used to hedge an asset (as in the
example above), the value of that asset — the hedged item — will move in the opposite
direction to the derivative’s value. Thus, a fall in the price of the hedged asset will be
offset by a gain in the derivative (or vice versa). Under SFAS 133, the firm can recognize
as earnings both the change in the derivative’s value and the offsetting change in the
hedged item’s. If the gains and losses are closely correlated, the net effect on reported
earnings will be very small or zero.
OFHEO’s 2004 report analyzed a number of derivatives transactions in detail and
found numerous specific practices that do not conform with SFAS 133. A common theme
is the inappropriate use of “short-cuts” that produce the desired result of perfectly
effective hedges that will have no impact on the bottom line. OFHEO found that Fannie
Mae’s failures to follow SFAS 133 were consistent with the objectives of minimizing
earnings volatility and simplifying operations.⁷ The Rudman report concludes that Fannie
Mae deviated from the clear requirements of SFAS 133 in numerous and important
respects, and concurs with OFHEO’s assessment of Fannie’s motivation.
Amortization of Purchase Discounts, Premiums, and Fees (SFAS 91).
When Fannie Mae buys mortgages or MBS, it does not pay the exact amount of unpaid

³ Ibid, p. 48.
⁴ Office of Federal Housing Enterprise Oversight, Office of Compliance, Report of Findings to
Date: Special Examination of Fannie Mae, Sept. 17, 2004, 198 p. (Hereinafter cited as OFHEO,
Report of Findings To Date.)
⁵ A Report to the Special Review Committee of the Board of Directors of Fannie Mae, Feb. 23,

2006. Available at [http://www.fanniemae.com]. (Hereinafter cited as Rudman Report.)

⁶ See archived CRS Report 98-52, Derivatives: A New Accounting Standard, by Mark Jickling
(available from author).
⁷ OFHEO, Report of Findings To Date, p. 122.

premium balance outstanding on the loans. If the interest rate (or coupon rate) paid by the
borrower is above current market interest rates, the loan will sell at a premium, above the
unpaid balance. If the coupon rate is below current market rates, the loan is less valuable,
and will sell at a discount. To calculate the effective yield on the loan, Fannie Mae must
take these premiums and discounts into account. (A loan bought at a premium is less
valuable than the coupon rate would imply, and vice versa for loans purchased at a
discount.) Under SFAS 91, a Financial Accounting Standards Board (FASB) rule, the
amount of these premiums and discounts must be amortized, or recognized over the
estimated life of the purchased loans (or MBS). The amounts recognized appear on the
income statement as an adjustment to current interest income.
OFHEO found that Fannie Mae did not follow this standard in a consistent manner
but chose to apply it as needed to produce the financial results management wanted. In
the fall of 1998, as central banks struggled to contain global financial panic, interest rates
fell dramatically. The drop in rates adversely affected Fannie and Freddie by accelerating
the rate of mortgage prepayments. The effect of the speed-up in prepayments on Fannie
Mae’s earnings was a $400 million expense, which according to SFAS 91 should have
been recognized and charged against 1998 earnings. However, Fannie chose to recognize
only $200 million and deferred recognition of the other half.
The deferred $200 million became known within Fannie Mae as the “catch-up.”
OFHEO claimed that Fannie used “inordinate flexibility” in its handling of the catch-up
amount, and used it as an accounting reserve, or “cookie jar,” that gave it wide discretion
to report or defer amortization income in order to obtain the accounting results it wanted.
Fannie adopted polices “specifically intended to manage the catch-up position as a buffer
to sudden changes in interest rates and the resultant volatility of amortization accounts.”⁸
OFHEO put forward two explanations for Fannie Mae’s failure to follow SFAS 91.
First, management sought to create the impression that the company’s operations were
stable, predictable, and low risk. Second, the report analyzed Fannie Mae’s earnings in
1998 and concludes that if the full $400 million had been charged against earnings, top
executives would not have received bonuses linked to earnings per share target levels.⁹
The Rudman report found that the desire to meet the bonus target provides the only
plausible explanation for the 1998 accounting maneuver.
Classification of Securities (SFAS 115). Fannie Mae holds a large portfolio
of debt securities, mostly mortgage-backed bonds. How these securities are valued affects
earnings. The value of bonds falls when interest rates rise and climbs when rates fall.
Fluctuations in the value of bond portfolios should be reported in current income, unless
the bonds are to be held to maturity (in which case the price changes do not matter, since
they do not affect the interest and principal payments the holder receives). SFAS 115
requires firms to classify bond portfolios as either “hold-to-maturity” (HTM) or
“available-for-sale” (AFS). Bonds in the latter category must be revalued at every
accounting period, and changes in value reported as current income. OFHEO finds that
Fannie Mae did not properly apply this rule, but chose the classification that would
produce the financial results it wanted.

⁸ OFHEO, Report of Findings to Date, p. 13.
⁹ Ibid., pp. 10-12.

Structural Problems in Accounting Operations and Review. The 2004
OFHEO report found significant problems with the way Fannie Mae’s accounting results
are generated and reviewed. Individuals involved in the process were encumbered by a
“heavy workload, weak technical skills, and a weak review environment.”¹⁰ The Rudman
report is even more critical: accountants were unqualified, resulting in haphazard
implementation of accounting rules, and failed to understand or carry out their roles in¹¹
making accounting policy. Accounting systems are described as “grossly inadequate.”
The Rudman report notes at the outset, however, that the remedial steps taken by Fannie
Mae since 2004 essentially encompass all the recommendations that report’s authors
would have made.¹²
The Supplemental Agreement. On March 8, 2005, Fannie Mae entered into a
supplemental agreement to correct further accounting problems identified by OFHEO.¹³
Among the accounting issues (and the relevant FASB standards) are
^!valuation of mortgage loans held in portfolio (SFAS 65);
^!improper classification of securities as either “hold to maturity” or
“available for sale” (SFAS 115);
^!policies regarding sale and repurchase of securities, called “dollar rolls”
(SFAS 140);
^!failure to account for certain purchase and sale commitments relating to
mortgage assets as derivatives (SFAS 149); and
^!an accounting policy related to pools of mortgage-backed securities
(FASB Interpretation No. 46).
According to the Rudman report, Fannie Mae has “diligently pursued” its obligations
under the OFHEO agreements.¹⁴
The Restatement
On December 6, 2006, Fannie Mae issued a restatement of earnings covering the
period from January 2002 through June 2004. Earnings were originally misreported by
a total of $9.1 billion, but, because some of the errors understated earnings, the net effect
was to reduce retained earnings over the period by $6.3 billion. The largest item in the
restatement was unreported derivatives losses totaling $7.9 billion.

¹⁰ Ibid., p. 168.
¹¹ Rudman Report, executive summary, p. 5.
¹² Ibid., p. 2.
¹³ For a description of the agreement, see testimony of OFHEO Director Armando Falcon, before
the Subcommittee on Capital Markets, Insurance, and GSEs, House Committee on Financial
Services, Apr. 6, 2005.
¹⁴ Rudman Report, executive summary, p. 2.

The Regulatory Response
On September 27, 2004, Fannie Mae’s board of directors reached an agreement with
OFHEO to take a number of actions to address problems identified in the report. Fannie
Mae will (1) correct its accounting practices related to SFAS 91 and 133, (2) supplement
its capital surplus by an amount equal to 30% of the required minimum capital, (3) review
staff structure, responsibilities, independence, compensation, and incentives, (4) appoint
an independent chief risk officer and separate key business functions now performed
jointly by certain individuals or departments, and (5) put in place new controls and
policies to assure adherence to accounting rules.
On November 15, 2004, Fannie informed the Securities and Exchange Commission
(SEC) that it could not file a third-quarter earnings report because its outside auditor,
KPMG, had declined to sign off on the financial statements. On December 15, 2004, the
chief accountant of the SEC issued a statement that Fannie Mae’s accounting was not in
compliance with SFAS 91 and 133.¹⁵ The SEC directed Fannie Mae to restate its
financial statements for the period from 2001 through mid-2004.
On March 8, 2005, OFHEO entered into a supplemental agreement with Fannie Mae,
relating to further discoveries of accounting irregularity, as described briefly above.
In May 2006, Fannie Mae reached settlements with OFHEO and the SEC. The two
regulators will collect about $400 million in fines. The company agreed not to expand
its mortgage portfolio beyond the asset level of December 31, 2005 (about $727 billion),
except with the advance approval of OFHEO. The firm also agreed to address all the
recommendations in the final OFHEO report, including modifications to internal controls,
accounting practices, governance, corporate culture, disclosure, and personnel oversight
and compensation.
In December 2006, with the release of Fannie Mae’s restatement of earnings,
OFHEO announced that it intended to file suit against former CEO Franklin Raines and
CFO Tim Howard to seek recovery of millions of dollars in bonuses that were linked to
manipulated earnings.
Congressional Action
Two bills in the 109^th Congress — S. 190 (reported by the Senate Banking
Committee on July 28, 2005) and H.R. 1461 (passed the House on October 26, 2005) —
proposed to restructure GSE regulation, by replacing OFHEO with an independent agency¹⁶
with authority over Fannie, Freddie, and the Federal Home Loan Banks. The bills
would enhance the safety and soundness tools available to the GSE regulator, giving it
more flexibility to establish and enforce risk management, operational, and capital
standards, and allowing it to put a GSE into receivership, if necessary.

¹⁵ “Office of the Chief Accountant Issues Statement on Fannie Mae’s Accounting,” Press
Release 2004-172, Dec. 15, 2004.
¹⁶ For a summary of the provisions of these bills, see CRS Report RL32795, Government-
Sponsored Enterprises: Regulatory reform Proposals, by Mark Jickling.