EVENTS

Date:	Thursday, October 28, 2004
Time:	2:00 PM -- 4:00 PM
Location:	Wohlstetter Conference Center, Twelfth Floor, AEI 1150 Seventeenth Street, N.W., Washington, D.C. 20036

October 2004

Understanding OFHEO's Report on Fannie Mae

On October 28, AEI held a conference to analyze OFHEO's recent report on Fannie Mae. Whether Fannie Mae's accounting reflected a deliberate violation of the rules--as the Office of Federal Housing Enterprise Oversight contends--or a difference of opinion among accountants--as Fannie argues--has become a matter of considerable importance and could be the determining factor in whether Fannie's current management retain their positions. Moreover, there is also a question of whether the resolution of these differences will result in recognizing that Fannie's capital has been seriously depleted and its earnings overstated, or a far less dramatic outcome. At this conference, four financial specialists who have made careful studies of Fannie's accounting over the years outlined their views and attempted to bring some clarification to these issues.

John Barnett
Hovde Capital Advisors

First, I believe Fannie will file its 10-Q on time, but that it will not have an endorsement by its auditor, KPMG. In my opinion, the FAS 91 issues are the most egregious accounting failures committed by Fannie Mae. The Office of Federal Housing Enterprise Oversight (OFHEO) report concludes that Fannie Mae's accounting remarks do not reflect the economic condition of the company, but for all the talk about these issues being too complex, I do not think that understanding the fundamentals of accounting is necessary to recognize that there is a serious problem. Beginning in 2002, fluctuations in the duration gap would have indicated that earnings would decrease, but instead they increased. They were reporting earnings that do not reflect their business practices. Variances in fair value can be explained, but you cannot explain a consistent cumulative divergence like this. They have clearly over-reported earnings and mismanaged their interest rate risk. I do not think it can be argued that this company is safe or sound if their capital standard can be so easily manipulated by accounting tricks. The standards are very clear.
 
Bert Ely
Ely & Company

The OFHEO report is fundamentally flawed, but it does address the serious accounting issues Fannie Mae is facing. It lacks sufficient quantification of the dollar magnitude of Fannie's accounting distortions. While it includes too much verbiage and emphasizes interviews with Fannie personnel, the report does outline the numerous accounting and financial reporting problems at Fannie that demand attention and regulatory action. The two main accounting problems revolve around FAS 133 and FAS 91. They focus on a loss of cash reserves and valuation of deferred tax assets, among other things. These irregularities call into question the adequacy of Fannie's entire accounting system. The SEC must address these in a timely manner and determine whether Fannie needs to restate its earnings and promise to mend its ways. It must ensure that Fannie follow the same rules applicable to other public companies. An accounting restatement may show that Fannie was less than "adequately capitalized" at various times. Possible OFHEO supervisory actions that could result from a restatement include higher capital requirements, fines and penalties, and a slowdown in Fannie's growth. I predict that this restatement of financial reports will occur. It is unlikely that Fannie will file its third-quarter 10-Q because of auditor and certification problems. For a year or two Fannie could go "dark" while it cleans up its accounting problems. While the full extent of Fannie's capital problems is likely to be uncovered, the residential mortgage market will not be hurt. Fannie Mae's problems provide yet another impetus for fundamental GSE reform and privatization.
 
Mark Haefele
Sonic Capital

Fannie Mae has been operating with too much risk and is highly leveraged. In the past, I have characterized Fannie Mae's accounting as legal but lousy. I was wrong--according to OFHEO, Fannie's regulator, the accounting was not legal, it was just lousy. They violated accounting principles, and OFHEO has taken a courageous step to review Fannie Mae despite all the facts and a final investigation. Just because only two accounting rules have been violated so far, it is enough to consider a restatement. Fannie would have you believe that the accounting issues are too complex and that reasonable people can disagree on their applications. In general, I do not think that the experts are supporting this theory. The OFHEO report explains motive: Fannie inappropriately deferred expenses, which affected executive compensation. The vast majority of executive compensation is linked to earnings per share. The motive is there to manipulate earnings per share. Secondly, the report cites a lack of control that begins with the chairman and controller--neither of whom are CPAs. One can infer that these executives are endorsing an EPS accounting method on a system that is not robust enough to hit its targets and appropriately account for its earnings. Chief Executive Officer Franklin D. Raines said there were no facts in the OFHEO report--a contradiction to a statement by Mr. Howard.

Dwight Jaffee
University of California-Berkeley

Clear violations in the OFHEO report include the "Black Letter" GAAP rules--Fannie ignored FAS 133 rules for hedge accounting of derivatives--and the SEC "fair disclosure" rules. As a result, investors, researchers, and regulators were all misled. Fannie Mae's rate disclosures, such as its duration gap, are wrong. We are likely to find that Fannie Mae violated capital rules past and present. Rigged disclosures like this make it impossible to determine if unwarranted risk is imposed on U.S. taxpayers. Congress created GSEs to assist the mortgage market, and it is outrageous that these firms would cook their books out of self-interest. The issue is not the complexity of rules but the chain of command. Fannie Mae managers have misled supervisory and regulatory entities. These entities, management, OFHEO, Congress, and the board of directors must now act to restore confidence and limit taxpayer risks. OFHEO should require quarterly fair value accounts, and these requirements should be part of OFHEO's capital rule. FASB and OFHEO must verify and audit valuation methods and hold the board of directors accountable. OFHEO's new oversight zeal is applauded, but many issues remain. The ultimate responsibility lies with the U.S. Congress.
 
AEI research assistant Jessica Browning prepared this summary.