TOPICS > Economy

Fannie Mae’s Financial Troubles

December 22, 2004 at 12:00 AM EST
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TERENCE SMITH: The housing finance giant Fannie Mae took another hit yesterday as two of its top officers were compelled to step down. The company’s board of directors announced that chief executive officer Franklin Raines was taking early retirement, while its chief financial officer, Timothy Howard, was resigning. Both departures came after months of critical reports, federal investigations and congressional hearings that questioned the way Fannie Mae operates. Last week the Securities and Exchange Commission ordered Fannie Mae to declare $9 billion in losses because of accounting violations.

To tell us more about this, I’m joined by Mike McNamee, who’s been covering the story for Business Week. He’s deputy chief of the magazine’s Washington bureau. Mike, welcome.

MIKE McNAMEE: Thank you.

TERENCE SMITH: Why were Raines and Howard forced to step down? And I take it they were compelled to step down.

MIKE McNAMEE: They were compelled to step down. Their regulator, Fannie Mae’s regulator had just declared the company undercapitalized due to this $9 billion write-down. The write-down occurred because of accounting systems that Howard had designed and run and overseen, and it all occurred on Raines’ watch. On top of that, Raines had more or less said to the regulator twice, “Come and get me, Copper.” He had dared them to find accounting problems at Fannie Mae, and they did find them. And the SEC ratified those decisions. And it was untenable for them to stay any longer.

TERENCE SMITH: And he had argued very vigorously that they were in the right until the SEC ruled otherwise.

MIKE McNAMEE: He went to Capitol Hill on Oct. 6 and said “We have good, solid systems. We are sound. And if it’s found otherwise I will be held accountable.” So he was.

TERENCE SMITH: So he was. Back up just for a minute, if you will, and explain in layman’s terms how Fannie Mae works.

MIKE McNAMEE: Fannie Mae is an intermediary, a middleman in the mortgage system. You go to your bank and you take out a mortgage. In the old days before Fannie Mae, the mortgage would have sat on the bank’s books and it would have tied up their capital, their money. Now, since the 1930s, the bank can turn around and sell that mortgage to Fannie Mae. Fannie Mae takes your mortgage and the mortgage of thousands of other people, packages them into a bond-like security called a collateralized mortgage obligation, and sells that on the market.

What this does is it frees your bank to make more loans because the money is not tied up; it brings in money from outside your local area so your mortgage market is now national. It’s not tied to the economic fortunes of your area. And it saves money, because in part because Fannie has some special government privileges, it cuts the rate on your mortgage by a half or a quarter point.

TERENCE SMITH: This trouble at Fannie Mae, is it likely to affect either mortgage rates, mortgage availability or what the average homeowner pays?

MIKE McNAMEE: It will have a small, probably imperceptible effect to most people on the mortgage rates. Fannie is undercapitalized. They have got to slow down their business until their capital catches back up with their book of business, the size of their business. So they will… they have already slowed down the mortgage buying process; that will push up rates a tiny bit. Fortunately, you know, in the 60 years since the company was founded, there have been private competitors that have sprung up to do the same thing and they can take some of the slack.

TERENCE SMITH: What are they accused of doing wrong, if you can explain it to a layman like me?

MIKE McNAMEE: Try to boil this down. Because Fannie is hugely exposed to interest rate risk, –

TERENCE SMITH: Right.

MIKE McNAMEE: — they do very complicated financial dealings that are called hedges, like a farmer who sells a future contract so that he can lock in the price of his grain in the future. They try to lock in interest rates for the longer term. The accounting for these hedges is very complex. They’re supposed to adjust their earnings as the value of the hedges rises and falls.

There’s an exception that lets them not adjust their earnings quite as frequently. And that smoothes out their earnings. And companies today, as we all know, like to have nice, smooth, steady earnings growth. So Fannie was using the exception but they did not qualify for the exception. They weren’t taking all the proper bookkeeping steps, all the proper record-keeping and attribution steps. And they basically didn’t follow the rule.

TERENCE SMITH: And they are accused of, as you say, smoothing out this profit line, this statistic in order to make the company’s books look better, and did it also add to their own personal compensation, the top officers?

MIKE McNAMEE: Absolutely. I mean, Fannie like every other company has incentive pay, bonuses, stock options, things that depend very much on the earnings course being, you know, what is projected. And so Raines, you know, made $20 million last year. A big chunk of that would have been based on the fact that he was delivering earnings performance.

TERENCE SMITH: Now both Democratic and Republican lawmakers have publicly called for some of that money to be returned if it’s proven that it was based on faulty numbers.

MIKE McNAMEE: If the Securities and Exchange Commission can prove fraud– and they are investigating very vigorously right now– then they have the power to order Raines and Howard and perhaps other executives to pay back bonuses that were earned based on faulty earnings.

TERENCE SMITH: Are there investigations that involve criminal as well as civil charges?

MIKE McNAMEE: The Justice Department is looking into the accounting of Fannie Mae as well.

TERENCE SMITH: Now, who is running the show now, and how is the market likely to respond to that?

MIKE McNAMEE: They have promoted from within, very clearly saying that they are interim executives, the chief operating officer has become the chief executive. They’ve promoted an interim CFO, chief financial officer. The precedent here is that they will almost certainly have to go outside for permanent replacements. When Freddy Mac, a very similar company, got into accounting problems in 2003, the regulator cleaned house and made them go entirely outside.

TERENCE SMITH: Now, this is Washington. There’s politics in most things. Is there politics in this?

MIKE McNAMEE: Fannie Mae is a very heavily identified with the Democratic Party. Frank Raines himself was a cabinet official, budget director in the Clinton administration. The party… sorry, the company, because of its long association with affordable housing, has a very Democratic constituency. So they have run afoul of the Republicans who are in charge of the town and the Republicans on the Hill in particular are not too sad to see Fannie Mae getting its comeuppance.

TERENCE SMITH: And so a new chairman might have stronger Republican credentials?

MIKE McNAMEE: I think if they’re smart… well, first of all there will have to be two new executives; they’re separating the job of chairman and CEO, and they would be smart to have one of those have some Republican connection.

TERENCE SMITH: What’s the larger significance of this, Fannie Mae’s troubles, in this era of corporate scandals?

MIKE McNAMEE: Well, it proves that no company is too big and too powerful to run afoul of accounting rules and to be called to heel. Fannie Mae is a company that has… that employs hundreds of lobbyists and employs lobbyists not to lobby for other people; it puts people on their payroll basically to keep them from working for other people. Raines, I think, very much counted on his clout on the Hill, his deep connections to see him through this scandal, and basically the accounting degree and the green eye shades, won.

TERENCE SMITH: So it sounds as though, with investigations still to be completed and so forth, that there may be other shoes to drop in this.

MIKE McNAMEE: Well, they’re getting a new auditor. That’s the third piece besides replacing the two executives. And when you call in a new auditor, a new accounting firm, they’re going to see things that the other people didn’t see. There are also some unresolved issues from the September report that initiated all this. The question of back in 1998 whether they underreported expenses to trigger some executive bonuses that otherwise wouldn’t have been paid.

TERENCE SMITH: And yet, finally, the market today, the shares of Fannie Mae went up.

MIKE McNAMEE: By $1.50.

TERENCE SMITH: Yes.

MIKE McNAMEE: I think the market is probably relieved. They’ve known since last Wednesday night, when the SEC came out with its finding, that something would have to change. And the more Fannie’s board dug in and dragged its heels the more uncertainty there was. Now we know that things are going to move ahead.

TERENCE SMITH: Mike McNamee, thanks very much.

MIKE McNAMEE: It was my pleasure.