Our Business is the American Dream

The Office of Federal Housing Enterprise Oversight (OFHEO) issued a lengthy report about Fannie Mae yesterday. A settlement with the OFHEO and the SEC will soon be announced where Fannie Mae will pay a fine of $400 million for its past transgressions.

Many consecutive quarterly reports of steady profit growth were "illusions deliberately and systematically created" through improper accounting practices and manipulation of earnings by senior executives, which ultimately led to the $11 billion accounting scandal.

From the AP report:

The OFHEO review, involving nearly 8 million pages of documents, details what the agency describes as an arrogant and unethical corporate culture, calling Fannie Mae's image of company prestige and excellence a sham. It said Fannie Mae employees manipulated accounting so that senior executives could collect millions in bonuses from 1998 to 2004.
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"The image of Fannie Mae as one of the lowest-risk and 'best in class' institutions was a facade," James B. Lockhart, OFHEO's acting director, said in a statement as the report was released. "Our examination found an environment where the ends justified the means. Senior management manipulated accounting, reaped maximum, undeserved bonuses, and prevented the rest of the world from knowing."

The scandal under Franklin Raines is truly astonishing if for no other reason than the sheer height to which one can rise and then quickly fall. One of just a few African American CEOs at Fortune 500 companies, educated at Harvard and Harvard Law School, a Rhodes Scholar, and then White House Budget Director under President Clinton, he presided over an institution originally setup in the 1938 as a secondary market for FHA insured mortgages.

Through six years as the chief executive officer at Fannie Mae, over half of his $90 million in compensation was directly tied to meeting targets for earnings per share. After testifying before Congress on a number of occasions during 2004 and pledging to vacate his position if irregularities were found, Raines along with other senior management sought to interfere with OFHEO’s investigation by directing lobbyists to use their ties to Congressional staff to:

Generate a Congressional request for the Inspector General of the Department of Housing and Urban Development (HUD) to investigate OFHEO’s conduct of that examination

Insert into an appropriations bill language that would reduce the agency’s appropriations until the Director of OFHEO was replaced.

After the release of the September 2004 OFHEO report alleging widespread accounting errors, Mr. Raines accepted an 'early retirement' a few months later. The entire 348 page report is available from the OFHEO - this summary by the Wall Street Journal ($) hits a few of the key points (the first item is in reference to the earnings per share target of $6.46, the figure Fannie Mae was shooting for after the company set a goal in 1999 of doubling it by the end of 2003.)

Fine-Tuning EPS

The EPS goal became the corporate mantra -- everything else was secondary to hitting that target. Even Sampath Rajappa, Senior Vice President for Operations Risk and head of Internal Audit, the corporate financial watch-dog, fell under its spell. In 2000, after becoming the head of the Office of Auditing, Mr. Rajappa gave a speech to the internal auditors that encapsulated the corporate culture of Fannie Mae under Mr. Raines' stewardship. Mr. Rajappa stated:

"By now every one of you must have 6.46 branded in your brains. You must be able to say it in your sleep, you must be able to recite it forwards and backwards, you must have a raging fire in your belly that burns away all doubts, you must live, breath and dream 6.46, you must be obsessed on 6.46. . . After all, thanks to Frank, we all have a lot of money riding on it. …

Faulty Accounting Practices

The overriding goals of achieving stable growth in earnings and hitting EPS targets encouraged the use of accounting practices that aimed at achieving EPS goals, rather than practices that complied with GAAP.

That was exemplified by an e-mail from CFO Timothy Howard to Controller Leanne Spencer in which Mr. Howard state that he had discussed with Mr. Raines the potential EPS for the third quarter of 2003.

Mr. Howard noted that:

"[Mr. Raines had a] thought for the third quarter -- which I think is a good one ... to come in at an EPS number that would be a double-digit increase from the third quarter of 2002 .... If that's what we want to do, doing $400 million buyback tomorrow would cause us to fall short of our objective .... So -- we need a lower cap. I'd be inclined to say $350."

Ms. Spencer sent a reply e-mail, noting, "I'm comfortable with $350. Let's let that be cap." Although the email is discussing a $50 million adjustment, there is no discussion, nor apparent concern, about what level of debt buybacks made economic sense for Fannie Mae. Mr. Raines set an EPS target with the apparent understanding that Mr. Howard and Ms. Spencer would achieve it through any means necessary. As Ms. Spencer noted in an e-mail exchange with Mr. Howard, "I've just learned over time that [Mr. Raines] always has an opinion."
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Failing to Acknowledge Deficiencies

Another example of that behavior occurred during a press briefing on July 30, 2003. During that briefing Mr. Raines attempted to reassure the participants that Fannie Mae did not have the types of accounting problems then plaguing Freddie Mac. His statements about the quality of Fannie Mae's internal control system were categorical and sweeping:

"So it is possible to run these things properly, but you've got to make the investments. You've got to say that this has got to stand scrutiny internal and external. You can't just go get [sic] by saying, Well, let's do the cheapest or easiest thing to do. So Fannie Mae had always made the investments. We made the investments over Y2K. We've made the investments in our accounting systems. We've centralized our accounting so we don't have to go all over the company to find out what the facts are you can to one place….

Management does matter, and a management that cares a lot about internal control does matter. I think that's really the important difference. It would not take 500 people for us to go back, even if we had made the same mistakes, because we have these systems automated and we can go back and quickly adjust them."

Fannie Mae will forever be remembered as the organization that first made widespread use of mortgage backed securities, where loans are packaged into securities of like risk and return, then sold to investors along with derivative products to hedge against default and interest rate risk.

Their lowering of credit standards through a more 'sophisticated' credit scoring system was adopted by the rest of the mortgage lending industry, which, when combined with ultra-low interest rates beginning in 2001, were the genesis of the U.S. housing market boom.

When the history is written for the U.S. housing boom that took place in the first half of this decade, Fannie Mae will take a prominent position as one of its progenitors, causing many to wonder whose dreams they were referring to in their slogan - theirs or other Americans.