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OFHEO Says Fannie Image Was "Facade"

$400 million settlement reached

May 23, 2006

By COCO SALAZAR


photo of Coco Salazar

A 340-page report from Fannie Mae's regulator offers interesting insight into the $400 million settlement announced today.

The Office of Federal Housing Enterprise Oversight detailed the government-sponsored enterprise's "arrogant and unethical" corporate culture from 1998 through 2004 in its Report of the Special Examination of Fannie Mae. The lengthy report concludes more than two years of in-depth review involving nearly 8 million pages of documents.

"The image of Fannie Mae as one of the lowest-risk and 'best in class' institutions was a facade," said James B. Lockhart, OFHEO acting director, in an announcement. "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. They co-opted their internal auditors. They stonewalled OFHEO."

Such misconduct has prompted a series of events from the Securities and Exchange Commission directing Fannie to restate its financial results for 2002 through mid-2004 to the departure of former Fannie Chairman and Chief Executive Franklin Raines and former Chief Financial Officer Timothy Howard, as well as billions of dollars in market capitalization losses for shareholders, and expenses for the restatement process, regulatory examinations, investigations, and litigation that Fannie estimates to exceed $1.3 billion in 2005 and 2006 alone.

But in the latest developments, today's settlements with OFHEO and the SEC, Fannie has agreed to implement corrective measures and pay a collective penalty of $400 million dollars relating to the misstatement of its financial statements from at least 1998 through 2004, according to announcements following the release of the report.

"The penalty and settlements represent a major step in correcting a dangerous course that had been followed by one of the largest financial institutions in the world," Lockhart said. "Unprincipled corporate behavior and inadequate controls will simply not be tolerated."

OFHEO's special examination report highlighted the role of Franklin Raines, who became chairman and chief executive officer in 1999 and reportedly sought to lead Fannie into a new era of growth in business volumes and profits by challenging senior management and employees to double earnings per share in five years, from $3.23 in 1998 to $6.46 in 2003.

Raines clearly communicated it was these results that mattered, not how they were achieved, and he made changes to compensation programs to enhance incentives to achieve EPS goals, OFHEO said in the report. The intense focus on earnings per share results reduced attention to other objectives and led to inappropriate last-minute adjustments from time to time to reach the targets whether on a quarterly basis to meet analysts' expectations, or on an annual basis to meet compensation targets.

In 1998, for example, Fannie manipulated earnings to maximize bonuses and exceeded analysts' expectations by understating the full amount of calculated expenses, recording only $240 million of amortization expenses, by overstating $199 million in pretax income and making additional adjustments in the fourth quarter that offset nearly half of the amortization expense adjustment, the SEC reported.

One of three compensation plans OFHEO said depended directly on reaching EPS targets was the Annual Incentive Plan, which based payout on annual EPS performance. This plan encouraged the shifting of income forward in years of plentiful core business earnings to meet targets in future years as well, and by 2003, more than 700 employees were eligible for bonuses under the program and the bonus pool grew to $65.1 million from $8.5 million in 1993, OFHEO reported.

Another, the EPS Challenge Grant, a company-wide program championed by Raines, tied the award of a substantial amount of stock options to the doubling of core business EPS from 1998 to 2003, the report said.

Of Raines' $90 million compensation from 1998 through 2003, $52 million was directly tied to achieving earnings per share targets, OFHEO said.

Fannie conveyed it was a low-risk financial institution that was "so well managed that it could hit announced profit targets on the nose every year, regardless of the state of the economy, and that compensated its senior executives appropriately for its extraordinary performance," OFHEO wrote.

Such financial success gave Fannie great political influence and led management to expect to write the rules that applied to the enterprise, such as deciding "when to comply with Generally Accepted Accounting Principles and engaging in and concealing improper earnings management for the purpose of achieving announced earnings targets," as well as failing to cooperate and trying to interfere with OFHEO's special examination, the report said.

Fannie did not comply with a large number of GAAP accounting policies and practices. Additionally, the serous problems of internal control, financial reporting, and corporate governance resulted in Fannie overstating income and capital by a currently estimated $10.6 billion, according to the report.

"Strong accounting controls, though a recognized cost center, can significantly help detect and deter violations of the federal securities laws," said Paul R. Berger, an SEC associate director, in the settlement announcement. "Fannie Mae failed to devote sufficient resources to its accounting, and the results for the company and for its investors have been unfortunate. Public companies should learn from this lesson and ensure that their internal controls and accounting practices are, at a minimum, sufficient to meet their compliance obligations."

Fannie senior management aimed at forcing OFHEO to rely on the enterprise for information and expertise to such a degree that it would essentially be regulated only by itself. Among its efforts to achieve this, Fannie lobbied to ensure OFHEO was poorly funded and resisted special examination by lobbying to generate a Congressional request for the Inspector General of HUD to investigate OFHEO's conduct of the examination, as well as to insert into an appropriations bill language that would punish OFHEO by reducing its appropriations until Director Armando Falcon, who had initiated that examination, was replaced, according to the report.

Without admitting or denying the allegations, Fannie said it was glad to resolve matters with OFHEO and the SEC.

Among the terms of the settlement, Fannie has agreed to limit growth of its portfolio mortgage assets to the level of December 31, 2005, except as provided in a plan to be submitted to OFHEO within 60 days and subject to its approval.

Additionally, Fannie has agreed to undertake a review of current and separated employees for remedial actions, place qualified individuals in adequate positions and provide a strong training program.

Fannie was also directed to undertake a comprehensive reform program aimed at top-to-bottom change, from corporate culture and tone to specific changes in journal entries, accounting procedures, briefings of the board and officers on legal responsibilities, operational risk, reorganization of internal audit and other control functions.

"We have all learned some powerful lessons here about getting things right and about hubris and humility," said Daniel H. Mudd, Fannie president and CEO, in a written statement. "We pledge to continue to work closely and cooperatively with our regulators as we continue to move forward with remedial measures, carry out the terms of our regulatory agreements, complete our restatement and build a better company."

The SEC said its investigation of Fannie is continuing.


Coco Salazar is an assistant editor and staff writer for MortgageDaily.com.

e-mail: [email protected]


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