Not So Smooth A Move
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It has been 19 months since the first alarm was raised about America's
two giant, federally chartered loan corporations. This past week the chickens
started coming home to roost.
In February, 2003, the Federal Home Loan Mortgage Corporation, almost universally
known as Freddie Mac, came under fire for illegal accounting practices. Specifically,
Freddie was accused of using unlawful techniques to "smooth out"
volatility in revenues and earnings, with an alleged primary aim of meeting
goals that would generate bonuses for top senior management. These practices
would also, presumably, encourage increases in the corporation's stock
value.
Then, on September 22, 2004, The Federal National Mortgage Corporation, usually
called Fannie Mae, the larger of the two chartered entities, was accused of
nearly identical "smoothing" practices.
Any discussion of accounting operations and abuses makes my eyes glaze over.
Without talking about derivatives, which only three people in the whole world
understand, here is a brief explanation of the issue. Freddie and Fannie were
both putting some revenues and some anticipated and actual expenses into what
the Chairman of the Office of Federal Housing Enterprise Oversight, which is
involved in the investigation, called a "cookie jar." Accountants
could then dip into that jar and pull out appropriate amounts of income or expenses
to insure the quarterly or yearly financial results desired by the corporations.
Thus, if the corporations had sensational revenues or profits in 2004 and anticipated
a more bleak 2005, they could hide part of the 2004 goodies in the cookie jar
and later credit its contents to 2005, or even further down the line to ensure
against radical gyrations in stock and, maybe, guarantee those executive bonuses.
Creative? Certainly!.
Legal? Certainly not!
Last December Freddie Mac paid $125 million in fines for its innovative accounting
practices. It had already fired or retired three of its top executives and restated
its 2000-2002 earnings upward by $5 billion while admitting it had also not
reported a loss from a previous quarter. Who knows when you might need a little
negative income?
Then, on October 4, 2004 it announced it was shutting down its Securities Sales
and Trading Group, blamed for many of the accounting irregularities. The group's
market-making activities and operations involving investments and mortgages
will be moved to other divisions of the corporation.
Since the charges against Fannie Mae were disclosed late last month, as might
be expected, at least three class action lawsuits have been filed against the
corporation by firms representing Fannie Mae's investors. There will certainly
be more of these to come.
On Wednesday, October 6, officers of Fannie Mae appeared before a subcommittee
of the House Financial Services Committee. Chairman and CEO Franklin Raines
and CFO Timothy Howard both testified that regulators' accusations of
irregularities in accounting practices merely exemplified a difference in interpretation
of "what are, admittedly, complex rules" Mr. Raines stated that
he believed these rules had been applied (by Fannie Mae) in accordance with
"generally accepted accounting practices."
So, and we seem to be asking this question all too frequently, should anybody
care?
Well Freddy and Fannie's stockholders certainly should. Both stocks have
been on a wild ride since February 2003. Stock in Freddie (FRE) has recovered
much of its losses, standing at $67.00 on October 7. But Fannie's stock
(FNM) had a mid-day quote of $68.60 on October 7, well below its 52 week high
of $80.82 on February 23.
But there are more global issues at play.
- The two corporations are privately owned by millions of investors and
are both traded on the New York Stock Exchange (FNM and FRE). They are often
described as 1,000 lb gorillas, and no wonder. Their market capitalization totals
$111.4 billion. In February 2004, Federal Reserve Chairman Alan Greenspan told
Congress that Freddie and Fannie, if allowed to grow unchecked, are likely to
threaten the stability of the U.S. financial system.
- The two corporations stand behind some four trillion dollars in home
mortgages, representing better than 75% of the single family mortgages in the
country. Fannie Mae, on its own, is the second largest financial institution
in the United States.
- Both corporations are currently the subject of investigations by the
U. S. Department of Justice.
- The two, because they were originally chartered by the Federal Government,
retain some unusual prerogatives. Both are allowed to borrow directly from the
U.S. Treasury at lower rates than are generally available to other mortgage
entities. These funds are used to purchase mortgages from banks, thrifts, and
mortgage companies, thus funneling billions of dollars to facilitate home buying
throughout the country. Many of these mortgages are then packaged into securities
and resold to Wall Street investors.
In this way, the two operate exactly as they were designed to, making home
ownership available to countless families previously unable to qualify for this
privilege. One must, however, question how competition on a level field might
further the end goal. And, continuing these unusual advantages, they are exempt
from several Securities and Exchange Commission requirements when filing these
securitized mortgage packages.
And, of course, politics always comes into play.
The two have many competitors who resent their special status and which have
been actively lobbying Congress to reign in the two giants. And while F &
F have supporters in Congress, many powerful Republicans are not among them.
In particular, Rep Howard Baker, Chairman of the House panel hearing the testimony
of Raines and Howard, is a longtime critic of both corporations.
They are also resented for their political clout. Raines is a former budget
director in the Clinton administration. Other current and former officials include
a member of the 9/11 Commission, the secretary of the Smithsonian Institution,
an advisor to Vice President Walter Mondale, and a partner of President Bush
when he owned the Texas Rangers.
So, might this imbroglio impact on the ability of millions of Americans to
buy homes and place mortgages, as they have done for years, through Freddie
and Fannie? Who knows? There will certainly be ramifications (Freddy has already
been required to raise its minimum capital requirement by 30% until it gets
its house in order), which could result in tighter control over the two corporations.
While this "scandal" has been going on for over a year, with Congress,
the Justice Department, and the SEC involved, the story is just beginning.
Stay tuned.
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