Fannie Mae: With Friends Like These

Jon D. Markman Fannie Mae: With Friends Like These By Jon D. Markman RealMoney.com Contributor 9/30/2005 1:19 PM EDT

This column was originally published on RealMoney on Sept. 29 at 7:43 a.m. EDT. It's being republished as a bonus for TheStreet.com readers.

It's going to be very interesting over the next few days and weeks to see who comes to the defense of Fannie Mae (FNM:NYSE) , the badly wounded mortgage lending giant that weathered a new blow on Wednesday.

So far, it looks like the Wall Street investment banks that have been its counterparty or underwriter on hundreds of billions of dollars worth of swaps, bonds and assorted exotic securities are maintaining an eerie, disquieting silence.

The most recent hit came late in the day Wednesday, when Dow Jones Newswires reported that investigators studying Fannie Mae finances have found evidence that the company may have overvalued assets, underreported credit losses, misused tax credits and purchased "finite insurance" to hide shortfalls. Quoting anonymous sources, the report said there were indications that the new accounting violations "were designed to embellish the company's earnings" and are in addition to the violations that the company and its regulator have already disclosed.

The story kicked off an 11% plunge in Fannie Mae shares, its biggest decline since the 1987 crash. The stock closed at $41.71, near its 52-week low, with few buyers apparently willing to step in and aggressively buy at the close.

Little wonder. If the story is accurate -- and there's no reason to suspect it isn't, as the reporter has done a good job of covering Fannie for some time -- it may be a bombshell. These are the kind of allegations that could move the story out of the realm of mere incompetence and fair-minded disputes of accounting arcana, and closer to potential fraud.

To take just one example, finite insurance is, very glibly, the practice of borrowing money from an insurance company for awhile so you can categorize it as revenue or reserves, then paying it back. The game, as uncovered by New York Attorney General Eliot Spitzer, has been revealed elsewhere to be an elaborate Ponzi scheme used to either to hide losses and deceive investors about the erratic nature of quarterly income, or to falsely shore up reserves.

For years, Fannie Mae's former chief executive Franklin Raines proudly told investors that Fannie Mae had an unbroken record of annual income growth of around 15%. But as most savvy investors know, there is virtually no legitimate way to post a perfect growth record in the financial services business.

There will always be up quarters and down quarters, and up years and down years, as the economy ebbs and flows. Warren Buffett has long disparaged the notion that a company should even aspire to produce a seamless earnings stream, in part because he recognizes it is impossible to achieve without accounting sleight of hand.

To be more blunt, if the charges stick, Fannie Mae will stand accused of tricking investors large and small into thinking it had earnings that it didn't. That could open the company to years of lawsuits from the securities bar not just here, but also in Europe and Asia, where U.S. agency debt has been a core holding. If you thought pharmaceuticals maker Merck (MRK:NYSE) had become a trust fund for lawyers and litigants in the wake of its Vioxx mess, just wait til you see what happens with Fannie if this scenario plays out. A bank has virtually nothing but its credibility and financial strength to sell -- no drug pipeline, scientists or patents. Without its implicit government guarantee, Fannie's very survival may be in question.

Disquieting Statements of Support On Wednesday night, a couple of major brokerages waded out with tepid opinions that showed they didn't know quite what to do in this situation, considering they had been the company's cheerleader for so long. This response recalled their deer-in-the-headlights reaction to unfolding revelations of Enron's misdeeds.

Morgan Stanley analyst Kenneth Posner sent a note to clients that continued to list a price target for Fannie Mae stock at $67, yet stated: "While our target price for Fannie shows significant upside potential, it will be a year or longer before we have disclosures with which to judge our forecast and valuation. In the interim, it is hard for us to imagine what arguments bullish investors or analysts would use to defend the stock. As such, we remain on the sidelines."

J.P. Morgan analyst George A. Sacco Jr. told clients in a report that he thinks the new issues raised in the Dow Jones story will be "very small relative to the overall accounting restatement." He added: "We believe that any wrongdoing was committed by the prior management team and these new accusations do not pertain to the way Fannie managed the risks in its mortgage portfolio." Sacco strangely put an "overweight" rating on the stock, yet set his 12-month price target set at a paltry $45, which was a dollar below the price at which Fannie Mae opened on Wednesday. That also makes you kind of go, "Huh?!"

UBS analyst Eric E. Wasserstrom at least took a pass on judging the merits of the Dow Jones story, stating, "At this stage ... we have no confirmed information and therefore have no changes to our view." He maintained his price target at $88.

So there you go. Either the stock is the buy of a lifetime, or it's going to zero. Either some value buyers are going to make their careers buying into this panic, or will have their heads handed to them.

But they sure aren't getting much help either way from analysts who are paid a lot of money to offer direction. And that's probably because, as longtime partners of the rogue mortgage lender, the investment banks are too deeply involved.

From a technical point of view, you should note that the shares broke a massive head-and-shoulders pattern Wednesday, invalidating a potential triple-bottom that had been brewing. Depending on how you do the calculation, the price target now measures out to either $20 or, well, -$7. Sounds like Fannie's kind of math.

Friendly reminder of who is involved in this scandal.

JAMES A. JOHNSON James A. Johnson is Vice Chairman of Perseus, L.L.C., a merchant banking and private equity firm based in Washington, DC and New York City. Beginning in January of 1990 and continuing through December 1999 he was employed by Fannie Mae. He served as Vice Chairman (1990), Chairman and CEO (1991-1998), and Chairman of the Executive Committee (1999). Prior to joining Fannie Mae, Johnson was a managing director in corporate finance at Lehman Brothers. Before joining Lehman, he was the president of Public Strategies, a Washington- based consulting firm he founded to advise corporations on strategic issues. From 1977 to 1981, he served as executive assistant to Vice President Walter F. Mondale, where he advised the Vice President on domestic and foreign policy and political matters. Earlier, he was employed by the Target Corporation, worked as a staff member in the U.S. Senate, and was on the faculty at Princeton University. Johnson serves as chairman of The John F. Kennedy Center for the Performing Arts and is chairman of the board of trustees of The Brookings Institution. He also serves on the board of the following organizations: The Enterprise Foundation; Gannett, Inc.; The Goldman Sachs Group, Inc.; KB Home; National Association on Fetal Alcohol Syndrome; National Housing Endowment; Target Corporation; Temple-Inland, Inc.; and UnitedHealth Group. He is also a member of The American Friends of Bilderberg, The Business Council, the Council on Foreign Relations, the Trilateral Commission, and he is Chairman of the Advisory Council for Public Strategies Incorporated. In March 1994, Johnson was named "CEO of the Year" by The George Washington University School of Business and Public Management. He also was named a 1998 “Washingtonian of the Year” by WashingtonianMagazine. In May 2001, he was elected to the American Academy of Arts and Sciences. Johnson received a B.A. degree in political science from the University of Minnesota and a Masters Degree in public affairs from the Woodrow Wilson School at Princeton. In 1997, Mr. Johnson received an Honorary Doctor of Laws Degree from Colby College, in 1999 he received an Honorary Doctor of Humane Letters Degree from Howard University, and in 2002, he received a Doctor of Laws Degree from Skidmore College.

Franklin Raines was born January 14, 1949. He attended Harvard College in Boston, where he received his B.A. degree magna cum laude. He continued his education at Harvard Law School where he graduated cum laude with his J.D. (law degree). His studies also included Magdalen College and Oxford University (as a Rhodes Scholar). He went on to serve as the Associate Director for Economics and Government in the Office of Management and Budget (OMB), Executive Office of the President; and Assistant Director of the White House Domestic Policy Staff between 1977 and 1979. He then joined the firm of Lazard Freres & Company where he was a general partner. His tenure there was 11 years. From 1991 to 1996, he was Vice Chairman of Fannie Mae, in charge of the company's legal, credit policy, finance, and other corporate functions. For two years he was the President's (William Jefferson Clinton) key negotiator in the talks that led to passage of the bipartisan Balanced Budget Act of 1997. Raines was the first OMB director in a generation to balance the federal budget. Raines also helped the President manage the federal government by coordinating procurement, financial management, information technology, and regulatory policies for all federal agencies. The Fannie Mae Board of Directors designated Raines as the successor to James A. Johnson in April 1998. From May through December 31, 1998, Raines served as Chairman and CEO-Designate. Franklin D. Raines now serves as Chairman and Chief Executive Officer of Fannie Mae. Fannie Mae is the largest non-bank financial services company in the world. He became Chairman and Chief Executive Officer on January 1, 1999.

Jamie S. Gorelick (born May 6, 1950) was the number two official in the U.S. Department of Justice during the Clinton administration. She was appointed by Senate Democratic Leader Tom Daschle to serve as a commissioner on the bipartisan National Commission on Terrorist Attacks Upon the United States, which sought to investigate the circumstances leading up to the terrorist attacks of September 11, 2001. Gorelick served as Vice Chairman of the Federal National Mortgage Association from 1997 to 2003. Before serving as Deputy Attorney General of the United States, she was General Counsel of the Department of Defense and a prominent attorney with the firm of Miller, Cassidy, Larroca & Lewin. She also served as an assistant to the U.S. Secretary of Energy from 1979 to 1980. Gorelick was president of the District of Columbia Bar from 1992 to 1993. She is currently a law partner in the Washington office of Wilmer, Cutler & Pickering.

Yes indeed she does.

"SLB.com > About Schlumberger > Guiding Principles > Corporate Governance > Board of Directors

Board of Directors

* John Deutch
* Jamie S. Gorelick
* Andrew Gould
* Tony Isaac
* Adrian Lajous
* Andre Levy-Lang
* Michael E. Marks
* Didier Primat
* Tore I. Sandvold
* Nicolas Seydoux
* Linda Gillespie Stuntz
* Rana Talwar

John Deutch
John Deutch, 66, is an institute professor at Massachusetts Institute of Technology, Cambridge, Massachusetts. Deutch is a director of Citigroup, a banking and insurance organization, where he serves on its Audit, Public Affairs and Governance and Nominating Committees; Cummins Inc., a manufacturer of diesel engines and components, where he serves on its Technology, Finance and Governance and Nominating Committees; and Raytheon Corporation, a defense technology company, where he serves on its Governance and Nominating and Public Affairs Committees. Deutch has served on the Schlumberger Board of Directors since 1997.

Jamie S. Gorelick
Jamie S. Gorelick, 54, is a partner in Wilmer Cutler Pickering Hale and Door LLP, an international law firm since July 2003. Gorelick was vice chair of Fannie Mae, financing of home mortgages from May 1997 to July 2003, Washington, D.C. She is a director of United Technologies Corporation, a provider of high technology products and services to the aerospace industry, where she serves on its Audit, Finance and Public Issues Review Committees. She also serves on the Boards of the John D. and Catherine T. MacArthur Foundation, America's Promise, and the Carnegie Endowment for International Peace. She is a member of the Council on Foreign Relations and has served on the Schlumberger Board of Directors since 2002."

http://www.washingtonpost.com/wp-dyn/content/article/2005/04/06/AR2005040601941_pf.html

False Signatures Aided Fannie Mae Bonuses, Falcon Says

By Kathleen Day and Terence O'Hara
Washington Post Staff Writers
Thursday, April 7, 2005; E01

Fannie Mae employees falsified signatures on accounting transactions that helped the company meet earnings targets for 1998, a "manipulation" that triggered multimillion-dollar bonuses for top executives, a federal regulator said yesterday.

Armando Falcon Jr., director of the Office of Federal Housing Enterprise Oversight, said the entries were related to the movement of $200 million in expenses from 1998 to later periods. The result of the changes was an increase in Fannie Mae's 1998 earnings per share and the release of a $27.1 million bonus pool for senior executives.

Fannie Mae reported paying the following executive bonuses in 1998: chairman and chief executive James A. Johnson received $1.932 million; Franklin D. Raines, chairman-designate, received $1.11 million; Chief Operating Officer Lawrence M. Small received $1.108 million; Vice Chairman Jamie S. Gorelick received $779,625; Chief Financial Officer J. Timothy Howard received $493,750; and Robert J. Levin, an executive vice president, received $493,750.

Raines and Howard were ousted by the Fannie Mae board in December after the chief accountant of the Securities and Exchange Commission agreed with OFHEO's criticism of the company's accounting, including the 1998 bonus maneuver. He directed the company to correct financial statements, a move that could wipe out $9 billion in reported profit dating to 2001.

Falcon, during congressional testimony and in comments afterward, publicly drew a link for the first time between the falsified signatures, which his agency disclosed last month, and the accounting manipulations that led to bonuses, which OFHEO disclosed in the fall. A Fannie Mae employee has told investigators that financial records from 1999 to 2002 bore his name and signature but were not prepared by him, Falcon testified.

"We have identified several problems involving procedures for preparing, reviewing, authorizing and recording" Fannie Mae's accounting, Falcon said. His office has said it is sharing all information from its probe with the Securities and Exchange Commission and the Department of Justice.

Falcon said OFHEO has ordered Fannie Mae to determine whose signatures were falsified, why, and whether any executives who received bonuses as a result of the transactions knew about them or the circumstances leading up to them. He would not disclose the names of the employees interviewed, the names used in the falsified signatures or who might have signed the names.

"We're looking into who did it and how far up it went," Falcon said. He made his comments during and following a hearing by a House Financial Services subcommittee, as Congress prepares to consider legislation that would create a new regulator for Fannie Mae and its smaller rival, Freddie Mac.

A spokesman for Fannie Mae, Charles V. Greener, said the company had no comment. Lawyers for Raines and Howard did not return telephone calls seeking comment on whether they knew about the falsified signatures or other problems Falcon cited. Small declined to comment. Gorelick did not return a phone message. The company would not make Levin, who still works there, available.

Falcon said his office obtained testimony from an employee in Fannie Mae's controller's division indicating the employee would change the books when asked, even though he often did not understand the purpose of the changes. OFHEO is investigating the extent and circumstances of those changes, Falcon said.

In his testimony, Falcon also criticized the company's policy of holding mortgage-backed securities for a month before deciding whether to sell them or hold them in the company's own investment portfolio.

"This practice appears to stand in stark contrast to the company's denials of engaging in 'cherry picking' when the matter was reviewed by a 2003 Task Force on Mortgage-Backed Securities Disclosure," Falcon told lawmakers. The task force included officials from OFHEO, the SEC and the Treasury Department.

Fannie Mae's Greener declined to comment on the issue, though the company has denied using its vast nonpublic information base about the home loans it buys to determine which mortgages or mortgage-backed securities to keep or sell. Critics have said use of such inside information is unfair to the broader market Fannie Mae resells to because the company obtains the information through its quasi-government status.

The OFHEO probe began last year following a similar investigation into accounting mistakes at McLean-based Freddie Mac, a scandal that led to the ouster of several top executives there, including two chief executives.

The accounting scandals are being used by Rep. Richard H. Baker (R-La.), chairman of the subcommittee that held the hearing, and the Bush administration to move forward on legislation that would increase oversight and curb the growth of Fannie Mae and Freddie Mac. Baker and others have tried for years to pass such legislation, only to find it defeated by the lobbying efforts of the two companies.

The companies' accounting scandals have bolstered the position of critics, such as Federal Reserve Board Chairman Alan Greenspan. He told the Senate Banking Committee yesterday that the companies' federal subsidies may not benefit homeowners and that the firms' large size and dominance of housing markets could pose a threat to the nation's financial system if they ever fell into trouble.

While there is a general consensus in Congress that Fannie Mae and Freddie Mac need a new, stronger regulator, Greenspan's testimony focused largely on the most controversial aspect of the debate: the size of the companies' portfolios of mortgage assets. Together, the mortgages and mortgage-backed securities that Fannie Mae and Freddie Mac own total $1.5 trillion, a more than tenfold increase in the past 15 years.

The Fed chairman called on Congress to sharply reduce the two companies' massive mortgage portfolios "while we can," saying that without a reduction, they will "inevitably" have major financial problems, causing a crisis in the economy.

Fannie Mae, Freddie Mac and housing industry advocates say the two companies' growing size has strengthened their financial health and improved their flexibility for providing a stable and affordable flow of cash to the home mortgage market -- their congressionally chartered mission.

But Greenspan said the only reason he could find for the vast increase in the companies' balance sheets is to allow Fannie Mae and Freddie Mac to make more money for their shareholders. The companies, , because of their implicit government backing -- what he repeatedly called a "subsidy" -- are able to borrow money at below-market rates and invest the money in market-rate investments. This "spread" between their borrowing costs and what they make on mortgage investments creates a "profit motive" that is at odds with their public mission to provide affordable mortgages and, further, concentrates mortgage investment market risks in two large companies, he said.

Baker's bill calls for giving a new regulator authority to restrict the size of either Fannie Mae or Freddie Mac if the size of the portfolio poses a safety and soundness risk, but it does not call for specific limits or decreases in their balance sheets.

Armando Falcon Jr., OFHEO director, testified yesterday.

Rep. Richard H. Baker, right, who headed the hearing on Fannie Mae and Freddie Mac, with Paul E. Kanjorski (D-Pa.).

Armando Falcon Jr. said OFHEO is looking into how many people knew about falsified signatures.
© 2005 The Washington Post Company

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