The Safety Net That Never Was – Part XXII

On Friday, BusinessWeek did a brief summary [1] of Fannie Mae’s 2006.

• Stock rose about 23%
• Filed its first earnings statement since late 2004
• Was fined $400 million in May, one of the largest civil penalties ever in an accounting fraud case
• spent $1 billion to fix its accounting
• Restated past earnings in December, wiping out $6.3 billion in profit
  • That’s a big deal (company posted "only" $2.13 billion profit in 2005)
  • But … it was less than the expected loss of $10.8 billion

That was about it for the MSM looking back at a year full of stories about the big GSE, except for a brief note [2] in TheStreet approving OFHEO’s recent decision to sue the CEO, CFO, and Comptroller from Fannie’s scandal-era management team. On the other hand, Doom readers may recall that a considerable number of additional items about the company came up in the last year, and even in the last week.

But first of all, there is the dog that didn’t bark. The Housing GSEs research project at the neo-con American Enterprise Institute has been eerily quiet for over a year. Wallison, Pollock, Ely, and their colleagues have produced four full length books and numerous shorter publications and panel discussions on Fannie and Freddie since about 2000. It is deeply surprising that they have essentially gone silent at the very time the scenarios they have long warned against are in the process of being realized.

The BW article didn’t look too hard at the facts they summarized. That 23% stock rise should have been astounding in view of the housing bubble bursting this year, but the article’s author doesn’t blink. What’s missing from the analysis is the simple observation that investors in FNM stock are focussed almost exclusively on regulatory and government risk. Nothing concrete was accomplished in the recent lame duck session, and Congress (at least the House) is now firmly in the hands of the Democratic Party, traditionally favorable to the GSE lobby. The market is soothed at the thought there is the political will to bail out Fannie or Freddie if either gets into trouble in this challenging environment. Outside of St Louis Fed President William Poole, it seems to have occurred to very few that these companies are so mind-bogglingly huge that any bailout would likely be too large to accomplish.

The story glosses over what Fannie actually achieved for that $1 billion (that’s about the rate they are spending per year) in accounting efforts. On Dec 4th, they achieved their 10-K for 2004. That means that now they’re a bit less then three years behind on their accounting deadlines. Few noted that around the same time the NYSE finally drew a line in the sand. Exactly one year from now, if Bob Blakely’s gang has not yet delivered Fannie’s 10-K for 2005, then the Exchange will order in a bunch of pizza and think really, really, hard about delisting FNM. Sarcasm aside, it is very significant that a regulator has tied its credibility to a hard date, however distant. Come back in a year, and you may find that these players have painted themselves into a corner.

It seems odd that the accounting rewrite has made about $4.5 million of the originally estimated earnings restatement vanish. Now most of these errors were attributed to the notoriously complicated derivatives rules. Followers of reader K’s insights, mostly found under Doom’s Credit Contraction category, will recognize that derivatives are coming under increasing real world discipline as the bubble deflates. As derivative positions are wound up, Fannie’s actual standing with regards to their interest rate swaps and so on should become even clearer.

Just in the last couple of days, OFHEO has reported that Fannie had been "significantly" undercapitalized towards the end of both 2002 and 2003. This new information may appear to be of merely historical interest, but nobody seems to be questioning what it means for 2005 and beyond, where we don’t have good financials yet. And finally, on Friday, Fannie tightened up the rules [3] for its own mortgage partners. The big GSEs may, by definition, have limited exposure to the non-conforming market, but Fannie, for one, seems to be taking few chances.

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Notes and References

[1]: "The Year in Review: Fannie Mae recovers", Associated Press, December 29, 2006.

Shares of Fannie Mae rose about 23 percent this year as the mortgage financier tries to clean up its books and put a massive accounting scandal behind it.

[2]: "The Five Smartest Things on Wall Street This Year", by Colin Barr, TheStreet, December 29, 2006.

Thanks to a diligent regulator, the geniuses who led Fannie Mae into accounting quicksand will have their day in court.

This month the Office of Federal Housing Enterprise Oversight, led by James Lockhart, sued former CEO Franklin Raines. The civil action charges Raines and two other executives with improperly manipulating the firm’s earnings to maximize their incentive-driven bonuses.

[3]: "Fannie Overhauls Core Servicing Requirements", by P. Jackson, HousingWire, December 29, 2006.

Fannie Mae announced today that it has amended core requirements for servicers managing both its fixed and adjustable rate loans, including new requirements for default management and loan administration.

Key among the changes are new requirements for approved custodial depositories, including a revised set of guidelines covering which institutions will be considered eligible for servicers’ deposit receipts. Servicers will be subject to a 120-deadline to transfer funds out of a non-approved bank.

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