New Accounting Problems at Fannie Mae

Citing anonymous sources “close to” or “who have been involved” in the accounting investigation at Fannie Mae, the Dow Jones Newswires said late Wednesday that the company had “overvalued its assets, underreported credit losses, and misused tax credits,” the Washington Post reported. Evidence came to light suggesting that Fannie Mae had purchased finite insurance policies to hide losses These insurance policies could be a form of financial reinsurance considered abusive by regulators “that are more akin to loans, where little or no risk is transferred to the insurer,” according to the Wall Street Journal.

Fannie Mae and the company’s chief regulator, the Office of Federal Housing Enterprise Oversight (OFHEO,) both declined to comment on the story. Earlier this year, Fannie Mae admitted that it had violated accounting principles in recording its derivatives and other transactions that permit the company to hedge its assets against interest rate fluctuations. The cumulative losses for the years 2001 through 2004 could be as high as $10.8 billion dollars. The company has already warned investors that the original restatement for 2004 cannot be counted on, and that management is “likely to conclude” that its financial reporting for 2005 will be “ineffective.”

Federal Reserve Chairman Alan Greenspan, in a letter to Senator Robert Bennett (R., Utah) on September 2nd said that as Fannie Mae and Freddie Mac increase in size, the ability of the financial markets “to quickly correct the inevitable misjudgments inherent in their complex hedging strategies becomes more difficult, the Wall Street Journal, which reviewed the letter, reported. Greenspan goes on to say “excessive caution in reducing their [Fannie Mae’s and Freddie Mac’s] portfolios could be destabilizing to our financial system as a whole and in the end could seriously diminish the availability of home mortgage funds.” Earlier this year the Journal reported that the Federal Reserve Chairman criticized legislation pending in the House as worse than doing nothing. The combined holdings of Fannie Mae and Freddie Mac have declined so far this year to $1.449 trillion, down 7 percent from 2004, the Journal reported.

Responding to Mr. Greenspan’s comments, Freddie Mac’s spokesman sought to play down the possibility of systemic risk in the two companies’ portfolios. “Our portfolio is very conservatively managed and tightly regulated,” said David Palombi speaking for the company, the Journal said. In marked contrast to Fannie Mae, Freddie Mac showed after-tax profits deferred to future quarters of $5.3 billion in its restatement for 2003.

OFHEO issued a statement on Wednesday that Fannie Mae had met its capital requirements as of June 30 and would be able to come up with the additional $5.9 billion that OFHEO has mandated for September 30, the Washington Post reported.

After a decline on Thursday of 11 percent on the report of new accounting problems, Fannie’s stock recovered somewhat on Friday, according to Bloomberg News. The stock has declined 37 percent for the year.

JPMorgan analyst, George Sacco, told Bloomberg News that the use of finite insurance and questionable tax credits are “likely to have a relatively small impact on the restatement.” He said the impact of the new accounting issues would be around $1 billion.

Given the size of the restatement, $10.8 billion, Robert Lacoursiere, an analyst at Banc of America Securities, told Bloomberg. “It wouldn’t surprise us if they discovered more than what has been thus far disclosed by management” to explain the rationale for the restatement.

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