Fannie Mae Goes Along to Get Along

By agreeing to its regulator's demands, the mortgage titan has largely stalled its critics and distanced itself from scandal

By Mike McNamee

Fannie Mae's political savvy apparently has rubbed off on its board. Moving quickly to defuse a showdown with their regulator, the mortgage giant's directors signed off Sept. 27 on an agreement promising to boost Fannie's capital, tighten up its accounting, strengthen the board's audit committee, and scrub down the CFO shop, where expenses allegedly were manipulated to smooth reported earnings for several years.

The prompt deal is a clear win-win outcome: The Office of Federal Housing Enterprise Oversight (OFHEO), the long-invisible agency that regulates Fannie Mae and Freddie Mac, emerges looking stronger, while Fannie's directors, in reassuring nervous investors and easing tensions in Washington, look smarter.

RELIEF ON THE STREET.

  A third party, however, is still to be heard from. Fannie's management team, while pledging "full support" for the interim agreement, has not yet responded to the allegations of misleading accounting, slipshod financial controls, and earnings management that OFHEO raised in its Sept. 22 "special examination" report. CEO Franklin D. Raines and his colleagues know they'll make little headway arguing against OFHEO's allegations immediately.

Outside critics of Fannie are pointing to the OFHEO report's lack of hard numbers as evidence that the regulators don't have a smoking gun to prove that Fannie's accounting went awry. And the amounts involved in Fannie's accounting missteps may be too small in the end to matter at a company that reported $7.9 billion in earnings in 2003.

Figuring out the size of Fannie's flubs may take as long as two years. Directors, shaken by the 15% drop in Fannie's stock last week after the OFHEO report, couldn't wait for that resolution. By negotiating through the weekend, they struck a deal that buys them time, avoids a quick shakeup among Fannie's top managers, and already has calmed the markets. Fannie's stock rose 99 cents on Sept. 27, to close at $66.50.

The centerpiece of the deal: Fannie pledged to build a capital cushion by next June that will be 30% greater than the minimum capital OFHEO normally requires. Last June 30, the minimum requirement was $31.2 billion, and Fannie reported it had $36.1 billion on hand, a 14% cushion. If the 30% cushion had been required then, the company would have been $4.5 billion short. Fannie declined to provide figures for its current capital, except to say that it had 18% more than the minimum on Aug. 31.

SEC SCRUTINY.

  That cushion should help satisfy investors worried about the remote possibility that the accounting scandal could take Fannie down. But meeting the capital target will force it to either raise more funds -- by retaining earnings or selling preferred or common stock -- or to slow its asset growth to reduce the amount of capital it needs.

Neither course will come easily to the mortgage giant: Investors aren't going to line up for new shares when Fannie's financial statements are under scrutiny, and the company's hallmark has long been strong, steady growth.

The deal also requires Fannie to hew more closely to two accounting standards -- Financial Accounting Standard 133, which governs bookkeeping for Fannie's huge portfolio of hedging instruments, and FAS 91, which controls Fannie's projections for the earnings hit when it pays a premium to buy a pool of mortgages. Fannie pledged to recalculate its earnings, applying the rules more strictly, as far back as 1998.

But that doesn't mean earnings will be restated: The Securities & Exchange Commission, not OFHEO, will determine whether Fannie's accounting practices produced material mistakes. SEC officials haven't had sufficient time to review OFHEO's report and are treading carefully on predicting whether Fannie will have to restate earnings.

THE NEXT HAND.

  Fannie's board also pledged to call in independent experts to scrutinize the finance operation run by CFO Timothy Howard. OFHEO found that Howard was in charge of both setting financial targets and measuring how well they had been met -- a serious breach of internal controls. The deal requires Fannie to overhaul its organization and control systems to foster "a culture of adherence" to accounting and legal requirements.

But Howard -- the most likely candidate for firing in any management shakeup -- has kept his job, at least for now. And while Republican Fannie critics on Capitol Hill are still planning hearings into the OFHEO report, the Fannie directors' quick capitulation should take some steam out of the drive to replace OFHEO with a tougher regulator housed in the Treasury Dept.

For Fannie's skilled lobbyists, accustomed to winning by overwhelming their opposition, quick surrender is an unusual tactic. But by knowing when to fold a losing hand, Fannie's directors are making sure they will still be in the game when it counts.

McNamee is BusinessWeek's deputy bureau chief in Washington