Franklin Raines's Lost Gamble

Fannie Mae's chairman and CEO bet that his political prowess could protect him from an accounting scandal. He was wrong

By Mike McNamee

Franklin D. Raines, long known for his steady hand and deep Washington connections, staked his job as chairman and CEO of Fannie Mae (FNM ) on a series of political bets. On Dec. 21, he lost big.

After days of meetings, the board of the Washington (D.C.)-based mortgage giant announced that Raines would take early retirement in the wake of the company's accounting scandal. Longtime CFO J. Timothy Howard resigned, and the board plans to replace KPMG as Fannie's auditor. Raines, Howard, and KMPG could not immediately be reached for comment for this story. In a statement released on Dec. 21, Raines said: "Although, to my knowledge, the company has always made good-faith efforts to get its accounting right, the SEC has determined that mistakes were made."

To outsiders, the departures had seemed inevitable since Dec. 15, when the Securities & Exchange Commission's chief accountant ruled that Fannie had improperly accounted for hedging transactions in its trillion-dollar portfolio of derivatives. The SEC ordered it to start working on a restatement that's likely to lop $9 billion off its earnings -- 40% of reported profits from 2001 through mid-2004.


  But Fannie's board, through long hours of meetings, defended Raines for almost a week. The final straw: On Dec. 21, Fannie's regulator, the Office of Federal Housing Enterprise Oversight, declared that the $9 billion earnings hit had left the company "significantly undercapitalized." At $28.86 billion, Fannie's core capital was $2.98 billion, or almost 10%, below the required minimum.

That declaration opened the way for the OFHEO to force significant changes in Fannie's operations and management -- and no one doubted any longer that the regulator would start by forcing out Raines and Howard. Their departure gives Fannie a clean slate to begin trying to work with federal authorities and shareholders as it reins in growth plans and adjusts its portfolio to bolster its balance sheet.

That effort will be led by Daniel H. Mudd, currently Fannie's chief operating officer, who'll step in as interim CEO; director Stephen B. Ashley, a mortgage banker who'll serve as nonexecutive chairman; and interim CFO Robert Levin, currently Fannie's executive vice-president. If the OFHEO follows the model it set in a 2003 accounting scandal at Freddie Mac, Fannie Mae is likely to look outside for permanent replacements for Raines and Howard.


  For Raines, early retirement at age 55 is an inglorious end to a charmed career. From his childhood -- one of seven children of a Seattle city worker and a Boeing mechanic -- Raines earned degrees from Harvard College and then its Law School, a Rhodes scholarship, and enoyed a successful a career with investment banker Lazard Freres until he became Fannie's vice-chairman in 1991.

He took two years off to serve as President Clinton's Office of Management & Budget directory -- the first OMB chief to preside over a balanced budget in 30 years. He returned to Fannie in 1998 and became the first African-American CEO of a Fortune 500 company in 1999.

Yet for all his political acumen -- and the lobbying clout he built around Fannie -- Raines severely misjudged and mishandled the current financial crisis. When sibling Freddie Mac, another government-sponsored mortgage giant, revealed problems with its books in June, 2003, Raines insisted that Fannie was above reproach. His high-handed attitude spurred the OFHEO into conducting a white-glove examination.


  The result: A Sept. 17 report charging that Fannie had smoothed its earnings for 3-1/2 years by violating accounting standards for its hedging transactions. The OFHEO also found that Howard had extraordinary control over every aspect of Fannie's financials, resulting in "weak or nonexistent" financial controls.

Still, Raines was willing to gamble. He insisted that the SEC would vindicate Fannie's methods, betting that the securities cops would back the politically potent company over its pitifully weak regulator, the OFHEO. But the SEC, citing its own long-held precedents, rejected what the chief accountant dryly called Fannie's "own unique methodology" for valuing derivatives.

At an Oct. 6 congressional hearing -- where Raines rallied his longtime supporters on Capitol Hill -- the CEO tossed down the gauntlet. " is determined that our company made significant mistakes, our board and our shareholders will hold me accountable," he declared. "And I'll hold myself accountable." On Dec. 21, he had to live up to those words.

McNamee is deputy chief for BusinessWeek's Washington bureau

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