It Looks Like Fannie Had Some Help

Major players on the Street may be tied to the fiasco at the mortgage giant

You might think there couldn't be any more bad news about Fannie Mae (FNM ), the mortgage-finance giant accused of manipulating earnings and defrauding investors. But additional disheartening revelations could be on the way as regulators focus on the major Wall Street firms and other advisers that gobbled up Fannie business and allegedly aided in a $10.8 billion accounting fiasco.

Fannie agreed on May 23 to pay $400 million to resolve federal civil allegations that from 1998 through 2004 it prettified its books in a way that allowed executives to inflate their pay. Before the last microphone was shut off at the Washington press conference announcing that deal, government investigators were looking into whether some of the financial world's biggest names facilitated Fannie's misbehavior.

Securities & Exchange Commission staff members are looking into deals in which Goldman Sachs Group (GS ), among others, allegedly helped Fannie rearrange earnings to maintain the appearance of steady profit growth, according to people familiar with the inquiries. Investigators also are scrutinizing KPMG, which, as Fannie's outside auditor, approved financial statements since deemed misleading. And the SEC staff is examining deals designed by Lehman Brothers Inc. (LEH ) and later executed by KPMG that the Internal Revenue Service has determined improperly deferred taxes.

The list goes on. Referring to one arrangement that could come back to haunt insurer Radian Group Inc., a Fannie official wrote in a Jan. 9, 2002, internal e-mail: "I am terrified of the negative public-relations aspects of a disclosure of a transaction like this."


Radian, Goldman, and KPMG all said they had behaved properly when advising Fannie. Lehman declined to comment. In its settlement, Fannie didn't admit or deny wrongdoing.

Veteran observers of corporate excess say the Fannie saga is unfolding according to script. "When a company has engaged in wrongful conduct, the inquiry [inevitably turns to] who knew about it, who could have prevented it, who facilitated it," says former SEC Chairman Harvey Pitt, who now heads Kalorama Partners, a Washington consulting firm. As one of the nation's largest financial-services companies, Fannie offered a veritable feast of business opportunities to professional advisers.

SEC Chairman Christopher Cox has told reporters, without getting specific, that people and "entities whose actions and inactions" contributed to the Fannie debacle will be "vigorously pursued." Ex-CEO Franklin D. Raines and other current and former top Fannie officials are among those facing potential civil and even criminal charges, federal officials say. Raines has denied wrongdoing. Wary of the collapse of an entire company, as happened after the Enron-related prosecution of auditor Arthur Andersen, the government is expected to stick to civil actions if it moves against businesses that advised Fannie, according to a knowledgeable federal official.

Regulators say a big motive behind the generation of Fannie's illusory double-digit annual profit growth was the outsize bonuses those figures triggered for Raines and his deputies. Fannie fine-tuned its earnings to the "one-hundredth of a penny" to maximize those bonuses, according to James B. Lockhart, acting director of Fannie's special overseer, the Office of Federal Housing Enterprise Oversight (OFHEO).

Some of the more creative methods for massaging the numbers came from outside the company, OFHEO said in a 340-page report issued by after a nearly three-year investigation. The report alleges a cornucopia of dubious deals, a number of which delayed the acknowledgment of earnings so that profits would rise smoothly and predictably.

Many of the transactions involved mortgage-backed securities, Fannie's stock in trade. The government-chartered company helps boost the amount of cash available for mortgage loans by buying loans from lenders and bundling them into securities, which it sells to investors or holds in its own portfolio.

In 2001, Goldman designed a mortgage-backed security that it said in a Nov. 19 presentation would allow Fannie to "better manage the recognition of income" for accounting purposes, according to the OFHEO report. The security allowed Fannie to push $107 million in income to future years, when the company expected a rise in interest rates would depress its earnings. Goldman received $625,000 in fees for one of the two transactions, which OFHEO said "had no significant purpose other than to achieve desired accounting results."

Goldman spokesman Peter Rose counters that the transactions had the legitimate goal of "matching tax liabilities with the receipt of taxable income."


Four years earlier, Lehman had designed a short-term mortgage-backed security for Fannie, the purpose of which was to minimize taxes and "thereby increase reported earnings," OFHEO concluded. KPMG ended up as the lead adviser on two versions of this transaction, in 1998 and 2000, and received $1.8 million for its work, according to OFHEO. The IRS later determined that the 1998 deal was "abusive" and demanded payment of hundreds of millions of dollars that Fannie had put off paying, OFHEO said. The IRS was still analyzing the 2000 deal as of April, 2006, OFHEO said.

KPMG's role has drawn the interest of investigators at the Justice Dept. as well as the staffs of the SEC and OFHEO, according to people familiar with the situation. KPMG audited Fannie's books for 25 years, until it lost that role in 2004. OFHEO chief accountant Wanda DeLeo said on May 23 that the auditor approved financial statements it knew were marred by "significant departures" from generally accepted accounting principles.

KPMG spokesman George Ledwith says the auditor made "decisions based on the information provided to us at the time" by Fannie. The OFHEO report does note a number of instances when Fannie "kept KPMG in the dark."

On another front, Fannie approached several major insurance carriers about purchasing finite-risk policies intended to help manage its earnings, OFHEO said. Such policies are the subject of a separate investigation of the insurance industry by New York State Attorney General Eliot Spitzer and other regulators. The policies, if structured so they don't transfer any real potential for claims liability to the insurer, resemble loans and can be used to manipulate earnings.

Fannie bought a finite-risk policy from Radian in 2002 to shift roughly $40 million in income to 2003 and 2004, according to OFHEO. Radian General Counsel Howard Yaruss said: "We have not done anything improper or illegal in this particular case or in any other case." He added that Radian booked the transaction as if it were a loan. In contrast, Fannie accounted for the transaction as an insurance policy, OFHEO said.

The arrangement provoked that outraged e-mail sent on Jan. 9, 2002, by Louis Hoyes, then Fannie's residential mortgage chief: "I would like to express an extremely strong no vote" about the Radian deal, Hoyes wrote to other top executives, including current CEO Daniel Mudd. Hoyes added: "Should we be exposing Fannie Mae to this type of political risk to 'move' $40 million of income? I believe not."

By Dawn Kopecki, with Mara Der Hovanesian

— With assistance by Mara Der Hovanesian

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