Fannie Mae Agrees to Pay $400 Million Penalty After Investigation

The Securities and Exchange Commission (Commissin) and the Office of Federal Housing Enterprise Oversight (OFHEO) announced yesterday that the Federal National Mortgage Association (Fannie Mae) has agreed to settle charges relating to the misstatement of its financial statements from at least 1998 through 2004.  Fannie Mae has agreed to the entry of a permanent injunction and to pay a $400 million penalty.

Linda Chatman Thomsen, the SEC’s Director of Enforcement said, “Fannie Mae’s departure from proper accounting practices allowed it to present to its shareholders and the marketplace financial statements showing stable and predictable earnings.  But the impression created by the Company’s financial statements was a false one.  Transparency and accurate disclosure are the keys to good corporate governance and should be the rule, not the exception.”

“Strong accounting controls, though a recognized cost center, can significantly help detect and deter violations of the federal securities laws,” said Paul R. Berger, Associate Director of Enforcement.  “Fannie Mae failed to devote sufficient resources to its accounting, and the results for the company and for its investors have been unfortunate.  Public companies should learn from this lesson and ensure that their internal controls and accounting practices are, at a minimum, sufficient to meet their compliance obligations.”

In its settlement with the Commission, the company agreed, without admitting or denying the allegations, to the entry of a final judgment that permanently enjoins the company from violations of the anti-fraud, reporting, books and records and internal controls provisions of the federal securities laws.  The root cause of the accounting fraud described in the Commission’s Complaint, was a corporate culture that placed significant emphasis on stable earnings growth and avoidance of income statement volatility, and insufficient emphasis on ensuring compliance with applicable accounting regulations and federal securities laws.  The company’s misconduct took various forms.  For example: 

At the end of 1998, senior management manipulated the company’s earnings in order to obtain bonuses they otherwise would not have received.  Senior management of the company directed employees to record only $240 million of amortization expenses.  By not recording the full amount of the calculated expenses, Fannie Mae understated its expenses and overstated its income by a pre-tax amount of $199 million.  The company’s management made two additional adjustments in the fourth quarter of 1998 that had the effect of offsetting nearly half the $240 million amortization expense adjustment.  This resulted in the company not only exceeding Wall Street expectations but also hitting the earnings per share target necessary to trigger maximum bonuses.  Fannie Mae has agreed, without admitting or denying these allegations, to a fraud injunction for violations of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder.

From at least 1998 through 2004, the company’s financial results were smoothed as a result of the misapplication of certain Generally Accepted Accounting Principles (GAAP); namely rules relating to the amortization of loan fees, premiums and discounts, known as SFAS 91, and rules relating to hedge accounting, known as SFAS 133.  In both instances, while Fannie Mae recognized that the company was departing from GAAP, it failed properly to consider whether the departures were material.

Under SFAS 91, companies are required to recognize loan fees, premiums and discounts as an adjustment over the life of the applicable loans.  Fannie Mae had a policy of not recording those amounts that fell within a company-calculated threshold.  Such a policy was an improper departure from GAAP and had the effect of reducing earnings volatility.  The company also failed on many occasions to comply with SFAS 133, which essentially provides that derivatives must be revalued every reporting period, and changes to value must be reported in the income statement.  Fannie Mae disregarded the requirements of SFAS 133 and qualified transactions for certain hedge accounting treatment based on erroneous interpretations and an unjustified reliance on materiality.  As a result, it failed to measure and record the differential between the change in value of the derivative and the change in value of the item being hedged by the derivative. 

These failures to comply with SFAS 91 and SFAS 133 led to the Company publicly issuing materially false and misleading financial statements from at least 1998 through the second quarter of 2004.  Fannie Mae has agreed, without admitting or denying these allegations, to an injunction for violations of Section 17(a)(2) and (3) of the Securities Act of 1933. 

As a result of the violations described in the Commission’s complaint, Fannie Mae expects to restate its historical financial statements for the years ended Dec. 31, 2003, and 2002, and for the quarters ended June 30, 2004, and March 31, 2004.  The company currently estimates that its restatement will result in at least an $11 billion reduction of previously reported net income.