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Not to harp on an old thread, but did you happen catch the Barron's follow-up article over the weekend?
Link
[quote]Mortgaging the Future
Fannie Mae's troubles are far from over
THE BIG HEADS FINALLY ROLLED at Fannie Mae last week, but the soap opera starring the company's crummy accounting is far from over.
Two weeks ago, the Securities and Exchange Commission stunned Fannie Mae and its many camp followers in Wall Street's analytic community and on Capitol Hill by corroborating serious accounting violations at the government-sponsored mortgage giant that will entail the reversal of about $9 billion in profits reported by Fannie over the past three and a half years. Then, on Tuesday, Fannie directors forced the departure of chief executive Franklin Raines and chief financial officer Tim Howard, and dismissed Fannie's outside accounting firm KPMG.
Raines, a former high-ranking official in the Clinton Administration, was a big-time power broker in Washington D.C., with the ability to reward politicians with large campaign donations and funding for pet housing initiatives in home districts. Fannie played the lobbying game with unmatched vigor and aplomb. Adding to Raines's cachet was the fact that he was one of the first African-Americans to head a Fortune 500 company.
Barron's readers were amply prepared for the latest developments. In a cover story earlier this year ("Swept Away," May 17) we warned that the quasi-public housing giant used unorthodox accounting to pump up its earnings and capital position and, at the same time, justify huge pay packages for Raines and other senior managers. We even detailed where the accounting games were being played: [b]The company classified more than $13 billion of losing derivative positions as "cash-flow" hedges.
This treatment allowed Fannie to spread the losses over many years rather than expensing them immediately. These losses were incurred as a result of Fannie's inept hedging and ill-timed bet that mortgage rates would remain steady or rise.
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Fannie's Franklin Raines: out of a job
Three months ago, Fannie's regulator, the Office of Federal Housing Enterprise (Ofheo), released a stinging 200-page report that delineated serious violations of accounting rules. It charged Fannie with abuse of, among other things, expense recognition and its use of derivative accounting. Raines and other Fannie officials stoutly defended the outfit's accounting procedures in subsequent congressional hearings, stating that it would abide by any decision on accounting questions by the SEC, which in the meantime had launched its own investigation. Thus, Fannie rolled the dice and lost big-time when the SEC, in effect, ruled in favor of Ofheo.
Yet Fannie's chorus of cheerleaders on Wall Street remains mostly in denial. Last week, Robert Napoli of PiperJaffray held to his view that the Fannie contretemps is largely a mere "accounting issue" and kept his 12-month target price for Fannie's stock at 95. The shares currently trade around 72.
Jonathan Gray of Sanford Bernstein, a longtime holder of Fannie in his personal account, saw fit to drop his price target to 84 from 86, following the departures of Raines and Howard. Yet he has long depicted Ofheo's investigation of Fannie as a witch hunt by an overzealous regulatory agency.
We would observe the following, however. Since it will take Fannie months, if not years, to restate nearly four years of results, the company will be unable to file current earnings reports with the SEC for many, many quarters to come. Thus, earnings projections are an exercise in the theater of the absurd.
And more bad news seems likely to emerge as Ofheo continues to probe other accounting areas at Fannie. Likewise, Wall Street seems to be ignoring an ongoing Justice Department probe of possible criminal-accounting fraud at Fannie. Before it's all over, Fannie may well enjoy the dubious distinction of perpetrating the largest accounting fraud in U.S. corporate history, topping the $11 billion mark set by WorldCom that sent the telecom concern careening into bankruptcy in 2002.
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After expensing its derivative losses, Fannie will be some $3 billion below its Ofheo-mandated minimum-capital requirement, with regulatory capital of around $30 billion. At least that's the capital deficiency as of the end of the third quarter. If nothing materially changes, that capital deficiency would balloon to over $12 billion by June 30, 2005, when Fannie must meet an Ofheo-mandated capital surcharge of 30%.
At a minimum, Fannie likely will have to suspend its dividend, which would save it about $2 billion a year. The company likely will marshal more capital by shrinking its billion-dollar investment portfolio through run-off and cutbacks on new purchases of mortgages and mortgage-backed securities.
Some analysts hope Fannie can realize gains in its investment portfolio. (Gray claims that as of the end of last year there were $14 billion of such after-tax gains, based on Fannie's "fair value", marked-to-market balance sheet.) However, most of these gains can't be harvested because they sit in Fannie's hold-to-maturity portfolio. Besides, at this point, who can believe the values Fannie assigned to either its assets or liabilities as of that date? And rising rates won't help much in paring the losses in its derivative portfolio, since the bulk of those losses already have been locked in or offset by swap positions that would lose value in a rising rate environment.
Fannie over the years has used its huge permitted capital leverage to gun its growth and earnings. But leverage can hurt when operations are shrunk. To come up with $10 billion in new capital if all else fails, Fannie would have to dump over $300 million of its trillion-dollar investment portfolio. That, of course, would decimate earnings. Sadly, Fannie promises to be a falling-rock zone for stock investors for the foreseeable future.
-- Jonathan R. Laing
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By the way ... I celebrate drinking 
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