Fannie Mae Mortgages It's Future.
Case Study of the Impact of Sarbanes-Oxley Act ("SOX")

Office of Federal Housing Enterprise Oversight (OFHEO) Director Armando Falcon, testifying under oath at a SEC hearing, stated that Fannie Mae (FNM) senior management improperly put off booking income to a future reporting period "to create a cookie jar reserve that it could dip into whenever it best served the interests of senior management." Those interests included smoothing out volatility in earnings from quarter to quarter and meeting earnings-per-share targets linked to bonuses for executives, Mr. Falcon said. Since 2001, earnings at the mortgage company have been overstated by an estimated $5 billion.

Mr. Falcon singled out CFO Timothy Howard for blame in the scandal, saying in a report of the regulators' ongoing investigation that he failed to provide adequate oversight.

Testifying before Congress, chairman and chief executive Franklin Raines and chief financial officer Timothy Howard said Fannie Mae did nothing wrong in its accounting and insisted that the regulators' allegations represent an arguable interpretation of complex rules. They specifically denied the allegation that, in an instance in 1998, accounting rules were deliberately violated so that top executives could collect full bonuses. Bonuses to senior executives totaled $250 million since 2001.

Roger Barnes,the former Fannie Mae accountant who raised questions about the mortgage giant's bookkeeping said Wednesday that he took his concerns directly to chief executive Franklin Raines in 2002 and asked him to investigate. Barnes, who was a manager in the Controller's Division, said that he anonymously sent the two executives a memo on Sept. 23, 2002, calling himself a Finance Division Manager. The information he provided was "easily traceable" to him because he was among only a handful of managers who had detailed data on the company's process for accounting for expenses over time, said Barnes.

"I urged Mr. Raines and Mr. Howard to investigate the issues identified," Barnes said in written testimony submitted for a hearing by the House Financial Services subcommittee that oversees Fannie Mae.

"Neither Mr. Raines nor Mr. Howard, nor anyone from their staffs, investigated these concerns or took corrective action" Mr. Barnes stated. "Thus, the practices I had identified continued, and I faced continuing reprisal for raising concerns about these issues." At Fannie Mae, Mr. Barnes testified that "The atmosphere and culture, particularly within the Controller's Division, is one of intimidation, restraint of dissenting opinions and pressure to be part of the 'team,'".

"These accounting standards are highly complex and require determinations over which experts often disagree," Raines said in testimony prepared for his appearance before the panel. In his written testimony, Raines noted that Fannie Mae's outside auditor, KPMG, had endorsed the company's application of accounting rules.

What is the Impact of SOX on Fannie Mae ?

It was recently reported that Fannnie Mae would miss filing third quarter financial statements with the SEC (for the quarter ending September 30, 2004) since KPMG was unable to certify that Fannie Mae followed GAAP. With SOX in effect, expect the finger pointing to continue between executives at Fannie Mae and their auditors KPMG. Under SOX, KPMG would bear responsibility if they signed off on the accounting treatment as part of U.S. generally accepted accounting practices (GAAP).

CEO Franklin Raines and CFO Timothy Howard both certified in writing the accuracy of Fannie Mae's financial results, so both would have violated provisions under SOX had they been aware of the accounting irregularities when they signed off.

Under SOX, both Mr. Raines and Mr. Howard could be facing criminal penalties including $5 Million fine and imprisonment of 20 years in prison. In addition, both executives, if found guilty of wrong doing, could also be asked to return any compensation based on financial results. Other senior executives may also be asked to return those "bonuses".

If what Roger Barnes, the whistle blowing accountant at Fannie Mae testified was an accurate depiction of the events that occurred, the CEO and CFO should have authorized a subordinate to initiate an investigation or at a minimum, consulted with KPMG immediately.

It also seems clear that Fannie Mae did not have a clear reporting structure where Mr. Barnes could speak freely without fear of retribution. Mr. Barnes testified of a hostile environment. This is a culture that needs to change immediately regardless of the outcome of the government probe.

Updates after December 22, 2004:

While continuing its' negotiations with government regulators, Fannie Mae announced CEO Franklin Raines and CFO Timothy Howard both resigned. Daniel Mud, Fannie Mae's Chief Operating Officer will be the interim CEO. Robert Leaven, a senior executive with Fannie Mae will serve as CFO.

The mortgage giant also announced that company auditors KPMG will also be replaced.

Regardless of the announcements, expect Mr. Raines, Mr. Howard and KPMG to be named in lawsuits from shareholders. In addition, the former CEO and CFOs will still be culpable and asked to return their bonuses along with a substantial fine from the SEC.


© 2004 - 2005 Nelson Chin.

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