Fannie Mae’s Accounting Scandal

Introduction

The name Fannie Mae is perhaps one of the most popular corporate names among United States households, but not entirely for the right reasons. Established in the year 1938 as a federal agency and chartered in 1968 by the Congress, Fannie Mae was charged with a threefold responsibility: to provide stability, affordability and liquidity to mortgage and housing markets across the United States. As such, it was a government sponsored enterprise (GSE). Its modus operandi is such that it works with primary mortgage market partners in order to ensure that individuals interested in buying homes can have access to loans at affordable rates. Basically, Fannie Mae funds its mortgage investments through issuance of debt securities, both locally and internationally. In the year 2004, Fannie Mae came into the limelight when it was placed under investigation following claims of accounting malpractices. In September, 2004, a report was released by the Office of Federal Housing Enterprise Oversight, citing serious accounting errors. This study seeks to establish the nature of the scandal at Fannie Mae, how it managed to hide those irregularities, the factors that motivated those abuses, the impact on the stakeholders, as well as the solutions recommended to the problem.

Fannie Mae and its Fraudulent Operations

The scandal at Fannie Mae can be traced between 1998 and 2004. Basically, there are two accounting principles that are of critical importance to it. These are: accounting for derivative instruments and hedge activities (FAS 133), and Financial Accounting Standards 91 (FAS 91).

As far as FAS 91 was concerned, the senior management was involved in misconduct by manipulating the earnings with the intention of obtaining the highest bonus payout. Their misconduct went so far as not booking some of the expenses, a move that was against the Generally Accepted Accounting Principles (GAAP) (Securities and Exchange Commission, 2006). These top officials also saw it fit to adjust the income statement in order to earn the maximum possible management bonuses. At same time, the senior management failed to record loan adjustments that were below their expectation. According to FAS 91, it is imperative that a company recognizes loan fees, discounts and premiums as adjustments; however, it allows the company to determine what items are to be included in their income statements. Fannie Mae failed in this respect because even in this case, it was expected to comply with GAAP. This led to reduced earnings volatility.

One of the reasons why Fannie Mae managed to continue with its fraudulent activities was its assumption of a simplified method of hedge accounting. This method assumed no ineffectiveness, allowing it to avoid recording and measuring the difference between change derivatives’ value, and the value of items hedged by those derivatives in its income statements. This was a contravention of the requirements of FAS 133 (The International Monetary Fund, 2007). Furthermore, the senior management did not want to comply with the provisions requiring the periodic assessment and measurement of both effectiveness and ineffectiveness. This was because they wanted to avoid income statement volatility.

The impact of these misconducts can never be overstated; investors as well as other stakeholders lost over 11 billion dollars in the years 2002, 2003, up to June 30, 2004. The SEC considers this as one of the largest frauds in American corporate history.

In the year 2006, Securities and Exchange Commission imposed a penalty of about four hundred million dollars on Fannie Mae for the accounting fraud (The International Monetary Fund, 2007). This was meant to deter such fraud in future. It was also expected that part of this amount would compensate those investors who had been defrauded by Fannie Mae. In addition to this, Fannie Mae resolved to completely abstain from violation of the provisions of anti-fraud, internal control, books and records, and reporting requirements of the laws of the federal securities.

Conclusion

The misconduct of the senior management at Fannie Mae weighed heavily on the investors. In order to avoid such an occurrence in the future, it is important that stiffer measures be put in place requiring full and fair disclosure of all the relevant information regarding the companies. The Securities and Exchange Commission should not come in when the water is already spilled. It is important that its regulatory powers be extended to enforcing a compulsory registration and periodic reporting for Fannie Mae and other government assisted enterprises. The operation of ‘exempt securities’ is perhaps one of the reasons why this fraud happened. It is important that in the future all companies comply with the federal securities laws without exemption. Never should there be voluntary reporting and registration in the future, otherwise the investors will continue to lose their hard earned savings.

References

Fannie Mae. (2010). About Fannie Mae. Retrieved June 01, 2010, from http://www.fanniemae.com/kb/index?page=home&c=aboutus

The International Monetary Fund (2007). Subprime: Tentacles of a Crisis. Finance and Development, 44 (4): 1-3

U.S. Securities and Exchange Commission. (2006). Accounting Irregularities at Fannie Mae. Retrieved June 01, 2010, from http://www.sec.gov/news/testimony/2006/ts061506cc.htm