Fannie Mae Case
Essay Preview: Fannie Mae Case
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Fannie Mae case.
Federal regulators noted a growing string of high profile scandals at major U.S. corporations in recent years. The number of fraud cases investigated by the Securities and Exchange Commission jumped 41 percent in the last three years (112 cases in 2001 compare to 79 cases investigated in 1998), resulting in tens of millions of dollars in fines to settle the charges.
I have decided to take a closer look at Fannie May. This company operates in the residential mortgage finance industry. It facilitates the flow of mortgage capital to increase the availability of homeownership for low, moderate, and middle-income Americans. Its lender customers are part of the primary mortgage market, where mortgages are originated and funds are loaned to borrowers.
Fannie Maes accounting came under scrutiny because last year regulators found it had violated accounting rules on the treatment of derivatives used to hedge interest-rate risks. Fannie is struggling to shore up capital depleted by losses on derivatives. Fannie was $4.5 billion short of the capital it needed by Sept. 30 in 2005 to meet its minimum requirement.
Fannie Mae also received a notice from the Securities and Exchange Commission, which opened an informal inquiry into the companys accounting practices. SEC also has ordered a restatement of the companys results for the past several years. And now the Office of Federal Housing Enterprise Oversight (OFHEO) and the Department of Justice are both investigating Fannie Maes accounting irregularities. The latter is conducting a criminal investigation.
Among others OFHEO charges that Fannie Mae used so-called “cookie jar” reserve of funds by improperly deferring $200 million in company expenses in 1998. By recording those expenses at a later date, Fannie Mae met earnings targets that allowed executives to receive their maximum bonuses for the year. Roger Barnes, a former Fannie Mae accountant told supervisors that those costs, which were being amortized in as little as seven months, should have been accounted for over 10 to 15 years. The OFHEO findings also say that Fannie Mae might have to restate its earnings for several years, in part because it used accounting methods that didnt comply with GAAP.
The effects on Fannie Mae, a highly politically connected company, could be enormous. The company holds over $1 trillion in assets, and purchases more mortgage loans than any other lender in the U.S.
When the accounting errors first emerged Fannie Mae estimated that there would be an adjustment of about $9 billion in its reported earnings over the contested period. That number has since increased to over $11 billion but may increase again as further irregularities discovered with insurance related issues. No estimate of these additional potential revisions is currently available.
On December 21, 2004, Franklin D. Raines stepped down as Chairman and Chief Executive Officer and J. Timothy Howard resigned as Chief Financial Officer. Raines departure, at age 55, was structured as an early retirement. Under his employment agreement and the terms of the Executive Pension Plan, Raines is entitled to receive 60 percent of his “High-Three Total Compensation”, which is his highest total compensation for three consecutive years during the last 10 years. Upon early retirement, this number is slightly reduced leaving him with estimated annual benefits of $1,085,462. Furthermore, the companys Stock Compensation Plan of 1993 allows all options to become immediately exercisable and fully vested upon early retirement. The 2003 fiscal year end value of Raines outstanding exercisable and non-exercisable options was over $11.8 million.
Mr. Howard will receive only his accrued base salary until his termination date if his resignation is seen as a termination by the employee without good reason. Vested options will remain exercisable.
Had Raines departure been treated as termination for cause, his benefits would have been somewhat different. Under his most recent employment contract, Raines would have received salary and incentives pro rata to service, but all unvested options would have been forfeited and any options that were granted after the employment agreement (on or after July 1, 2004) would also be cancelled. In addition, his pension would have been reduced by 50%.
However, on September 17, 2004, just 5 days before the company first announced OFHEOs initial investigation, Raines received a letter from Anne Mulcahy, who was chairman of the Compensation Committee at the time and who resigned shortly after the investigation first began. The letter proposed amendments to Raines employment agreement. Of course, it turned out that the changes did not affect Raines benefits because he has not been terminated for a cause and allowed to take early retirement.
It is certain that some of the actions taken by the compensation committee in amending employment agreements in this atmosphere caused considerable concern. But it is also certain that the board, in allowing Raines to take early retirement rather than taking positive action themselves, has not acted in the best interests of stockholders. If Raines and Howard are incriminated in the misstatement of accounts, a termination for cause should be available to the board. Now, of course, that each has been allowed to leave voluntarily without the inquiry being completed, no such recourse is available.
Analysts say that unlike many other corporate accounting scandals, the dispute between OFHEO and