WASHINGTON – Regulators have discovered serious accounting problems at mortgage giant Fannie Mae (FNM), prompting an inquiry by the Securities and Exchange Commission (search) and calling into question its financial soundness, the company disclosed Wednesday. Its shares fell 7 percent.
The board of the government-sponsored company has named a special committee of outside directors to respond to the crisis at the second-largest U.S. financial institution behind Citigroup.
In at least one instance, the regulators found, it appeared that Fannie Mae's accounting for expenses was put off to a future reporting period in order to meet earnings targets that brought bonuses for executives.
The developments come a little more than a year after Freddie Mac (FRE), Fannie Mae's competitor in the multitrillion-dolar home mortgage market, disclosed that it had understated profits by some $4.5 billion for 2000-2002 in an effort to smooth earnings and maintain its image as a steady performer.
Sen. Richard Shelby, R-Ala., chairman of the Senate Banking Committee (search), called the revelations concerning Fannie Mae "seriously troubling."
On Monday, federal regulators who have been investigating Fannie Mae's accounting for eight months submitted a report to its board that found earnings manipulation, lax internal controls and a corporate culture "that emphasized stable earnings at the expense of accurate financial disclosures," according to a letter to the directors.
The letter from the Office of Federal Housing Enterprise Oversight (search) was disclosed in a public statement Wednesday by Ann McLaughlin Korologos, the presiding director of the Fannie Mae board.
The regulators found that Fannie Mae violated generally accepted accounting principles in its reckoning for transactions involving derivatives, financial instruments that it uses to hedge against interest-rate and other risk.
They also found that the company used an improper "cookie jar" reserve in accounting for some items. The SEC maintains that the practice — setting aside artificially large cash reserves to reduce revenues, with the idea of reversing that procedure to bolster revenues in less profitable times — gives investors an inaccurate picture of a company's financial performance.
OFHEO's report said its findings "are serious and raise doubts concerning the validity of previously reported financial results, the adequacy of regulatory capital, the quality of management supervision, and the overall safety and soundness" of Fannie Mae, according to Korologos' statement.
Korologos also disclosed the preliminary inquiry by the SEC, which she said includes issues raised in OFHEO's report.
SEC spokesman John Nester declined to comment. OFHEO spokeswoman Corinne Russell also declined to comment, except to note that the agency has not made the report public. It couldn't be determined when, or whether, it planned to do so.
In addition, Korologos said, the Fannie Mae board has named a committee of independent directors to deal with the accounting matters.
That means a crucial function effectively has been removed from Fannie Mae's chairman and chief executive, Franklin Raines (search), and other top managers. Raines has in recent months defended the company's accounting and said that it has unfairly suffered "collateral damage" from the accounting crisis at Freddie Mac.
He said in a statement Wednesday that company management "strongly supports the leadership" shown by Korologos and the other outside directors in responding to OFHEO's investigation and the SEC inquiry. "We will assist them in any way we can as they carry out their duties," Raines said.
Korologos said the board had hired attorney and former New Hampshire senator Warren Rudman as independent counsel to advise the new committee. Rudman's law firm will in turn hire an outside accounting firm, her statement said.
Of the Big Four accounting firms, two, KPMG and Ernst & Young, already have been retained by Fannie Mae, a third, Deloitte & Touche, is advising OFHEO and the fourth, (PricewaterhouseCoopers, is Freddie Mac's outside auditor.
Last October, Fannie Mae disclosed a $1.2 billion accounting error for the third quarter, which it said was due to a change in accounting rules and did not affect net income.
The company's profits edged up nearly 1 percent to $1.11 billion in the second quarter of this year, beating analysts' expectations.
Shares in Fannie Mae fell $5.20 to $70.45 on the New York Stock Exchange (search), where Freddie Mac shares lost 4 percent, or $2.19, to $66.81.
Last year's accounting crisis at Freddie Mac brought the ouster of several top executives, investigations by the SEC and the Justice Department, and a record $125 million fine in a settlement with OFHEO.
Fannie Mae and Freddie Mac were created by Congress to pump money into the home mortgage market by buying home loans from lenders and packaging them as securities for sale on Wall Street. They have grown explosively in recent years and now stand behind $4 trillion of home mortgages, representing more than three-fourths of the single-family mortgages in the country.