Fannie Mae And Freddie Mac Are Back: More “Adjustments”, More Calls For Reform

By • May 12th, 2014 • Category: Pure Content, You Can Quote Me On That

American Banker reported on Friday that, “The chance of any housing finance reform bill moving in Congress this year — as well as in the foreseeable future — is now seriously in question…”

That is too bad, since something must surely be done about recidivist accounting screw-ups Fannie Mae and Freddie Mac.

Dan Freed of TheStreet.com reported on Thursday. (He’s added a followup with another quote from me today.)

Fannie Mae (FNMA) quietly acknowledged several errors in its financial statements that have largely gone unnoticed, even by sophisticated investors who made daring contrarian bets on the turnaround of the controversial mortgage giant.

Fannie Mae reported the errors, which add up to nearly $4 billion, during five consecutive quarters from the fourth quarter of 2011 through the fourth quarter of 2012 and also in the second quarter of 2010.

How could such large errors go unnoticed for so long?  (The New York Times’ Floyd Norris asked my favorite question when Bank of America recently admitted to the same kid of thing: Where was Bank of America’s auditor PwC when the bank was putting the wrong number, by billions, in its MD&A disclosures year after year?)

While Fannie Mae did disclose the errors, one reason they did not attract more scrutiny is likely the manner in which they were disclosed — as out-of-period adjustments rather than restatements. In correspondence with the Securities and Exchange Commission, Fannie Mae took the position that the errors were too small to be of much interest to investors.

In an Aug. 30 letter to the Securities and Exchange Commission, explaining $528 million worth of adjustments in the first half of 2012, Fannie Mae CFO Susan McFarland (who left Fannie Mae in 2013) wrote:

We do not plan to include disclosure regarding how these misstatements were discovered in our future filings because we believe the effects of these misstatements, both quantitatively and qualitatively, are not material to prior periods or to our projected annual 2012 income; therefore we do not believe additional information regarding the detection of these items would be meaningful to investors.

The SEC followed up on the issue, we learn from McFarland’s response to the SEC on Dec. 13. Among the SEC’s requests:

Please provide your analysis supporting your conclusion that you do not have a material weakness with respect to the accounting for the allowance for loan losses and reserve for guaranty losses as of December 31, 2011 and discuss any new processes or procedures you have put in place to prevent these types of errors from recurring in the future.

McFarland’s response contended in part that the adjustments did not indicate a “material weakness” because they were relatively small.

These misstatements were less than 2% of our allowance for loan losses as of December 31, 2011 and less than 5% of our net loss for the year ended December 31, 2011. Additionally, we concluded that the misstatements were not material to our projected 2012 consolidated financial statements taken as a whole.

However, they grew larger. The additional $850 million and $172 million discovered in the third and fourth quarters, respectively, were not discussed in this correspondence, even though the $850 million was already disclosed at the time of the second letter.

Dan Freed asked for my comments and added them to the story after it was initially published. You can sum them up with this one:

McKenna says many companies classify mistakes as out-of-period adjustments because restatements are more likely to cause the stock to drop, which can lead to lawsuits.

More important, however, formal restatements require an 8-K filing with the SEC, which gives companies or their regulators the ability to claw back executive compensation under the 2002 Sarbanes Oxley Act. While the 2010 Dodd Frank legislation made it easier in some respects to claw back executive compensation, companies can still use out-of-period adjustments to skate around the issue, McKenna says.

While the SEC could require a restatement, it has not shown a willingness to pursue these cases aggressively and in all possible circumstances, McKenna contends.

I’ve written about the stealth restatement problem, the SEC’s clawback problem, materiality, and the chronic accounting ineptitude that adds up to recklessness at Fannie Mae and Freddie Mac more than once and for a while.

GoingConcern.com does a nice job summing up the problem of allowing the GSE’s to continue to make excuses:

“…this isn’t Fannie Mae’s first rodeo. If accounting errors were felonies in California, Fannie Mae would already be serving life under Three Strikes.

See 2005: Fannie Mae Finds More Errors, Names New CFO

2006: Still More Errors Are Found in Accounting at Fannie Mae

See also, this 2006 SEC complaint, which saw Fannie settling with a $400 million penalty:

In its federal court Complaint, the Commission charged that, between 1998 and 2004, Fannie Mae engaged in a financial fraud involving multiple violations of Generally Accepted Accounting Principles (“GAAP”) in connection with the preparation of its annual and quarterly financial statements. These violations had the effect, among other things, of falsely portraying stable earnings growth and reduced income statement volatility, and – for year-ended 1998 – of maximizing bonuses and achieving forecasted earnings.

So you see, Fannie is a habitual offender. One can only deduce that they are either really, really bad at accounting (possible) or doing this on purpose (also possible). Olga Usvyatsky of Audit Analytics seems to feel maybe it is just an honest mistake but our pal Francine McKenna does not share that opinion.

Olga Usvyatsky, an accountant with a research firm called Audit Analytics, believes the errors may point to “control deficiencies” — a catch-all accounting phrase that encompasses issues such as poorly trained or inadequate staffing, inadequate technological capabilities or ineffective business processes, among other examples.

“From what I see on the surface, it does not look like intentional manipulation,” she said. “It looks more like [the] financial statements in general are not very reliable because they keep finding those errors.”

Leave it to Francine to point out the obvious: when you do the math on numerous immaterial errors, it adds up to one big error. Now where have we seen that before?

“How do you know? That’s the WorldCom situation. Nobody adds it all up until someone says ‘Wait a minute. Over five years we’ve had so many billions of non-material errors it adds up to be material.'”

Fannie Mae’s auditor is Deloitte. You may recall that KPMG used to audit Fannie Mae. In 2010 I wrote at Forbes that Fannie and Freddie must go.

Fannie Mae’ s external auditor until 2005 was KPMG. Fannie Mae and KPMG finally settled their lawsuits against each other this past May.

That baggage didn’t bother Deloitte, who jumped at the chance to get close to Fannie when her dance card opened.

Freddie Mac’s external auditor is PwC, who never abandons a sinking ship even when that client sues them repeatedly.

PwC inherited that mess from Arthur Andersen.

Four years later I haven’t changed my mind.

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10 Responses »

  1. Out-of-period adjustments.

    Where is that described in the accounting literature? How in the world is that different than a correction of an error? Is there a secret codicil in ASC that I can’t find? Guess I’ve been sleeping too much and need to hit the books.

    Not material.

    The non-restatement restatements add up to $4B over 5 quarters. The 2013 10-K shows interest income of $125B for ’12 and $23B net interest income. Bottom line was $17B positive for ’12 and $17B negative for ’11. At the end of ’12, total assets were $3,222B with equity of only $7B.

    The $4B is a quarter of ’12 profit or a quarter of ’11 loss, take your pick. It’s over half of equity. What was the thought process that said $4B wasn’t material?

  2. I agree that them reporting these accounting corrections as out-of-period adjustments could lead to market confusion in relation to their stock price. The mistakes they made related to adjustments in their tax-deferred assets and loan loss provisions. The complexity of the accounting in their situation is likely exacerbated by the details of their conservatorship obligations. The likelihood that they made mistakes intentionally to boost their stock price or compensation levels is remote because their stock price is heavily weighed down by the details of the Preferred Stock Purchase Agreement that they have with the Treasury Department. No material benefit would have been had by mis-stating the numbers to the degree that they were mis-stated. Additionally, they un-covered the mistakes fairly quickly and sought guidance from the SEC on how they should report the corrections to the financial statements. If the SEC gave them the green light to disclose the mistakes in the manner that they were disclosed then it would have been up to their conservator to force a re-statement of earnings. It appears that Director DeMarco of the FHFA did not have a problem with how they disclosed these accounting mistakes. It has been over 2 years now since the mistakes have happened.

    I think it is sort of reckless for Mr. Freed and yourself to write provocative headlines and conclusions in order to support an adversarial position against the continued existence of the GSEs. Fannie Mae and Freddie Mac are certainly easy targets. There is no doubt that financial organizations like Bank of America and the GSEs have organizational structures and operations that can test the intellectual limits of even experts to understand. With bad intentions fraud at these organizations is not easy to detect. Ultimately, it is shareholder’s that have to pay the price for accounting mistakes. I rather have relatively insignificant accounting mistakes at Fannie Mae than Mr. Freed and yourself cheering on the liquidation of a business that I own stock in.

    I’ve done enough due diligence on the operations of the GSEs that I consider myself an expert on the subject of housing finance. I can tell you with certainty that GSE reform proposals like Johnson/Crapo and Corker/Warner pose a very high risk to the economic recovery in housing and in the overall economy. I think people fail to realize how bad the Great Recession could have been and how much risk still exists in the system. It is simply not intelligent to implement large structural reforms to the housing finance system in the current economic context.

  3. @FNMA Shareholder

    I have a question… Given everything you’ve said, why are you a shareholder?

  4. @Francine

    The various possible outcomes make owning shares in Fannie Mae a good investment in my opinion. I can’t find a realistic outcome where I lose money long-term.

  5. @FNMA Shareholder

    I saw this —I saw Ackman do a double take live— and I wondered why anyone would own shares in FNMA or FRE.
    February 2011:

    http://dealbook.nytimes.com/2011/02/09/freddie-director-no-fiduciary-duty-to-shareholders/?_php=true&_type=blogs&_r=0

    Clayton S. Rose, a director at Freddie Mac and a professor at Harvard Business School, said on CNBC on Wednesday morning that he was focused on the company’s conservatorship. Legally, he said, he does not need to take the concerns of Freddie’s shareholders into account.

    “As a legal matter, our responsibilities and our duties run to the conservator here,” said Mr. Rose, a former senior executive at JPMorgan.

    The biggest private shareholder owns less than 2 percent of Freddie Mac.

    Here is a transcription of a conversation between Mr. Rose and William A. Ackman, the head of Pershing Square Capital Management, regarding the subject:

    Mr. Ackman: So you can make decisions that are adverse to shareholders?
    Mr. Rose: Correct.
    Mr. Ackman: And there’s no liability to you?
    Mr. Rose: Correct.

  6. @Francine

    It depends on the situation. The goal of conservatorship under H.E.R.A. is to “preserve and conserve” the assets of the Enterprises and o bring them into a “sound and solvent” condition. The boards of the companies should certainly vocalize opposition to decisions by the conservator that make the legislative intent of HERA less likely to succeed. When the conservator signed agreements with the Treasury Department to take almost all of the Enterprises profits, the directors should have voiced opposition. Even if the Treasury does not intend for the profit sweep amendment to be permanent, the legal intention of the profit sweep amendment is permanent. Good or bad, there should be no ambiguity about the intentions of the conservator and the Treasury department. Shareholder’s in the GSEs have a right to know whether the Preferred Stock Purchase Agreement’s are being used as tactical tools by the conservator to further the ultimate legislative intent of HERA, or as a technical method to wipe-out shareholder’s. We shouldn’t have to guess their intentions in this situation. And for whatever reason they refuse to tell us. So now there are 20 lawsuits against them that could have been easily avoided.

  7. @FNMA Shareholder

    “We shouldn’t have to guess their intentions in this situation. And for whatever reason they refuse to tell us. So now there are 20 lawsuits against them that could have been easily avoided.”

    Sounds worse than Facebook.

  8. @Francine

    I appreciate you taking the time to respond to my comments. Fannie and Freddie have changed a lot since 2008. Almost all of the management has been replaced and about half their employees. Their book of business since 2009 is excellent. Homeowners and renters save a lot of money because of the GSEs. Do these accounting mistakes anger me? Absolutely. But not because I think they are running their businesses badly or carelessly. It bothers me because of the 12,000 employees that have worked their hearts out for their companies and for the country. They deserve some respect and I’m going to defend them even if my investment becomes worthless. What they do for the country and for the economy is honorable. They help make it possible for people to have a 30 year mortgage. Millions of middle income people can buy a decent home and hunker down in living room of the American Dream because of Fannie Mae and Freddie Mac.

    Here are a list of GSE facts that might surprise you:

    They have paid back 202 billion dollars to the Treasury and were only lent 187 billion.

    The taxpayers have made a profit of between 60-80 billion dollars on their bail-out. The “Senior Preferred Stock” that the government owns pays a 10 percent dividend. Not only have the GSEs successfully paid the full amount they have paid in excess of it.

    Private label MBS fail at almost 3x the rate of GSE securities.

    There are 20 lawsuits from shareholders of Fannie Mae and Freddie Mac against the government pending.

    The GSE model is extremely efficient, regardless of the propaganda that you’ll read in the media that is being encouraged by bank lobbyists and publicists.
    Congress encouraged the GSEs to relax their standards on credit quality and should share a large part of the blame for why they needed a bail-out.

    Currently, Fannie Mae and Freddie Mac have never been ran better. Their net failure rate for mortgages that they purchase is under 1 percent. The average loan to value ratio of loans they insure against default is at 70 percent of current home values and that is across their entire portfolio of assets. The average credit score of an insured borrower is 760.

    Half the employees have been replaced. Most of the management has been replaced. They have imposed an almost religious discipline in how they operate and those efforts are paying huge. In 2013 Fannie Mae was the most profitable company IN THE ENTIRE WORLD. They recorded the largest 1 year profit of any company in history.

    If Fannie and Freddie didn’t exist you probably would not have gotten a mortgage after 2008. They control almost the entire market and for good reason. No one can do what they do better.

  9. @FNMA Shareholder

    I appreciate you making these thoughtful comments.

    I’d like to separate my criticism of the chronic accounting issues at Fannie and Freddie from the policy purpose of having the GSEs. I am pro housing affordability and availability. However, I can see how the GSEs were caught up in the securitization frenzy and are only now holding the mortgage originators and others to account for the lack of compliance with standards. A good book about the role of the GSEs is http://www.amazon.com/Reckless-Endangerment-Outsized-Corruption-Financial/dp/B00B2RTQUU Gretchen Morgenson’s book Reckless Endangerment. There were many books that have been written about the crisis and none of them cover all angles. You have to put them all together to get the big picture.

    You say that half the employees have been replaced. Unfortunately, the auditors have not been replaced. Deloitte An interesting factoid about the companies the government took majority ownership of—GM, Citigroup, AIG and the GSEs: All of them retained the same auditor who presided over the issues that led them to the brink. That alone is enough for me to say that the status quo will continue. And then there is FNMA CEO Tim Mayopolous. He came from Bank of America, one of the biggest, maybe the biggest, producers of non conforming mortgages. And CFO Benson, from Merrill Lynch. He’s the 4th CFO since 2008. http://online.wsj.com/news/articles/SB10001424052702303970604576401502794262830 http://www.housingwire.com/articles/fannie-mae-cfo-promoted-internally We know what ML’s role in the mortgage crisis was and where it is now. Owned by BAC. So not enough has changed to give me the same optimism about Fannie Mae’s accounting.

  10. I take issue with the fact that Fannie Mae even issues income statements. Why doesn’t Fannie Mae report as if it were a regulated investment company? The value of Fannie Mae lies with its mortgages. If the value of the mortgages goes down, Fannie Mae’s value goes down. If the value of the mortgages goes up, Fannie Mae’s value goes up. The income statement tells you nothing about the value of this entity.