The $9 Billion Accounting Fraud

“American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgages.”

—Alan Greenspan, Chairman of the Federal Reserve, 1987–2006

Early in his second term as president, Bill Clinton announced his National Homeownership Strategy. It had an explicit goal of raising the number of homeowners by 8 million families over the next six years. To get there, the administration advocated “financing strategies fueled by creativity to help home buyers who lacked the cash to buy a home or the income to make the down payments.”

When George W. Bush became president in 2000, he showed no sign of stepping back from Clinton’s strategy. Quite the opposite: during Bush’s campaign, part of the Republican Party platform was that “homeownership is central to the American Dream.”

But Hank Paulson, the Goldman Sachs executive who would serve as Bush’s third Treasury Secretary, later wrote this about the president: “He had a deep disdain for entities like Fannie and Freddie, which he saw as a part of a permanent Washington elite, detached from the heartland, with former government officials and lobbyists cycling through their ranks endlessly while the companies minted money, thanks, in effect, to a federal entitlement.” And there were others in the White House, including some on the National Economic Council, who were long time GSE critics and were just hoping for a way to rein them in.

The spark that lit the fire was the Enron scandal, which put its accountant, Arthur Andersen, out of business. After that, Freddie Mac, which had also employed Andersen, hired PricewaterhouseCoopers. The new accountants scrubbed Freddie’s books—and in 2003, Freddie admitted that it had understated its profits for years in an effort to produce the smooth earnings that investors like to see. The company agreed to a $5 billion restatement and ousted many of its top executives.

It was a huge embarrassment for the beleaguered OFHEO, which had signed off on Freddie’s safety and soundness just months before the announcement. OFHEO’s director by then was Armando Falcon, a Texas Democrat. Instead of accepting Fannie’s assurances that its accounts were just fine, in early 2004, Falcon hired the accounting firm Deloitte to do an investigation of Fannie.

All at once, what had been sporadic, fairly uncoordinated efforts to rein in the GSEs became a concerted push with the force of the government behind it. The Bush Administration made common cause with Falcon and began ramping up a push for new, stronger regulation of Fannie and Freddie. Later, Raines and his lawyers even subpoenaed the White House to try to find what his lawyers called “evidence that officials in the most powerful office in the country were part of a plan to influence the political debate about Fannie Mae.”

Greenspan, with support from the administration, began to testify in Congress about the risks the GSEs, particularly their huge portfolios of mortgages, posed to the financial system. He wasn’t worried about credit risk—the risk that homeowners wouldn’t pay their mortgages. At the time, no one thought that was a risk. Instead, he was worried about all the derivatives Fannie and Freddie used to manage the interest-rate risk on those huge portfolios. His sharpest comments came in early 2004, when he told Congress that “to fend off possible future systemic difficulties, which we assess as likely if G.S.E. expansion continues unabated, preventative actions are required sooner rather than later, according to Tim Howard.”

Greenspan also seemingly went out of his way to question the wisdom of consumers’ preference for financing their homes with 30-year fixed-rate mortgages—the loan type that comprised over 90 percent of Fannie Mae’s business at the time. He said, “American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgages.”

For years, Congressman Richard Baker of Louisiana had been one of the few lonely voices questioning Fannie and Freddie, but he was now joined by Republican Senator Richard Shelby of Alabama. Mark Calabria, who was then a staffer for Shelby, later explained in a paper that Shelby told his staff he wanted a GSE regulator that was as “bank-like” as possible, with the ability to impose strong capital conditions and to place a failing GSE into either conservatorship, in an effort to conserve their assets and restore them to a safe and sound financial condition, or receivership, which was a procedure for reorganizing Fannie or Freddie in the event of a bankruptcy.

Calabria later wrote that as they tried to hammer out a bill, of particular importance were the large holdings of Fannie and Freddie debt by foreign governments, especially foreign banks. He wrote: “Some of these central banks, such as the Chinese and Russian, have unique and critical relationships with the United States. These central banks are also large purchasers of U.S. Treasury debt. The Banking Committee was not unaware of these relationships. In fact concerns were repeatedly voiced that if left to the Treasury, credit losses on GSE debt holders by foreign central banks would be transferred to the American taxpayer. This was viewed as an unacceptable outcome.”

By setting up a receivership mechanism, the government would be sending an unmistakable message: It would not stand behind Fannie and Freddie’s debt. That, of course, would negate Fannie’s most powerful advantage, which was its low cost of funds.

Initially, Fannie’s political power frustrated even the White House’s attempts to rein in the GSEs. “It was the height of how influential we were,” a former GSE lobbyist recalls. “Raines said, ‘We can’t support something that changes the deal for bondholders.’ So Fannie convinced Bennett [Republican Senator Bob Bennett of Utah] and Enzi [Republican Senator Mike Enzi of Wyoming] to sponsor an amendment.” The amendment gave Congress a 45-day window to veto the receivership. That completely undercut the notion that the government would no longer back the GSEs.

The former lobbyist recalls that Fannie executives showed a roomful of Democrats a report from Standard & Poor’s, which said the agency might cut its rating on Fannie’s debt should the bill pass, because the debt would no longer be regarded as super-safe. Raines explained to the assembled Democrats that that would hurt the commercial banks in their areas, because they all held Fannie and Freddie debt, and they would have to take losses if the rating were cut. The Democrats all supported Bennett and Enzi’s amendment, and as a result Shelby pulled his badly weakened bill.

In April 2004, the Wall Street Journal published a story that discussed many ways that the administration could weaken the GSEs. “Frustrated by its inability to win congressional approval to tighten regulation of mortgage giants Fannie Mae and Freddie Mac, the government is pursuing the same goal through regulatory fiat,” it said.

One of the things the Bush Administration did was to have HUD ramp up the GSEs’ affordable-housing goals—the amount of business Fannie and Freddie were required to do with low-and moderate-income borrowers—to significantly higher levels to make sure that they were actually delivering on the obligations in their charters, and to make sure that Fannie and Freddie understood who was boss in the relationship.

But it was OFHEO that would do in Fannie. On September 22, 2004, OFHEO released the results of its accounting examination. Part of the report alleged that Fannie’s management had improperly shifted expenses from one year to the next in order to meet bonus targets for its executives, but the majority of the report was focused on Fannie’s misuse of a complicated new accounting statute governing how gains and losses from derivatives are recorded. It was too dense for most people to follow the details, but the outcome was clear: OFHEO said that Fannie had overstated its earnings by $9 billion since 2001, representing a staggering 40 percent of its profits. In a letter to the Fannie Mae board accompanying the report, Armando Falcon wrote: “These findings cannot be explained as mere differences in interpretation of accounting principles, but clear instances in which management sought to misapply and ignore accounting principles for the purposes of meeting investment analyst expectations [and] reducing volatility in reported earnings.” Management, of course, was Franklin Raines and Tim Howard.

Fannie tried to fight back—after all, its accountants, PricewaterhouseCoopers, had signed off on its financial statements. Raines was so confident that the company had done nothing wrong that he took the unique step of going to the Securities and Exchange Commission for an independent judgment. But the final blow came when the Securities and Exchange Commission’s chief accountant, Donald Nicolaisen, weighed in. In a meeting at the SEC’s offices, he held up a sheet of paper. If the four corners represented what was possible under accounting rules and the center was perfect compliance, he told Raines, “You weren’t even on the page.”

By the end of the year, both Raines and Howard were gone from Fannie. OFHEO later filed charges against both men, and also against another Fannie executive, seeking more than $215 million in bonus payments and fines. Fannie was ordered by OFHEO to restate its earnings from 2001 through 2004. Falcon even called Fannie Mae a “government-sponsored Enron.” Both the SEC and the Department of Justice launched investigations.

A $9 billion accounting fraud is a major story, and for months Fannie Mae was all over the headlines. And the number was soon revised upward, to almost $11 billion.

Fannie didn’t go down without a fight. Bill Maloni, the Fannie lobbyist, got Kit Bond, a Republican senator from Missouri, to launch an investigation into OFHEO. The resulting report was highly unusual, at least if you expect a regulator to care about the welfare of the companies it regulates. The report said that OFHEO had a “very strong intent to embarrass Fannie Mae.” Falcon’s special counsel, a man named Steve Blumenthal, responded to one e-mail chain with an apparent non sequitur. “Fannie and Freddie are the axis of evil and must be destroyed,” he wrote. “Get with the program.” Both OFHEO’s chief accountant, Wanda DeLeo, and its chief examiner, Scott Calhoun, complained that Falcon and his special counsel were overstating Fannie’s problems for political impact.

Fannie always argued that the accounting issue wasn’t caused by malfeasance, and that there was no hidden loss. When Fannie finally released its restated numbers at the end of 2006, shareholders’ equity, which is the most important measure of a company’s health, had actually increased by $4.1 billion over the contested period from 2002 until mid-2004. David Fiderer, who was an early skeptic about OFHEO’s case, later wrote that “after the overblown media narrative about Fannie Mae’s accounting problems had calcified into the zeitgeist, almost no one looked at the numbers and asked where they came from. By every standard metric—cumulative net income, shareholder’s equity, corporate cash flows—Fannie’s financial position turned out to be far stronger than originally reported.”

Both Raines and Howard settled OFHEO’s charges, but neither man admitted guilt. Most of their combined $31 million settlement consisted of worthless stock options that OFHEO valued at their grant prices, rather than at the actual stock price at the time, in order to arrive at a grand-sounding number. “In an ironic way, it was a fitting climax: a suit that began with OFHEO accusing us of deliberate fraud ended with OFHEO putting a deliberately fraudulent value on what we paid to settle it,” Howard wrote in his book. Both the SEC and the Justice Department quietly dropped their investigations.

And finally, in the fall of 2012, after eight years, 67 million pages of documents, and testimony from over 150 witnesses, a civil suit against Howard, Raines, and another executive ended with the federal judge dismissing all the charges. He concluded that there was no evidence that either Raines or Howard had purposefully tried to deceive anyone. The SEC’s former chief accountant, Nicolaisen, was deposed. Fiderer reported that he seemed to be more equivocal than he had been back in 2004. As it turned out, many other companies had done their accounting the way Fannie did. “What I expressed was my view and professional judgment,” Nicolaisen said. “In my opinion, it was outside the professional bounds. But that is an opinion. I mean, I’ll be very clear also in saying a lot of other people concluded otherwise.” Today, Nicolaisen says that in the wake of a string of accounting scandals in the early 2000s, including Enron, he was “very frustrated” with the accounting-and-audit profession and was trying to draw a strong line about what was acceptable and what wasn’t. But, he says, he was opining only on how Fannie had implemented a complex accounting rule and not whether anyone at Fannie had purposefully done anything wrong. About Raines, he says, “My impression was that he intended that Fannie comply fully with the relevant accounting standards.”

The result of all this was a complete tangle: Fannie and Freddie’s stable management was gone; their institutional reputations were badly tarnished; but no one among the GSEs’ many critics had the nerve—or the political support—to create anything positive out of the mess. Although Senator Shelby tried again to pass new, much tougher legislation governing Fannie and Freddie, he couldn’t do it, even with a Republican White House and Congress. So the GSEs rolled on, deeply wounded, with thin levels of capital and ever more onerous requirements to put their stamp on riskier loans as the mortgage market entered its most dangerous period in history, until it all crashed and government conservatorship began.