Fannie Mae Accounting Scandal for Dummies

"The Mortgage Wars," by Timothy Howard, garnered favorable reviews, though some reviewers seemed reluctant to accept the author's claim, that the government's charges against Fannie Mae, pertaining to accounting violations, were baseless and politically motivated.

They have reason to be skeptical. As Fannie's former CFO, Howard is the opposite of an unbiased party. In 2004 the allegations caused Howard, along with CEO Franklin Raines and controller Leanne Spencer, to lose their jobs. And they faced a class action lawsuit for securities fraud, which dragged on for eight years.

Finally, in late 2012, U.S. District Court Judge Richard Leon dismissed the cases against all three. He ruled that there was zero credible evidence to suggest that Howard, Raines or Spencer had ever intended to deceive anyone. He also ruled that the charge of improper earnings manipulation, which was the basis of an earlier SEC lawsuit alleging securities fraud, was not supported by evidence.

Would Regulators Deceive the Public?

Still, reviewers seem to believe that there had to be something there, that U.S. regulators would not simply fabricate bogus charges of whole cloth.

Except that is precisely what happened. The Fannie Mae "accounting scandal," is an especially timely parable to remind us how easily members of Congress and the media are bamboozled by an onslaught of doublespeak.

Remember Debits = Credits?

To make sense of it all, we need to go back to accounting basics. If you've ever taken a course in the subject, you know everything revolves around a two-part question: Where do the debits go and where do the credits go? If you can't answer that question, you are clueless. Debits and the credits, both sides of the journal, must always balance out.

So if you want to accuse somebody of an accounting violation, you must address three questions: Where are debits and credits supposed to go? Where, if anywhere, did they show up instead? How did the improper posting of debits or credits deceive others?

Fannie's accusers, the Office of Housing Enterprise Finance Oversight and the Securities and Exchange Commission, sidestepped those questions. Which is why reading through 600 pages of OFHEO reports, here and here, is largely a waste of time.

An $11 Billion Sleight of Hand

Consider how, in May 2006, an $11 billion loss suddenly emerged out of nowhere:

"Fannie Mae's accounting policies and practices did not comply with Generally Accepted Accounting Principles," said an OFHEO press release.  Consequently, "errors resulted in Fannie Mae overstating reported income and capital by a currently estimated $10.6 billion."

SEC Chairman Christopher Cox piled on. "The significance of the corporate failings at Fannie Mae cannot be overstated," he told Congress in June 2006. "The company has estimated its restatements for 2003 and 2002 and for the first two quarters of 2004, will result in at least an $11 billion reduction of previously reported net income. This will be one of the largest restatements in American corporate history."

Those claims were false and highly misleading. So that everyone understands why, here's a second grade level explanation.

Suppose Fannie wrote, in its quarterly report, "There are five toes on your right foot." Also suppose Fannie wrote, somewhere else in the same report, "There are five toes on your left foot." Fannie assumed that you could read the information in both places and figure out that you have 10 toes in total.

But Fannie's accusers read the quarterly report selectively. They saw the statement about toes on the right foot, but they ignored the statement about the left foot. Then they declared, "Fannie Mae understated the total number of toes by five! In so doing, Fannie violated generally accepted principles of podiatry. The significance of Fannie's corporate failings cannot be overstated."

Really. You cannot make this stuff up.

Here's how I would explain it to a high school student. In Fannie Mae's quarterly financial statements, it presents net income on the Income Statement, aka the Profit & Loss Statement, or P&L. In addition, Fannie presents Other Comprehensive Income somewhere else, on the Statement of on Changes in Shareholder Equity.

Because it is labeled "other" income, you should be able to figure out that this category of income is separate and distinct from income presented on the P&L. And therefore, to calculate total income, you must add the net income from the P&L with Other Comprehensive Income. Fannie's income on the P&L was positive, whereas the Other Comprehensive Income was negative.

And if you had completed Accounting 101, you'd know that you needed to add P&L income with Other Comprehensive Income in order to calculate total equity. Otherwise, the credits would not equal the debits on the balance sheet.

When the OFHEO and the SEC accused Fannie of overstating income by about $10.6 billion, they simply ignored Fannie's full disclosure of Accumulated Other Comprehensive Income, which was reported as a negative $10 billion as of June 30, 2004.

But the OFHEO and the SEC tried to deceive everyone into thinking that these losses had been kept from public view.

Remember, OFHEO and the SEC have no semantic fig leaf. Though many informally refer to Other Comprehensive Income as a "direct adjustment to equity," the accounting rules say quite clearly, that this is income (loss). Neither agency ever acknowledged that the loss had been fully disclosed to investors.

Mark-to-market Losses Always Affect Income and Always End Up on the P&L

The pretext behind the OFHEO/SEC claim, that Fannie had "overstated" its total income, was the accusation that Fannie had improperly designated its mark-to-market gains/losses on derivatives and other financial instruments.

Fannie had allocated derivative and investment losses to Other Comprehensive Income. Whereas the regulators insisted that those losses should have been properly posted on the P&L. They read Financial Accounting Standard 133, which deals with accounting for derivatives and financial hedges, in a very particular way.

Eventually, all derivative income shows up on the P&L. When a derivative is sold or liquidated, the mark-to-market loss becomes a cash loss. Simultaneously, the mark-to-market loss is removed from Accumulated Other Comprehensive Income and transferred on to the P&L. (I know, many readers are thinking, "Duh.")

In December 2006, Fannie was allowed to issue its restated financials, and the results a significant boost in shareholder equity. It turned out that Accumulated Other Comprehensive Income was revised, on an after-tax basis, from a negative $10 billion to a negative $6.3 billion.

And, of course, the negative amount showed up on the P&L instead of on the Statement of Changes in Equity. In fact, all financial metrics, net income, equity and cash flows, improved from what had been reported previously.

Accountants Agreed with Fannie All Along

It's worth noting that a broad consensus of accounting experts, from the Financial Accounting Standards Board, KPMG, Ernst & Young, PriceWaterhouse Coopers, and elsewhere, specifically endorsed Fannie's original interpretation of FAS 133.

The consensus position was later affirmed by Conrad Hewitt, the chief accountant for the SEC. In March 2007, his office revoked the position of his predecessor, and validated Fannie's interpretation of FAS 133.

Hewitt's action came a little late for Fannie, Citigroup, Bank of America, GE Capital, Ford Motor Credit, and almost 300 other major companies that applied the rules the same way that Fannie did. They were all compelled to restate their financials because of the SEC's earlier position. Which is why Cox's claim about Fannie's restatement, being one of the biggest in American corporate history, was pretty misleading. You have to wonder why the SEC filed a civil complaint against Fannie and none of the other similarly situated companies.

The only recognized accounting expert, anywhere, who suggested that Fannie's interpretation of the rules was improper was Hewitt's predecessor, Donald Nicoliasen. "In my view," testified Nicoliasen in November 2009, Fannie's application of the rules, "was outside professional accounting standards… But that is an opinion. I mean, I'll be very clear also in saying a lot of other people concluded otherwise."

Yet Nicoliasen acknowledged the obvious, which was that the difference was a matter of form, not substance. "The information is actually in the financial statements as to losses that are deferred on hedging contracts," he testified. "A lot of that has already been—had been recorded through equity, not through the income statement." He failed to mention this little detail when he testified before Congress in February 2005.

There was only one reason why Congress solicited Nicoliasen's testimony back in February 2005. OFHEO Director Armando Falcon told Congress in October 2004 that these so-called FAS 133 violations threatened Fannie's safety and soundness. "We feel very strongly that these are black and white accounting issues," he said. "These are not issues of interpretation."

Mark Twain said, "A lie can travel half way around the world while the truth is putting on its shoes." So far, the shoes have not been laced up.

David Fiderer has previously worked in energy banking for more than 20 years. He is currently working on a book about the ratings agencies.