FANNIE MAE: LESS ENRON, MORE TYCO
By Janice Revell

(FORTUNE Magazine) – SHOCK, OUTRAGE, CONDEMNATION. Those were the perfectly understandable reactions to the news that Fannie Mae, a company that owns or guarantees more than $2.3 trillion in U.S. residential mortgage debt, had been accused of cooking the books. In late September, Fannie's regulator, the U.S. Office of Federal Housing Enterprise Oversight, released a blistering 211-page report that charged the company's management team with everything from manipulative "cookie jar" accounting to improperly reporting billions of dollars of derivatives losses. Most of it, claimed OFHEO, was done to perpetuate the illusion of steady earnings growth at the company--and to keep the multimillion-dollar bonuses for top executives rolling in. In summary, said OFHEO, the whole mess now brings into question the "overall safety and soundness of the Enterprise."

"This is a sad and disturbing day," said Congressman Richard Baker (R-Louisiana), a longtime Fannie critic. "Investors have been fooled, homebuyers have been cheated, and taxpayers are at risk."

There's no question that the story at Fannie is likely to get a whole lot uglier. The SEC is investigating the company's accounting, and the Department of Justice has opened its own investigation into possible accounting fraud. Baker, meanwhile, is spearheading a fresh round of congressional hearings, set to begin in October. And all this comes barely a year after a similar accounting scandal rocked Fannie's sibling, Freddie Mac. But the situation is less Enron, where bad accounting was masking a bad business, and more Tyco. In other words, for Fannie, bad accounting will mean headaches, scandal headlines, and executive ousters--but it also means that the business itself will survive.

Way too big--far too risky. Those have always been the major worries when it comes to Fannie and Freddie. Not only do they now own or guarantee about half of the $7.9 trillion or so of the country's residential mortgage debt, but they're also heavily leveraged. In February, Federal Reserve chairman Alan Greenspan warned Congress that in order to "fend off possible future systemic difficulties," the two companies' growth would have to be curbed, "sooner rather than later."

In the wake of its report, OFHEO has already started to turn the screws on Fannie, ordering the company to beef up its capital reserves within the next nine months by an additional 30% (estimated at about $4.4 billion). Analysts say Fannie Mae could easily raise that capital by cutting back on the amount of mortgages it buys and holds in its own portfolio--choosing instead to pump new money into the mortgage market through securitizing the mortgages it buys--a move that would reduce its overall risk but crimp future earnings growth. OFHEO has also wrested a host of other concessions out of Fannie's board, including having the final say over dividend payouts and share repurchases, that will give it much more control over the company's capital reserves in the future.

But Fannie may also be forced to make big restatements to its prior years' earnings, in which case it would have to raise even more capital. In the absolute-worst-case scenario, says Sanford C. Bernstein analyst Jonathan Gray, OFHEO would force Fannie to sell off huge chunks of its mortgage portfolio and halt any new purchases. That, in turn, would make it far more difficult for other lenders to issue mortgages--as a consequence, rates would rise sharply, triggering a decline in home prices and overall economic expansion. But Gray adds that's a highly unlikely--and politically unpalatable--scenario. After all, he notes, "homeowners are voters."

Whatever happens, two things are certain: Investors are facing months of gut-wrenching volatility, and at Fannie headquarters, heads are almost certain to roll--the obvious targets being chairman and CEO Franklin Raines and chief financial officer Timothy Howard. In that sense, it's got something in common with both Enron and Tyco--the top guys rarely survive a scandal this big. -- Janice Revell

Fannie Mae

Richard Baker

Following its stunning report, OFHEO is already turning the screws on Fannie.