(FORTUNE Magazine) – LAST DECEMBER, WHEN THE SEC RULED that mortgage giant Fannie Mae had overstated its profits by some $9 billion since 2001, many of the company's longtime supporters, both in Washington and on Wall Street, rallied to its defense. Fannie's management, including former CEO Frank Raines and former CFO Tim Howard, they said, had innocently broken some very complicated accounting rules.

That line of thinking just became a lot less credible. In late February, Fannie said the ongoing investigation by its regulator, the Office of Federal Housing Enterprise Oversight, or OFHEO, had identified a laundry list of additional accounting issues. Fannie skeptics joke that they're "still searching for a mortgage-finance accounting rule that Fannie may not have broken." (See "The Fall of Fannie Mae," on fortune.com.)

It was Fannie, not OFHEO, that made the late February announcement, and the release didn't spell out the size of the new problems. They are not small, and things are likely to get worse before they get better. One major area of suspicion involves Fannie's QSPEs (or qualified special-purpose entities, which the company uses to issue mortgage-backed securities). Fannie has $1.4 trillion of such securities in its off-balance-sheet QSPEs. If off- balance-sheet accounting is found to be invalid for a portion of the securities, that would make Fannie's existing regulatory capital shortfall even worse. In truth, no one has a clue what Fannie Mae's financial statements really look like.

If Fannie Mae were a normal company, even diehard believers would be bolting for the exits. But it's not. For one thing, it's a top fee payer on Wall Street, and even as its stock price has slid to a four-year low recently, Wall Street analysts have continued to reiterate buy ratings. "Opportunities Abound" was the title of a recent Merrill Lynch report. Citigroup, which recently disclosed that it owns more than 6% of Fannie's stock, has also issued bullish reports. The best (or worst) comes from Lehman Brothers, which earned $75 million in fees in late 2004 when Fannie sold preferred stock to shore up its capital. Analyst Bruce Harting not only has kept his $100 price target on the $59 stock but also defends that target by creating a measure he calls "true" book value, which simply ignores the $9 billion restatement.

Credit-rating agencies, which are paid by the companies that they rate--and Fannie Mae is one of the world's largest issuers of debt--are equally supportive. In a recent report, Fitch Ratings defended Fannie's triple-A rating (which is critical to Fannie's business, because it allows the company to borrow money cheaply) in part by citing the "quality of systems used to measure and manage interest rate and credit risk." That flies in the face of OFHEO's contention that Fannie has "internal control deficiencies that it believes raise safety and soundness concerns." Fitch also cited the "assumption of support from the U.S. government that would be provided in the event of severe financial stress" at Fannie. But the U.S. government does not in fact guarantee Fannie's debt, and one of the purported goals of new legislation is to make this clear. "I don't think anything should be too big to fail," says Senator Richard Shelby (R-Alabama).

Indeed, in Washington the story is a bit different. There, the drumbeat against Fannie and its sibling Freddie Mac has grown steadily louder. In testimony before the House Financial Services Committee on Feb. 17, Alan Greenspan, in response to questioning by Richard Baker (R-Louisiana), said he thought Fannie and Freddie should have to shrink their mortgage holdings to a combined $100 billion to $200 billion, down from the $1.5 trillion that the two companies own today. Otherwise, said the Fed chairman, "we are placing the total financial system of the future at substantial risk." There's some evidence that Greenspan's views, once considered dangerously "anti-housing," are becoming more mainstream. They will have a "significant impact" on the new legislation to govern Fannie and Freddie that Baker is planning to introduce, says Michael diResto, Baker's spokesperson.

The conventional wisdom is that the recent news from Fannie has increased chances that new legislation will be passed this year; Senator Shelby says the odds are "excellent." Both Fannie and Freddie want new legislation to remove the uncertainty. The Bush administration, which has taken a harder line than Congress on Fannie and Freddie for ideological but also pragmatic reasons (the administration doesn't want to be implicated in a major business scandal), has been silent. That's no accident, says one person close to the furor. After all, if Fannie continues to dig itself into a deeper accounting hole, why not wait to create even tougher regulation? "Slow torture" is how this person describes the attitude toward Fannie and Freddie. In some quarters there's even a belief that new legislation shouldn't be considered without a real debate about the risks and rewards of Fannie and Freddie's continued existence as government-sponsored entities. That would be something even Wall Street would have a hard time ignoring.

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