The long-held image of mortgage finance giant Fannie Mae as a low-risk, best-in-class institution was a “façade,” the government sponsored corporation’s regulator said today in a report summing up findings of a 27-month-long investigation into Fannie’s accounting practices.

The report from the Office of Federal Housing Enterprise Oversight details an unethical corporate culture where Fannie Mae employees manipulated accounting and earnings to trigger bonuses for senior executives from 1998 to 2004.

Fannie Mae has agreed to pay $400 million in fines and implement corrective measures as part of settlements with OFHEO and the Securities and Exchange Commission, the regulator said today.

OFHEO also has directed Fannie Mae to limit growth of its portfolio mortgage assets to the level of Dec. 31, 2005, and to review current and former employees for remedial action.

“As the OFHEO report shows, the image of Fannie Mae as one of the lowest-risk and ‘best in class’ institutions was a façade. In fact, it was just the opposite. They promoted unconstrained growth while undermining proper internal controls by under investing in systems, risk management and staff,” James B. Lockhart, OFHEO’s acting director said in a statement today.

“Our examination found an environment where the ends justified the means. There was a systematic effort by senior management to manipulate accounting, reap financial rewards, and prevent the rest of the world from knowing about it,” Lockhart said.

A large number of Fannie Mae’s accounting policies and practices did not comply with Generally Accepted Accounting Principles (GAAP), OFHEO found, and the mortgage company also had serious problems of internal control, financial reporting, and corporate governance. Those errors resulted in Fannie Mae overstating reported income and capital by a currently estimated $10.6 billion.

From 1998 to mid-2004, Fannie Mae reported smooth profit growth and hit announced targets for earnings per share precisely each quarter, OFHEO said, and those achievements were “illusions deliberately and systematically created by the Enterprise’s senior management with the aid of inappropriate accounting and improper earnings management.”

By deliberately and intentionally manipulating accounting to hit earnings targets, senior management maximized the bonuses and other executive compensation they received, at the expense of shareholders, OFHEO said. Earnings management made a significant contribution to the compensation of former Fannie Mae Chairman and CEO Franklin Raines, which totaled over $90 million from 1998 through 2003. Of that total, more than $52 million was directly tied to achieving earnings per share targets, the regulator said.

Fannie Mae’s board of directors contributed to problems by failing to be sufficiently informed and to act independently of its chairman, Franklin Raines, and other senior executives, failing to exercise the requisite oversight over the enterprise’s operations, and failing to discover or ensure the correction of a wide variety of unsafe and unsound practices, even after the Freddie Mac problems became apparent, OFHEO said.

Senior management did not make investments in accounting systems, computer systems, other infrastructure and staffing needed to support a sound internal control system, proper accounting, and GAAP-consistent financial reporting, the regulator said.

“As a government-sponsored enterprise, Fannie Mae has a unique position among American corporations and an extremely important mission,” said Lockhart. “It is also the second largest borrower in the world, only behind the U.S. government. As such, Fannie Mae has a special mandate and position of public trust. The previous management team violated that trust and did serious harm to Fannie Mae,” Lockhart said.

Fannie Mae and Freddie Mac were chartered by Congress to increase home ownership by keeping a steady flow of mortgage funds available. The companies purchase mortgages and package them as securities for resale to investors or for their own investment.

Both mortgage giants have been rocked by accounting scandals.

“The (Fannie Mae) penalty and settlements represent a major step in correcting a dangerous course that had been followed by one of the largest financial institutions in the world,” Lockhart said today. “Unprincipled corporate behavior and inadequate controls will simply not be tolerated.”

***

Send tips or a Letter to the Editor to jessica@inman.com or call (510) 658-9252, ext. 133.

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