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The AAO Weblog covers accounting issues and current events as they relate the practice of investment analysis.

Apr 7

Written by: Jack Ciesielski
4/7/2005 8:00 AM 

With the financial press now fixated on AIG and MBIA (there's a trading rule for you: don't go long on financial institutions whose names are acronyms), the Fannie Mae investigation doesn't have the same grip on investors as it did a few months ago. Yet the news from the Office of Federal Housing Enterprise Oversight (OFHEO) continues to stream forth, and it sounds like the investigation is winding down.

Yesterday, Armando Falcon, OFHEO director Armando Falcon delivered a statement before the Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises outlining current developments in the Fannie Mae special examination - and delivering the punch line that he would retire from his post on May 20, "barring extraordinary circumstances." His appointment expired last October, but he stayed on to stick with the investigation, which now appears to be drawing to a close.

Falcon's statement included descriptions of the recent findings, but no figures. A few highlights:

Statement 65: Acquired mortgage loans are to be classified as held-for-investment (HFI) or held-for-sale (HFS). Fannie policy was to designate the classification at acquisition of th loans, depending on the intent. So far, so good; where it went sour was in the data processing system. For the last 21 years, it incorrectly classified all acquired mortgage loans as HFI, regardless of the initial classification. The accounting for HFI and HFS securities differs after acqusition, so there's 21 years of accumulated fixing-up to do.

Statement 115: Another classification issue. Statement 115 requires different treatment for securities held-to-maturity (amortized cost), available-for-sale (fair value, changes through other comprehensive income), and trading (fair value, changes through earnings). Figuring which balance sheet bucket into which a freshly-acquired security is dropped should happen when the security is bought. Fannie Mae essentially would give itself a month to make that decision, giving itself the gift of 20/20 hindsight - and the ability to better "cherry-pick" its portfolio by making transfers from one bucket to another. The usual consequences of such malfeasance: the offending company loses the right to classify securities as held-to-maturity, something Falcon hinted might occur.

Other misapplied accounting related to securitizations, derivatives and consolidation of variable interest entities. Once the numbers are spelled out on all of the accounting recasts, it'll be very interesting to see what the real Fannie Mae capital ratios look like compared to what they were. One note on the Statement 115 hitch: it's more evidence that the thirteen-year old standard needs to be overhauled or gutted. Three distinct classifications for investment securities with three different earnings effects leaves plenty of opportunity for earnings management - and Fannie provides first-class evidence that it happens.