EXHIBIT 99.2
A REPORT TO THE
SPECIAL REVIEW COMMITTEE
OF THE
BOARD OF DIRECTORS OF FANNIE MAE
PAUL, WEISS, RIFKIND, WHARTON & GARRISON LLP
Warren B. Rudman Alex Young K. Oh
Robert P. Parker Daniel J. Kramer
HURON CONSULTING GROUP INC.
George E. Massaro Jeffrey H. Ellis
February 23,2006
TABLE OF CONTENTS
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CHAPTER I: EXECUTIVE SUMMARY ............................................................ (Separate Volume)
CHAPTER II: INVESTIGATION METHODOLOGY .................................................... 2
I. INTRODUCTION ..................................................................... 2
A. The OFHEO Report ......................................................... 2
1. FAS 91 ................................................................ 3
2. FAS 133 ............................................................... 4
3. Other Chapters ........................................................ 4
B. Issues to be Reviewed by Agreement with OFHEO ............................ 6
1. September 2004 Agreement .............................................. 6
2. The February 2005 OFHEO Letter and Supplemental Agreement ............. 8
C. Other Issues Brought to Paul, Weiss's Attention .......................... 9
1. Directive to Employees to Come Forward ................................ 9
2. Monitoring Consultants's Activities ................................... 9
3. The Company's November 10, 2005 12b-25 Filing ......................... 12
D. Engagement of Huron ...................................................... 12
E. Documents Reviewed ....................................................... 13
F. Interviews Conducted ..................................................... 14
G. Independent Collection and Analysis of Electronic Materials .............. 15
H. Assessment as to the Company's Cooperation ............................... 17
1. The Board, the SRC and Management ..................................... 17
2. The Leanne Spencer Document Incident .................................. 18
CHAPTER III: BACKGROUND ................................................................... 21
I. INTRODUCTION ..................................................................... 21
II. THE EVOLUTION OF FANNIE MAE ...................................................... 21
III. FANNIE MAE'S ROLE TODAY .......................................................... 24
IV. FANNIE MAE'S PRIMARY BUSINESS ACTIVITIES ......................................... 25
A. Portfolio Investment ..................................................... 25
B. Credit Guaranty .......................................................... 26
V. REGULATORY REGIME ................................................................ 27
A. HUD ...................................................................... 28
B. OFHEO .................................................................... 29
1. Capital Requirements .................................................. 29
2. Corporate Governance .................................................. 30
CHAPTER IV: ACCOUNTING FOR THE AMORTIZATION OF PREMIUM/DISCOUNT ON LOANS AND
MORTGAGE - BACKED SECURITIES ................................................. 33
I. INTRODUCTION ..................................................................... 33
II. BACKGROUND ....................................................................... 34
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A. Applicable Accounting Standard ....................................................... 34
B. Relevant Amortization Accounting Systems ............................................. 36
C. Accounting Practices Under FAS 91 Prior to 1998 ...................................... 37
1. Management Never Recorded Catch-up Until 1998 ..................................... 37
2. Management Did Not Model Its Non-Core Book In Accordance With GAAP ................ 38
III. 1998 CATCH-UP CALCULATION AND ADJUSTMENT ..................................................... 42
A. The Catch-Up Calculation for 1998 .................................................... 42
B. Evidence Reflecting Management's Focus on Meeting EPS Targets ........................ 43
C. Other Adjustments Made to Mitigate Impact of Catch-Up Expense on 1998 EPS ............ 50
1. Changes in Accounting for LIHTC ................................................... 50
2. $3.9 Million in Miscellaneous Income from Account 162200 .......................... 54
D. Management's Disclosures About the 1998 Adjustments .................................. 57
1. Disclosures to KPMG ............................................................... 57
2. Disclosures Made to the Board of Directors ........................................ 59
3. Disclosures Made to the Public .................................................... 62
E. Management's Reasons for Recording Only $240 Million ................................. 63
1. Interest Rates Volatility Contributed to the Large Catch-Up ....................... 64
2. Management's View That Interest Rates Would Rise in the Future .................... 65
3. Imprecision of the Modeling for the Non-Core Book ................................. 67
4. Inadequacy of the Modeling Systems for the Core Book .............................. 70
F. Findings Regarding the 1998 Catch-Up Decision ........................................ 71
IV. FANNIE MAE'S PREMIUM AND DISCOUNT AMORTIZATION POLICY ........................................ 73
A. Development of the Policy ............................................................ 73
1. Practice Prior to 1999 ............................................................ 73
2. Development of the Amortization Policy ............................................ 74
3. Evidence Reflecting Management's Purpose for the Amortization Policy .............. 75
4. KPMG's Involvement in the Development of the Amortization Policy .................. 81
5. The Final Amortization Policy Adopted in December 2000 ............................ 81
B. The Application of the Amortization Policy ........................................... 84
1. Management Used a Variety of Tools To Manage Catch-Up ............................. 85
2. Catch-Up Was Initially Calculated for Year-End .................................... 88
3. Management Made Adjustments Even When Catch- Up Fell Within the Predetermined
Threshold ......................................................................... 89
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4. KPMG's Awareness of the Manner in Which the Amortization Policy Was
Implemented ................................................................... 90
C. Inadequate Disclosures to the Board About the Amortization Policy and
Its Application .................................................................. 92
D. 2004 Revisions to the Amortization Policy ........................................ 93
E. Findings Regarding the Amortization Policy ....................................... 94
CHAPTER IV APPENDIX: FANNIE MAE'S FAS 91-RELATED SYSTEMS ........................................... 96
CHAPTER V: ACCOUNT FOR DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES ............................ 101
I. INTRODUCTION ............................................................................ 101
II. BACKGROUND .............................................................................. 103
A. Fannie Mae's Debt Policies and Practices ......................................... 103
B. Derivatives and Hedging .......................................................... 105
C. Significant Hedge Transactions ................................................... 108
III. AN OVERVIEW OF FAS 133 .................................................................. 111
1. Requirements for Hedge Accounting ............................................. 112
2. Accounting for Ineffectiveness ................................................ 114
3. Term-Out Transactions and the "Fannie Mae Carve - Out" ........................ 117
IV. FINDINGS REGARDING FANNIE MAE'S IMPLEMENTATION OF FAS 133 ............................... 118
A. The Three Tenets ................................................................. 119
B. Development Efforts During 1999 and 2000 ......................................... 128
C. FAS 138 .......................................................................... 132
D. Post-Effective Date Developments ................................................. 133
V. FINDINGS REGARDING FANNIE MAE'S ACCOUNTING FOR HEDGE TRANSACTIONS ............................. 135
A. Hedge Accounting Methodology ..................................................... 136
B. Significant Aspects of Fannie Mae's Hedge Accounting ............................. 140
1. Fair Value Equal to Zero ...................................................... 140
2. Seven-Day Tolerance for Matching Repricing Dates .............................. 143
3. Forecasted Transactions ....................................................... 145
4. The De Minimis Test ........................................................... 149
5. Identification and Probability of Forecasted Transactions ..................... 152
6. Term-Outs ..................................................................... 155
C. Hedge Documentation .............................................................. 156
D. Other Hedge Accounting Policies .................................................. 160
VI. FINDINGS REGARDING OVERSIGHT OF FANNIE MAE'S HEDGE ACCOUNTING ................................ 162
A. Senior Management ............................................................. 163
B. The Board and the Audit Committee ............................................. 163
C. FASB .......................................................................... 165
D. KPMG .......................................................................... 167
E. OFHEO ......................................................................... 171
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F. Internal Audit ................................................................... 172
CHAPTER VI: OTHER ACCOUNTING ISSUES .................................................................. 174
PART A: ACCOUNTING FOR THE ALLOWANCE FOR LOAN LOSSES .......................................... 174
I. INTRODUCTION .......................................................................... 174
II. BACKGROUND ............................................................................ 175
A. Identification of the Allowance as a Potential Issue ............................. 175
B. Relevant Accounting Principles ................................................... 178
III. FINDINGS CONCERNING FANNIE MAE'S ACCOUNTING FOR THE ALLOWANCE ......................... 179
A. Fannie Mae's Historical Practice for Setting the Allowance ....................... 179
1. Overview of the Components of Fannie Mae's Allowance .......................... 179
2. Management's Process for Setting the Allowance ................................ 180
B. Evidence Reflecting Management's View of the Allowance ........................... 189
1. Management's Awareness that the Allowance May Be Overstated ................... 189
2. Evidence Reflecting Management's Consideration of Using the Allowance to
Offset Unrelated Expenses ..................................................... 191
3. Management's Safety and Soundness Perspective on the Allowance ................ 192
C. Transparency of the Allowance Setting Process to OFHEO ........................... 194
D. Conclusions Regarding Fannie Mae's Accounting for the Allowance .................. 196
PART B: ACCOUNTING FOR DOLLAR ROLLS ........................................................... 197
I. INTRODUCTION .......................................................................... 197
II. BACKGROUND ............................................................................ 199
A. FAS 140 and Other Accounting Literature .......................................... 199
B. OFHEO'S Concerns ................................................................. 201
C. Fannie Mae's Accounting Policy ................................................... 202
D. Fannie Mae's Dollar Roll Transactions ............................................ 205
1. Mechanics of the Dollar Roll Transaction ...................................... 205
2. Dollar Roll Fails ............................................................. 205
3. Return of Substantially the Same Collateral ................................... 206
III. FINDINGS .............................................................................. 214
PART C: ACCOUNTING FOR FORWARD COMMITMENTS .................................................... 214
I. INTRODUCTION .......................................................................... 214
II. BACKGROUND ON FAS 149 ................................................................. 217
A. Commitments under FAS 133 Prior to FAS 149 ....................................... 217
B. Adoption of FAS 149 .............................................................. 218
III. BACKGROUND ON FANNIE MAE'S FIRM COMMITMENT PRACTICES .................................. 219
IV. FINDINGS REGARDING FANNIE MAE'S IMPLEMENTATION OF FAS 149 ............................. 221
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V. FINDINGS REGARDING FANNIE MAE'S ACCOUNTING FOR FIRM COMMITMENTS ............................... 226
A. The Company's FAS 149 Policy ............................................................... 226
B. Documentation of Hedged Transactions ....................................................... 228
C. The Probability Assessment ................................................................. 231
VI. FINDINGS REGARDING SENIOR MANAGEMENT, OFHEO, AND THE BOARD .................................... 235
PART D: CLASSIFICATION OF SECURITIES HELD IN PORTFOLIO ................................................ 238
I. INTRODUCTION .................................................................................. 238
II. BACKGROUND .................................................................................... 239
A. Applicable Accounting Principles ........................................................... 239
B. Fannie Mae's Accounting Policy ............................................................. 241
III. FINDINGS ...................................................................................... 241
A. Fannie Mae's Classification of Debt Securities ............................................. 241
B. Practical Application of the Company's Policies ............................................ 245
C. KPMG Review ................................................................................ 248
D. Executive Involvement and the Report to the Audit Committee ................................ 249
IV. CONCLUSIONS ................................................................................... 249
PART E: RECOGNITION OF INTEREST EXPENSE AND INCOME .................................................... 250
I. INTRODUCTION .................................................................................. 250
II. BACKGROUND .................................................................................... 251
III. FINDINGS REGARDING THE RECOGNITION OF INTEREST EXPENSE AND INCOME ............................. 257
PART F: ACCOUNTING FOR OTHER-THAN-TEMPORARY IMPAIRMENT OF MANUFACTURED HOUSING BONDS AND
AIRCRAFT ASSET-BACKED SECURITIES .............................................................. 257
I. INTRODUCTION .................................................................................. 257
II. BACKGROUND .................................................................................... 258
A. Applicable Accounting Standards ............................................................ 258
B. Fannie Mae's Practice and Policy ........................................................... 260
1. OTTI Recorded ........................................................................... 260
2. Types of Investments .................................................................... 262
3. OTTI Accounting and Monitoring Methodologies ............................................ 264
III. FINDINGS ...................................................................................... 269
A. Accounting Policy and Monitoring ........................................................... 269
B. Management Modification of the MH Bond DCF Modeling ........................................ 270
C. Fair Value Determinations .................................................................. 273
1. MH Bonds ................................................................................ 273
2. Aircraft ABS ............................................................................ 274
D. Timing of Recognition ...................................................................... 276
PART G: ACCOUNTING FOR INVESTMENTS IN INTEREST-ONLY MORTGAGE-BACKED SECURITIES ........................ 277
I. INTRODUCTION .................................................................................. 277
II. BACKGROUND .................................................................................... 278
A. Applicable Accounting Standards ............................................................ 278
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B. Fannie Mae's Accounting for Investments in IO MBS ....................................... 278
1. Motivation for the Decision to Combine IO MBS with Other Securities
for Accounting Purposes .............................................................. 279
2. Discussions with KPMG ................................................................ 281
3. The Internal Policy for the Acquisition of IO MBS .................................... 283
4. Subsequent Accounting for Synthetic MBS .............................................. 285
III. FINDINGS ...................................................................................... 287
A. Management's Disclosures About Accounting for IO MBS to the Board of Directors
or its Committees ....................................................................... 287
B. Discussions with the SEC Regarding Accounting for IO MBS ................................ 289
IV. CONCLUSIONS ................................................................................... 290
PART H: SECURITIZATION OF WHOLLY-OWNED MBS ............................................................ 291
I. INTRODUCTION .................................................................................. 292
II. BACKGROUND .................................................................................... 292
A. Accounting Literature on Consolidation .................................................. 292
B. OFHEO's Concerns ........................................................................ 293
C. The Company's Approach to Consolidation ................................................. 294
III. CONCLUSIONS ................................................................................... 299
PART I: ACCOUNTING FOR INCOME TAX RESERVES AND CERTAIN TAX-ADVANTAGED TRANSACTIONS .................... 300
I. INTRODUCTION .................................................................................. 300
II. BACKGROUND .................................................................................... 300
A. Applicable Authoritative Literature and Principles ...................................... 300
B. Fannie Mae's Accounting for Income Tax Reserves and Tax-Advantaged Transactions ......... 301
1. Tax Reserves ......................................................................... 301
2. Fannie Mae's Recognition of Synfuel Tax Credits ...................................... 304
3. Issues Related to the STIS Transactions .............................................. 308
III. FINDINGS ...................................................................................... 312
PART J: ACCOUNTING FOR INSURANCE PRODUCTS ............................................................. 313
I. INTRODUCTION .................................................................................. 313
II. BACKGROUND .................................................................................... 314
A. Role of Credit Policy, Generally ........................................................ 314
B. Fannie Mae's Consideration of Finite Risk Insurance Policies ............................ 316
1. MMC Proposal ......................................................................... 316
2. Radian Transaction ................................................................... 318
3. ACE Proposal ......................................................................... 323
4. Corporate Owned Life Insurance ....................................................... 326
III. FINDINGS REGARDING INSURANCE PRODUCTS ......................................................... 328
PART K: ACCOUNTING FOR OUT-OF-PORTFOLIO SECURITIZATION ("PORTFOLIO POOLING SYSTEM") ................... 331
I. INTRODUCTION .................................................................................. 331
II. BACKGROUND .................................................................................... 332
A. PPS and the Coding Error ................................................................ 332
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B. Accounting for HFS Loans ................................................................ 334
III. FINDINGS REGARDING THE PORTFOLIO POOLING SYSTEM ............................................. 335
PART L: THE DEBT REPURCHASE ("BUYBACK") PROGRAM ..................................................... 336
I. INTRODUCTION ................................................................................ 336
II. BACKGROUND .................................................................................. 337
III. FINDINGS REGARDING FANNIE MAE'S BUYBACK PROGRAM ............................................. 340
A. Earnings-Related Strategy ............................................................... 341
B. Documentation for Buyback Decisions ..................................................... 344
C. Economics of Fannie Mae Debt Buybacks ................................................... 345
D. Disclosures ............................................................................. 347
1. Public Disclosure .................................................................... 347
2. Board Disclosure ..................................................................... 350
IV. RECOMMENDATIONS ............................................................................. 352
PART M: ACCOUNTING FOR THE AMORTIZATION OF CALLABLE DEBT EXPENSES ................................... 353
I. INTRODUCTION ................................................................................ 353
II. BACKGROUND .................................................................................. 354
A. Applicable Accounting Principles ........................................................ 354
B. Fannie Mae's Application of the Literature .............................................. 355
C. Amortization End-Date Changes ........................................................... 357
D. The September 2002 End-Date Adjustment .................................................. 360
III. FINDINGS .................................................................................... 364
PART N: MINORITY LENDING INITIATIVE ................................................................. 365
I. INTRODUCTION ................................................................................ 365
II. BACKGROUND .................................................................................. 365
A. The MLI Program ......................................................................... 365
B. Accounting for the Payments to RBMG ..................................................... 368
III. FINDINGS REGARDING THE MLI PROGRAM .......................................................... 369
PART O: ACCOUNTING FOR REALIGNMENTS AND THE SECURITY MASTER PROJECT ................................. 369
I. INTRODUCTION ................................................................................ 369
II. BACKGROUND .................................................................................. 370
III. FINDINGS REGARDING THE ACCOUNTING TREATMENT OF REALIGNMENT IMPACTS .......................... 371
A. Management's Deferral of Realignment Impacts ............................................ 371
1. Deferral of STATS Realignment Impacts ................................................ 372
2. Deferral of LASER Realignments Prior to 1998 ......................................... 375
B. Some Realignment Impacts Were Recorded into Income in the Period in Which They Were
Identified .............................................................................. 375
C. Inclusion of Realignment Impacts in the Analysis of Catch - Up .......................... 376
1. Security Master Project .............................................................. 376
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2. Management's Inclusion of Realignment Impacts in
Catch-up Calculation Was Not Consistent with
GAAP ......................................................... 384
D. Findings Regarding Fannie Mae's Belated Proposal of a
Realignment Policy that Was Inadequate Under GAAP .................. 385
PART P: ACCOUNTING FOR INVESTMENTS IN AFFORDABLE HOUSING PARTNERSHIPS ................ 387
I. INTRODUCTION ................................................................. 387
II. BACKGROUND ................................................................... 387
A. Applicable Accounting Standards .................................... 387
B. Fannie Mae's Investments in Affordable Housing Partnerships ........ 389
C. Fannie Mae's Partnership Accounting ................................ 390
1. Accounting for Capital Contributions ......................... 390
2. The Company's Accounting Methodologies ....................... 392
3. Impairment Analysis .......................................... 397
III. FINDINGS .................................................................... 399
CHAPTER VII: CORPORATE GOVERNANCE AND INTERNAL CONTROLS ................................... 401
I. BOARD OF DIRECTORS ........................................................... 401
A. Summary ............................................................ 401
B. Overview Prior to September 2004 ................................... 402
1. Overview of the Board ........................................ 402
2. Committees of the Board ...................................... 406
3. Board Oversight of Accounting and Financial Reporting
In Practice .................................................. 413
C. Findings ........................................................... 416
1. The Board Sought to Meet Evolving Corporate Governance
Standards .................................................... 416
2. The Board Was Engaged on Accounting and Financial Reporting
Issues ....................................................... 418
D. Subsequent Developments ............................................ 418
1. Separation of Chairman and CEO Functions ..................... 418
2. Changes to Board Committee Structure ......................... 420
3. Changes to Policies and Practices ............................ 422
II. OFFICE OF THE CHAIRMAN ....................................................... 424
A. Summary ............................................................ 424
B. Overview Prior to September 2004 ................................... 425
1. Chairman and Chief Executive Officer ......................... 425
2. Vice Chairmen of the Board ................................... 427
3. Other Members of the Office of the Chairman .................. 430
4. Management Committees ........................................ 431
C. Findings ........................................................... 437
1. Management Did Not Fully Inform the Board of Accounting
Issues or Internal Control Deficiencies ...................... 437
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2. Management Created an Environment that was not Conducive to
Open Discussion and Exchange of Views .............................. 438
3. Inadequate Management of Corporate Risks ........................... 446
D. Subsequent Developments ................................................... 449
1. Personnel and Structural Changes to Senior Management .............. 450
2. Changes to Corporate Culture ....................................... 454
III. OFFICE OF AUDITING .............................................................. 456
A. Summary ................................................................... 456
B. Overview Prior to September 2004 .......................................... 457
1. Functions and Responsibilities ..................................... 457
2. Organization and Structure ......................................... 458
3. Past Evaluations of the Office of Auditing ......................... 463
C. Findings .................................................................. 464
1. Leadership ......................................................... 464
2. Relationship with Management ....................................... 465
3. Resource Deficiencies .............................................. 468
4. Inadequate Communications .......................................... 472
5. Deficiencies in the Office of Auditing's SOX 404 Work .............. 475
D. Subsequent Developments ................................................... 476
1. Changes in Leadership and Reporting Line ........................... 476
2. Focus on Core Audit Mission ........................................ 477
3. Internal Structure and Staffing .................................... 477
4. Changes to Audit Reporting ......................................... 478
IV. ETHICS AND COMPLIANCE FUNCTIONS ................................................. 478
A. Summary ................................................................... 478
B. Overview Prior to September 2004 .......................................... 479
1. Code of Business Conduct ........................................... 479
2. Structure of Board Oversight ....................................... 481
3. Management Oversight and Activities ................................ 483
4. Office of Corporate Justice ........................................ 489
5. Office of Corporate Compliance ..................................... 495
C. Findings .................................................................. 498
1. Unstructured Information Flow to the Board ......................... 499
2. Insufficient Resources ............................................. 499
3. Inappropriate Placement of the Ethics and Compliance
Functions .......................................................... 500
4. Weakness of the Chief Compliance Officer Position .................. 500
5. Insufficient Cross-Enterprise Coordination ......................... 501
D. Subsequent Developments ................................................... 501
1. Creation of an Independent Ethics, Compliance & Investigations
Organization ....................................................... 501
2. Expanded Role of Compliance Committee .............................. 503
3. Enhanced Reporting to the Board .................................... 504
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V. OFFICE OF THE CONTROLLER ........................................................ 505
A. Summary ................................................................... 505
B. Overview Prior to September 2004 .......................................... 506
1. Range of Responsibilities ........................................... 506
2. Senior Vice President and Controller ................................ 506
3. Key Units within Controller's Office ................................ 507
C. Findings .................................................................. 510
1. Inadequate Resources ................................................ 511
2. Deficiencies in the Closing Process ................................. 514
D. Subsequent Developments ................................................... 516
1. Change in Leadership ................................................ 516
2. Structural and Related Personnel Changes ............................ 516
3. Staffing Levels ..................................................... 519
4. Changes to the Closing Process ...................................... 519
CHAPTER VIII: EXECUTIVE COMPENSATION ....................................................... 520
I. INTRODUCTION .................................................................... 520
II. PAUL, WEISS'S INVESTIGATION ..................................................... 522
A. Document Review ........................................................... 522
B. Interviews ................................................................ 522
III. EXECUTIVE COMPENSATION AT FANNIE MAE ............................................ 523
A. Executive Compensation Overview ........................................... 523
1. Fannie Mae's Charter ................................................ 523
2. Fannie Mae's Compensation Philosophy ................................ 523
3. Components of Compensation .......................................... 525
B. The Annual Incentive Plan ................................................. 526
1. Calculation of the AIP Pool and Individual Awards ................... 526
2. Maximizing AIP Funding Pools ........................................ 528
3. The Role of the EPS Incentive ....................................... 533
4. Reducing the Influence of EPS on Compensation ....................... 535
C. Performance Share Plan .................................................... 537
1. Quantitative (EPS) Component ........................................ 538
2. Qualitative (Subjective) Component .................................. 539
IV. LEGAL DEPARTMENT INVOLVEMENT IN COMPENSATION DECISIONS .......................... 544
CHAPTER IX: FANNIE MAE'S INVESTIGATION OF ROGER BARNES'S ALLEGATIONS ........................ 546
I. INTRODUCTION .................................................................... 546
II. BACKGROUND ...................................................................... 547
A. Barnes's Work History ..................................................... 547
B. Barnes's Allegations and the Company's Investigations ..................... 548
III. FINDINGS REGARDING THE INVESTIGATION INTO BARNES'S ACCOUNTING ALLEGATIONS ....... 552
A. August 4, 2003 ............................................................ 552
B. August 5, 2003 ............................................................ 553
C. August 6-7, 2003 .......................................................... 555
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D. August 8, 2003 ......................................................... 556
E. August 9-12, 2003 ...................................................... 558
IV. FINDINGS REGARDING ROGER BARNES'S FAS 91-RELATED ALLEGATIONS ................ 559
A. Factor Anomalies ....................................................... 559
B. Manual Factor Changes .................................................. 561
C. CPR Edits .............................................................. 562
V. FINDINGS REGARDING THE INVESTIGATION INTO BARNES'S CULTURAL COMPLAINTS ...... 563
VI. FINDINGS REGARDING THE INVESTIGATION INTO BARNES'S DISCRIMINATION
ALLEGATIONS ................................................................. 564
VII. FINDINGS REGARDING THE RESULTS OF THE OCC INVESTIGATIONS .................... 564
A. OCC Decision Part A: Internal Audit's Analysis ......................... 564
B. OCC Decision Part B: Controller's Office Culture ....................... 565
VIII. FINDINGS REGARDING THE RESULTS OF THE OCJ INVESTIGATION ..................... 566
IX. FINDINGS REGARDING BARNES'S RESIGNATION AND SETTLEMENT OF THREATENED
LITIGATION .................................................................. 567
X. FINDINGS REGARDING KPMG'S REVIEW AND FINAL REPORT ........................... 569
XI. FINDINGS REGARDING BARNES'S TESTIMONY TO OFHEO AND CONGRESS ................. 570
CHAPTER X: MANAGEMENT'S CONDUCT DURING OFHEO'S SPECIAL EXAMINATION ................... 571
I. INTRODUCTION ................................................................ 571
II. BACKGROUND .................................................................. 571
A. Freddie Mac's Announcement ............................................. 571
B. OFHEO's Announcement to Examine Fannie Mae ............................. 571
III. FANNIE MAE'S RESPONSE TO OFHEO REQUESTS ..................................... 572
A. Document Preservation Efforts .......................................... 572
B. E-mail Review .......................................................... 575
C. Hardcopy Documents ..................................................... 577
D. Interviews ............................................................. 578
E. Findings Regarding the Company's Response to OFHEO Requests ............ 578
IV. CONDUCT OF THE LEGAL DEPARTMENT AND ITS ADVISORS DURING THE SPECIAL
EXAMINATION ................................................................. 582
A. There is No Evidence That Privilege Assertions Were Made in Bad
Faith to "Cloak" Relevant Documents from OFHEO ......................... 582
B. The Board Was Advised By Wilmer and E&Y That the Company's
Accounting Was Reasonable and Defensible ............................... 582
CHAPTER XI: OTHER ALLEGATIONS ......................................................... 589
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PART A: ISSUES RAISED BY CURRENT OR FORMER FANNIE MAE EMPLOYEES .......................... 589
I. INTRODUCTION ..................................................................... 589
A. HTM/AFS Redesignation ....................................................... 591
B. Non-Specific Anonymous Call ................................................. 591
C. Home Solutions (Minority Lending Initiative) ................................ 591
D. Contract and Procurement Systems ("CAPS") ................................... 592
E. Anticipatory Hedge Transaction .............................................. 593
F. Human Resources ............................................................. 593
G. Radian Credit Enhancement Product ........................................... 593
H. Partnership Office .......................................................... 594
I. Fannie Mae Loan Servicing Litigation ...................................... 594
PART B: FANNIE MAE'S EQUITY INVESTMENTS IN GULF BANK ..................................... 595
I. INTRODUCTION ..................................................................... 595
II. BACKGROUND ON THE CDFI PROGRAM ................................................... 597
A. The CDFI Program ............................................................ 597
B. The "Typical" CDFI Transaction Life Cycle ................................... 597
C. The Gulf Bank Transaction ................................................... 598
1. Genesis of Fannie Mae's Relationship with Gulf Bank ..................... 598
2. The Request for an Equity Investment .................................... 599
3. The CDFI Investment Committee ........................................... 600
4. The Transaction Loses Momentum .......................................... 603
5. Gulf Bank's Disclosure Regarding the FRB Examination .................... 605
6. Fannie Mae's Evaluation of the Gulf Bank Disclosure ..................... 606
7. The Closing ............................................................. 608
8. The Cease and Desist Order .............................................. 609
9. Renewal of the CD and the Write-Off ..................................... 610
10. Subsequent Events ...................................................... 611
III. FINDINGS ......................................................................... 611
A. Due Diligence ............................................................... 611
B. Valuation ................................................................... 611
C. Policy Against Having Both CD and Equity Investment ......................... 612
D. Allegations of Wrongdoing Against Rob Levin ................................. 612
E. Levin's Relationship with Salvador Bonilla .................................. 613
F. Levin's Receipt of Gifts .................................................... 613
G. Franchise Value and the CDFI Program Generally .............................. 614
1. Franchise Value ......................................................... 614
2. Mission Value ........................................................... 614
3. Economic Value .......................................................... 615
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CHAPTER I: EXECUTIVE SUMMARY
(Separate Volume)
1
CHAPTER II: INVESTIGATION METHODOLOGY
I. INTRODUCTION
This Chapter details the scope of Paul, Weiss's investigation and its
investigation methodologies. Paul, Weiss was retained by the Special Review
Committee of the Board of Directors of Fannie Mae ("SRC") in September 2004
after OFHEO issued its report, in which OFHEO found, among other things, that
several of the Company's critical accounting policies were not consistent with
GAAP.(1) The scope of Paul, Weiss's review was initially defined by an agreement
executed between the Board of Directors of Fannie Mae and OFHEO (the "September
2004 Agreement"),(2) which agreement was supplemented in March 2005 (the
"Supplemental Agreement").(3) Other matters came to Paul, Weiss's attention
during the review, which were incorporated into the scope. Pursuant to the above
agreements, and with the authorization of both the SRC and OFHEO, Paul, Weiss
retained Huron Consulting Group ("Huron"), a forensic consulting firm, to
provide expert assistance in the investigation.
The facts set forth in this report are based on our review of all of
the documentary and other information made available to us by Fannie Mae and its
agents, and on our interviews of certain former and current employees of the
Company and its agents. In addition, Huron conducted independent and forensic
collection and analysis of electronic data directly from Fannie Mae.
A. The OFHEO Report
In September 2004, almost a year after issuing its first document
request to Fannie Mae, OFHEO issued its Report, which set forth OFHEO findings
to date from the Special Examination. This section briefly summarizes some of
the critical findings of the OFHEO Report, which were incorporated into the
scope of Paul, Weiss's review.
- ----------
(1) OFHEO Report, available at
http://www.ofheo.gov/media/pdf/FNMfindingstodate17 sept04.pdf.
(2) Agreement between the SRC and OFHEO, dated Sept. 27, 2004, P VI.2.(a)
(hereinafter "September 2004 Agreement"), available at:
http://www.ofheo.gov/media/pdf/fnmagreement92704.pdf. This and other
examples of documents relevant to the discussion in this Chapter can be
found in the accompanying, "A Report to the Special Review Committee of the
Board of Directors of Fannie Mae: Appendix" (hereinafter "Appendix"), at
Tab A.
(3) Supplemental agreement between the SRC and OFHEO, dated Mar. 7, 2005,
(hereinafter "Supplemental Agreement"), available at:
http://www.ofheo.gov/media/pdf/fannie05agreement.pdf.
2
1. FAS 91
OFHEO concluded in its Report that the Company's accounting for
purchase premium and discount amortization and amortization of other deferred
charges pursuant to FAS 91 was not in accordance with GAAP. With regard to the
Company's FAS 91 accounting for 1998 in particular, OFHEO found that "the
Enterprise has not provided OFHEO with any credible analysis which supports the
recording of only half of the calculated" amortization expense amount,(4) and
that management's deferral of approximately $200 million of estimated
amortization expense, "enabled management of the Enterprise to receive 100% of
their annual bonus compensation."(5)
With respect to the Company's amortization policy, which contained a
predetermined materiality threshold within which management could choose not to
make adjustments required under FAS 91,(6) OFHEO concluded that this policy was
"inconsistent with GAAP, and [was] designed to provide earnings flexibility and
minimize earnings volatility."(7) OFHEO further concluded that management
inconsistently applied the policy, generated multiple estimates of amortization
with varying assumptions so that it could select the estimates with optimal
results, and engaged in other efforts the result of which was to create a
"cookie jar" reserve to manipulate earnings.(8)
OFHEO also concluded that there were "a number of significant control
weaknesses in the process of accounting for amortization" used by Fannie Mae
that call into question the accuracy of the Company's premium and discount
amortization.(9) Specifically, OFHEO found that management: (1) did not
appropriately segregate duties and allowed the formation of key person
dependencies; (2) poorly documented its accounting practices and results, and
did not create or maintain adequate audit trails; (3) used bad data, including
illogical or anomalous amortization factors; and (4) modeled multiple
alternatives to produce desired results.(10)
In a related area, OFHEO deemed inadequate the investigation by the
Office of Auditing ("Internal Audit") into the allegations raised in 2003 by
then
- ----------
(4) OFHEO Report at 8 (footnote omitted).
(5) Id. at 1.
(6) Id. at 19.
(7) Id. at 13 (emphasis omitted).
(8) Id at 1-2.
(9) Id. at 65.
(10) Id. at 66.
3
employee, Roger Barnes. Barnes's allegations related to purported irregularities
in management's amortization accounting and the modeling process, including
manual factor changes. OFHEO concluded that "the OA [Office of Auditing]
analysis... was flawed for the simple reason that their procedures were
insufficient to asses the breadth of the issues or their quantitative impact on
the catch-up analysis."(11) And furthermore, "[t]he lack of diligence on behalf
of the OA in the matter of the manual factor change is inconsistent with their
responsibility to exercise due professional care."(12)
2. FAS 133
With respect to FAS 133, OFHEO concluded in its Report that Fannie
Mae's implementation of FAS 133 was designed primarily to minimize earning
volatility and simplify operations, and that it "misapplied GAAP... in
pursuit of these objectives."(13) OFHEO highlighted several specific
deficiencies in the Company's approach to FAS 133, including its: (1) failure to
perform adequate assessments of hedge effectiveness by inappropriately treating
the vast majority of its hedges as "perfectly effective"; (2) improper hedge
accounting for derivatives with offsetting terms; (3) misapplication of the
"short-cut" or "matched terms" method; (4) improper accounting for changes in
both the time and intrinsic value components of purchased interest rate caps;
and (5) ambiguous and incomplete documentation of hedging relationships.(14)
In addition, OFHEO made a number of observations relating to Fannie
Mae personnel and the overall environment within which the Company developed its
derivative accounting policies, including: (1) the Company relied on strained
Financial Standards resources for advice on the application of accounting
policy; (2) accounting and treasury operations personnel lacked an adequate
understanding of FAS 133's requirements; and (3) Fannie Mae was willing, on at
least one occasion, to proceed with a desired accounting treatment even though
they were unable to persuade the Financial Accounting Standards Board to
incorporate that accounting into FAS 133.(15)
3. Other Chapters
The OFHEO Report also drew several conclusions relating to the various
controls and processes surrounding Fannie Mae's accounting and financial
reporting, including accounting policy development and review, segregation of
duties, and key
- ----------
(11) Id. at 74.
(12) Id. at 78 (emphasis omitted).
(13) Id. at 82.
(14) Id. at 90-91.
(15) Id. at 87-89.
4
person dependencies. OFHEO focused on the roles and responsibilities of the CFO
and executives in the Controller's Office.(16)
OFHEO found, among other things, that the Company failed to properly
develop and review accounting policies. According to OFHEO, this was partially
because the Company relied on too few individuals to make key accounting policy
decisions. OFHEO found that "the accounting policy development process within
the Controller's Department lends itself to the formation of accounting policies
that are aggressive in nature and which do not comport with a strict
interpretation of GAAP."(17) OFHEO also identified "critical resource shortages
and a lack of technical accounting expertise within the Controller's Office that
resulted in key person dependencies."(18) According to OFHEO, both of these
circumstances "resulted in an environment that impeded independent thinking and
encouraged an inadequate level of policy and procedure development and
documentation."(19) Moreover, OFHEO found that the lack of a formal process for
developing accounting policy resulted in incomplete disclosures on critical
accounting policies by the CFO to the Audit Committee of the Board.(20)
The OFHEO Report also criticized a lack of proper segregation of
duties in several areas. OFHEO noted that the reporting relationship between the
head of Internal Audit and the CFO, which gave the CFO the authority to evaluate
and affect compensation decisions for the head of Internal Audit, "critically
impairs the independence of [Internal Audit]."(21) OFHEO found that the head of
Internal Audit should be independent from the CFO and should report directly to
the Audit Committee of the Board.(22) OFHEO also stated that the fact that the
head of Internal Audit had been the prior Controller also presented "a major
conflict of interest."(23)
OFHEO additionally criticized the aggregation of responsibilities in
the CFO position at Fannie Mae.(24) In addition to overseeing the head of
Internal Audit, the CFO's responsibilities included "risk management, the
retained portfolio, the accounting
- ----------
(16) See id. at 146-69.
(17) Id. at 146.
(18) Id.
(19) Id. at 147.
(20) Id. at 151-52.
(21) Id. at 161.
(22) Id.
(23) Id. at 162.
(24) Id. at 157.
5
function, investor relations, treasury, and financial reporting."(25) OFHEO
similarly concluded that the Senior Vice President--Financial Reporting and
Planning inappropriately oversaw both forecasting the financial statements and
financial reporting: "[h]aving the dual responsibility of modeling the
amortization and reporting amortization results to the financial statements
under the authority of a single individual is a major control weakness that
undermines the integrity of the financial reporting process."(26) Similarly,
OFHEO criticized as a control weakness the fact that a Director-Financial
Reporting was responsible for both modeling the purchase premium and discount
amortization amount as well as recording that amortization amount to the
financial statements.(27)
In sum, OFHEO concluded that "[a] combination of heavy workload, weak
technical skills and a weak review environment contributed to the development of
key person dependencies" and inadequate segregation of duties.(28)
B. Issues to be Reviewed by Agreement with OFHEO
1. September 2004 Agreement
In the aftermath of the OFHEO Report, on September 27, 2004, OFHEO and
the Board of Fannie Mae entered into the September 2004 Agreement.(29) The
September 2004 Agreement required the Board to retain an independent counsel and
accounting firm to conduct reviews of several areas, including: (1) Fannie Mae's
internal controls relating to accounting; (2) Fannie Mae's accounting and other
corporate policies; (3) Fannie Mae's organizational structure and staffing,
particularly related to its CFO, Controller's Office, accounting, audit,
financial reporting, business planning and
- ----------
(25) Id. at 156.
(26) Id. at 159.
(27) Id. at 159-60.
(28) Id. at 168, 169. Subsequent to the OFHEO Report, and at Fannie Mae's
request, the SEC's Office of the Chief Accountant ("OCA") reviewed the
propriety of the Company's historical accounting practices under FAS 91 and
FAS 133 as represented to the OCA by Fannie Mae. Letter from Jonathan
Boyles to Stephen M. Cutler and Paul Berger, dated Nov. 3, 2004, FNMSEC
151-59; Letter from J. Boyles to S. Cutler and P Berger, dated Oct. 19,
2004, FMSEC 2215-64. On December 15, 2004, after reviewing Fannie Mae's
submissions, the OCA concluded that Fannie Mae's accounting under both FAS
91 and FAS 133 were not in accordance with GAAP. SEC press release, dated
Dec. 15, 2004, available at http://www.sec.gov/news/press/2004-172.htm.
(29) See supra note 2; see also OFHEO press release, dated Sept. 27, 2004,
available at http://www.ofheo.gov/News.asp?FormMode=Releases&ID=187.
6
forecasting, and modeling and financial standards functions; (4) Fannie Mae's
compensation regime as related to strategic planning, and its impact on
accounting and transaction decisions; and (5) Fannie Mae's governance
procedures.(30) The terms of the September 2004 Agreement required Fannie Mae to
undertake immediate steps in certain areas to remediate the concerns raised by
OFHEO. Other provisions of the Agreement required Fannie Mae to retain third
party experts to review and recommend various changes consistent with OFHEO's
recommendations. As discussed in greater detail below, Paul, Weiss reviewed some
of the work that was undertaken by the Company to implement the September 2004
Agreement, but such matters were not incorporated into Paul, Weiss's independent
review.
OFHEO approved of the Board's selection of Paul, Weiss as independent
counsel on October 5, 2004.(31) Paul, Weiss's mandate under the September 2004
Agreement was to, among other things, conduct a "comprehensive review of the
company's accounting policies and practices to ensure they accurately reflect
the Board's objectives in complying with law and regulation and in overseeing
the operations of Fannie Mae."(32)
On October 19, 2004, the Board resolved that the SRC, comprised of
independent directors, would oversee the work of Paul, Weiss.(33) The SRC would
"oversee the independent reviews conducted by independent counsel and its
consultant(s) as required in the agreement between the corporation and [OFHEO]
dated September 27, 2004."(34) In its plan for implementing the September 2004
Agreement, the Board stated that the SRC "has instructed the Company to provide
Paul, Weiss and the accounting firm the full support and resources of the
Company. Paul, Weiss will also have access to all consultants hired in
connection with this Agreement."(35) Furthermore, on October 12, 2004, the SRC
caused a memorandum to be sent to Fannie Mae's Senior Leadership Team directing
that Paul, Weiss and its forensic consulting firm receive "complete access
- ----------
(30) September 2004 Agreement P VI.2.(a).
(31) Letter from Armando Falcon, Jr. to Ann M. Korologos, dated Oct. 5, 2004.
(32) September 2004 Agreement P VI.2.(a).
(33) Minutes of the Meeting of the Board of Directors of Fannie Mae, dated Oct.
19, 2004, FMSE 504466-85 at FMSE 504480-82.
(34) Id. at FMSE 504481.
(35) Plan of Fannie Mae for Implementing the September 27, 2004 Agreement
between OFHEO and Fannie Mae, dated Oct. 2004, FMSE-IR 547280-307, at
FMSE-IR 547304.
7
to all Fannie Mae personnel and records as they deem necessary during the course
of the review."(36)
In October 2004, Huron and Paul, Weiss jointly prepared a work plan
for the various accounting and other topics consistent with the directives
contained in the September 2004 Agreement. The work plan was submitted to, and
approved by, both the SRC and OFHEO.
2. The February 2005 OFHEO Letter and Supplemental Agreement
OFHEO's Special Examination continued after the issuance of the OFHEO
Report. In a letter dated February 11, 2005, OFHEO notified Fannie Mae of
preliminary conclusions concerning additional accounting issues that OFHEO had
been reviewing as part of its Special Examination.(37) The letter stated that
OFHEO had "identified polices that do not appear to be consistent with GAAP"
under FAS 65, FAS 115, FAS 140, FAS 149, and FIN 46.(38) OFHEO also expressed
concern over the Company's apparent development and application of accounting
practices to smooth the recognition of certain income and expense amounts.(39)
In addition to these accounting policies, OFHEO raised issues about the internal
controls and/or limitations pertaining to Fannie Mae's journal entries,
amortization systems, and database modifications as they relate to the amounts
of amortization of deferred price adjustments recorded pursuant to FAS 91.(40)
The Company announced on February 23, 2005 that the Board and Paul,
Weiss would address the issues raised in the February 11, 2005 letter.(41)
Pursuant to the February 11, 2005 letter, on March 7, 2005, OFHEO and Fannie Mae
entered into the Supplemental Agreement.(42) The Supplemental Agreement called
for a number of further internal reviews to be conducted, including reviews of:
(1) the procedures relating to "the preparing, revising, validating, authorizing
and recording of journal entries";
- ----------
(36) Mem. from Michael J. Williams to Senior Leadership Team, dated Oct. 12,
2004.
(37) Letter from Christopher H. Dickerson to Stephen B. Ashley, dated Feb. 11,
2005, FMSE-IR 547318-30 (hereinafter "February 11, 2005 OFHEO Letter").
(38) Id. at FMSE-IR 547318-26.
(39) Id. at FMSE-IR 547326-27.
(40) Id. at FMSE-IR 547327-29. OFHEO also expressed concern over factor array
manipulation. Id. at FMSE-IR 547329-30.
(41) Fannie Mae press release, dated Feb. 23, 2005, available at http://www.sec.
gov/Archives/edgar/data/310522/000095013305000679/w06038exv99w2.htm.
(42) See supra note 3.
8
(2) Fannie Mae's "internal controls relating to modifications of databases
supporting the general ledger"; (3) "Fannie Mae's legal and regulatory
compliance structures," including recommended "changes to organizational
structures, responsibilities and personnel"; and (4) Fannie Mae's current
"bylaws and codes of conduct to assure that they support legal and regulatory
compliance" and to suggest needed changes.(43)
Furthermore, the Supplemental Agreement required the Company to
conduct a reaudit and restatement for prior earnings periods, as necessary, and
to review its accounting for several accounting standards in addition to FAS 91
and FAS 133, such as FAS 115, FAS 140, FAS 65, FAS 149, and FIN 46.(44)
After the SRC requested that Paul, Weiss incorporate the additional
accounting policy areas of concern raised in the February 2005 OFHEO letter,
Huron and Paul, Weiss jointly prepared a supplemental work plan to address the
new accounting areas, which was also submitted to the SRC and OFHEO for
approval.
C. Other Issues Brought to Paul, Weiss's Attention
1. Directive to Employees to Come Forward
As set forth more fully in Chapter XI, Section A, over the course of
Paul, Weiss's investigation, additional information was brought to Paul, Weiss's
attention, including from anonymous sources and former employees. These
additional issues, to the extent feasible, were added to Paul, Weiss's scope.
On November 29, 2004, then General Counsel Ann M. Kappler sent an
e-mail to all Fannie Mae employees containing the Chairperson of the SRC's
instruction that "all employees who have any information or knowledge whatsoever
about any unusual or atypical transactions in the past five years to provide
Paul, Weiss" with information about such transactions directly.(45) Several
employees contacted Paul, Weiss with information, some on the condition of
anonymity. To the extent that sufficient information or questions were raised,
we reviewed the issues raised and will address them later in this Report.
2. Monitoring Consultants's Activities
As noted above, in addition to the tasks assigned to us in the
September 2004 Agreement and the Supplemental Agreement, we were asked to
monitor the efforts of the following consultants retained by Fannie Mae, Semler
Brossy Consulting Group LLC ("Semler Brossy"), Mercer Oliver Wyman ("Mercer"),
and Hildebrandt
- ----------
(43) Supplemental Agreement PP II.A.1., II.A.4., II.C.1., II.C.5.
(44) Id. P II.D.2.
(45) E-mail from Ann M. Kappler to all Fannie Mae employees, dated Nov. 29,
2004.
9
International, Inc. ("Hildebrandt"). Semler Brossy, Mercer, and Hildebrandt were
engaged directly by Fannie Mae, pursuant to the September 2004 Agreement, in
order to provide prospective guidance on executive compensation, corporate
governance, and regulatory compliance issues.
(a) Semler Brossy
The Compliance Committee of Fannie Mae's Board of Directors first
engaged Semler Brossy in 2003 to consult on senior management compensation
issues and the draft employment contracts for Franklin D. Raines, Daniel H.
Mudd, and Timothy Howard. The Committee subsequently engaged Semler Brossy to
address executive compensation issues in the September 2004 Agreement.
Section IV of the September 2004 Agreement states, in relevant part:
"The Board shall cause to be prepared a report to OFHEO on the compensation
regime and its relation to strategic plans and their impact on accounting and
transaction decisions and any revisions to avoid inappropriate incentives."(46)
The Committee tasked Semler Brossy with assessing current executive compensation
plans and developing future plans as required by Section IV of the September
2004 Agreement between OFHEO and Fannie Mae; the Committee did not ask Semler
Brossy to include any forensic analysis of past executive compensation issues in
its review. Semler Brossy provided its report to OFHEO on February 24, 2005,
analyzing the metrics used by the Company to determine executive compensation
levels and recommending certain changes to those metrics, as well as revisions
to the overall executive compensation scheme. We understand that these
recommendations may not be implemented until the restatement of earnings is
complete, due to uncertainty regarding staffing changes and financial data that
will affect the Company's executive compensation plans going forward.
We have had a cooperative relationship with Semler Brossy during the
course of our review. We met and conferred with Roger Brossy of Semler Brossy on
several occasions, particularly as Semler Brossy was undertaking the engagement,
developing a workplan, and preparing its final report. In addition, Brossy, as a
representative of Semler Brossy, was available to us as a resource for
information regarding particular executive compensation contracts and practices
at Fannie Mae. Further, in light of Semler Brossy's engagement by Fannie Mae in
2003, Paul, Weiss interviewed Roger Brossy as part of our inquiry into past
executive compensation practices.
(b) Mercer
The Compliance Committee also engaged Mercer in 2004 to work on
organizational redesign pursuant to the September 2004 Agreement. Section I.1 of
the September 2004 Agreement required that Fannie Mae separate "the function of
business planning and forecasting from the controller's function" and "modeling
and accounting
- ----------
(46) September 2004 Agreement P IV.
10
functions" from each other.(47) Section II.B of the Supplemental Agreement also
required the Board of Directors to make certain organizational and staffing
changes.(48) To assist in these changes, Fannie Mae expanded Mercer's
engagement.
Accordingly, Mercer's work has been focused on (1) substantially
reorganizing the Finance operation (including the Controller's Office), and (2)
forming and building out the new Risk operation, followed by the new Compliance
and Ethics operation. In each area, Mercer's work has involved structural
recommendations, followed by staffing recommendations (levels, nature of
expertise needed, position descriptions, etc.). Mercer has made recommendations
to Fannie Mae regarding organizational design and continues to work with Fannie
Mae on an advisory capacity.
Throughout its work at Fannie Mae, Mercer has provided Paul, Weiss
with informal status updates on a regular basis and has requested our review and
comments on their preliminary workplans, findings, and recommendations from time
to time. On our part, we asked questions, suggested additional areas for their
analysis, and reviewed their tentative findings.
(c) Hildebrandt
Fannie Mae engaged Hildebrandt in response to Section II.C. of the
Supplemental Agreement, which requires the Board to "cause to be conducted a
review of Fannie Mae's legal and regulatory compliance structures."(49)
Hildebrandt's assessment of the Company's legal and regulatory compliance
operations has included (1) assessing past division and effectiveness of
compliance operations within the Company, (2) recommendations for division of
compliance responsibilities between, and compliance coordination among, the new
Compliance and Ethics operation, the new Risk operation, the Legal Department,
and Internal Audit (including the new Compliance and Ethics operation), and (3)
recommendations for the role of the Legal Department going forward. Hildebrandt
has sought our views on their tentative workplan and tentative findings and
conclusions. As of the date of this writing, Hildebrandt had not completed its
review, but is anticipated to do so within the next several months.
As we have done with Mercer, we engaged in substantive interactions
with Hildebrandt. Hildebrandt has been receptive to our comments and aided our
understanding and analysis of regulatory issues.
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(47) Id. P I.1.(a)-(d).
(48) Supplemental Agreement P II.B.
(49) Id. P II.C.1.
11
3. The Company's November 10, 2005 12b-25 Filing
Finally, on November 10, 2005, Fannie Mae filed a Form 12b-25,
Notification of Late Filing, with the SEC, in which it described, inter alia,
"certain accounting matters that may significantly impact the results of
operations for third quarter 2005 and the results of operations for third
quarter 2004 that Fannie Mae ultimately reports."(50) Certain of the items had
been identified as topics for review as part of the September 2004 Agreement,
such as Fannie Mae's accounting practices under FAS 91 and FAS 133.(51) Other
items were new. In particular, Fannie Mae announced that it had:
- Failed to periodically assess for impairment guaranty fee assets
resulting from "buy-up" payments made by Fannie Mae to lenders
that adjusted the guaranty fee paid by the lender in order to
adjust the pass-through interest rate on mortgage-backed
securities;(52)
- Incorrectly used the effective yield method instead of the equity
method for, or consolidated investments in, Low Income Housing
Tax Credit investment partnerships and three synthetic fuel
investments;(53) and
- Incorrectly gave insurance accounting treatment to a putative
mortgage insurance transaction that Fannie Mae subsequently
determined did not sufficiently transfer risk to warrant such
treatment.(54)
Paul, Weiss was asked by the "[t]he Board . . . to review the circumstances
surrounding this [insurance] policy and . . . other insurance arrangements."(55)
D) Engagement of Huron
As noted above, the September 2004 Agreement specifically contemplated
the retention of "an independent accounting firm" to conduct the reviews called
for in the
- ----------
(50) Fannie Mae, Notification of Late Filing (Form 12b-25), at 6 (Nov. 10, 2005)
(hereinafter "Form 12b-25"), available at
http://www.fanniemae.com/media/pdf/newsreleases/f12b25111005.pdf.
(51) September 2004 Agreement P I.2-3.
(52) Form 12b-25 at 7.
(53) Id.
(54) Id. at 8.
(55) Id.
12
agreement.(56) Pursuant to the agreement, and with the approval of the SRC and
OFHEO as required under the September 2004 Agreement, Paul, Weiss engaged Huron,
a consulting firm specializing in the areas of forensic accounting and
investigative services.
The Huron team was led by George Massaro, the Vice Chairman of Huron,
who has more than thirty-two years of audit and accounting experience, and
Jeffrey Ellis, a Managing Director with more than eighteen years of public
accounting experience, including several as a member of the national office
accounting advisory groups of the firms with which he was associated, and has
been a member of various working groups assisting the Emerging Issues Task Force
of the FASB. Other senior members of the Huron team included: Paul Charnetzki, a
Managing Director who has more than twenty-five years of experience as a
consultant and expert in litigation matters involving, among other issues, the
application of accounting and auditing principles; Joseph Pope, a Managing
Director with fourteen years of experience providing financial and forensic
accounting services to clients in litigation and complex business disputes and
with industry specialization relating to financial markets, securities and
derivatives; Tamika L. Tremaglio, a Managing Director with twelve years of
experience in forensic accounting and investigations covering a broad spectrum
of industries; and John Sullivan, a Managing Director with eighteen years of
public accounting experience that included audit clients in a variety of
industries.
The scope of the Huron team's work ranged from the forensic collection
of electronic data, including imaging hard drives of the computers used by
individuals who were deemed to be of interest to our investigation, restoring
backup tapes, examining documents collected by the Company from employees and
assisting in witness interviews.
E. Documents Reviewed
Since our engagement on October 5, 2004, we have made over 400
document requests of the Company and its agents. As of the date of this writing,
Fannie Mae had produced approximately 721,139 documents in response to our
requests. During the course of the investigation to date, Paul, Weiss and Huron
professionals reviewed over 2 million pages of hardcopy documents and
approximately 2 million electronic documents. In addition, Paul, Weiss and Huron
professionals conducted on-site inspection of various accounting and other
systems and hardcopy documents made available by the Company.
In addition to the documents produced in response to Paul, Weiss's
requests, we reviewed a number of documents that the Company had produced in the
course of the OFHEO Special Examination. As set forth more fully in Chapter X,
prior to Paul, Weiss's engagement on October 5, 2004, Fannie Mae had produced
approximately 427,467 documents to OFHEO in the course of the Special
Examination. Fannie Mae also had produced 32,458 pages directly to the SEC.
Since that date, Fannie
- ----------
(56) September 2004 Agreement P VI.2.(a).
13
Mae has produced roughly 450,000 pages in response to OFHEO's and the SEC's
requests. Paul, Weiss and Huron also reviewed all of these documents in both
hardcopy and electronic format. We also continued to receive copies of all
documents that Fannie Mae produced to OFHEO and to the SEC pursuant to the
respective regulators' requests or subpoenas after the issuance of the OFHEO
Report in September 2004.
In addition to Fannie Mae's documents, we also reviewed documents from
various Fannie Mae agents, including Wilmer and E&Y. Further, we requested and
received access to information from KPMG, Fannie Mae's former auditor.
Paul, Weiss and Huron professionals also inspected systems and
documents directly at Fannie Mae, including HomeSite, the SOX database (which
contains Sarbanes-Oxley documentation), Financial Dashboard, and ALEX. Fannie
Mae also provided us with an Excel model that used historical PDAMS logic to run
FAS 91-related calculations and historical input files from year-end 1998. We
also conducted on-site examinations of files kept at Fannie Mae's Office of
Corporate Justice ("OCJ") and others regarding selected topics.
Paul, Weiss and Huron had access to all documents irrespective of any
claim of privilege the Company may have over the materials.(57)
F. Interviews Conducted
As of the date of this writing, we conducted 241 interviews of 148
current and former employees, and third parties. Our interviews were generally
organized by topic, which required multiple interviews of certain individuals.
Because our investigation was not based on any judicial process, we lacked the
power to compel the testimony of any witnesses who refused to appear, and
therefore relied on the voluntary cooperation of witnesses. The interviews were
not transcribed.
A handful of employees declined our requests for an interview. Most
significantly, Timothy Howard, the former Chief Financial Officer, Vice
Chairman, and member of the Board of Directors of Fannie Mae, declined repeated
requests for an interview. While his counsel in December 2005 made a submission
focused on certain limited topics, we have not had the opportunity to inquire
directly of Howard his bases for the various accounting decisions that were made
under his leadership.
- ----------
(57) As of this writing, we learned that the Company discovered in a warehouse
approximately twenty-two computers that may have belonged to former or
current executives of the Company, which computers had never been imaged or
produced before to Paul, Weiss. While we have no reason to believe that the
information contained in such computers will contain any new issues, we
will nevertheless review these and other materials even after the issuance
of this Report, and if any information is discovered that causes us to
change or correct any findings in this Report, we will do so.
14
We interviewed Leanne G. Spencer, the former Senior Vice President and
Controller of the Company, on four occasions. However, beginning in or about
June 2005, Spencer declined further interviews following the late discovery in
her files of certain documents that were highly relevant to the 1998 catch-up
decision.
Jeffrey Juliane, the former Director--Accounting and Audit, appeared
for three interviews, but declined further interviews beginning in or about June
2005, when he separated from the Company.
Several other former employees declined to be interviewed, including
Joe Amato, Vice President--Portfolio Strategies, Debbie Cohen, Vice
President--Portfolio Management, William E. Einstein, Vice President--Corporate
Tax, Lan Nguyen, Director--Financial Reporting, and Ilan Sussan, Senior Project
Manager--Financial Standards.
G. Independent Collection and Analysis of Electronic Materials
In addition to materials collected and produced by Fannie Mae in
response to our requests, we conducted an independent forensic analysis and
collection of electronic documents at Fannie Mae. This forensic analysis began
with interviews of Fannie Mae information technology ("IT") staff responsible
for maintaining and backing up Fannie Mae's information systems. Through these
interviews, we identified potential sources of additional data that may be of
interest to our review from the following sources: (a) backup tapes maintained
by the Company as part of its normal IT operations for disaster recovery
purposes, which contained both shared network spaces devoted to particular
business units, network spaces of individual employees, and e-mail; (b)
documents maintained by individuals on their individual hard drives, and in
hardcopy format in file cabinets, etc.; (c) old hard drives and images of hard
drives formerly used by Fannie Mae employees who were of interest to our
investigation, especially old systems of Fannie Mae executives; and (d) other
e-mails that the Company collected but deemed non-responsive and did not produce
to OFHEO.(58)
For each of the potential data sources, we carried out three tasks:
(1) verified what the Company already had collected and produced from these
sources; (2) analyzed whether additional relevant information was available from
these sources; and (3) tested and collected any additional information that was
available.
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(58) We were notified on February 16, 2006 that the Company had located in a
warehouse approximately twenty-two additional computers that belonged to
former and current employees of the Company. The Company is imaging the
hard drives of these computers and will provide the images to Paul, Weiss
for review. At this time, we do not have any reasons to believe that there
are new or additional information contained in these computers; however, we
do intend to review these hard drives and if any new information is
discovered in these computers that affect the findings or conclusions in
this Report, we will supplement them accordingly.
15
We restored forty-seven backup "sessions" for twelve Novell network
servers containing electronic documents organized by individual users and
departments. Each "session" corresponds to a point-in-time snapshot of the data
contained on a specific server. The Novell and ADSM backup sessions we restored
were created between 2002 and 2004, but contain data stored on the server at the
time of the backup. We restored five backup sessions of the Netscape e-mail
server. The sessions were created between 1998 and 2004.
As of the date of this writing, we have imaged 127 hard drives
associated with forty non-attorney users and nine attorney users. We imaged an
additional nineteen hard drives for which at the time of imaging no specific
custodian information was available, but which appeared likely to contain
relevant material. Our imaging process included extraction of user-created files
in the recycle bins of each hard drive, as well as a review of the unallocated
spaces - where deleted files are sometimes recoverable - of the hard drives of
the users who may have information relevant to our review. We imaged sets of CDs
and DVDs that contained backups of senior management hard drives, as maintained
by the Company as part of its normal IT support practices.(59)
We also received from Fannie Mae copies of five forensic images of
hard drives used by members of the Controller's Office which were created at the
request of Fannie Mae's Legal Department in connection with the investigation
into Barnes's allegations in 2003.
As part of our hard drive imaging program, we also copied images of
the hard drives of executive users that were made by the Executive Support Team,
which provides technical assistance to senior management, as a regular part of
PC maintenance. We also imaged the old systems of executives that Fannie Mae
maintained rather than donated to charities pursuant to a company-wide policy of
donating computers that had been in use for three or more years and were
therefore out of warranty coverage. Additionally, we imaged those hard drives
that we believed were associated with executives as well as "ghost images," and
similar data created by the Executive Support Team in connection with servicing
senior executives' computers.
Apart from Fannie Mae executives, our efforts to locate and image
other employees' former systems were less successful. Despite our efforts and
those of Fannie Mae's IT staff, we were unable to locate approximately two
systems that we had identified as being issued previously to Fannie Mae
employees, which hard drives may contain information relevant to our
investigation. Nonetheless, we were successful in imaging other systems that had
been used by each of those users. Additionally, we were unable to image one
computer because it was corrupted, but since then we made an image of the data
Unisys recovered from it at Fannie Mae's behest.
- ----------
(59) A backup, which captures live files, will generally contain less
information than an image, which will also capture any information in the
unallocated space of a hard drive.
16
We also were unable to image three hard drives that were donated. In
particular, a hard drive used by Spencer was donated to Phi Psi on December 15,
2004, a hard drive used by Richard Stawarz was donated to Vanessa Ali Ministries
on December 3, 2004, and a hard drive used by Mona Patel was donated to
Children's Health Project in November 2004. Additionally, a hard drive used by a
Treasurer's Office employee was salvaged on February 25, 2004. Although the
Company does not have any documentation regarding why this computer needed to be
salvaged, we have been told that it was Fannie Mae's practice to salvage
computers that were non-functional.
Finally, our review also included materials previously determined by
Company counsel in the course of the Special Examination as non-responsive. We
obtained and reviewed over 600,000 electronic items in this regard, which had
been reviewed during the course of responding to the Special Examination but
determined to be non-responsive to OFHEO's document requests. Our review
revealed that many of these documents were of interest to the regulators, and we
produced the relevant documents.
H. Assessment as to the Company's Cooperation
1. The Board, the SRC and Management
The SRC and the Board of Directors of Fannie Mae cooperated fully in
our investigation. The SRC, in particular, not only directed management and all
employees to provide full cooperation to the investigation, but instructed all
employees to come forward with any information the employee may have concerning
any questionable or irregular transactions, among other things. As set forth
more fully in Chapter XI, Section A, this directive from the SRC resulted in
several employees coming forward with information.
In addition, the SRC instructed the Company and its outside counsel to
provide to Paul, Weiss and Huron full access to all information requested.(60)
As for cooperation from management, in late 2004, management appeared
to view Paul, Weiss's role as that of an adversary, rather than as the SRC's
counsel. We experienced some initial difficulties and delays in obtaining access
to all relevant information. For example, management initially declined to
produce information that was responsive to Paul, Weiss's request or sought to
disclose it only on the condition that Paul, Weiss would not share it further.
Moreover, in the beginning of our engagement, management through counsel
continued to make the best "arguments" in defense of accounting practices
criticized by OFHEO in its Report, rather than disclosing all information in its
possession concerning the accounting practices at issue. Finally, on one
occasion, we learned that an employee's counsel had access through the Company's
attorneys to important documents that had not been provided to Paul, Weiss,
despite the fact that the documents were responsive to pending Paul, Weiss
requests. While the
- ----------
(60) Mem. from M. Williams to Senior Leadership Team, dated Oct. 12, 2004.
17
relevant documents were promptly produced once the Company was notified of this
situation, we were concerned in the beginning about the level of cooperation
being provided by then management.
Beginning in late 2004 and early 2005, with the creation of a new team
within Fannie Mae that was directed to respond directly to Paul, Weiss's
requests, we began to receive full cooperation and full access to information
requested. The new team reported not to the Legal Department or incumbent
management but directly to Michael J. Williams, then Senior Vice
President--e-Business, who had been instructed by the Board to oversee the
implementation of the September 2004 Agreement.
2. The Leanne Spencer Document Incident
The only exception to the generally good cooperation we received from
management and employees throughout 2005 was Leanne Spencer. In May 2005, we
became aware of a document in Spencer's files that provided highly-relevant
information concerning management's motive and intent behind the decision to
record only part of the catch-up expense in 1998 ("the Spencer Document").(61)
The Spencer Document had not been produced voluntarily by Spencer, even though
it was responsive to Paul, Weiss's document requests to Fannie Mae dating back
to October 2004. Also around this time, we learned that, in connection with her
office move in January 2005, Spencer brought home two boxes of documents that
were never reviewed for responsiveness to the regulators' or Paul, Weiss's
requests, and that contained responsive documents.
The Company discovered the Spencer Document on April 27, 2005. The
Spencer Document was discovered in connection with Fannie Mae's efforts, begun
in March of 2005, to ensure that all responsive materials from Spencer were
collected and reviewed. The Company began this effort after discovering three
boxes from Spencer's former office after she moved into a new office that had
not been collected or reviewed previously, and that contained certain responsive
materials. As a result, the individual in Michael Williams's group who was
overseeing the Company's response to Paul, Weiss requests, sent a team to go
into Spencer's new office without warning while Spencer was not present, and
pack up all documents and photocopied them. The Spencer Document was discovered
in the course of reviewing these documents.
Unquestionably, a number of different attorneys from Wilmer and Fannie
Mae's Legal Department, as well as people working on responding to Paul, Weiss's
requests, had met with Spencer on several occasion to collect responsive
documents, including those documents relating to the 1998 event. Spencer herself
was interviewed several times by OFHEO, by Paul, Weiss, and by the Company
lawyers about 1998
- ----------
(61) Risk Review with CFO, dated Sept. 22, 1998, FMSE-IR 321564-68.
18
events, and therefore plainly understood the relevance of the Spencer Document
to the 1998 events.(62) Nevertheless, Spencer did not voluntarily produce these
documents.
In early January 2006, Spencer's counsel submitted a letter describing
the circumstances behind Spencer's failure to identify the Spencer Document to
Company counsel.(63) According to the submission, the Spencer Document was "not
identified earlier only because of the procedures employed during the company's
document collection process."(64) But, instead of identifying what it was about
the process that led to her failure to produce this document, Spencer stated
only that she apparently did not identify the document as responsive to OFHEO's
requests because the label of the file in which the document was kept was named
"Buy Up, Buy Down," as opposed to "FAS 91," and the document itself did not
reference "a meeting in 1998."(65) Spencer's submission did not address why she
did not produce the document in response to Paul, Weiss's requests or whether
she had reviewed the files for responsive documents in response to Paul, Weiss's
requests.
Given that the Spencer Document flatly contradicted Spencer's previous
assertions to OFHEO and to Paul, Weiss that the decision to record only $240
million in catch-up expense in 1998 was based on her belief that it was the best
estimate and that the decision had nothing to do with EPS, it is difficult to
believe that Spencer's failure to produce the document was a mere oversight.
Indeed, based on the statements made by Spencer in her Paul, Weiss interviews
before the document was discovered, we think that it is entirely possible that
Spencer had reviewed the document as late as January 2005 in preparation for the
Paul, Weiss interview, but never produced the document.(66) With respect to the
documents discovered at Spencer's home, it is unclear whether anyone from Wilmer
or the Legal Department inquired of Spencer as to whether Spencer might have
responsive documents at her home. However, we have learned that Spencer took
documents home after the Special Examination began, and therefore Spencer
clearly
- ----------
(62) Indeed, in October 2004 alone, in the aftermath of the OFHEO Report and in
connection with preparing Franklin D. Raines's and Timothy Howard's
congressional testimony, the Company's in-house and outside lawyers met
with Leanne G. Spencer at least three times to go over the 1998 catch-up
and to ask her for any relevant documents.
(63) Letter from David S. Krakoff to Senator Warren B. Rudman, dated Jan. 5,
2006.
(64) Id. at 3.
(65) Id.
(66) Spencer described the attendees and agenda of the September 22, 1998 "Risk
Review with CFO" with precision at her January 13, 2005 interview with
Paul, Weiss, yet did not describe any documents relating to the meeting;
Spencer also conveniently omitted any discussions about the focus on EPS
management that was reflected in the agenda for the meeting.
19
knew that even documents at home may be responsive and should have produced them
earlier.
20
CHAPTER III: BACKGROUND
I. INTRODUCTION
This Chapter provides a brief overview of Fannie Mae's history, its
role today, its primary areas of business, and the regulatory regime under which
it operates.
II. THE EVOLUTION OF FANNIE MAE
The Federal Housing Administration ("FHA") created the Federal
National Mortgage Association ("Fannie Mae") in 1938(67) to purchase and sell
mortgages in order to increase the availability of funds to mortgage
borrowers.(68) Fannie Mae was to borrow money for such purposes through the
issuance of notes, bonds, debentures, and other obligations.(69) While Fannie
Mae was initially authorized only to purchase FHA-insured mortgages,(70)
Congress approved a mortgage insurance program in 1944 that enabled Fannie Mae
to purchase loans guaranteed by the Veterans Administration ("VA") as well.(71)
In 1954, Congress rechartered Fannie Mae to expand its functions (as
amended from time to time, the "Charter Act").(72) Fannie Mae at that time was
intended
- ----------
(67) Understanding Fannie Mae: Our History,
http://www.fanniemae.com/aboutfm/understanding/index.jhtml?p=About+Fannie+
Mae&s=Understanding+Fannie+Mae (hereinafter "Fannie Mae History") (last
visited Feb. 17, 2006). The FHA created the "National Mortgage Association
of Washington" on February 10, 1938 (changing its name later that same year
to the "Federal National Mortgage Association"), acting under Title III of
the National Housing Act, ch. 847, 48 Stat. 1246, 1252 (1934).
(68) National Housing Act, ch. 847, 48 Stat. 1246, 1252 (1934).
(69) Id.
(70) See Gen. Accounting Office Report to the Chairman of the Subcomm. on
Capital Markets, Insurance, and Government Sponsored Enterprises of the H.
Comm. on Financial Servs. on the Federal Housing Enterprises: HUD's Mission
Oversight Needs to Be Strengthened 2 n.6, dated July 1998 (hereinafter
"July 1998 GAO Report"), available at
http://www.gao.gov/archive/1998/gg98173.pdf.
(71) See SERVICEMEN'S READJUSTMENT ACT OF 1944, ch. 268, Section 501, 58 Stat.
284, 292 (repealed and reenacted by Pub. L. No. 85-857, 72 Stat. 1105
(1958)).
(72) The "Federal National Mortgage Association Charter Act" was enacted as part
of the Housing Act of 1954, Pub. L. No. 560, Section 301, 68 Stat. 590, 612
(codified as amended at 12 U.S.C. Section 1716 (2000)).
21
to become a secondary market facility for home mortgages financed to the maximum
degree feasible by private capital.(73)
The 1954 Charter Act also initiated the transition of Fannie Mae from
a government-owned entity to private company. Under the Act, the government no
longer backed any debt that Fannie Mae used to purchase mortgages, but continued
to provide protection in other forms, including certain tax benefits and the
support of the Federal Reserve Banks.(74) The Charter Act also established a
means of replacing government ownership with private stockholders: Fannie Mae
would gradually sell common stock and use the proceeds to retire Treasury-owned
preferred stock.(75) Fannie Mae retired the last of its government stock on
September 30, 1968.(76)
In 1965, the Department of Housing and Urban Development ("HUD") was
created as a cabinet-level agency to administer U.S. government programs that
provide housing assistance and support for the development of American
communities.(77) Three years later, Congress assigned HUD the task of serving as
Fannie Mae's regulator.(78)
The government also amended the Charter Act in 1968, further
transitioning Fannie Mae away from the government sector.(79) The amended Act
carved out special assistance programs from Fannie Mae's mandate and made them
the responsibility of a new government enterprise, the Governmental National
Mortgage Association ("Ginnie Mae").(80) Fannie Mae retained responsibility for
the secondary
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(73) See id.
(74) See Charter Act, Pub. L. No. 560, Section 309, 68 Stat. 590, 621 (1954).
(75) Understanding Fannie Mae: Our Charter,
http://www.fanniemae.com/aboutfm/understanding/charter.jhtml?p=About+
Fannie+Mae&s=Understanding+Fannie+Mae&t=Our+Charter (last visited Feb. 17,
2006).
(76) See id.
(77) See Department of Housing and Urban Development Act of 1965, Pub. L. No.
89-174, 79 Stat. 667 (codified as amended at 42 U.S.C. Section 3531
(2000)).
(78) See July 1998 GAO Report at 3. The subsequent creation of the Office of
Federal Housing Enterprise Oversight ("OFHEO") to supervise the safety and
soundness of Fannie Mae and Freddie Mac is discussed in Subsection V.
below.
(79) See generally Housing and Urban Development Act of 1968, Pub. L. No. 90-448
Sections 802-06, 82 Stat. 476, 536-44 (codified as amended at 12 U.S.C.
Section 1716(b) (2000)) (hereinafter "HUD Act of 1968").
(80) See id. Section 801, 82 Stat. at 536. Ginnie Mae is an instrumentality of
the United States contained within HUD. The partitioning of Fannie Mae into
the two separate bodies
22
mortgage market, and was designated a "[g]overnment-sponsored private
corporation."(81) In addition, the amended Act gave Fannie Mae the authority to
issue mortgage-backed securities ("MBS").(82)
In 1970, Congress authorized Fannie Mae to buy and sell conventional
mortgages.(83) That same year, Congress created another entity, the Federal Home
Loan Mortgage Corporation ("Freddie Mac"), to increase liquidity in the mortgage
market through the purchase of conventional mortgages.(84) While HUD remained
responsible for overseeing Fannie Mae, the Federal Home Loan Bank Board
regulated the newly created Freddie Mac.(85)
Fannie Mae first listed its stock on the New York Stock Exchange
("NYSE") on August 31, 1970.(86) By 1976, Fannie Mae was purchasing more
conventional mortgages than FHA and VA loans.(87) In the early 1980s, Fannie Mae
continued a shift away from FHA and VA loans and began to purchase
adjustable-rate mortgages and second mortgages.(88) In addition, Fannie Mae
introduced its MBS
- ----------
became effective on September 1, 1968. See Charter Act, 12 U.S.C. Section
1717(a)(2) (2000).
(81) HUD Act of 1968 Section 801, 82 Stat. at 536. Fannie Mae and Freddie Mac
are often now referred to as government-sponsored enterprises or "GSEs."
See 12 U.S.C. Section 4501 (2000).
(82) See HUD Act of 1968 Section 804(a), 82 Stat. at 542. In particular, the
statute authorized Fannie Mae to issue debt obligations or trust
certificates for beneficial interests in pools of mortgages, and could
guarantee the timely payment of principal and interest. See 12 U.S.C.
Section 1719(d) (2000).
(83) See Emergency Home Finance Act of 1970, Pub. L. No. 91-351 Section 201, 84
Stat. 450-51. The legislation required a one-time approval by HUD before
Fannie Mae could initiate its conventional mortgage program. Conventional
mortgages are defined as mortgages that are not insured or guaranteed by
the FHA or VA. See id.
(84) See Federal Home Loan Mortgage Corporation Act, Pub. L. No. 91-351 Sections
301-10, 84 Stat. 451-58 (1970) (hereinafter the "Corporation Act").
(85) See id. Section 303, 84 Stat. at 452.
(86) New York Stock Exchange, Fannie Mae,
http://www.nyse.com/about/listed/fnm.html (last visited Feb. 17, 2006).
(87) Fannie Mae History, supra note 67.
(88) See Secondary Mortgage Market Enhancement Act of 1984, Pub. L. No. 98-440,
Section 203, 98 Stat. 1689, 1693 (authorizing Fannie Mae to buy and sell
subordinate lien mortgages).
23
business in 1981.(89) In 1992, Fannie Mae surpassed Ginnie Mae and Freddie Mac
as the largest issuer and guarantor of MBS.(90)
III. FANNIE MAE'S ROLE TODAY
Fannie Mae helps maintain liquidity in the primary mortgage market
through the purchase of primary mortgages from entities such as mortgage
companies, savings and loan associations, commercial banks, and state and local
housing finance agencies.(91)
Fannie Mae currently represents the largest source of funds to
mortgage lenders in the nation.(92) In 2004, it purchased or guaranteed
mortgages valued at $725 billion, and issued new MBS valued at $552 billion.(93)
While Fannie Mae serves as both a broad purchaser of mortgages and a
creator of MBS products, the Company also encourages equal housing access
through programs targeted at particular populations. In its 1994 Trillion Dollar
Commitment, Fannie Mae committed to provide $1 trillion in financing to ten
million traditionally underserved families.(94) After achieving its goal in
1999, Fannie Mae launched its
- ----------
(89) Fannie Mae History, supra note 67.
(90) Fannie Mae History, supra note 67.
(91) See Jason T. Strickland, The Proposed Regulatory Changes to Fannie Mae and
Freddie Mac: An Analysis, 8 N.C. BANKING INST. 267, 270-72 (2004)
(providing, in part, a history of Fannie Mae and outlining the functions
and importance of the enterprise to the mortgage market); see also Fannie
Mae, 2003 Annual Report (Form 10-K), at 4 (Mar. 15, 2004) (hereinafter
"2003 Form 10-K"), available at
http://www.fanniemae.com/ir/pdf/sec/2004/f10k03152004.pdf.
(92) 2003 Form 10-K at 1.
(93) 2005 OFHEO Report to Congress, dated June 15, 2005, at 2 (hereinafter "2005
OFHEO Report to Congress"), available at
http://www.ofheo.gov/media/pdf/2005reporttocongress.pdf. As a comparison,
Freddie Mac in 2004 purchased or guaranteed mortgages valued at $495
billion, and issued new MBS valued at $365 billion. Id.
(94) 2003 Form 10-K at 1; see also Regulations of Housing Finance Industry:
Hearing Before the Subcomm. on Capital Markets, Securities, and Government
Sponsored Enterprises of the H. Comm. on Financial Servs., 106th Cong. 10
(2000) (statement of Franklin D. Raines, Chairman and CEO, Fannie Mae)
(testifying that the Trillion Dollar Commitment goals were met eight months
early) (hereinafter "Raines May 2000 Congressional Testimony"), available
at
http://www.fanniemae.com/global/pdf/media/issues/archive/2000/051600.pdf.
24
American Dream Commitment in 2000, through which it planned to provide $2
trillion to eighteen million underserved households by 2010.(95) The American
Dream Commitment makes funds available to underserved Americans through lender
and community partnerships established by the Company, including collaborative
relationships with the National Association of Home Builders, the National Urban
League, and the National Association of Hispanic Real Estate Professionals.(96)
In January 2004, Fannie Mae expanded its American Dream Commitment by pledging
to help six million families become first-time homeowners within a decade,
including 1.8 million minority families.(97)
IV. FANNIE MAE'S PRIMARY BUSINESS ACTIVITIES
Fannie Mae's business falls primarily into two segments: the Portfolio
Investment business and the Credit Guaranty business.(98)
A. Portfolio Investment
The Portfolio Investment business engages in essentially two
activities: mortgage portfolio investments and liquid investments. The mortgage
investment portfolio consists largely of conventional, single-family fixed- or
adjustable-rate first lien mortgage loans, as well as mortgage-related
securities acquired from lenders, securities dealers, and investors.(99) Fannie
Mae's liquid investments consist largely of short-term, non-mortgage assets,
which can be used to generate cash to meet Fannie Mae's liquidity needs.(100)
Fannie Mae funds the purchase of its mortgage-related and liquid assets from
equity capital and through the sale of debt securities to investors
worldwide.(101) Fannie
- ----------
(95) 2003 Form 10-K at 1; see also Raines May 2000 Congressional Testimony at 10
(testifying that the American Dream Commitment would prioritize "increasing
homeownership among minorities, young families, women-headed families, new
immigrants, and others whose homeownership rates lag the general
population").
(96) See Fannie Mae's Commitment to Minority Homeownership,
http://www.fanniemae.com/initiatives/minority/index.jhtml?p=Initiatives&s=
Minority+Homeownership (last visited Feb. 17, 2006).
(97) Fannie Mae press release, dated Jan. 27, 2004,
http://www.fanniemae.com/initiatives/adc/expansion.jhtml?p=Initiatives&s=
Expanding+the+American+Dream+Commitment (last visited Feb. 17, 2006).
(98) 2003 Form 10-K at 2.
(99) Id. at 9.
(100) Id. at 2, 7. Fannie Mae has "set a goal to maintain liquid assets equal to
at least [five] percent of total on-balance sheet assets." Id. at 10.
(101) Id. at 2.
25
Mae derives income from the difference between the yield it earns on portfolio
investments and the interest it pays on Company debt.(102)
B. Credit Guaranty
In its Credit Guaranty business, Fannie Mae pools mortgages originated
by lenders and returns MBS to those lenders.(103) With respect to a majority of
Fannie Mae's MBS, the process begins when a primary mortgage lender transfers a
pool of similar loans (e.g., similar interest rate or maturity features) to a
trust that assumes legal ownership,(104) with Fannie Mae as trustee.(105) The
trust certificate holders (usually investment banks, commercial banks, thrifts,
and funds) receive monthly distributions funded by the principal and interest
payments on the underlying loans.(106)
The Credit Guaranty business obtains its primary stream of income from
charging fees for the risks it assumes and the services it provides. For
example, the Company guarantees the payment of principal and interest due on the
mortgages underlying MBS, assuring the MBS holders of steady income (aside from
prepayment risk) and no risk of borrower default.(107) In return, Fannie Mae
charges a guaranty fee based on the credit risk it assumes as well as the costs
of administering the MBS.(108) Fannie Mae receives monthly payments of the
guaranty fee by retaining a portion of the interest payments received on the
underlying mortgage loans.(109)
- ----------
(102) Id. at 7.
(103) Id. at 11. The original lenders can hold the MBS for investment or sell
them to other investors. Id. at 2.
(104) Id.; see also Task Force on Mortgage-Backed Securities Disclosure Staff
Report on Enhancing Disclosure in the Mortgage-Backed Securities Markets,
dated Jan. 2003 (providing a basic description of the MBS pass-through
security and REMIC structures), available at
http://www.ofheo.gov/Media/Archive/docs/press/mbsdisclosure.pdf.
(105) 2003 Form 10-K at 11.
(106) Id.; see also May 2003 Cong. Budget Office Report 3, available at
http://www.cbo.gov/ftpdocs/41xx/doc4199/05-06-03-GSEs.pdf.
(107) 2003 Form 10-K at 13.
(108) 2003 Form 10-K at 2; see also May 2001 Cong. Budget Office Report 9,
available at http://www.cbo.gov/ftpdocs/28xx/doc2841/GSEs.pdf.
(109) 2003 Form 10-K at 11.
26
V. REGULATORY REGIME
In 1989, Congress abandoned the separate regulatory regimes for Fannie
Mae and Freddie Mac and brought Freddie Mac under the regulatory authority of
HUD.(110) Following a Congressionally mandated study conducted by the
Comptroller General,(111) Congress altered the regulatory scheme again, creating
a new agency to oversee the safety and soundness of both enterprises.(112)
Specifically, the Federal Housing Enterprises Financial Safety and Soundness Act
of 1992 ("Safety and Soundness Act") amended the Charter Act to create the
Office of Federal Housing Enterprise Oversight ("OFHEO"), an agency within HUD,
to "ensure that [Fannie Mae and Freddie Mac] are adequately capitalized and
operating safely."(113) In addition to granting safety and soundness oversight
powers to OFHEO, this legislation modified the oversight responsibilities
retained by HUD with respect to the GSEs' housing-related missions. Among other
things, the Safety and Soundness Act clarified the procedures that HUD must
follow when reviewing and approving new mortgage programs to be offered by
Fannie Mae and Freddie Mac.(114)
In 2003, Fannie Mae voluntarily registered its common stock with the
Securities and Exchange Commission ("SEC") under Section 12(g) of the Securities
Exchange Act of 1934, bringing Fannie Mae under SEC regulatory and enforcement
authority for issues pertaining to accounting, financial disclosures, and
corporate governance.(115)
- ----------
(110) Financial Institutions Reform, Recovery, and Enforcement Act of 1989, Pub.
L. No. 101-73, Section 731, 103 Stat. 183, 431 (codified as amended 12
U.S.C. Section 1811 (2000)).
(111) Id. Section 1004, 103 Stat. at 509-11 (mandating a study on GSE risk
exposure); see also GAO Report on Government-Sponsored Enterprises: The
Government's Exposure to Risks, dated Aug. 1990, available at
http://archive.gao.gov/d23t8/142017.pdf.
(112) Federal Housing Enterprises Financial Safety and Soundness Act of 1992,
Pub. L. No. 102-550, Section 1311, 106 Stat. 3941, 3944 (codified as
amended 12 U.S.C. Section 4501 (2000)).
(113) See id. Section 1313, 106 Stat. at 3945.
(114) See id. Section 1322, 106 Stat. at 3953-54.
(115) Fannie Mae, Registration of Securities (Form 10-12G) (Mar. 31, 2003)
(hereinafter "Form 10-12G"), available at
http://www.fanniemae.com/ir/sec/index.jhtml?s=SEC+Filings (follow "All SEC
Filings" hyperlink; then follow "Registration Statements" hyperlink for PDF
format); see also Standard & Poor's Corporate Governance Score: Fannie Mae,
dated Jan. 30, 2003, at 2-3, available at
http://www2.standardandpoors.com/spf/pdf/products/Fannie%20MaeFINAL1.pdf.
27
A. HUD
Under the Safety and Soundness Act, HUD has the authority to ensure
that Fannie Mae is accomplishing its mission of expanding housing opportunities
in traditionally underserved communities.(116) Except for matters falling under
the purview of OFHEO, HUD has general regulatory power over Fannie Mae and is
directed by Congress to make rules and regulations that accomplish the goals of
the Charter Act and the Corporation Act.(117)
As noted, Fannie Mae must obtain HUD approval prior to the
introduction of any new mortgage program.(118) In addition, HUD enforces fair
housing rules by administrating anti-discrimination regulations and requiring
that each enterprise investigate whether mortgage lenders comply with the Fair
Housing Act and the Equal Credit Opportunity Act.(119)
Finally, the Safety and Soundness Act requires HUD to set specific
housing goals for Fannie Mae each year.(120) The Company must dedicate a
specified percentage of new business to fulfilling these goals.(121)
By statute, HUD must submit an annual report to Congress detailing the
extent to which each GSE is achieving its annual housing goals and fulfilling
its statutory mission.(122) The most recent HUD report, issued in January 2005,
concluded that Fannie Mae met its housing goals each year from 1996 through
2003.(123)
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(116) See 12 U.S.C. Section 4541 (2000).
(117) See id.
(118) See id. Section 4542(a).
(119) See id. Section 4545.
(120) See id. Section 4561(a). The three annual housing goals consist of (1) a
low- and moderate-income housing goal, (2) a special affordable housing
goal, and (3) an underserved areas housing goal. See id. Sections
4562-4564.
(121) See Sections 4562-4564.
(122) See 12 U.S.C. Section 4544 (2000).
(123) See HUD Report Overview of the GSE's Housing Goal Performance, 1996-2003,
dated Jan. 2005, available at
http://www.huduser.org/Datasets/GSE/gse2003.pdf.
28
B. OFHEO
As noted above, OFHEO functions as an independent agency within HUD.
Its mission is to ensure that Fannie Mae and Freddie Mac are adequately
capitalized and operate safely and soundly in compliance with applicable laws,
rules, and regulations.(124)
OFHEO conducts an annual examination to assess Fannie Mae's financial
safety and soundness.(125) In 2004, OFHEO's annual examination found weaknesses
in management, documentation of policies, internal controls, and information
flow. Among other things, OFHEO found deficiencies in the standardization of
written policies, information flow to the Board, the operations of the
Controller's Department, operational risk management, the functioning of the
Office of Auditing, and liquidity management.(126) OFHEO's 2005 Annual Report to
Congress noted, however, that Fannie Mae has devoted significant resources to
correcting the deficiencies identified in the 2004 annual examination and in
OFHEO's Special Examination.(127)
The following paragraphs outline some of the primary areas in which
OFHEO regulates Fannie Mae's activities.
1. Capital Requirements
OFHEO makes quarterly findings on the adequacy of Fannie Mae's
capitalization.(128) OFHEO classifies the Company as adequately capitalized,
undercapitalized, significantly undercapitalized, or critically
undercapitalized.(129) Fannie Mae must meet both a minimum capital standard and
a risk-based capital standard to be classified as adequately capitalized.(130)
In December 2004, OFHEO announced that it had classified Fannie Mae as
significantly undercapitalized as of September 30, 2004.(131) In May 2005, OFHEO
- ----------
(124) 12 C.F.R. Section 1700.1(a) (2005).
(125) See, e.g., 2005 OFHEO Report to Congress at 10.
(126) Id. at 10-11.
(127) Id. at 12-13.
(128) About OFHEO, http://www.ofheo.gov/Mission.asp (last visited Feb. 17,
2006).
(129) OFHEO press release, dated Sept. 28, 2005, at 1, available at
http://www.ofheo.gov/media/pdf/capclass92805.pdf.
(130) Id.
(131) OFHEO press release, dated Dec. 21, 2004, at 1, available at
http://www.ofheo.gov/media/pdf/capclass122104.pdf.
29
announced that, as a consequence of an increased capital surplus that was
"sufficient to absorb uncertainties in the estimated impact to capital of the
accounting errors," it found Fannie Mae to be adequately capitalized as of March
31, 2005.(132) More recently, OFHEO announced in September 2005 that, as of June
30, 2005, Fannie Mae remained adequately capitalized, due once again to a
capital surplus that was sufficient to absorb uncertainties in the estimated
impact of accounting errors on the Company's capital.(133) In addition, OFHEO
announced in early November 2005 that Fannie Mae had achieved, by an imposed
September 30, 2005 deadline, a thirty percent capital surplus required by the
Company's September 2004 and March 2005 agreements with OFHEO.(134)
2. Corporate Governance
In June 2002, OFHEO issued corporate governance regulations applicable
to Fannie Mae and Freddie Mac.(135) The regulations set forth a number of
requirements focused on the board of directors and board committees.
Among other things, these regulations directed Fannie Mae and Freddie
Mac to select and follow the corporate governance practices and procedures of a
particular body of law, so long as consistent with federal law and the safe and
sound operation of the enterprise.(136) In addition, the regulations required
each enterprise to incorporate in its bylaws both an audit committee and a
compensation committee of the board of directors. The regulation provided that
the Company's audit committee had to comply with the audit committee rules of
the NYSE, while the compensation committee
- ----------
(132) Id.
(133) OFHEO press release, dated Sept. 28, 2005, at 2, available at
http://www.ofheo.gov/media/pdf/capclass92805.pdf.
(134) OFHEO press release, dated Nov. 1, 2005, available at
http://www.ofheo.gov/News.asp?FormMode=Releases&ID=250 (last visited Feb.
17, 2006). The September 2004 agreement and the March 2005 supplemental
agreement are discussed in Chapter II.
(135) See 67 Fed. Reg. 38,361, 38,370-71 (June 4, 2002) (codified at 12 C.F.R.
Sections 1710.1-1710.20 (2002)). While the chartering acts of Fannie Mae
and Freddie Mac contained some corporate governance provisions, they lacked
others commonly associated with state-chartered corporations. When issuing
these regulations, OFHEO noted the increased focus on sound corporate
governance practices by regulators, corporations, investors, and stock
exchanges. Id. at 38,362.
(136) 12 C.F.R. Section 1710.10 (2002). Fannie Mae elected to follow Delaware
law. See Fannie Mae Bylaws, art. I, Section 1.05, available at
http://www.fanniemae.com/governance/bylaws/article1.jhtml?p=Corporate+
Governance&s=Bylaws&t=Article+1:+General+Provisions (last visited Feb. 17,
2006).
30
had to include three or more independent board members.(137) The regulations
also set forth certain minimum standards for board conduct and responsibilities,
including a requirement to stay reasonably informed of the relevant enterprise's
condition, activities, and operations.(138)
In April 2004, OFHEO issued proposed amendments to its corporate
governance regulations.(139) After a comment period, OFHEO issued final
amendments in April 2005, effective June 6, 2005.(140)
The amended regulations impose board member term limits, require the
majority of seated board members to be independent as defined under NYSE rules,
and mandate board meetings no less than eight times a year (with at least one
meeting per calendar quarter).(141) The board of directors is tasked with
oversight of legal and regulatory compliance, as well as corporate
performance.(142) Furthermore, the audit, compensation, and nominating/corporate
governance committees are required to comply with new Sarbanes-Oxley Act
requirements and the NYSE rules.(143)
Aside from board-directed changes, the 2005 amendments require
rotation of the outside audit firm's lead or coordinating audit partner at least
every five years.(144) In addition, Fannie Mae must maintain both a compliance
program designed to ensure that it follows all applicable laws, regulations, and
internal controls, and a risk management program designed to manage operational
risk; the head of each program must report directly to the board of directors or
an appropriate board committee.(145) The amended regulations also require each
enterprise to draft and administer a code of
- ----------
(137) 12 C.F.R. Section 1710.12 (2002).
(138) See id. Section 1710.15.
(139) 69 Fed. Reg. 19,126 (proposed Apr. 12, 2004).
(140) 70 Fed. Reg. at 17,310-12 (codified as 12 C.F.R. Sections 1710.1-.30
(2005)). The final version of the amendments did not include several of the
proposed provisions. For example, a provision to prohibit a GSE chairman of
the board from also serving as CEO was excluded after Fannie Mae and
Freddie Mac each separately agreed with OFHEO to divide the positions. 70
Fed. Reg. at 17,305.
(141) 12 C.F.R. Section 1710.11 (2005).
(142) See id. Section 1710.15.
(143) See id. Section 1710.12.
(144) See id. Section 1710.18.
(145) See id. Section 1710.19.
31
conduct and ethics that includes the standards required under Section 406 of the
Sarbanes-Oxley Act.(146)
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(146) See id. Section 1710.14.
32
CHAPTER IV: ACCOUNTING FOR THE AMORTIZATION OF
PREMIUM/DISCOUNT ON LOANS AND MORTGAGE-BACKED SECURITIES
I. INTRODUCTION
We address in this Chapter Fannie Mae's accounting for the
amortization of premium and discount on loans and other securities pursuant to
Statement of Financial Accounting Standards No. 91, Accounting for Nonrefundable
Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct
Costs of Leases ("FAS 91" or the "Statement"). In particular, we focused on two
areas: (1) Fannie Mae's decision to book $240 million in net unamortized premium
expense in the fourth quarter of 1998 and to defer the recognition of
approximately $199 million in net unamortized premium expense that had been
calculated through the use of the Company's then existing systems; and (2)
management's creation and implementation of a purchase premium and discount
amortization policy (the "Amortization Policy" or the "Policy") in 2000 that
included, among other things, a "precision threshold" within which management
retained substantial discretion to not make adjustments that were required under
FAS 91.
Based on all of the facts gathered, we have formed the following
conclusions about management's 1998 catch-up decision:
- The decision to record only $240 million of the $439 million in
calculated catch-up expense was motivated by a desire to meet
earnings per share ("EPS") and Fannie Mae's Annual Incentive Plan
("AIP") targets and was not consistent with GAAP;
- Management made other adjustments for 1998 to compensate for the
EPS shortfall created by recording $240 million in catch-up
expense: first, management accelerated a planned accounting
method change for recording low income housing tax credits, which
resulted in the recognition of two years' worth of tax credits in
1998; second, management reversed $3.9 million of credit balances
from an account carrying aged suspense items into income as
"miscellaneous income";
- KPMG was aware of both the full catch-up expense, the decision to
record only $240 million in expense, and the other adjustments
and proposed an audit difference for the unrecorded catch-up
calculation; however, KPMG did not qualify its opinion on the
Company's financial statements; and
- Management's disclosure concerning both the catch-up and the
other adjustments to the Fannie Mae Board of Directors, and its
disclosure regarding the other adjustments to the public, was
incomplete and misleading.
33
With respect to the development and implementation of the Amortization Policy,
we conclude that:
- The Policy was developed primarily to avoid audit differences
with KPMG, and to provide substantial discretion to management to
avoid recording catch-up adjustments, rather than to comply with
GAAP;
- Various provisions of the Policy were not, in fact, consistent
with GAAP;
- Management implemented the Policy inconsistently and recorded
catch-up in a manner designed to reduce income statement
volatility; and
- Management's disclosures to the Board about the Policy and its
implementation were misleading.
II. BACKGROUND
A. Applicable Accounting Standard
FAS 91 sets forth the accounting for nonrefundable fees and costs
associated with originations and purchases of loans. FAS 91 applies to various
types of assets on Fannie Mae's books, including loans, mortgage-backed
securities ("MBS"), and real estate mortgage investment conduits ("REMICs")
(collectively, "loans"). For purposes of this report, we will refer to purchase
premiums, discounts, and other deferred price adjustments relevant to FAS 91
collectively as "deferred price adjustments."
FAS 91 requires the use of the interest method, which recognizes
interest income net of deferred price adjustments at a constant effective yield
(also referred to as "effective" or "level" yield). Under the interest method,
deferred price adjustments should be recognized over the life of the loans as an
adjustment to the loans' yield.
Under FAS 91, if certain specified criteria (discussed in more detail
below) are met, then anticipated prepayments may also be considered in
determining the period over which the deferred price adjustments are recognized.
As stated in FAS 91:
If the enterprise holds a large number of similar loans for which
prepayments are probable and the timing and amount of prepayments can
be reasonably estimated, the enterprise may consider estimates of
future principal prepayments in
34
the calculation of the constant effective yield necessary to apply the
interest method.(147)
Therefore, a company such as Fannie Mae may estimate future
prepayments in its calculation of the constant effective yield if the following
conditions are met: (1) the company holds a large number of similar loans; (2)
the prepayment of those loans is probable; (3) the timing of the prepayments can
be reasonably estimated; and (4) the amount of the prepayments can be reasonably
estimated. Fannie Mae claimed to have satisfied these conditions and therefore
elected to include estimates of future prepayments in its level yield
calculation.
Once an enterprise elects to anticipate prepayments in making its FAS
91 calculation, two situations may arise that may impact the timing of the
amortization of the deferred price adjustments. The first is a difference
between the estimated prepayments and actual prepayments. The second is when the
company periodically revises its estimate of future prepayments. These two
situations can occur simultaneously. When one or both of these situations occur,
the company must recalculate the effective yield to reflect actual prepayments
and the revised estimate of future prepayments. As set forth in FAS 91:
If the enterprise anticipates prepayments in applying the interest
method and a difference arises between the prepayments anticipated and actual
prepayments received, the enterprise shall recalculate the effective yield to
reflect actual payments to date and anticipated future payments. The net
investment in the loans shall be adjusted to the amount that would have existed
had the new effective yield been applied since the acquisition of the loans. The
investment in the loans shall be adjusted to the new balance with a
corresponding charge or credit to interest income.(148)
When Fannie Mae adopted FAS 91, it elected to include estimates of
future prepayments in its calculations of the constant effective yield.(149)
Accordingly, when Fannie Mae's actual prepayments differed from its prior
estimates, and/or when Fannie Mae revised its estimate of future prepayments,
the Company was required under
- ----------
(147) ACCOUNTING FOR NONREFUNDABLE FEES AND COSTS ASSOCIATED WITH ORIGINATING OR
ACQUIRING LOANS AND INITIAL DIRECT COSTS OF LEASES, Statement of Fin.
Accounting Standards No. 91, P 19 (Fin. Accounting Standards Bd. 1982).
(148) Id.
(149) Letter from Jonathan Boyles to Stephen M. Cutler and Paul Berger, dated
Nov. 3, 2004, FNMSEC 151-59, at FNMSEC 152 (hereinafter "OCA Letter");
Fannie Mae, 2002 Annual Report, at 52 (2003) available at
http://fanniemae.com/ir/pdf/ annualreport/2002/2002annualreport.pdf. This
and other examples of documents relevant to the discussion in this Chapter
can be found in the accompanying Appendix at Tab B.
35
FAS 91 to recalculate the constant effective yield to reflect the difference and
immediately recognize in income any cumulative adjustment required in the
amortization of its deferred price adjustments. Fannie Mae referred to this
cumulative adjustment as the "catch-up."
B. Relevant Amortization Accounting Systems
In order to better understand the Company's stated rationale for the
amount of the 1998 catch-up it recorded and the Amortization Policy generally,
as well as the investigation's findings relating to these issues, a brief
summary of the Company's FAS 91 amortization accounting systems is useful.(150)
The systems that Fannie Mae used to calculate FAS 91 amortization and
amortization catch-up can be separated into three groups: source, modeling, and
amortization systems.
The source systems have two main functions for FAS 91 amortization
accounting. First, they provide loan and security data such as the coupon rate,
time to maturity, unpaid principal balance, and original premium and discount
amounts to the modeling systems. In addition, the source systems provide
original premium and discount data to the amortization systems.
The modeling systems,(151) in turn, aggregate loan and security level
data into pools based on certain characteristics including asset type (referred
to at the Company as the "FAS 91 type"), month and year of acquisition, and
coupon rate. This information and the selected interest rate path is then
applied to prepayment models to generate estimates of conditional prepayment
rates ("CPRs"), cashflows, and updated amortization factors that are ultimately
used in the calculation of the catch-up estimate. Based on the catch-up
estimate, and when management deemed it appropriate, the Company would adjust
the actual amortization factors that are provided to the amortization system.
The amortization system - known as PDI(152) - applies amortization
factors received from the modeling systems to original premium and discount in
order to calculate amortization expense or income and post amortization entries
to the general ledger.
- ----------
(150) For a more detailed description of these accounting systems, we refer the
reader to the Appendix that discusses the Company's FAS 91-related systems
at the end of this Chapter.
(151) Fannie Mae's modeling system in 1998 was known as PDAMS. PDAMS was
replaced in October 2001 by AIMS. Tr. of Aug. 31, 2004 OFHEO Dep. of
Jeffrey Juliane, at 217:23-219:6 (hereinafter "Juliane OFHEO Testimony").
(152) PDI was subsequently replaced in 2003 by iPDI.
36
The Company's FAS 91 calculations, therefore, depended in part on
certain subjective criteria, including the Company's views on interest rates and
on prepayment estimates. The Company recognized this and disclosed FAS 91 as one
of the critical accounting estimates in its financial statements.(153) The
reliability and accuracy of the modeling systems were important components of
the Company's catch-up calculation.
C. Accounting Practices Under FAS 91 Prior to 1998
1. Management Never Recorded Catch-up Until 1998
Despite the fact that Fannie Mae adopted FAS 91 in 1987, management
elected not to record any associated catch-up in accordance with FAS 91 during
the periods prior to 1998. No legitimate explanation was offered as to why
management failed to comply with GAAP in those periods.(154)
It appears that KPMG was fully aware of this situation. KPMG noted an
audit difference for unrecorded catch-up as early as 1996, in the amount of
- ----------
(153) Fannie Mae, 2003 Annual Report (Form 10-K), at 42 (Mar. 15, 2004),
available at http://www.fanniemae.com/ir/pdf/sec/2004/f10k03152004.pdf.
(154) In a submission to Senator Warren B. Rudman dated December 8, 2005,
counsel for former Chief Financial Officer Timothy Howard asserted that
Fannie Mae never recorded catch-up amounts pre-1998 because "changes in the
catch-up its model calculated from quarter to quarter could just as easily
be caused by known modeling limitations and inherent estimation
uncertainties as by any actual differences between previously anticipated
future prepayment rates and currently anticipated future prepayment rates."
Mem. from Zuckerman Spaeder LLP to Senator W. Rudman, dated Dec. 7, 2005,
at 3-4 (hereinafter "Howard Submission"). A copy of the Howard Submission
can be found in the accompanying Appendix at Tab G.
We reject this rationale for two reasons. First, putting to one side the
merits of the claim about the "modeling limitations and inherent estimation
uncertainties," which we address infra in Subsections III.E.3 and III.E.4,
Howard's assertion ignores FAS 91's requirement to recognize the difference
between actual prepayments received and the previously estimated
prepayments. Given that there is no modeling needed to compare actual
prepayments received to previously estimated prepayments, we do not find
Howard's rationale persuasive. Second, if management genuinely was unsure
about the amount of catch-up to record due to a question about the
reliability of its modeling systems, then it should have sought to improve
its modeling systems. We have seen no evidence that management sought to
improve its modeling system beyond the capabilities of PDAMS in the
eleven-year period during which they ignored the requirements of FAS 91.
37
$103 million.(155) As explained in greater detail below, because the Company did
not consistently analyze, and did not report to KPMG, the catch-up associated
with its "non-core"(156) book of assets until 1998, the $103 million audit
difference only represented a portion of the catch-up that should have been
recorded under FAS 91.(157)
Management's failure to record any catch-up adjustments in periods
prior to 1998 contributed to the accumulation of Fannie Mae's catch-up in 1998.
In addition, documents showed that management likely understated catch-up
expense in periods before 1998 because it had used interest rate paths to
estimate prepayments that were higher than the prevailing market interest rates,
notwithstanding the general decline in interest rates in the same time
period.(158)
2. Management Did Not Model Its Non-Core Book In Accordance With
GAAP
Another factor contributing to the large catch-up in 1998 was the fact
that management historically did not model amortization on REMICs and "synthetic
- ----------
(155) See, e.g., Fannie Mae Audit Differences, dated Dec. 31, 1996, FMSE-IR
22059; Fannie Mae Audit Differences Dec. 31, 1997 - Restated. Leanne G.
Spencer said that there had been an unrecorded catch-up balance at Fannie
Mae since the Company's adoption of FAS 91, and that KPMG had noted an
audit difference about the unrecorded catch-up every year during that
period, prior to 2000.
(156) In the context of FAS 91 amortization, Fannie Mae refers to premium and
discount on whole loans and MBS (excluding REMICs), as well as buy-ups and
buy-downs on guaranty fees, as its "core" book and refers to premium and
discount on its REMICs and "synthetic REMICs" as its "non-core" book. See,
e.g., Fannie Mae Catch-Up Summary, dated Jan. 7, 1999, FMSE-IR 182475.
(157) Fannie Mae Accounting Issues Discussion Dec. 31, 1998, dated Jan. 8, 1999
(hereinafter "Accounting Issues Discussion").
(158) Fannie Mae PDA Catch-Up, dated Apr. 10, 2000, FMSE 104860. This document
showed that in October 1997, management used a thirty-year fixed rate
mortgage ("FRM") of 8.00% even though the actual thirty-year FRM had
declined to 7.29% by that time. The catch-up calculated using this rate was
$70.0 million, which appears to be the year-end catch-up amount that the
Company communicated to KPMG. Summary of Catch-Up as of Oct. 1997, FMSE-IR
34923. These documents also indicated that once the Company dropped the
rate it used to 7.40% approximately one month later, the catch-up for the
same assets more than doubled, to $148.8 million. Fannie Mae PDA Catch-Up,
dated Apr. 10, 2000, FMSE 104860. Accordingly, it appears that management
underestimated the 1997 year-end catch-up amount that was communicated to
KPMG. In the first three quarters of 1998, management continued to use an
interest rate that was higher than the current average FRM as published by
Freddie Mac. Id.
38
REMICs"(159) (collectively, the "non-core" book) in accordance with FAS 91.
Prior to 1998, the Company did not include REMICs in its level yield calculation
or its calculation of catch-up. Rather than amortizing deferred price
adjustments for REMICs at a constant effective yield, as is required by FAS 91,
management used sum-of-the-years digits ("SYD") and/or straight-line
amortization methods as a proxy for the interest method for these securities
(the "proxy amortization methods").(160)
Several reasons were offered by then management for using a proxy
amortization method for REMICs and synthetic REMICs historically, including the
inadequacy of the Company's modeling system to model these securities and the
then relatively small size of the non-core book.(161) These reasons
notwithstanding, as early as 1995, employees in Financial Standards recognized
that Fannie Mae's accounting for REMICs did not conform with GAAP, but nothing
was done primarily based on the belief that REMICs were difficult to model.(162)
More significantly, it does not appear that anyone assessed the modeling of
REMICs to determine whether the proxy amortization methods, in fact,
approximated the level yield method.(163)
Documents also showed that the Company's catch-up related to synthetic
REMICs had been growing since at least 1996.(164) As of June 1998, catch-up
related to
- ----------
(159) Synthetic REMICs were combinations of interest-only securities and other
securities, such as REMICs, MBS, and principal-only securities, that were
treated as a mortgage-backed security in order to avoid accounting for
possible impairments in the value of the interest-only securities. We
address the propriety under GAAP of the Company's accounting for "synthetic
REMICs" in Chapter V below.
(160) Mem. from J. Boyles to Distribution, dated Oct. 26, 1995, FMSE-IR
213989-91, at FMSE-IR 213989; IO/REMIC Package Briefing For Tim Howard,
dated Mar. 2, 1998, FM SRC 224143-47, at FM SRC 224145.
(161) Mem. from Robert Crane to Richard DePetris, J. Boyles, et al., dated Jan.
12, 1994, FMSE-IR 213974-75, at FMSE-IR 213974.
(162) Mem. from J. Boyles to Distribution, dated Oct. 26, 1995, FMSE-IR
213989-91, at FMSE-IR 213990; E-mail dated Mar. 2, 1998, FM SRC 224142-47,
at FM SRC 224145.
(163) A memorandum from Boyles, then a Director in Financial Standards,
acknowledged that "[t]o date, there has been no recalculation of the
effective yield to determine how closely [the proxy] method has reflected
actual and projected cash flows. Because of the difficulties in getting
historical cash flow information for the securities, this method will
continue to be used for the existing REMIC portfolio." Mem. from J. Boyles
to Distribution, dated Oct. 26, 1995, FMSE-IR 213989-91, at FMSE-IR 213990.
(164) IO/REMIC Package Briefing, dated Mar. 2, 1998. This document showed that
the synthetic REMICs were evaluated in the fall of 1996 and that Fannie Mae
had
39
the non-core book was approximately $186 million.(165) Documents showed that
management did not disclose to KPMG the catch-up balance associated with its
non-core book until January 8, 1999.(166) In fact, a document that management
provided to KPMG on January 8 appeared to have been redacted in ways to suggest
that there was no catch-up balance related to Fannie Mae's non-core book prior
to year-end 1998.(167)
While KPMG became aware of Fannie Mae's non-GAAP accounting treatment
of the non-core book by year-end 1998,(168) we have found no evidence showing
that KPMG was aware of this treatment prior to 1998. We also saw no evidence
that KPMG took steps to quantify the effect of the error on prior period
financial statements when it learned of the Company's treatment.
By 1998, the size of Fannie Mae's non-core book had grown
substantially. The Company's 1998 financial statements note that the net
principal balance associated with the non-core book more than doubled that year,
increasing from $35 billion as of December 31, 1997, to $77 billion as of
December 31, 1998.(169) Perhaps recognizing that the "small size of the book"
rationale no longer justified the proxy amortization methods, management began a
project in early 1998 - which was known as the "Quick Strike Task Force" - to
convert its amortization for the non-core book from the proxy amortization
methods to the effective yield method.(170) By the end of 1998, management had
been able
- ----------
"determined that [that it] had under-amortized premium [or had not recorded
enough expense] into earnings by $28 million."
(165) Risk Review with CFO, dated Sept. 22, 1998, FMSE-IR 308237-48, at FMSE-IR
308244-45.
(166) Accounting Issues Discussion.
(167) Compare id., with Fannie Mae Catch-Up Summary, dated Jan. 7, 1999, FMSE-IR
182475. The latter document, which was used internally at the Company,
identified catch-up related to the non-core book for 1996, 1997, and prior
to October 1998, and included these amounts in the "Corporate Total"
catch-up balance. In contrast, the former document, a "Fannie Mae Catch-Up
Summary" dated January 8, 1999 - which was found in KPMG's workpapers - was
similar in format, but not only had the catch-up balances related to the
non-core book prior to October 1998 been removed, but the "Corporate Total"
calculations prior to October 1998 omitted the catch-up numbers associated
with the non-core book in the January 7, 1999 document.
(168) Accounting Issues Discussion.
(169) Fannie Mae, 1998 Annual Report, at 46 (1999) (hereinafter "1998 Annual
Report"), available at
http://www.fanniemae.com/global/pdf/ir/annualreport/1998/fullreport.pdf.
(170) Undated Notes, FM SRC 310342-44, at FM SRC 310343; Howard Submission at 5.
40
to model approximately fifty-eight percent of the Company's REMICs using the
effective yield method.(171) Other documents indicate that the Company may have
modeled a higher percentage of synthetic REMICs using the effective yield method
by the end of 1998.(172) The Company converted essentially all of its
amortization for the non-core book to the level yield method sometime in
2000.(173)
Significantly, the level yield modeling of a portion of these non-core
book securities in 1998 showed that the Company needed to record a catch-up
expense of nearly $298 million.(174) Under paragraph 13 of Accounting Principles
Board Opinion No. 20, Accounting Changes ("APB 20"), "[a] change from an
accounting principle that is not generally accepted to one that is generally
accepted is a correction of an error for purposes of applying this
Opinion."(175) Since the Company switched from a non-GAAP proxy amortization
method to a GAAP amortization method for its non-core book, management should
have considered the change to be the correction of an error under
- ----------
(171) Undated Unmodeled REMIC Premium/Discount as of May 28, 1998, FMSE-IR
28020; Mem. from Jeffrey Juliane and Rene LeRouzes to Janet L. Pennewell,
et al., dated June 16, 1999, FMSE-IR 25223-24, at FMSE-IR 25223. These
documents indicated that as of May 28, 1998, the Company had modeled
fifty-eight percent of its REMICs using the level yield method and that
this percentage remained approximately the same as of June 1999. Since we
have not been provided with any analysis that shows the percentage of the
non-core book that was modeled as of December 31, 1998, and the next
analysis we have seen that showed an increased percentage of REMICs modeled
is dated June 16, 1999, we assume that only approximately fifty-eight
percent of the book was modeled by the end of 1998.
(172) An analysis performed as of May 28, 1998 indicates that synthetic REMICs
were not part of the fifty-eight percent of REMICs modeled at that time.
See Draft of March 1998 REMIC Premium and Discount, dated May 28, 1998,
FMSE-IR 26684-85. Several documents indicate that a higher percentage of
synthetic REMICs had been modeled using the effective yield method by the
end of 1998. See, e.g., 1998 IO Bundle Catch-up, FMSE-IR 23163-64 FMSE-IR
23168-69.
(173) See Mem. from J. Pennewell to T. Howard, dated Sept. 15, 2000, FMSE
217491-92, at FMSE 217491. This document, which has the subject
"Amortization Policy" states: "Subsequent to that analysis taking place [in
June 2000], we achieved a major deliverable of converting our REMIC
portfolio to level yield accounting. Not only does this allow us to account
for these securities correctly (and consistent with how we are modeling
them), it also allows us to now apply the on-top amortization that we have
been recording to the general ledger but not been able apply to the
individual securities." Id.
(174) Fannie Mae PDA Catch-Up, dated Apr. 10, 2000, FMSE 104860.
(175) ACCOUNTING CHANGES, Accounting Principles Board Opinion 20, P 13
(Accounting Principles Bd. 1971) (hereinafter "APB 20").
41
APB 20, and the impact of the correction on prior periods should have been
assessed.(176) There is no evidence that anyone at the Company did so either in
1998 or in subsequent periods as an increased percentage of the non-core book
was modeled.
III. 1998 CATCH-UP CALCULATION AND ADJUSTMENT
With this background, we now turn to 1998 and discuss in this Section
the facts relating to the decision to record only $240 million of the $439
million in calculated catch-up expense for 1998. We conclude that the evidence
strongly suggests that management's decision was motivated by the desire to meet
published EPS and internal bonus (AIP) targets.
A. The Catch-Up Calculation for 1998
Based on the Company's then existing systems, modeling, and estimation
methods, the total catch-up estimated as of year-end 1998 was $439.7 million, of
which $141.7 million was attributable to the Company's core book, and $298.0
million was attributable to its non-core book.(177) To derive this number,
management applied the base interest rate path of 6.75% for the remaining life
of its core and non-core book.(178) This base interest rate path was the rate
path used at the time for other financial planning and accounting purposes
throughout the Company.(179)
Despite the total calculated amount of $439 million in catch-up
expense, management recorded only $240 million in catch-up expense as of
December 31, 1998 ($180 million was charged to net interest income and $60
million was charged to guaranty fees).(180) Had management recorded the entire
$439 million catch-up expense, the Company would not only have missed Wall
Street analyst EPS expectations of $3.22 per share, but it would also have
missed even the minimum AIP target, resulting in no AIP bonuses for 1998.(181)
As is discussed infra in Subsection III.B., management's
- ----------
(176) Any subsequent change in the catch-up generated by the increase in the
percentage of REMICs modeled using the constant effective yield method also
should have been considered as the correction of an error and analyzed
under APB 20.
(177) Fannie Mae Catch-Up Summary, dated Jan. 7, 1999, FMSE-IR 182475.
(178) Id.
(179) Undated Q4 Earnings Forecast-Scenario Comparison, FMSE-IR 23789; Catchup
Summary: Scenario 2 as of Dec. 31, 1998, dated Jan. 13, 1999, FNMSEC 2678;
Accounting Issues Discussion.
(180) Journal Entries, dated Jan. 9, 1999, FNMSEC 2710, 2712.
(181) Assuming a thirty-five percent statutory tax rate, the after-tax impact of
recording the additional $199.7 million of catch-up expense would have been
$129.8 million. When divided by the Company's 1,037.4 million diluted
average shares outstanding
42
reasons for recording only part of the total catch-up number included interest
rate volatility and modeling imprecision, which purportedly rendered the $439
million to be an unreliable estimate. Management thus deferred the recognition
of the remaining $199 million catch-up expense to subsequent financial reporting
periods, and planned to reduce this amount, in part, through scheduled on-top
adjustments in 1999 of roughly $8 million per month.(182)
As for how management came to select the $240 million number as the
appropriate catch-up expense, then Controller, Leanne G. Spencer, conceded that
there is no financial analysis that would show the calculation from which the
$240 million expense was derived. According to Spencer, she and Timothy Howard,
then Chief Financial Officer, simply became "comfortable" that the $240 million
was the "best estimate" to record. As demonstrated below, documents obtained
from the Company's files showed that management chose $240 million because it
was the greatest amount of catch-up expense the Company could afford to record,
and, by making certain other offsetting adjustments, still exceed then Wall
Street expectations of $3.22 per share for 1998.
B. Evidence Reflecting Management's Focus on Meeting EPS Targets
Documents showed that management at Fannie Mae was focused on the
growing catch-up and its potential impact on the Company's ability to meet EPS
targets for 1998. Further, documents showed that management was concerned about
employee morale should the Company fail to meet maximum bonus targets.
Management at the highest levels was focused in 1998 on the growing
catch-up and its potential impact on the financial statements. For example, in a
memorandum dated July 13, 1998 from Spencer, then Vice President--Financial
Reporting, to Lawrence M. Small, then President and Chief Operating Officer,
with copies to Howard and the Controller, Spencer responded to Small's question,
which was to determine "whether it would be practicable to create an allowance
linked to our purchased premium and discount amortization."(183) Spencer
responded that this was not a good "approach" because, among other reasons, a
reserve was not permitted by GAAP and in any event, creating such a reserve
would result in Fannie Mae having to "take a
- ----------
in 1998, the after-tax impact of recording the entire $439 million expense
would have reduced the 1998 EPS to $3.1058, which was below the Company's
minimum AIP target of $3.1300. Materials for Jan. 19, 1999 Meeting of the
Compensation Committee of the Board of Directors of Fannie Mae, FMSE-IR
276226-73, at FMSE-IR 276233.
(182) Monthly Summary of Amortization Adjustments, dated July 14, 1999, FMSE-SP
3102.
(183) Mem. from L. Spencer to Lawrence M. Small, dated July 13, 1998, FMSE-SP
85799.
43
charge to income that would put us essentially in the same place as we are
without a reserve."(184)
Documents also showed that senior management was concerned not only
about meeting EPS targets, but also about meeting maximum bonus, or AIP,
targets. First, a draft memorandum from Spencer and Janet L. Pennewell, then
Director--Business Planning, addressed to Small, Howard and others, dated July
24, 1998, highlighted management's focus on reaching Wall Street analyst EPS
expectations for 1998.(185) The memorandum states:
Despite the $61.7 billion increase in business volume and 2.1 percent
increase in our overall book of business, our EPS remains flat to plan
for 1998 and has fallen in each of the out years. We will be working
closely with Tim and Rob to develop strategies for reaching a minimum
of $3.20 for 1998, which is the analysts' consensus for the year.(186)
A few weeks later, in a memorandum dated August 10, 1998, Small
explained to then CEO-Designate Franklin D. Raines the significance of reaching
not only Wall Street EPS expectations of $3.21 for 1998, but also of reaching
$3.23 to achieve maximum AIP bonuses for employee morale.(187) In his
memorandum, Small observed that management's then forecast for 1998 was
approximately two cents short of analysts' expectations, and wrote:
For 1998, I'm reasonably confident there's enough in the
"non-recurring earnings piggy bank" to get us to $3.21. While that
number should satisfy investors, you should be aware that last year
the AIP paid out just short of the maximum. This year, the maximum is
$3.23, so at $3.21, the bonus pool will be noticeably lower than in
1997, a fact
- ----------
(184) Id. In the memorandum, Spencer articulated two additional reasons why the
Company should not create a FAS 91 reserve: (1) "there is no accounting
concept of an allowance in the context of purchased premium/discount
amortization"; and (2) "the SEC has stated in the past that they are
against companies setting up general `corporate allowances' because they
are viewed as piggy banks for the company and do not have any basis in
accounting theory." Id.
(185) Mem. from L. Spencer and J. Pennewell to L. Small, Jamie S. Gorelick, T.
Howard and Robert J. Levin, dated July 24, 1998, Zantaz Document 1104455.
(186) Id. at 1.
(187) Mem. from L. Small to Franklin D. Raines, dated Aug. 10, 1998, FMSE-IR
331263-67, at FMSE-IR 331263-64.
44
which will, of course, be rapidly observed by officers and directors
come January.(188)
While he did not recall writing this memorandum specifically, when
asked to explain the reference to AIP goals, Small stated that as the COO of
Fannie Mae, he felt obliged to consider the effect of the Company's earnings
plan on the morale of the hundreds of people that benefited from the AIP.(189)
Additional documents showed that management's primary focus as it
considered the growing catch-up in 1998 was to manage it to a number that did
not cause the Company to miss EPS targets. In particular, a document suggested
that the large catch-up expense was discussed at an internal meeting - called
"Risk Review with CFO" - that took place on September 22, 1998.(190) The
document also suggested that the following participants attended the meeting:
Howard, Spencer, Thomas A. Lawler, then Senior Vice President--Portfolio
Analytics, and Jonathan Boyles, then Director of Financial Standards, among
others.(191) Among the items on the agenda for this Risk Review with CFO were
"Amortization of Core Book (PDAMS)" and "Amortization of REMICs."(192) While
Spencer declined to be interviewed about this memorandum, notwithstanding its
discovery in her files, Pennewell identified the pages that followed
- ----------
(188) Id. at FMSE-IR 331264.
(189) When asked to explain the phrase "non-recurring earnings piggy bank,"
Small stated that it was an unfortunate choice of words and what he likely
meant was that Fannie Mae could increase its earnings through unexpected
revenue or one-time events, like the gain on a sale of property, unexpected
payment of a loan, or finding savings in the budget.
(190) Risk Review with CFO, dated Sept. 22, 1998, FMSE-IR 321564-78, at FMSE-IR
321571-72 (hereinafter "Risk Review with CFO"). As described more fully in
Chapter X, this document was discovered in Spencer's office in May 2005
when Company employees took the proactive step of seizing and copying every
file from Spencer's office while she was absent. The document - which was
responsive to Paul, Weiss's request dating back to November 2004 - was
never produced voluntarily by Spencer. After the document was discovered,
Spencer declined any further Paul, Weiss requests for interviews.
(191) Id. at FMSE-IR 321564. Spencer's calendar contained an entry on September
22, 1998 for a "PDAMS Project" meeting. L. Spencer's Weekly Calendar
Appointments for the Week of Sept. 7, 1998 to Oct. 2, 1998, dated Jan. 22,
1999, FMSE-IR 228752. In an earlier interview, before this document came to
light, Spencer described portions of this meeting in some detail and noted
the same participants as attendees of the meeting.
(192) Risk Review with CFO at FMSE-IR 321564.
45
the agenda in this document as notes that typically were prepared by
Spencer for important meetings with Howard ("Spencer notes").(193)
The Spencer notes stated in no uncertain terms that management's
"priority" as of September 1998 was to book amortization expense while still
"managing" the Company's EPS to $3.21, which was in accordance with then Wall
Street analysts' expectations.(194) In particular, the notes contained a "plan
for bringing catch-up into compliance" that included the following
"Recommendations":
1. Establish as priority one the goal of making $3.21 per share in
1998.
2. Manage earnings to that target and manage to the net interest
margin implied in the Q2 forecast against which we have set
expectations. To the extent that we have "surplus" NII [net
interest income] or extraordinary NII/g-fee [guaranty fee]
adjustments that manifest during the remainder of the year: apply
these amounts to increase the topside adjustments.
3. Doing number two will either reduce the catch-up somewhat or keep
it from growing further.
4. In the last week of December, the November Laser database will be
available. We will run our end of year process off of that
database to determine the appropriate
- ----------
(193) In addition to these pages of narrative, the "Risk Review with CFO"
document included several pages of charts illustrating the Company's
catch-up position, as well as charts related specifically to the REMICs and
synthetic REMICs catch-up and the Company's buy-up position. Risk Review
with CFO at FMSE-IR 321569-78.
(194) Risk Review with CFO at FMSE-IR 321567; Mem. from L. Small to F. Raines,
dated Aug. 10, 1998, FMSE-IR 331263-65, at FMSE-IR 331263.
A submission made on January 5, 2006 by counsel for Spencer explained the
focus in this document on reaching an EPS of $3.21 by stating: "In
achieving FAS 91 compliance, management continued to recognize the
Company's goal of meeting the earnings per share target of $3.21, by
applying surplus `NII' and `g-fee' income to reduce the catch-up for the
rest of the year." Letter from David S. Krakoff to Senator Rudman, dated
Jan. 5, 2006, at 6 (hereinafter "Spencer Submission"). (A copy of the
Spencer Submission can be found in the accompanying Appendix, at Tab G.)
This assertion fails to comprehend that compliance with FAS 91 does not
depend on having "surplus `NII' and `g-fee' income" and is required
regardless of impact on EPS.
46
amount of year-end adjustment necessary to bring the catch-up
into compliance (e.g. get it under $100 million and show it
turning around over the planning horizon). Based on the data in
our June database that entry would be in the neighborhood of $53
million. We would source those earnings from a reduction to our
loss reserves.
5. We propose bringing the catch-up down to $75 million at the end
of the year and then implementing an internal (not public to
KPMG) policy whereby we would not eradicate the catch-up in 1999,
but would NOT allow it to grow above $75 million. Thus, we would
book a topside entry through earnings each month if the in-use
factors caused the catch-up to grow.
6. Implement factor changes that increases [sic] speeds in
accordance with the rate path we'll assume for Q3, but absolutely
no later than for 99 Plan.(195)
We find, based on the contents of this document and the circumstances
of its discovery, that this document is credible evidence of management's
motivation in its handling of the large catch-up expense in 1998. In addition to
the express statement that meeting EPS targets was "priority one," the document
also reflected management's willingness to utilize other non-GAAP measures -
such as timing a reduction of excess loan loss reserves - to offset the impact
of the catch-up expense.
Finally, a set of schedules prepared in early January 1999
demonstrated further that management selected the $240 million catch-up number
by backing into the amount of catch-up expense that could be recognized while
still achieving an EPS of approximately $3.225,(196) which would have just
exceeded then Wall Street EPS consensus of $3.22.(197) These schedules reflect
consideration of three alternative catch-up adjustments for 1998 (the "Earnings
Alternatives Schedules"). Each alternative resulted in the target EPS of
approximately $3.225, and considered recording increasingly larger amounts of
catch-up expense, with correspondingly larger offsetting adjustments that
mitigated the impact of the catch-up expense.(198) According to Shaun Ross, then
Project
- ----------
(195) Risk Review with CFO at FMSE-IR 321567.
(196) Fannie Mae Income Statement, dated Jan. 7, 1999, FMSE-IR 21476-79
(hereinafter "Earnings Alternatives Schedules").
(197) Notes for Jan. 14, 1999 Conference Call, FMSE-IR 211000-07, at FMSE-IR
211000; Notes for Jan. 19, 1999 Board of Directors Meeting, FMSE-IR
182240-45, at FMSE-IR 182240.
(198) See Earnings Alternatives Schedules.
47
Manager--Business Planning in the Controller's Office, he prepared the
schedules in haste on the morning of January 7, 1999 at Spencer's
direction.(199)
The first alternative ("Alternative I") considered recording only $75
million in catch-up expense and contained no offsetting adjustments, resulting
in an EPS of $3.2246.(200) When shown the schedules at an interview, Spencer
acknowledged that Alternative I would have been "unacceptable" because it would
have recorded too little of the calculated catch-up expense of $439 million. The
second alternative ("Alternative II") considered recording $240 million in
catch-up expense.(201) This scenario also contemplated an offsetting adjustment
resulting from a change in the Company's method for accounting for its
investments in partnerships that generated low income housing tax credits
("LIHTC").(202) Based on the LIHTC accounting method change, the result of
Alternative II was a nearly identical EPS of $3.2254.(203) Management ultimately
selected Alternative II for 1998.
The third alternative ("Alternative III") included all of the
adjustments in Alternative II; in addition, it contemplated recording an
additional $100 million of catch-up expense for a total of $340 million.(204) At
the same time, Alternative III considered a
- ----------
(199) Spencer stated that she had no recollection about the schedules or how
they were used.
(200) Earnings Alternatives Schedules, at FMSE-IR 21477. The $75 million
adjustment was divided into a $15 million reduction to net interest income
and a $60 million reduction to guaranty fee income.
(201) Earnings Alternatives Schedules, at FMSE-IR 21478. The $240 million
adjustment was divided into a $180 million reduction to net interest income
and a $60 million reduction to guaranty fee income, which were the amounts
ultimately recorded for 1998.
(202) Id. In Alternative II, the recognition of an additional $165 million (the
$240 million considered in the second alternative less the $75 million
considered in Alternative I) of pre-tax catch-up expense (or $107.3 million
after-tax expense) was offset by adjustments related to LIHTC. These
adjustments relate to the accrual of the 1998 LIHTC, which generated $123.2
million of after-tax income, as well as the accrual of the related 1998 net
operating losses ("NOLs") and the reversal of excess depreciation expense
recorded in years prior to 1998, which contributed $23.2 million of pre-tax
expense (or $15.1 million after-tax expense). Combined, these LIHTC
adjustments had a $108.1 million after-tax income impact, which almost
exactly offset the additional $107.3 million after-tax expense impact of
increasing the amount of catch-up from Alternative I to $240 million in
Alternative II.
(203) Id.
(204) Id. at FMSE-IR 21479.
48
reversal of the Company's provision for loan losses by $100 million, which
reversal was not contemplated in Alternatives I or II.(205) This alternative,
therefore, would have allowed the Company to record a total of $340 million of
the $439 million catch-up expense while still achieving an EPS of $3.2254.(206)
Spencer did recognize the first page of the Earnings Alternatives
Schedules - the page that contained no proposed adjustments for catch-up or
offsetting adjustments - and stated that something similar to it was used in a
meeting with the Office of the Chairman in early 1999. Indeed, the calendars of
both Raines, the then new CEO, and Spencer, reflected a meeting - described in
Raines' calendar as an "Earnings Alternative Meeting" - at 8 a.m. on Friday,
January 8, 1999.(207) The attendees of the meeting, according to Spencer, were
Raines, Small, Jamie Gorelick, then Vice Chairman, Howard, Lawler, Sam Rajappa,
and Spencer.(208)
According to Spencer, at this meeting, she and others reported to the
Office of the Chairman on the work that had been done with respect to
calculating the catch-up, including the decision to record $240 million in
catch-up expense and deferring more than $199 million into future financial
reporting periods. Spencer recalled Raines stating, in substance, that if there
were any other "elephants under the table," that this was the time to "bring
them out," "clean them up," and "take care of them."(209) In other words,
according to Spencer, Raines insisted that the Company should book everything
that needed to be booked and should not go into 1999 with potential exposure.
However, Spencer stated that Raines ultimately became comfortable with her and
Howard's recommendation to record only $240 million of catch-up expense.
According to Spencer, she and Howard explained at this meeting their rationale
for leaving $199 million unrecorded, that is, interest rate volatility and
modeling imprecisions. Neither Spencer nor any of the other attendees of this
meeting recalled seeing or discussing the three Earnings Alternatives Schedules.
- ----------
(205) Id.
(206) Id. The $340 million adjustment was divided into a $280 million reduction
to net interest income and a $60 million reduction to guaranty fee income.
Spencer acknowledged that this alternative was also not acceptable without
any supporting work on the loan loss reserves, which she did not recall
being done at the time.
(207) L. Spencer's Weekly Calendar, dated Jan. 4, 1999 to Jan. 8, 1999, FMSE-IR
228765; F. Raines' Monthly Calendar, dated Jan. 1999, FMSE-IR 27702-13, at
FMSE-IR 27702.
(208) We have interviewed all of the alleged attendees of this meeting with the
exception of Howard, who declined our interview requests. No one other than
Spencer recalled the meeting or any discussions that may have occurred at
the meeting.
(209) Spencer said that the words in quotes were hers, not Raines's.
49
Spencer identified the following three documents as being used at the
January 8, 1999 meeting: (1) a document similar to the first page of the
Earnings Alternatives Schedules, but containing only the 1998 results with no
adjustments for catch-up;(210) (2) a document that showed the core book and
non-core book total catch-up numbers for the years 1995 through 2002, and
reflected the total 1998 catch-up expense amount of $439.7 million;(211) and (3)
a document that illustrated and quantified the change in income for 1998
resulting from the Company's accounting method change for LIHTC.(212)
In summary, the evidence shows that at this January 8 meeting, Spencer
and Howard briefed the attendees about the full catch-up, the decision to record
only $240 million for 1998, with the remaining $199 million to be recorded in
the future periods, and the LIHTC accounting change and its financial statement
impact. We saw no evidence that Spencer and Howard disclosed to the attendees
how they derived the $240 million number from $439 million, or what the
Company's obligations were under FAS 91.
C. Other Adjustments Made to Mitigate Impact of Catch-Up Expense on 1998
EPS
Management made two adjustments that appear to have been motivated by
a desire to offset the impact of the $240 million catch-up expense and to allow
the Company to meet EPS and AIP targets for 1998. These adjustments were: (1)
changing the accounting for LIHTC as of 1998, which had the effect of
recognizing two years' worth of LIHTC in one year, and (2) reversing
approximately $3.9 million from an account containing aged unreconciled items
into income as "miscellaneous income."
1. Changes in Accounting for LIHTC
As discussed more fully in Chapter V below, Fannie Mae began investing
in partnership entities that own low income housing in 1987.(213) The principal
benefit of investing in these partnerships was the ability to defer federal
income taxes through the use of accelerated depreciation and to reduce federal
income taxes with tax credits. Tax credits are granted to investors in low
income housing projects to encourage participation in these investments that
would typically result in losses.
- ----------
(210) Fannie Mae Income Statement, dated Jan. 7, 1999, FMSE-IR 182474.
(211) Fannie Mae Catch-Up Summary, dated Jan. 7, 1999, FMSE-IR 182475.
(212) Low Income Housing Tax Credit Investments, dated Jan. 7, 1999, FMSE-IR
182476.
(213) Undated Low Income Housing Tax Credit Investments (LIHTC), FMSE-IR
182493-97, at FMSE-IR 182493.
50
Fannie Mae's pre-1998 accounting for LIHTC was not consistent
with GAAP. The Company historically accounted for LIHTC on a cash basis, based
on information it received from the Schedule K-1 filings of the partnerships in
the subsequent year.(214) Documents showed management's awareness that this cash
basis accounting was not in accordance with GAAP.(215) Rajappa, who was
Controller of the Company from 1994 through 1998, acknowledged that accrual
basis accounting was "more consistent" with GAAP than cash basis accounting.
Similarly, Spencer stated that when she became Controller in 1998, she advocated
the change to GAAP basis accounting because it was "more appropriate." In
addition, prior to 1998, the Company improperly recognized its depreciation
expense related to LIHTC on an accelerated tax basis rather than on a GAAP
basis.(216) No legitimate explanations were offered as to why management was
comfortable accounting for LIHTC prior to 1998 in a manner that did not comply
with GAAP. Ken Russell from KPMG was aware in 1998 that the Company was taking
measures to implement the LIHTC accounting change.
Accrual basis accounting for LIHTC required the Company to record
the tax benefit in the year that the benefits were earned, and recognize its
share of the partnership's operating losses with depreciation expense computed
in accordance with GAAP. Given that the Company had been recording the credits
in arrears, that is, in the following year when the K-1s were received,
effectuating the accounting change was expected to result in the recognition of
two years' worth of tax credits in the year that the accounting change was
implemented.
Although there is some evidence showing that as early as 1996
management considered converting its accounting method for LIHTC to an accrual
basis accounting in 1998,(217) documents showed that by 1998, the Company was
planning to
- ----------
(214) Letter from L. Spencer, dated May 23, 1996, FMSE-IR 306206-23, at FMSE-IR
306206.
(215) See, e.g., Undated Low Income Housing Tax Credit Investments (LIHTC),
FMSE-IR 182493-97, at FMSE-IR 182495.
(216) Mem. from J. Boyles and Brian Harris to Distribution, dated Nov. 18, 1997,
FMSE-IR 213784-86, at FMSE-IR 213786; E-mail from R. DePetris to J. Boyles,
dated Feb. 3, 1997, FMSE-IR 213773-74, at FMSE-IR 213774.
(217) A note from Spencer dated May 23, 1996 reads:
The attached schedule details the latest outlook (per Q1 forecast) for
the income projected from the equity investments in affordable housing
projects. The projections assume, because of the sunset provision,
that we will do no new deals after 12/31/97.
These projections are cash basis in the forecast, i.e., 1996
recognition of [sic] Fannie Mae's books is the result of our
estimation of what will be received on the 1995 K-1 return. In the
51
implement the accounting change for 1999.(218) A document dated November 18,
1998, which reflected comments from Spencer and Pennewell on Small's planned
statement at an officers' meeting, contained the following note from Spencer and
Pennewell about the LIHTC accounting change:
Where you are talking about the accounting change. Nothing that
you state is incorrect. However, we would like to soften it a
little. Technically, if you "know" about a[n] accounting change
you are supposed to book it. We haven't informed KPMG that we
intend to implement this next year and our preference would be to
not talk to them about it prior to year-end 1998 so they don't
say `book it' at year-end. We've limited discussion of this to
the inner circle, so wouldn't want to broadcast it to the officer
group at this point.(219)
As this document demonstrates, not only was management planning to implement the
LIHTC accounting change for 1999 as of November 1998, but management also had
kept information about the LIHTC accounting from KPMG because of the concern
that KPMG would force management to make the change in a way that would be
inconsistent with management's timing for the change, which was to support EPS
growth in 1999.(220)
- ----------
period we should [choose] to change to an accrual method, you simply
pull forward the projections and in the year of change, you recognize
two year's [sic] worth of activity. My current thoughts would be 1998
would be the year to change.
Letter from L. Spencer, dated May 23, 1996, FMSE-IR 306206-23, at FMSE-IR
306206.
(218) See, e.g., id.; Letter from L. Spencer to T. Howard, et al., dated Dec. 2,
1998, FMSE-IR 182499.
(219) Mem. from L. Spencer and J. Pennewell to L. Small, dated Nov. 30, 1998,
Zantaz Document 1519161, at 3.
(220) See generally Mem. from J. Pennewell to L. Small, dated Nov. 25, 1998,
FMSE-IR 182506 (regarding EPS growth in 1999, Pennewell writes "[t]he
biggest contributor [for 1999 EPS growth] is the accounting change for the
low income tax credit investments (LIHTC) which adds 3.4 percent to EPS
growth. This includes changing from cash to accrual basis of accounting and
changing our depreciation method."); E-mail from Shaun Ross to T. Howard,
L. Spencer, and J. Pennewell, dated Dec. 22, 1998, FMSE-IR 182498
(forwarding to Howard "the 1999 income impact of the changes in the LIHTC
partnerships").
52
Notwithstanding the above documents, sometime in early January
1999, management determined to accelerate the timing of the accounting change
and to make the change for 1998.(221) This new timing for the change is
reflected for the first time in the Earnings Alternatives Schedules dated
January 7, 1999, discussed supra in Subsection III.B., as one of the adjustments
made to offset the impact of catch-up in Alternatives II and III.(222) The
change allowed Fannie Mae to recognize the LIHTC and net operating losses for
both 1997 and 1998 in 1998, and reverse the excess depreciation expense the
Company had recognized in prior years.(223)
Documents showed that management analyzed the change in the
depreciation method under APB 20 and concluded that the change "[was] closer to
a correction of an error,"(224) but other documents show that management
concluded ultimately that both issues should have been accounted for as a change
in accounting principle.(225) In our view, since both the cash-to-accrual and
the depreciation method changes essentially were a conversion from a non-GAAP to
a GAAP basis of accounting, the changes should have been considered as
corrections of errors under APB 20.(226) Management failed to appropriately
consider whether the error in its accounting for LIHTC was material to
previously issued financial statements; nor did it consider whether the
correction of that error in 1998 resulted in a material misstatement of the 1998
financial statements.
By accelerating the accounting change for LIHTC by one year
earlier, management was able to mitigate the impact of the $240 million catch-up
expense adjustment. Spencer claimed that she did not recall what motivated the
Company to
- ----------
(221) The Company also changed its depreciation method in 1998 to be consistent
with GAAP.
(222) Earnings Alternatives Schedules at FMSE-IR 21478-79.
(223) By the end of 1998, the excess of tax depreciation over book depreciation
had reached $75.4 million ($60.9 million of which related to the period
1987-1997). See Cumulative Catch-Up at Dec. 31, 1998, FMSE-IR 52445. In
addition, Fannie Mae estimated that NOLs for 1998 would be approximately
$97.7 million and the tax credits for 1998 would be approximately $123.2
million. 1998 Q4 Forecast - LIHTC Partnerships - 1998 Cur. Accr., dated
Jan. 6, 1999, FMSE-IR 52487.
(224) Mem. from Kimberly Rawls to L. Spencer, et al., dated Apr. 14, 1998,
FMSE-IR 178260-61, at FMSE-IR 178261. The memorandum concludes that the
effect of the correction could be treated like a change in accounting
principle because it was not material. Id.
(225) Undated Notes on Changes to LMI Accounting, FMSE-IR 178258-59, at FMSE-IR
178258.
(226) APB 20 P 13.
53
change LIHTC accounting methods one year ahead of plan. Howard declined to be
interviewed,(227) and Rajappa disclaimed any responsibility for the timing of
the accounting change, stating that he was transitioning from the Controller's
Office function to his new position in the Office of Auditing ("Internal Audit")
during this time period.
We conclude that the above evidence strongly suggests that
management's motive for accelerating the timing of the LIHTC accounting change
was to mitigate the impact of the $240 million catch-up expense and to meet Wall
Street EPS expectations. The decision to switch from non-GAAP to GAAP-based
accounting methods for LIHTC was appropriate. As discussed in greater detail
infra in Subsections III.D.2. and III.D.3., however, the disclosures made to the
public and the Board of Directors as to the nature and reason for the accounting
change were incomplete and misleading.
2. $3.9 Million in Miscellaneous Income from Account 162200
The second adjustment, which was a reversal of $3.9 million in
aged credit items to income from a suspense account for aged unreconciled items
known at the Company by the number 162200, was recorded on January 9, 1999.(228)
This entry, which was made on the day that the Company's books for 1998 closed,
allowed management to meet the maximum AIP bonus payouts for 1998.(229)
The journal entry reflecting this $3.9 million reversal from the
162200 account described the amount as "miscellaneous income."(230) This vague
description,
- ----------
(227) In the Howard Submission, counsel for Howard asserted that the decision to
make the LIHTC accounting change for 1998 was made only after personnel
recommended that the Company record only $240 million of catch-up expense,
and therefore the decision was made irrespective of EPS targets. Howard
Submission at 11. We have seen no evidence supporting this assertion, and
Howard has cited none. In fact, the evidence we have seen is to the
contrary: in Howard's own talking points prepared for a meeting of the
Board of Directors on January 19, 1999, he wrote that management decided to
make the $240 million adjustment in 1998 because there was "room" created
by the recognition of two years' worth of LIHTC credits. Undated Notes for
Jan. 19, 1999 Meeting of the Board of Directors of Fannie Mae, FMSE-IR
182240-64, at 182240-41.
(228) Journal Entry, dated Jan. 9, 1999, FMSE-IR 262764.
(229) The final reported 1998 EPS of $3.2309 was just enough to trigger maximum
bonus payouts under AIP. Under Fannie Mae's AIP for 1998, minimum bonuses
would have been triggered by an EPS of $3.1300, the target bonus would have
been triggered by an EPS of $3.1800, and maximum bonus triggered by an EPS
of $3.2300. Materials for Jan. 19, 1999 Meeting of the Compensation
Committee of the Board of Directors of Fannie Mae, FMSE-IR 276226-73, at
FMSE-IR 276233.
(230) Journal Entry, dated Jan. 9, 1999, FMSE-IR 262764.
54
along with the timing of the entry, caused us to review in greater detail the
activity in the 162200 account, which after the reversal of $3.9 million,
contained approximately $22.5 million of credit balances, among other items.
(231) We also observed that KPMG had identified credits in the 162200 account on
its list of audit differences going back to 1994, that is, KPMG had notified
management of its belief that credit balances in the account should be
reconciled and taken into income as early as 1994.(232) However, management did
not do so.
Management's prior refusal to reconcile and reverse the entire
credit balance in the 162200 account per KPMG's recommendation made the decision
to reverse $3.9 million into income on January 9, 1999 even more questionable.
Moreover, evidence shows that management contemplated using the credits in the
162200 account to "resolve earnings shortfalls" in prior years. In particular,
in a memo from Spencer to Howard that discusses the forecasted EPS for 1996,
Spencer identifies a list of items that are "up [her] sleeve to solve an
earnings shortfall," including what appears to be the 162200 account, which she
describes as containing a "cushion" available for this purpose.(233)
The $3.9 million entry was comprised of five specific credit
items from the 162200 account - credit items that were originally booked to this
account during the period June 1994 through January 1998.(234) While the journal
entry explained the $3.9
- ----------
(231) Fannie Mae Audit Differences Dec. 31, 1998.
(232) As early as 1994, KPMG had noted the balance of this account as an audit
difference. FNMA 1622-00 Analysis at Dec. 31, 1994. Every year since 1996,
KPMG proposed an audit adjustment, which would have reversed the credit
balances in Account 162200, but Fannie Mae did not record those proposed
adjustments. Fannie Mae Audit Differences Dec. 31, 1998; Undated mem. from
Lynden Collier to Lan Nguyen; Fannie Mae Audit Differences Dec. 31, 1997 -
restated; FNMA 1622-00 Analysis at Dec. 31, 1994. KPMG appears to have
reviewed the activity in this account on a quarterly basis. See Analysis of
Accounts Receivable - 162200, dated July 2003. Fannie Mae ultimately
reversed the remaining credit balances in Account 162200 in 2003. Journal
Entry, dated Nov. 4, 2003.
(233) Undated letter from L. Spencer to T. Howard, FMSE-IR 359599-601, at
FMSE-IR 359600. While this document does not specifically refer to the
162200 account by account number, it refers to a "bucket account" and
states that the "cushion" is mostly related to net interest income. When
shown this document, Pennewell stated her belief that the "bucket account"
referred to the 162200 account. Further, an analysis of the composition of
the 162200 account from 1999 indicated that the vast majority of the items
in this account related to net interest income. Analysis of Account 162200,
dated Nov. 30, 1999, FMSE-IR 307790.
(234) Compare Analysis of Account 1622-00 as of Sept. 30, 1998, dated Oct. 1998.
Analysis of Account 1622-00 as of Dec. 31, 1998, dated Dec. 1998.
55
million as "miscellaneous income," we have seen no contemporaneous analysis or
support showing that the items had been reconciled and were the only credits in
the 162200 account that warranted reversal into income at this time. Our
interview of the employee whose name appears on the journal entry as having
processed the entry, revealed no further information about the entry because the
employee had no memory of the event. No other witnesses interviewed offered any
additional information about this entry.
The after-tax impact of the $3.9 million entry from the 162200
account on the 1998 EPS was approximately $0.0024.(235) Internal Fannie Mae AIP
documents showed that the Company's reported EPS in 1998 was $3.2309.(236) If
this entry had not been booked, EPS would have been approximately $3.2285.
During our interviews, we learned from former Controller's Office
staff that while EPS was typically rounded to two decimal places for public
reporting purposes, for purposes of awarding bonuses under the AIP program, the
Company carried EPS to four decimal places.(237) Therefore, an EPS of $3.2285
would not have triggered the maximum AIP payout in 1998, which required an EPS
of $3.2300. With the $3.9 million of "miscellaneous income," the EPS for 1998
reached $3.2309. In the absence of any supporting justification for the reversal
of $3.9 million on January 9, 1999, we can only infer that the $3.9 million
entry was passed to trigger the maximum AIP bonuses. Our inference is supported
by the fact that even without the $3.9 million in additional "miscellaneous
income," the Company had reached $3.2285, which was sufficient to meet Wall
Street expectations of $3.22 per share. Our inference is further supported by
- ----------
(235) We derived this number by assuming a thirty-five percent statutory tax
rate, which resulted in the after-tax income impact of $2.5 million. When
divided by the Company's 1,037.4 million diluted average shares outstanding
for 1998, the after-tax impact on EPS is calculated to be $0.0024. Fannie
Mae, Selected Financial Information as of Dec. 31, 1998, available at
http://www.fanniemae.com/ir/ pdf/earnings/1998/iap123198.pdf.
(236) Materials for Jan. 19, 1999 Meeting of the Compensation Committee of the
Board of Directors of Fannie Mae, FMSE-IR 276226-73, at FMSE-IR 276233.
(237) See, e.g., Agenda-Compensation Committee of the Board of Directors-Fannie
Mae, dated Jan. 19, 1999, FMSE-IR 15796-874, at FMSE-IR 15802-03. This
document indicates that the maximum AIP bonus trigger in 1996 was $2.4800.
The EPS for that year was $2.4764, which the Company rounded up to $2.48
for purposes of presentation in the financial statements. Fannie Mae,
Fourth Quarter 1996 Investor Analysts Report, at 1 (1997), available at
http://www.fanniemae.com/global/pdf/ir/financial/pack/1996/iap96.pdf.
However, the AIP in 1996 allowed for only ninety-three percent of the
maximum bonus payout because the EPS of $2.4764 did not meet the maximum
AIP target of $2.4800. Agenda Compensation Committee of the Board of
Directors - Fannie Mae, dated Jan. 19, 1999, FMSE-IR 15796-764, at FMSE-IR
15802.
56
the fact that the Company previously had resisted KPMG's recommendations to
resolve and reverse the entire amount in the 162200 account. Finally, our
inference is supported by the fact that no one has offered any justification for
selecting the five credit items that were recognized as income on the day the
Company closed its books for 1998.
Based on goals that were set in January 1998, the Compensation
Committee of the Board of Directors of Fannie Mae estimated that the AIP bonus
pool would be funded at $25.9 million in 1998 if the Company achieved the
maximum EPS goal, $17.3 million if the Company reached the target EPS goal, and
$8.6 million if the Company achieved the minimum EPS goal.(238) By hitting
$3.2309, the Company exceeded the maximum EPS goal for 1998, and the AIP bonuses
paid for 1998 totaled $27.1 million.(239)
D. Management's Disclosures About the 1998 Adjustments
1. Disclosures to KPMG
Management fully disclosed to KPMG the full calculated catch-up
amount for 1998, its rationale for recording only $240 million in expense, and
the change in accounting for LIHTC. KPMG noted an audit difference for the
unrecorded catch-up expense of $199 million, but did not qualify its opinion for
the Company's 1998 financial statements. We have not seen any evidence that KPMG
considered any qualitative aspects associated with not recording the full
catch-up expense (such as the effect on the Company's EPS or AIP goals) in
concluding that the failure to record the full adjustment did not have a
material impact on the financial statements.
In a meeting on January 8, 1999, management disclosed to KPMG
that the catch-up expense calculated was approximately $439 million, but that it
was recording only $240 million in catch-up expense.(240) According to Spencer,
Boyles and James Parks, then Vice President and Multifamily Controller, attended
this meeting with KPMG with her. Based on a memorandum summarizing the meeting
that was found in KPMG's workpapers, it appears that management explained to
KPMG that it was only recording $240 million in catch-up expense because "the
calculation and projection of premium/discount amortization is complicated and
imprecise."(241) Specifically,
- ----------
(238) Annual Incentive Plan 1998 Plan Year, FMSE-IR 14834-36, at FMSE-IR 14836.
(239) Agenda-Compensation Committee of the Board of Directors, dated Jan. 19,
1999, FMSE-IR 15796-874, at FMSE-IR 15802. The actual AIP payout number
increased to $27.1 million from the estimate of $25.9 million in the
beginning of 1998 due to the changes during the year in the number of
employees eligible for the AIP or their salaries. Annual Incentive Plan
1998 Plan Year, FMSE-IR 14834-36, at FMSE-IR 14836.
(240) Accounting Issues Discussion.
(241) Accounting Issues Discussion.
57
management advised KPMG that: (1) interest rates were volatile and likely would
move back up, and the catch-up from the 6.75% base interest rate path used would
be completely reversed by the end of 1999 if the scenario were changed to an
"up" scenario of 7.00% for six months and 7.25% thereafter; and (2) the
projection of unamortized premium/discount uses a flat rate projected into the
future instead of more appropriately reflecting a rising rate environment, and
if a rising rate projection was used in the model, the catch-up estimate would
decrease.(242)
In response, KPMG advised management that, while its arguments
for recording only $240 million of the catch-up expense may have support, the
Company's budgeting and planning processes used the same base interest rate path
that had been used in the catch-up calculation resulting in the $439 million
number, and, therefore, the Company should have recorded the full $439 million
in catch-up expense for 1998.(243) Accordingly, KPMG would note an audit
difference in 1998 for the unrecognized catch-up expense of approximately $199
million.(244) KPMG then certified Fannie Mae's 1998 financial statements without
qualification.(245) It appears that management agreed to reduce the $199 million
in expense in 1999 through on-top adjustments.
As for the LIHTC accounting change, according to Spencer,
management made a presentation to KPMG at the January 8, 1999 meeting concerning
the Company's decision to change to an accrual basis accounting for LIHTC.(246)
While the LIHTC accounting change was not discussed in KPMG's workpapers that
relate to this meeting,(247) other KPMG workpapers did reflect the 1998 year-end
LIHTC adjustments.(248) However, these workpapers characterized the adjustments
as resulting from "improved information systems which improved the Company's
ability to estimate
- ----------
(242) Id. Ken Russell could not recall how management arrived at the $240
million figure, and also could not recall management providing their
calculations to KPMG. However, Russell did not tell his audit team to look
into the issue.
(243) Id.
(244) Id.
(245) 1998 Annual Report at 63.
(246) The presentation showed Fannie Mae implementing the LIHTC accounting
change for the year 1999 and not 1998. Undated Low Income Housing Tax
Credit Investments (LIHTC), FMSE-IR 182493-97, at FMSE-IR 182496. Spencer
stated that the purpose of the meeting was to walk KPMG through the
proposed adjustments for 1998 and that the document may have shown the
adjustment for 1999 to show that they were, in effect, "pulling 1999
activity into 1998."
(247) Accounting Issues Discussion.
(248) Fannie Mae Completion Memorandum Dec. 31, 1998, dated Mar. 15, 1999.
58
net operating losses and tax credits."(249) The description in KPMG's workpapers
did not describe the LIHTC adjustments as a change in accounting methodology or
a correction of an error. Russell was aware, however, that the LIHTC accounting
change would allow the Company to recognize additional credits.
Finally, as noted above, KPMG reviewed the 162200 account on a
quarterly basis since at least 1996, but we have seen no evidence that the $3.9
million income entry from account 162200 was discussed with KPMG in January
1999. Based on a review of its workpapers, KPMG advised that it did not see any
indication that it had raised any concerns with management about the reversal of
the five items totaling $3.9 million into income on January 9, 1999.(250) In
short, while management did not highlight the $3.9 million entry to KPMG, there
is also no evidence that management concealed this information from KPMG.
2. Disclosures Made to the Board of Directors
Management's disclosure about the 1998 adjustments to the Board
of Directors, however, was less complete. Management failed to disclose to the
Board of Directors the total catch-up expense number that was calculated, failed
to disclose the purported reasons for recording only $240 million out of $439
million in expense, failed to disclose the audit difference that was noted by
KPMG, and failed to disclose its decision to recognize the $3.9 million
"miscellaneous income." Moreover, the disclosure to the Board regarding the
LIHTC accounting change was misleading.
The Board was first advised of the 1998 results and the catch-up
at a meeting of the Board of Directors on January 19, 1999. While no individual
Board members had any specific recollections of the presentations made at this
particular meeting, some Board members did recall that Howard typically gave
presentations on financial results at Board meetings. The Company produced the
notes prepared by Howard for use at the January 1999 Board meeting from Howard's
files.(251)
Howard's notes for the Board meeting omitted the fact that the
Company's systems had calculated $439 million in catch-up expense, omitted the
fact that management chose to record only $240 million in catch-up expense, and
did not disclose
- ----------
(249) Id. Similarly, Russell recalled that he had meetings with James Parks
prior to the fourth quarter of 1998 during which he was made aware that
Fannie Mae had to gather information to change its LIHTC accounting method
and was working on developing a process to enable the Company to recognize
the credits for financial reporting purposes more quickly.
(250) Account 1622-00 Analysis - 12/31/98.
(251) Notes for Jan. 19, 1999 Meeting of the Board of Directors of Fannie Mae,
FMSE-IR 182240-64. Because Howard declined to be interviewed, we have not
confirmed with him how much of these notes he used at this Board meeting.
59
the fact that KPMG had noted an audit difference for the remaining $199 million
of unrecognized catch-up expense. Indeed, Howard's notes misleadingly portrayed
the $240 million catch-up expense as an adjustment that management "elected" to
record in the fourth quarter of 1998:(252)
what we did in the fourth quarter [of 1998] is decide to take a
large amount of unamortized premium and recognize it all at once,
rather than over a longer period. And we did something similar on
the guaranty fee line . . . . Just as we elected to make a
lump-sum adjustment to purchase premium to reflect[ ] faster
actual and expected prepayments, we made a similar adjustment to
guaranty fees.(253)
Howard's notes stated that management "elected" to record the
$240 million catch-up expense in 1998 because: (1) recording the adjustments at
that time allowed the Company to "report higher levels of net interest income
and guaranty fees over the next year or two," and (2) the Company had "room" to
recognize the catch-up expense "while still coming above the analysts' consensus
for the year, thanks to the tax credit adjustment and the exceptional strength
in net interest income due to extremely rapid portfolio growth in the second
half of the year."(254) The notes did not contain management's purported
concerns about the reliability of the Company's modeling systems, the expected
rise in interest rates, or the impact of modeling even a portion of the REMIC
book under the level yield method on the catch-up. Similarly, there was no
reference to KPMG's audit difference.
As for the accounting method change for LIHTC, Howard's notes did
refer to the LIHTC accounting change as creating "room" in which to record the
$240 million catch-up expense,(255) and stated that the change allowed the
Company to recognize two years' worth of tax credits in 1998.(256) However,
Howard's notes did not mention that the two years' worth of tax credits resulted
from a change in accounting methodology, that is, it was a non-recurring
one-time event, which would have informed the Board about the true quality of
the Company's earnings. The notes also did not
- ----------
(252) Id. at FMSE-IR 182241.
(253) Id. (emphasis added)
(254) Id.
(255) Id.
(256) Id. at FMSE-IR 182240.
60
mention that the Company's historical accounting for LIHTC was non-GAAP, and
therefore the change was a correction of an error.(257)
On February 16, 1999, Spencer made a presentation to the Audit
Committee concerning the Company's 1998 financial results, including the
catch-up. Howard was also present at this meeting.(258) Spencer's presentation
similarly failed to disclose critical information to the Board. According to the
talking points used by Spencer for this meeting, she described the catch-up
adjustment as: "$180 million and $60 million," which "represent our recording
additional amortization of purchase premium and discount balances associated
with our net mortgage portfolio, and a similar adjustment to prepaid or deferred
guaranty fees."(259)
Spencer failed to advise the Audit Committee of the audit
difference for $199 million. The audit difference was reported to the Audit
Committee a year later, in February 2000, in connection with KPMG's audit of the
Company's 1999 financial statements.(260) Spencer stated that management began
reporting all audit differences to the Audit Committee after the issuance of
Statement on Auditing Standards No. 90, Audit Committee Communications ("SAS
90"), in December 1999.(261)
While the above auditing standards may apply to KPMG, we conclude
that it was management's responsibility - particularly, Spencer's and Howard's -
to disclose the audit difference, which, if recorded, would have significantly
affected the Company's ability to meet EPS targets for 1998, to the Audit
Committee. At a minimum, the Compensation Committee of the Board should have
been advised of the $199 million catch-up expense and the impact of that
decision on bonus calculations under the AIP.
- ----------
(257) See id. The minutes of the meeting do not provide any further information
as to what Howard said about the LIHTC accounting change. Minutes of the
Meeting of the Board of Directors of Fannie Mae, dated Jan. 19, 1999, FMSE
1201-18.
(258) Minutes of the Meeting of the Audit Committee of the Board of Directors of
Fannie Mae, dated Feb. 16, 1999, FMSE 14146-60, at FMSE 14146.
(259) The Year in Review: The 1998 Annual Report, dated Feb. 16, 1999, FMSE-IR
22077-91, at FMSE-IR 22082.
(260) The Year in Review: The 1999 Annual Report, dated Feb. 15, 2000, FMSE
14590-607, at FMSE 14605-07; Minutes of the Meeting of the Audit Committee
of the Board of Directors of Fannie Mae, dated Feb. 15, 2000, FMSE
14501-09, at FMSE 14503.
(261) We suspect that Spencer was referring to Audit Adjustments, Statement on
Auditing Standards No. 89 (American Inst. of Certified Public Accountants
1999) ("SAS 89"), which was adopted on December 1999 and which required
KPMG to report all "passed" audit adjustments (also referred to as
"unadjusted" audit differences) to the Audit Committee, even if KPMG
considered them to be immaterial.
61
Russell and Julie Theobald, both from KPMG, were both present at
this February 1999 Audit Committee meeting, and either could have informed the
Audit Committee of the KPMG audit difference, but did not. The meeting minutes
only reflect that Russell stated that: (1) "KPMG did not identify any areas
within the [1998] financial statements that they believe include[d] unreasonable
estimates"; (2) "KPMG did not propose any adjustments that would have a
significant effect on the 1998 financial statements prepared by management"; (3)
"during their 1998 audit, KPMG had no disagreements with management"; and (4)
"Fannie Mae's significant accounting policies . . . [were] in accordance with
Generally Accepted Accounting Principles."(262)
As for the LIHTC accounting change, based on Spencer's notes, her
statements to the Board were misleading. Spencer's notes indicate that she made
the following statement to the Audit Committee: "Based on the utilization of
these improvements to our information and internal controls we were able to
refine the timing of recognition of these tax credits in 1998."(263) The talking
points failed to inform the Audit Committee that the Company's historical
accounting for LIHTC had not been GAAP-compliant, as management knew, and also
omitted the fact that the change related to a simple change in accounting
methodology. Further, the talking points failed to disclose that the accounting
methodology change to LIHTC resulted in a one-time event of recognizing two
years' worth of credits in a single year. None of the Audit Committee members
whom we interviewed who were at the February 1999 meeting recalled this
discussion.
3. Disclosures Made to the Public
Finally, management's public disclosures concerning the 1998
catch-up expense and the LIHTC accounting change tracked the disclosures made to
the Board, and accordingly, were similarly incomplete and misleading.(264) For
example, the MD&A
- ----------
(262) Minutes of the Meeting of the Audit Committee of the Board of Directors of
Fannie Mae, dated Feb. 16, 1999, FMSE 14146-60. Theobald apparently
recalled that, in February of 1999, she explained the audit difference to
Thomas Gerrity, who was then serving as the head of the Audit Committee.
However, as noted above, the minutes of the Audit Committee meeting
contradict this recollection, and we have found no documents that support
Theobald's recollection.
Regardless of whether Theobald discussed the audit difference with Gerrity
in February 1999, it was management's responsibility to provide full
disclosure to the Board, and we conclude that management failed to do so.
(263) The Year in Review: The 1998 Annual Report, dated Feb. 16, 1999, FMSE-IR
22077-91, at FMSE-IR 22082.
(264) 1998 Fourth Quarter Earnings Conference Call, dated Jan. 14, 1999, FMSE-IR
210990-99; Notes for Jan. 14, 1999 Conference Call, FMSE-IR 211000-07.
These are Howard's notes for, and the transcript of, a January 14, 1999
analyst conference call discussing Fannie Mae's 1998 financial results.
62
section of Fannie Mae's 1998 Annual Report noted only that management recorded
additional amortization in the fourth quarter, which reflected "management's
estimate of the effects of the decline in interest rates and the high level of
1998 refinancing activity on the unamortized premium and discount balances
associated with the net mortgage portfolio."(265) The MD&A section also
contained the following statements about the LIHTC accounting change:
The reduction in federal income tax expense and the effective
federal income tax rate for 1998 reflect the recording of
additional low-income housing tax credits in the fourth quarter
of 1998. The additional tax credits were a result of the
corporation using improved systems and information to refine the
timing of the recognition of the tax benefits associated with
investments qualifying for low-income housing tax credits.(266)
This disclosure did not accurately reflect that the true reason
for the LIHTC accounting change was a change in accounting methodology and also
failed to inform the reader that Fannie Mae recognized two years of tax credits
in 1998.
E. Management's Reasons for Recording Only $240 Million
This section considers the legitimacy of several reasons offered
by Howard and Spencer for recording only $240 million of catch-up expense for
1998, which reasons are contained in their statements to OFHEO and to Paul,
Weiss during our interviews of Spencer, and in submissions made to Senator
Rudman through counsel.(267) Both of these submissions in their entirety are
attached as exhibits behind Tab G in the Appendix to this Report.
Essentially, Howard and Spencer collectively offer the following
reasons for recording only $240 million in catch-up expense in 1998:
- The large 1998 catch-up was caused by the fact that interest
rates had dropped by the largest amount in any three month
period in the preceding nine years, which management
believed would not occur;(268)
- ----------
(265) 1998 Annual Report at 21.
(266) Id. at 22.
(267) See generally Spencer Submission at 4-7; Howard Submission.
(268) Howard Submission at 5-6, 8.
63
- Management expected interest rates to rise, and the
Company's exposure to interest rate volatility was not
"symmetrical," that is, even a small increase in interest
rates was expected to dramatically reduce the catch-up
expense, whereas a further decline in interest rates would
not cause the catch-up to grow materially;
- The catch-up associated with the non-core book, $298
million, was imprecise and believed to be
overestimated;(269) and
- The $439 million number was imprecise because, among other
things, Fannie Mae's then existing models were
imprecise.(270)
As a preliminary matter, we note that these explanations, if
credited, may explain why management doubted the accuracy of the full $439
million in catch-up expense for 1998; however, the explanations do not support
management's basis for selecting $240 million. In other words, there is still no
explanation as to why $240 million in expense was considered by management as
the "best estimate." In our view, evidence outlined above strongly supports the
conclusion that management selected $240 million because it was the most
catch-up expense it could record, and, considering the other adjustments, still
achieve the EPS target of $3.23.
Moving to the substance, our view is that the reasons proffered
by Howard and Spencer fail to support their decision to record only $240 million
in catch-up expense for 1998. We address each argument in turn.
1. Interest Rates Volatility Contributed to the Large Catch-Up
First, management's contention that the large catch-up number in
1998 was due to faster prepayments resulting from the unusually large drop in
interest rates at the end of 1998,(271) is inconsistent with our review of
historic interest rates. Our review of the average monthly rates for thirty-year
fixed-rate mortgages (referred to as the "thirty-year FRM"), shows that the
thirty-year FRM dropped from 7.00% in June 1998 to 6.72% by September 1998, a
drop of twenty-eight basis points.(272) However, the thirty-
- ----------
(269) Id. at 6-9; Spencer Submission at 7.
(270) Tr. of June 21, 2004 OFHEO Dep. of L. Spencer, at 45:4-22 (hereinafter
"Spencer OFHEO Testimony").
(271) Howard Submission at 5. Howard's counsel stated that "[i]n the quarter
ending September 30, 1998, interest rates dropped by the largest amount in
any three-month period in nine years." See also Spencer Submission at 5.
(272) Based on KPMG workpapers, it appears that these rates are the "30-year
FRM" rates identified on catch-up schedules created by Fannie Mae. Mem.
from Harry Argires to Fannie Mae Working Papers file, datede Apr. 11, 2000;
Fannie Mae PDA Catch-Up, dated Apr. 10, 2000, FMSE 104860; 30-Year Fixed
Rate Mortgages
64
year FRM dropped from 8.23% in September 1996 to 7.60% in December 1996, a drop
of sixty-three basis points.(273)
Moreover, the acceleration of prepayments due to declining
interest rates was only part of the reason for the large catch-up number in the
fourth quarter of 1998. As discussed supra in Subsection II.C.1., management had
never recorded catch-up prior to 1998, and documents indicated that management
probably had understated catch-up expense in the periods before 1998 because it
had used interest rate paths to estimate prepayments that were higher than the
prevailing market interest rates in a generally declining rate environment.
Also, as discussed supra in Subsection II.C.2., an even bigger component of the
$439 million ($298 million) was catch-up expense related to the level yield
modeling of a portion of the non-core book which had only begun in 1998.(274)
Accordingly, the large catch-up as of the end of 1998 was not just a result of a
decline in interest rates during the year.
2. Management's View That Interest Rates Would Rise in the
Future
Management also contends that based on what happened in 1999 -
that is, interest rates did rise and the negative catch-up did flip to a
positive catch-up - they were justified in believing the $439 million number was
too high.(275) However, the change to a positive catch-up in 1999 was not just
based on a rise in interest rates, but was mostly a result of the $158 million
of catch-up expense that management recorded through manual on-top entries.(276)
Had management not recorded these on-top adjustments in 1999, the catch-up in
1999 would have remained in a deferred expense position.
Management told KPMG in January 1999 that the 6.75% flat rate
path used in the 1998 catch-up calculation was not the most appropriate rate
path.(277) Management told KPMG that rates were volatile and likely to increase
over the next year, and therefore the catch-up generated from the 6.75% flat
rate path - which was the base interest rate path used at that time for other
purposes at Fannie Mae - was not the best
- ----------
Since 1971, available at http://www.freddiemac.com/pmms/pmms30.htm (last
visited Feb. 12, 2006).
(273) 30-Year Fixed Rate Mortgages Since 1971, available at
http://www.freddiemac.com/ pmms/pmms30.htm.
(274) Fannie Mae Catch-Up Summary, dated Jan. 7, 1999, FMSE-IR 182475.
(275) Howard Submission at 9.
(276) Fannie Mae PDA Catch-Up, dated Apr. 10, 2000, FMSE 104860; Fannie Mae 1999
Additional Amortization Booked On-Top Rate Schedule, FMSE-SP 29570; 1999
Monthly Summary of Amortization Adjustments, FMSE-IR 176231.
(277) See Accounting Issues Discussion.
65
estimate.(278) Management therefore calculated the catch-up in the fourth
quarter of 1998 using a rate path of 7.00% for six months and 7.25%
thereafter.(279) Management considered these rate paths to be the "up"
scenario.(280) In this scenario, the unrecognized portion of catch-up expense in
December 1998 would have been reduced from $199.7 million to $65.9 million, and
eventually would have become an unrecognized income position by December
1999.(281)
In addition, management created a "down" scenario for interest
rates using a rate path of 6.25% for six months and 6.75% thereafter.(282) In
this scenario, the unrecognized portion of catch-up expense in December 1998
would have increased from $199.7 million to $234.7 million.(283) Therefore, the
"down" scenario caused only a $35.0 million increase to unrecognized catch-up
expense, as opposed to the corresponding "up" scenario that caused an asymmetric
$133.8 million decrease to unrecognized catch-up expense.(284)
We note that a straight-forward approach to test the asymmetrical
exposure theory would have been to create "up" and "down" interest rate
scenarios that were symmetric around the base interest rate path. Instead, the
adjustments management made to interest rates in the "up" and "down" scenarios
in its analysis were not symmetric, as noted above. In the "up" scenario,
management assumed that interest rate would increase twenty-five basis points
(from 6.75% to 7.00%) for the subsequent six-month period and then increase
another twenty-five basis points (to 7.25%) and remain at that rate
indefinitely. In the "down" scenario, management assumed that interest rates
would decrease by fifty basis points (from 6.75% to 6.25%) for the next six
months and then increase fifty basis points (to 6.75%) and remain at the then
current base interest rate path of 6.75% indefinitely. Accordingly, we question
the validity of management's quantification of the asymmetric exposure.
Other documents indicate that management did create additional
interest rate scenarios, including a "down" scenario that was the symmetric
counterpart to the
- ----------
(278) Accounting Issues Discussion; Tr. of June 21, 2004 OFHEO Deposition of L.
Spencer at 44:25-45:22; Draft Letter from J. Boyles to SEC, dated Oct. 8,
2004, FMSE-IR 380348-49, at FMSE-IR.
(279) Accounting Issues Discussion.
(280) Id.
(281) Id.
(282) Id.
(283) Id.
(284) Id.
66
"up" scenario described above.(285) This "down" scenario assumed that interest
rates would decrease twenty-five basis points (from 6.75% to 6.50%) for the next
six months and then decrease by another twenty-five basis points (from 6.50% to
6.25%) and remain at that rate indefinitely.(286) The calculation of the
catch-up estimate based on this "down" scenario indicated that the catch-up
would increase more in the "down" scenario than it would decrease in the "up"
scenario.(287) In other words, based on this analysis, management's
aforementioned conclusions regarding the asymmetric exposure of the 1998
catch-up would appear erroneous.
Even aside from the validity of this analysis, the claim that the
decision to record only $240 million of catch-up expense was supported by the
"up" scenario is not accurate because in the "up" scenario, the calculated
catch-up was $305.9 million, not $240 million.(288) If management genuinely
believed that the "up" scenario accurately reflected future prepayments,
according to its own logic, management still under-recorded catch-up expense
based on this scenario by $65.9 million.(289) In fact, management's decision to
record $240 million of catch-up expense is consistent with none of the three
interest rate scenarios. No reasons were offered as to why management did not
record catch-up in line with its own analysis.
3. Imprecision of the Modeling for the Non-Core Book
Another reason management offered for its belief that the $439
million catch-up expense was too high was that the Company's FAS 91 modeling and
other
- ----------
(285) See Catch-Up Summary: Scenario 2 as of Dec. 31, 1998, dated Jan. 13, 1999,
FNMSEC 2678.
(286) See id.
(287) See id. The analysis of this additional "down" scenario only contemplated
core book (or PDAMS) catch-up. In this scenario, the unrecognized portion
of catch-up expense in December 1998 would have increased from $81.7
million to $274.3 million. Therefore, this "down" scenario caused a $192.6
million increase to unrecognized catch-up expense, as opposed to the
corresponding "up" scenario that only caused an asymmetric $66.8 million
decrease to unrecognized catch-up expense.
(288) See Howard Submission at 8; Accounting Issues Discussion.
(289) In addition, the Spencer Submission states that the results of the "up"
and "down" scenarios created a "band within which management had confidence
that prepayments would be estimable and probable of occurring." Spencer
Submission at 7.
67
systems were inadequate.(290) At his OFHEO interview and in the Howard
Submission, Howard offered several reasons for the belief that the catch-up
calculation for the non-core book as of the fourth quarter of 1998, in
particular, was an overestimate.(291)
Howard further testified before OFHEO that this belief was
validated when Fannie Mae "trued up" the non-core book in 1999 or 2000.(292)
Howard may have been referring to the fact that when the Company increased the
percentage of the REMIC book that was modeled under the level yield method in
May 2000 (when approximately ninety percent of the REMIC book was being
modeled), and October 2000 (when essentially all of the REMIC book was modeled),
it resulted in approximately $83 million(293) of additional catch-up income.
However, this assertion ignores what happened
- ----------
(290) Spencer Submission at 4; Howard Submission at 2-3; Tr. of Aug. 5, 2004
OFHEO Dep. of T. Howard, at 211:14-213:4 (hereinafter "Howard OFHEO
Testimony"); Spencer OFHEO Testimony at 45:4-22.
(291) Howard OFHEO Testimony at 212:12-213:25; Howard Submission at 9. Howard
stated that his belief was based on the fact that: (1) not all of the
REMICs and synthetic REMICs had been modeled at this time and many of the
securities not yet modeled were believed to be "net discounts," which
management believed, if modeled, would have reduced the catch-up associated
with the non-core book; and (2) management had been conservative in its
estimation of prepayment sensitivities of certain REMIC tranches since it
did not have data on the cash flow characteristics of all tranches of the
REMIC securities it owned. Id.
(292) In particular, during his August 2004 OFHEO testimony, Howard stated: When
we were building up to this $400 million number, it contained an estimate
of the amount of expense we thought we needed to take to book discount
expense on the REMIC book. That dollar amount, the negative, which I don't
recall, turned out once we got actual detail [in 1999 or 2000] to have been
overstated as a component of the $400 million. I don't recall by how much,
but it was enough to be certainly noticeable.
Howard OFHEO Testimony at 212:16-25.
(293) In May 2000, the REMIC-related catch-up changed by $69 million from a
deferred expense of $48 million to a deferred income of $21 million, as a
result of modeling an increased percentage of the non-core book using the
level yield method and a correction of an INTEX data error. The INTEX data
error accounted for $58 million of the $69 million change. Mem. From J.
Juliane and R. LeRouzes to Distribution, dated Apr. 12, 2000, FMSE-SP
303-04; Mem. from J. Juliane and R. LeRouzes to Distribution, dated May 23,
2000, FMSE-SP 299-300. Undated REMICs Catchup, FMSE-IR 55534; Mem. From
Harry Argires to Fannie Mae Working Papers File, dated July 11, 2000. (A
full description of INTEX is contained infra in the Appendix to this
Chapter that discusses the Company's FAS
68
in 1999: when the percentage of the REMIC book that was modeled increased to
sixty-four percent as of August 1999, it resulted in approximately $75 million
of additional catch-up expense.(294)
Moreover, Howard's statement to OFHEO ignores the fact that the
interest rate environment in 2000 was significantly different from the interest
rate environment in 1998. Interest rates increased from 6.74% at the end of 1998
to 8.21% at the beginning of 2000.(295) Comparing the results of a catch-up
calculation prepared in October 2000 to the results of a catch-up calculation
prepared in December 1998, given the differences in the interest rate
environments between the two periods, is like comparing apples and oranges.(296)
In addition, Howard's assertion ignores the fact that the 2000 catch-up
calculation incorporates post-1998 acquisitions and excludes REMICs that were
part of the portfolio in 1998 but had been liquidated prior to this subsequent
modeling.
We conclude that the appropriate manner in which to analyze the
estimated impact of the unmodeled REMIC book in 1998 is to analyze the REMIC
book as of 1998.
The Howard Submission's contention that the unmodeled portion of
the 1998 year-end REMIC book was "believed to be" securities that were acquired
at a discount(297) - meaning that they would have reduced the catch-up expense
if modeled - is contradicted by documents. First, we have found no documents
that support Howard's contention, and Howard has cited none. Second, documents
show that as of November 30, 1998, the REMIC book contained $584 million of
unamortized premium and $167
- ----------
91-related systems.) In October 2000, the REMIC-related deferred catch-up
income increased to $74 million as a result of modeling an increased
percentage of the non-core book using the level yield method. Mem. from J.
Juliane and R. LeRouzes to Distribution, dated Sept. 22, 2000, FMSE-IR
42932-33; Mem. from R. LeRouzes to Distribution, dated Oct. 17, 2000,
FMSE-SP 511-12. When considered together, these changes increased the
Company's catch-up income in 2000 by $83 million.
(294) Mem. from J. Juliane and R. LeRouzes to Distribution, dated Aug. 11, 1999,
FMSE-SP 615-16.
(295) 30-Year Fixed Rate Mortgages Since 1971, available at
http://www.freddiemac.com/ pmms/pmms30.htm.
(296) Even following Howard's logic, the reduction in catch-up expense of
approximately $83 million in 2000 was almost completely offset by the
increase in catch-up expense of $75 million in 1999, leading to the
conclusion that the $298 million catch-up expense calculated as of December
1998 could not have been materially misstated.
(297) Howard Submission at 9.
69
million of unamortized discount.(298) Also, the following table breaks down the
percentages of the premium and discount on REMICs that had been modeled as of
May 1998 and as of August 1999:(299)
Premium Discount
------- --------
May 1998 59.5% 57.3%
August 1999 52.0% 46.0%
Given the large disparity between unamortized premium and
discount amounts and the relatively consistent percentages of premium and
discount modeled in May 1998 and August 1999, it is unlikely that the unmodeled
portion of the REMIC book was in a "net discount" position, and that additional
modeling would have resulted in a significant offsetting adjustment to year-end
1998 catch-up.
Witnesses also contradict the assertion in the Howard Submission
that the large catch-up amount was the result of a "conservative" estimate of
the prepayment sensitivities of certain REMIC tranches made by management
because it did not have data on the cash flow characteristics of all tranches of
the REMIC securities it owned. A manager in Portfolio Strategy who was a member
of the "Quick Strike Task Force" that endeavored to model the Company's non-core
book using the level yield method stated that management did not include any
non-core book securities for which it did not know cash flow characteristics in
the calculation of the non-core book catch-up. In other words, management did
not include any estimate, conservative or otherwise, of catch-up associated with
the non-core book securities that were not yet modeled.
4. Inadequacy of the Modeling Systems for the Core Book
In addition to imprecision in the non-core book modeling,
management also has pointed to weaknesses in the PDAMS model as a rationale for
its belief that the $439 million in catch-up expense was imprecise.(300) This
assertion does not appear to be consistent with the facts. Despite management's
claims, we have not seen any contemporaneous documentation from 1998 (or
associated with the 1998 year-end procedures in early 1999) that supports the
contention that management had significant
- ----------
(298) Acquired Premium / Discount Balances as of Nov. 30, 1998, FMSE-SP 103389.
(299) Draft of March 1998 REMIC Premium and Discount, dated May 28, 1998,
FMSE-IR 26684-85; Mem. from J. Juliane and R. LeRouzes, dated Aug. 11,
1999, FMSE-SP 615-16.
(300) Spencer Submission at 4; Howard Submission at 2-3; Howard OFHEO Testimony
at 211:14-23:4.
70
concerns at that time about PDAMS' ability to provide reasonably accurate and
reliable amortization results.(301)
F. FINDINGS REGARDING THE 1998 CATCH-UP DECISION
We conclude, based on this evidence, that the decision to record only
$240 million of the $439.7 million catch-up expense for 1998 was not in
accordance with GAAP, and was motivated by management's desire to meet 1998 EPS
and AIP targets. While interest rate volatility and system imprecision may have
played some role in creating doubt in management's mind about the accuracy of
the $439 million number, the evidence surrounding how management selected $240
million out of $439 million plainly demonstrated that the primary focus was on
achieving 1998 EPS targets.
We also conclude that Howard and Spencer were the individuals
responsible for the decision to recognize only $240 million of the $439 million
in catch-up expense, and that they made the recommendation to the members of the
Company's Office of the Chairman at the January 8, 1999 meeting. We conclude
that while the attendees of this meeting were provided information by Howard and
Spencer about the full $439 million in catch-up expense, we saw no evidence that
the attendees were given the Earnings Alternatives Schedules, or any information
that would put into question the accuracy of Howard's and Spencer's presentation
at the meeting. Our conclusion is supported by, among other things, the Earnings
Alternatives Schedules, which were created at Spencer's direction shortly before
the January 8, 1999 meeting, the documents Spencer identified as having been
used at this meeting, and by Spencer's own statements
- ----------
(301) A document in KPMG's workpapers dated July 6, 1998 that appears to relate
to a meeting between certain members of management and KPMG regarding PDAMS
states that "[m]odels don't predict peaks and valleys that accurately."
PDAMS & Prepayment Rates, dated July 6, 1998. The document notes that
Lawler, Spencer and Rajappa attended this meeting on behalf of Fannie Mae
and Eric Smith, Theobald, and Russell attended from KPMG.
Another document from KPMG's workpapers relating to a December 7, 1998
meeting between certain members of management and KPMG states that "Pool
weighted average cots [sic] and weighted average maturities become issues
that PDAMS doesn't take into account. For example, PDAMS rounds to two
didgets [sic] to calculate WAC which leads to jumps in amortization when
the WAC does change." Fannie Mae Purchase/Discount Amortization Discussion,
dated Dec. 7, 1998. The document notes that Spencer and Boyles attended
this meeting from Fannie Mae, and Theobald and Smith attended from KPMG.
However, neither document necessarily supports a conclusion that the models
were incapable of producing a reliable estimate of catch-up under normal
circumstances. In fact, the December 1998 document specifically notes that
"Jonathan Boyles has done a lot of recalculations of pools and amortization
to ensure PDAMs is calculating everything appropriately." Id.
71
that it was she and Howard who ultimately became "comfortable" that $240 million
was the right number, and that she and Howard persuaded Raines at the meeting in
January 1999 to record only $240 million.(302)
In addition, we conclude that Howard and Spencer's decision to defer
the $199 million in unrecognized catch-up expense with a plan to reduce it
prospectively through "on-top" adjustments was not in accordance with GAAP. FAS
91 contains no exceptions to the requirement that catch-up be recognized in the
period it is calculated.(303) Moreover, management reduced the $199 million
catch-up by recording $158 million of additional amortization expense during
1999, even though interest rates did increase in 1999 and models were generating
positive catch-up. Documents show that management recorded these additional
amounts as a "reserve" against future interest rate changes.(304) Recording
expense to create a "reserve" or for "protection" against future events that may
or may not occur is not in accordance with GAAP.
We conclude that management failed to comply with FAS 91 prior to 1998
by failing to record any catch-up and failing to apply the interest method for
REMICs and synthetic REMICs. Management also failed to comply with GAAP by not
performing any tests to determine if the results of the proxy amortization
methods rendered materially different results from the interest method.
We also conclude that the decision to change the LIHTC accounting
method from cash to accrual was appropriate, but find that management's
motivation for instituting the accounting change for 1998 was to make up for the
earnings shortfall caused by recognizing the $240 million catch-up expense for
1998.
Furthermore, we conclude that while management disclosed its full
catch-up amount and its decision to book only part of it to KPMG, it failed to
disclose the same information to the Board. Management also failed to disclose
KPMG's audit difference to the Board until 2000. In addition, management's
disclosures to the Board and to the public regarding the LIHTC accounting change
were misleading because they did not disclose the true reason for the accounting
method change, which was simply going from a non-GAAP accounting method to a
method that complied with GAAP. We also find
- ----------
(302) Earnings Alternatives Schedules; Fannie Mae Income Statement, dated Jan.
7, 1999, FMSE-IR 182474; Fannie Mae Catch-Up Summary, dated Jan. 7, 1999,
FMSE-IR 182475; Low Income Housing Tax Credit Investments, dated Jan. 7,
1999, FMSE-IR 182476.
(303) In addition, the decision to recognize any portion the $199 million, much
less $158 million of the total, through on-tops in 1999 undercuts
management's assertion that the $439 million in catch-up was an unreliable
number. It also undercuts management's assertion that the systems were
unreliable.
(304) See, e.g., 1999 Monthly Summary of Amortization Adjustments, dated Jan.
28, 2000, FMSE-IR 176231-32.
72
that management should have highlighted to the public that this resulted in a
one-time event of recognizing two years' worth of credits for 1998, which
information would have permitted investors to assess the quality of the
Company's earnings.
Finally, we find that there is no evidence that management disclosed
to the Board the fact that the 1998 EPS was increased by the unsupported
decision to recognize $3.9 million in aged credits from the 16220 suspense
account in income.
IV. FANNIE MAE'S PREMIUM AND DISCOUNT AMORTIZATION POLICY
This section addresses the Company's development and implementation of
the Amortization Policy. In January 1999, after noting an audit difference for
the unrecognized catch-up expense of $199 million, KPMG requested management to
develop a policy formalizing the Company's FAS 91 accounting practice.
Management agreed, and nearly two years later, in December 2000, implemented the
Amortization Policy. Based on our review of the development process, the
Amortization Policy itself, and the manner in which the Policy was implemented,
we have formed the following conclusions:
- - the Amortization Policy was not consistent with GAAP;
- - the Amortization Policy was developed by the Controller's Office under the
oversight of Howard, and was developed for the primary purpose of managing
the income statement volatility that may result from recognizing catch-up
adjustments on a regular basis, and to avoid audit differences;
- - management implemented the Amortization Policy inconsistently with the
letter of the Policy, and at times recorded catch-up adjustments even
though the calculation yielded an amount within the Policy threshold, which
supposedly represented the "functional equivalent of zero"; and
- - management failed to fully disclose the Policy or its manner of
implementation to the Board of Directors.
A. DEVELOPMENT OF THE POLICY
1. Practice Prior to 1999
As noted above, prior to 1998, management did not recognize catch-up
under FAS 91. It appears that in the same period, management had an informal
understanding that KPMG would not require management to record catch-up if the
amount fell within a threshold of plus or minus $100 million, even though it may
treat the
73
unrecognized catch-up as an audit difference.(305) In addition, management
considered recording catch-up "prospectively," that is, to estimate and
recognize small catch-up amounts in periods subsequent to the measurement of
catch-up in order to avoid having to recognize a large catch-up amount in any
one period.(306)
Documents showed that as early as November 1995, management considered
using a threshold or "de minimis catch-up level" for catch-up, and considered
recognizing catch-up prospectively.(307) A document discovered in Financial
Standards' files stated: "Since true FAS-91 would introduce excessive variance
in income recognition from quarter to quarter, we have adopted a `prospective
method.'"(308)
Documents found in Spencer's files reflected a belief that, as late as
1998, catch-up below $100 million was considered desirable because KPMG would
not require Fannie Mae to book such an amount,(309) but management understood
that KPMG would propose an audit difference even if the catch-up was less than
$100 million.
Russell from KPMG did not recall being aware of any informal policy at
Fannie Mae pursuant to which management did not recognize catch-up if the amount
was within a $100 million threshold. However, documents showed that KPMG was
aware that management did not book any significant catch-up adjustments prior to
1998 and noted audit differences in 1996 and 1997 for unrecorded catch-up.(310)
2. Development of the Amortization Policy
In early 1999, after management explained its rationale for recording
only $240 million in calculated catch-up expense for 1998, KPMG asked management
to develop a formal policy for accounting for premium and discount amortization
under FAS 91. Pennewell in the Controller's Office led the process, and others
who participated in the development of the Policy included Spencer, Lawler,
Juliane and Rene
- ----------
(305) See, e.g., Undated Proposed Amortization Policy, FMSE-IR 34793-94; Mem.
from J. Pennewell to T. Howard, dated Sept. 23, 1999, FMSE-IR 34834-37;
Suggested Amortization Strategy, dated Apr. 2000, FMSE-IR 34843-44.
(306) Suggest Amortization Strategy, dated Apr. 2000, FMSE-IR 34843.
(307) PDAMS Notes, dated Nov. 27, 1995, FMSE-IR 214738-40, at FMSE-IR 214739.
(308) PDAM Analysis and Recommendation, dated Nov. 7, 1995, FMSE-IR 214741-43,
at FMSE-IR 214741. See, e.g., PDAMS Notes, dated Nov. 27, 1995, FMSE-IR
214738-40, at FMSE-IR 214739.
(309) Risk Review with CFO at FMSE-IR 321567.
(310) Fannie Mae Audit Differences Dec. 31, 1997, FMSE-IR 22058; Fannie Mae
Audit Differences Dec. 31, 1996, FMSE-IR 22059.
74
LeRouzes. In addition, as described in more detail infra in Subsection IV.A.3.,
Howard was very much involved in the development of the Policy, expounded some
of its key components, and had the overall approval authority over the Policy.
Individuals from KPMG were consulted periodically in the course of developing
the Policy.
Unlike other accounting policies at Fannie Mae, it was the
Controller's Office, and not Financial Standards, that took the lead in the
development of the Amortization Policy. Spencer and other witnesses have tried
to explain this anomaly by characterizing the Amortization Policy as an
"operational framework," not an "accounting policy."(311)
Boyles confirmed that Financial Standards, the department at Fannie
Mae that was charged with issuing accounting policies, was not required to
review and approve the Amortization Policy because it was not an official
"policy." Although Boyles is listed as a carbon copy recipient on certain early
drafts of the Amortization Policy and may have been consulted from time to time
by those drafting the Policy, we have seen no evidence that Financial Standards
or Boyles authorized the Policy that was ultimately adopted.
3. Evidence Reflecting Management's Purpose for the Amortization
Policy
Drafts of the Policy, from 1999 through the final draft in December
2000, suggested that management was focused primarily on articulating its
"practice" with respect to catch-up calculation that could be presented to KPMG
as evidence of an objective approach.(312) Most of the early drafts of the
Policy contain the following themes:
- minimizing "earnings volatility";
- using an average of multiple interest rate scenarios around the
Company's base interest rate forecast to determine the catch-up
for a given period;
- ----------
(311) Spencer could not provide a legitimate explanation of the differences
between an "operational framework," and an "accounting policy," or offer
any other incidents where the Controller's Office drafted and utilized an
"operational framework" separate and apart from Financial Standards.
(312) Mem. from L. Spencer and J. Pennewell to T. Howard, dated Mar. 2, 1999,
FMSE 217570-71; Mem. from J. Pennewell to T. Howard, dated Sept. 23, 1999,
FMSE-IR 34834-37; Purchase Premium and Discount Amortization Policy, dated
Dec. 2000, FMSE-IR 55470-71 (hereinafter "Amortization Policy").
75
- developing a predetermined threshold, targeted value or
"cushion," below which the Company would consider the catch-up to
be "immaterial";
- managing the catch-up so that it would not exceed that targeted
value; and
- reducing the catch-up balance over a period in the future if it
exceeds a certain amount.(313)
None of the above concepts is based on FAS 91. Rather, the concepts
reflect the twin goals of reducing earnings volatility and giving management as
much discretion as possible in managing the impact of catch-up on the income
statement.
Documents also showed that management was well aware of the
requirements of FAS 91 as it developed the Policy. For example, a draft policy
dated September 23, 1999 that was prepared by Pennewell showed that management
was aware that FAS 91 required catch-up to be recorded in the current period,
but nevertheless believed that a "materiality threshold" could be a rationale
for avoiding this requirement:
Accounting policy requires us to record any catch-up to adjust prior
period amortization in the current period. However, we believe it may
be appropriate to adjust the catch-up over time if the amount is not
material.(314)
In the same memorandum, Pennewell discussed the requirements of Staff Accounting
Bulletin No. 99, Materiality, (August 12, 1999) ("SAB 99"), and noted that the
SAB reflects "the SEC's concern about the tendency of companies, with the
acquiescence of their auditors, to manage earnings by designating certain
transactions or events below a certain percentage threshold as
`immaterial.'"(315) In our view, this memorandum supports the conclusion that
management considered the prospective treatment of catch-up, notwithstanding its
awareness that it did not conform with GAAP.
Two additional concepts that management considered in certain drafts
were treating catch-up that resulted in income ("positive catch-up") differently
than catch-up that resulted in expense ("negative catch-up"); and targeting a
specific catch-up balance in order to provide a "cushion" or "reserve" in the
event of future interest rate changes that could require a catch-up adjustment
to be recorded in the future.
- ----------
(313) See, e.g., Mem. from J. Pennewell and J. Juliane to T. Howard, dated Dec.
16, 1999, FMSE-IR 34848-50; see also Amortization Policy, FMSE-IR 55470-71.
(314) Mem from J. Pennewell to T. Howard, dated Sep. 23, 1999, FMSE-IR 34834-37,
at FMSE-IR 34836.
(315) Id.
76
For example, the September 23, 1999 draft policy contemplated that, if
the catch-up amount was negative (expense), the Company should recognize the
expense prospectively over a four-year period.(316) The same draft recommended
taking no action if the catch-up was positive (income) and management's
assumption was that interest rates would fall in the future.(317) Another draft
policy contained the following rationale for the differing treatment of negative
and positive catch-up:
Given the asymmetric nature of our catchup - the catchup usually
becomes more negative when rates go down [than] positive when rates go
up, following the asymmetric response of prepayments to changes in
interest rates - this recommendation would imply that our target
catchup level will usually be somewhat positive.(318)
The concept of targeting a specific catch-up balance was suggested by
Howard to Pennewell, in a memorandum dated October 27, 1999. Howard stated, as
an item for Pennewell to consider as she finalized the policy: ". . . `where
would we like our [catch-up target] to be' in order to minimize the amount and
frequency of PDA [purchase/discount amortization] adjustments we would have to
make as interest rates moved [sic] (as we know they will)."(319) This memorandum
further discussed targeting a particular catch-up balance that would shield the
Company from having to record adjustments in the event of interest rate
changes.(320) In other words, management would target a particular catch-up
balance in anticipation of interest rate volatility, which targeted balance
would serve as a "cushion" or "reserve" against future volatility. (321)
Additional evidence of management's perspective on recording catch-up
is reflected in the documents relating to the implementation of BancWare. In
1999, at Juliane's suggestion, management considered replacing PDAMS with
BancWare,(322)
- ----------
(316) Id. at FMSE-IR 34835.
(317) Id.
(318) Suggested Amortization Strategy, dated Apr. 2000, FMSE-IR 34843-44, at
FMSE-IR 34843.
(319) Mem. from T. Howard to J. Pennewell, dated Oct. 27, 1999, FMSE-IR 34847.
(320) Id.
(321) See, e.g., id.; Suggested and J. Juliane Amortization Strategy, dated Apr.
2000, FMSE-IR 34843-46; Mem. from J. Pennewell to T. Howard, dated Dec. 16,
1999, FMSE-IR 34848-50.
(322) A full description of BancWare is contained infra in the Appendix to this
Chapter that discusses the Company's FAS 91-related systems.
77
which management believed would allow it to "manipulate" factors to produce an
"array of recognition streams" and thus "`bleed' the catch-up within a specified
time period."(323) Juliane stated that BancWare had the capacity to target a
specific catch-up amount and to plan its reduction over a period of time.
According to a memorandum written by Juliane dated March 12, 1999, these
capabilities "strengthen[ ] the earnings management that is necessary when
dealing with a volatile book of business."(324) BancWare was in operation for a
brief period as a supplement to PDAMS, but, ultimately, it was not fully
implemented by the Company because of implementation difficulties and
management's belief that it could build a better system.(325)
Witness statements and documents also showed that management wanted a
Policy that would help avoid "artificial volatility" in the Company's financial
statements and permit the recording of catch-up into income prospectively over a
period.(326)
The latter practice appears to have been accepted by KPMG. Documents
found in KPMG's workpapers showed that Howard discussed the Company's then
growing catch-up number with Russell of KPMG, who was then the lead engagement
partner, during an August 11, 1998 meeting.(327) A memorandum in KPMG's
workpapers about the meeting reflected the following advice from Russell to
Howard:
I told Tim that in regard to the FAS 91 amortization of premiums and
discount relating to its loan portfolio, that we agree that
significant quarterly adjustments would not be the best way to react
to changes in prepay rates, however, possibly more frequent
prospective adjustments should be made by Fannie Mae to keep the FAS
91 difference at a lesser significant level. He appeared to agree that
there should be some level of materiality established and the Company
should look into how they could stay within that level. The increase
[sic] frequency seems to be a consideration that he found to be
acceptable. He was going
- ----------
(323) Mem. from J. Juliane to T. Lawler, L. Spencer, et al., dated Mar. 12,
1999, FMSE-SP 364-67, at FMSE-SP 365.
(324) Id.
(325) Juliane OFHEO Testimony at 217-18.
(326) See, e.g., Mem. from T. Howard to J. Pennewell, dated Oct. 27, 1999,
FMSE-IR 34847.
(327) Mem. from K. Russell to J. Theobald and E. Smith, dated Aug. 25, 1998.
78
to check with Leanne as to the possibilities of establishing some
policy like that.(328)
Thus, it appears Howard consulted at least Russell in 1998, and Russell agreed
with a prospective treatment of catch-up, provided that management establish a
"level of materiality" to limit the amount of current period unrecorded
catch-up. We saw no evidence that Howard had any subsequent discussions about
this issue with any subsequent engagement partners at KPMG.
On the concept of avoiding "artificial volatility," this directive was
most clearly reflected in Howard's October 27, 1999 memorandum to Pennewell. In
this memo, Howard explained how he thought management could use certain
practices to "help with our goal of minimizing unnecessary net income
volatility," and suggested:
to make our corporate sensitivity to these rate changes symmetric, I
figured that as long as our PDA sensitivity looked like this we should
aim for a PDA catchup position of a positive $85 million. (That way,
if rates moved up by 2 standard deviations the catchup would rise by
$80 million to a positive $165 million; if rates fell by 2 standard
deviations our catchup would decline by $250 million, to a negative
$165 million. That's symmetric.) . . . .
. . . [G]iven our current projected PDA sensitivity we want to be at
$85 million; our probability-weighted expectation is that we will be
at $160 million over the next three years, so to get where we want to
be we should amortize the difference ($75 million) evenly into income
over the next three years (at $25 million per year).(329)
Howard thus suggested to Pennewell that in a situation where management expected
its catch-up to increase from its target balance of $85 million to $160 million
in three years, the Company would manage its target balance by recording
catch-up adjustments of $25 million per year, which would help the Company avoid
having to recognize a large catch-up adjustment all at once.
Another e-mail drafted by Howard to Pennewell, copying Spencer and
Juliane, on or about November 25, 2000, further demonstrated his critical role
in developing the Policy.(330) The attachment to the e-mail was created by
Howard in
- ----------
(328) Id.
(329) Mem. from T. Howard to J. Pennewell, dated Oct. 27, 1999, FMSE-IR 34847.
(330) E-mail from T. Howard to J. Pennewell, L. Spencer and J. Juliane, dated
Nov. 25, 2000, FMSE-IR 660837-39, at FMSE-IR 660837.
79
advance of a meeting with KPMG, with the purpose of summarizing his "objectives
and point of view on this project."(331) The notes outlined three provisions
that were ultimately included in the final Policy: (1) calculating the catch-up
using the average of five scenarios; (2) a range within which the catch-up was
to be considered the "functional equivalent of zero"; and (3) a time horizon
over which the Company could bring the catch-up into income.(332) The notes
further proposed that the Company could prospectively "get a leg up" on getting
the catch-up below the predetermined threshold for future years by making
prospective on-top adjustments.(333) With regard to justifying the predetermined
range, Howard stated "I'm pretty comfortable that we can defend the range around
our target catch-up by linking it to the uncertainties about the assumptions
used to calculate the catch-up figure."(334)
Pennewell stated that she and others, including Spencer and Boyles,
were not comfortable that a Policy that allowed the Company to bring the amount
of catch-up in excess of the threshold into income over a long period of time
was consistent with GAAP, and that she and others communicated their concerns to
Howard. While Pennewell could not recall any specific discussions she had with
Howard, she generally recalled telling Howard that KPMG would not be comfortable
with the idea. A draft policy prepared by Pennewell supported her recollection
that she did, in fact, express to Howard that KPMG would not approve of using an
extended time horizon to bring certain levels of catch-up into income.(335)
Notwithstanding Pennewell's and others
- ----------
(331) Id. at FMSE-IR 660838-39.
(332) Id.
(333) Id. at FMSE-IR 660839.
(334) Id.
(335) Undated Proposed Amortization Policy, FMSE-IR 463599-600. The draft states
"we expect them [KPMG] to like the zero, but not the time horizon. They
would prefer a time horizon of the current year, with something like a +/-
$100 million as an acceptable range." Pennewell's recollection of
discussing her concerns with Howard was further corroborated by Howard's
critical view of Pennewell's contributions to the development of the
Policy. In a performance evaluation he wrote regarding Spencer in 2000,
Howard said:
Purchase discount has taken a very long time to come to the point of a
concrete recommendation, and I thought we went down some unproductive
avenues to get where we now are. You'll recall that I wasn't totally
convinced of the merits of the recommendation Janet made on this issue a
couple of months ago, but was willing to agree to it provided she accepted
the condition that if in a future instance her policy resulted in a
challenge for us it was clearly her responsibility.
80
concerns, the concept of reducing the catch-up over a three-year horizon was
incorporated into the final Policy.(336) According to Pennewell, however, Fannie
Mae never put this part of the Policy into practice.
4. KPMG's Involvement in the Development of the Amortization Policy
Management met with KPMG prior to finalizing the Amortization Policy.
While we have not seen a copy of the final Amortization Policy in KPMG's files,
we have seen an undated draft of the Policy.(337) An undated document prepared
by Pennewell showed management's expectation that KPMG would challenge certain
aspects of the policy, and included defenses to these potential challenges.(338)
For example, the document reflected management's anticipation that KPMG would
not approve of using as wide a range of interest rate scenarios as management
wanted to use (120 basis points) and that KPMG would want management to reduce
the catch-up, to the extent it was outside of the plus or minus $100 million
threshold, in the current year as opposed to over a three-year horizon.(339) As
discussed in more detail infra in Subsection IV.B.4, we find that KPMG was aware
of and did not disagree with the Policy's provisions allowing management to use
the average of five interest rate scenarios for calculating catch-up and a
predetermined threshold in which no catch-up would be recorded.
5. The Final Amortization Policy Adopted in December 2000
Management finalized a written purchase premium and amortization
policy in December 2000.(340) The December 2000 Policy contained three main
sections that addressed the following goals: (1) to calculate the current
catch-up position; (2) to determine a "target range" for the catch-up that
reflects "existing assumption risk"; and
- ----------
Mem. from T. Howard to L. Spencer, dated Dec. 9, 2000, FMSE-IR 28779-81, at
FMSE-IR 28780.
(336) Amortization Policy, FMSE-IR 55470-71.
(337) Undated Purchase Premium and Discount Amortization Policy.
(338) Undated Proposed Amortization Policy, FMSE-IR 34793-94. This document was
produced from the files of Pennewell on December 13, 2004. It was part of
binder entitled "FAS 91 Binders - Amortization Results 2000 - Current
(12/13/04)."
(339) Id. at FMSE-IR 34793.
(340) Amortization Policy. Spencer, Boyles, Pennewell and Juliane identified
this document as the Policy. Tr. of June 15, 2004 OFHEO Dep. of J.
Pennewell at 33:11-34:7.
81
(3) to "manage the catch-up over time."(341) By "existing assumption risk,"
management meant modeling imprecision due to the uncertainty related to
forecasting interest rates and the imprecision of estimating prepayments based
on its interest rate forecast, as well as other modeling "compromises" that
existed due to systems limitations.(342) The Policy also outlined when audit
differences would and would not be posted.(343)
(a) Average of Five Interest Rate Scenarios
The first provision of the Policy stated that the average of five
interest rate scenarios are to be used to calculate the catch-up, namely "the
base rate together with the four sensitivity runs that encompass a 95%
confidence interval around that base rate."(344) In the November 3, 2004 letter
to the SEC's Office of the Chief Accountant ("OCA") explaining the Amortization
Policy, the Company stated that multiple rate paths were used to capture the
asymmetries in how the catch-up might react to interest rate changes and that
five interest rate scenarios were used to capture the likely interest rate
fluctuations consistent with a ninety-five percent confidence interval.(345) Our
investigation has not uncovered, and witnesses were unable to point to, any
contemporaneous analysis that supported the Company's determination that the
estimate of the five interest rate scenarios would capture the future interest
rate path with ninety-five percent confidence.
(b) Precision Thresholds
The second provision of the Policy set the target catch-up at plus or
minus one percent of related revenue for net interest income and plus or minus
two percent for guaranty fees, and stated that catch-up in this target range or
"precision threshold" is "the functional equivalent of zero," meaning, all
numbers within the range can be viewed as zero, and no catch-up would be
required to be recorded.(346) The Company's November 3, 2004 letter to the OCA
stated that management developed these ranges by measuring the imprecision in
its prepayment projections by comparing the impact on its catch-up estimates to
a range of prepayment forecasts from Wall Street firms.(347) Again, we found
- ----------
(341) Amortization Policy.
(342) OCA Letter at FNMSEC 153-55.
(343) Amortization Policy at FMSE-IR 55470.
(344) Id.
(345) OCA Letter at FNMSEC 154.
(346) Amortization Policy at FMSE-IR 55470.
(347) OCA Letter at FNMSEC 155.
82
no contemporaneous evidence to show that management did, in fact, conduct such
an analysis.
Further, the OCA letter stated that the precision threshold was
designed with three objectives in mind: (i) "to deal with the degree of
imprecision associated with forecasting prepayments"; (ii) "to objectively limit
the amount of imprecision that the company would tolerate based on
pre-established thresholds"; and (iii) "to ensure that the estimation process
was done in a consistent and objective fashion."(348) We do not believe that
such objectives are consistent with FAS 91, and in any event, the evidence
showed that management's implementation of the Policy plainly did not follow
such stated objectives.(349)
Finally, if the catch-up fell within the precision threshold, then "no
audit difference would be posted."(350) If the catch-up for either net interest
income or guaranty fees exceeded the respective precision threshold, then an
audit difference for that line item would be posted for the amount in excess of
the target.(351)
- ----------
(348) Id. at 154.
Notably, the Amortization Policy accounted for the imprecision in
forecasting prepayment speeds twice - first when calculating the catch-up
using an average of five interest rate scenarios and again when considering
the "precision threshold" to determine whether or not the calculated amount
needed to be recorded.
(349) What's more, the stated rationale for such a "precision threshold," that
prepayment forecasts were "imprecise," was contradicted by employees
outside the Controller's Office who had expertise in such a matter. For
example, Boyles stated that it was his belief that management not only had
the ability to reasonably estimate prepayments, but that Fannie Mae
considers its ability to predict prepayments to be a "core competence" of
the Company. Additionally, an employee who was responsible for the
prepayment modeling systems in Portfolio Analytics characterized Fannie
Mae's ability to model CPRs as "state of the art."
(350) Amortization Policy at FMSE-IR 55470.
The Policy also described a "de minimis amount" beyond the predetermined
thresholds within which no audit differences would be posted. This "de
minimis amount" appeared to be an additional measure of materiality;
however, we have seen no indication that management considered the "de
minimis amount" in practice. The Policy defined the de minimis amount to be
"the lesser of an adjustment: that impacts pretax Earnings Per Share by 1
cent, an adjustment that causes the net interest margin to change by 1
basis point or an adjustment that causes the Guaranty Fee Rate to change by
[0].1 basis point, as applicable." Id.
(351) Id.
83
(c) Managing Catch-up Over a Three-Year Period
The third section of the Policy outlined a method for managing the
catch-up over a three-year time period.(352) The policy stated that when
catch-up exceeded the target threshold, management should aim for catch-up
within the range based on future forecasts so that the catch-up will be within
the "functional equivalent of zero" range within the three years.(353) The
Policy suggested that management would achieve these goals by making on-top
adjustments, and that the on-tops would generally be front-loaded, but would be
made on no specific timetable other than three years.(354)
Controller's Office personnel stated that, notwithstanding the written
document, the third provision of the Policy was not implemented. Both Spencer
and Pennewell conceded that the third section of the Policy had no support in
GAAP, and that the only reason it was in the Policy was to appease Howard.(355)
* * * *
In summary, as discussed above, the Policy merely outlined the
numerous ways - in calculating catch-up, in assessing what amount should be
recognized, and in delaying the recognition of catch-up over a period of three
years - through which management could retain significant discretion to avoid
recording catch-up adjustments, which would mitigate the impact of recording
catch-up on the Company's financial statements and avoid audit differences.
B. The Application of the Amortization Policy
The evidence of the manner in which management implemented the
Amortization Policy further demonstrated that, notwithstanding the Policy,
management's primary goal was to manage the catch-up's impact on the Company's
income statements.
- ----------
(352) Id.
(353) Id. at FMSE-IR 55471.
(354) Id.
(355) Juliane said that KPMG told management in the first quarter of 2001 that
it disapproved of this provision. Juliane also said that management always
reduced the catch-up so that it was within the threshold by year-end.
Boyles stated that he was not aware of this provision of the Policy until
OFHEO began the Special Examination, at which point he told Spencer that
this provision was not in accordance with GAAP. Boyles said that Spencer
told him that he should not be concerned because this aspect of the Policy
had never been implemented.
84
Management did use five interest rate scenarios for calculating
catch-up, and also applied the "precision thresholds" to not record catch-up
from time to time. However, evidence showed that management also recorded
catch-up in ways that deviated from the terms of the Policy. In particular,
management used a variety of other tools to manage the catch-up balance,
including booking on-top adjustments, changing interest rate paths, and editing
CPRs that fed into the modeling system. Significantly, management also
recognized catch-up that fell within the "precision threshold" through 2002,
even though by the Policy's own terms, any amount within the range was the
"functional equivalent of zero." Finally, until 2003, management failed to
calculate catch-up as of the interim balance sheet date. Instead, it used an
estimate of year-end catch-up to determine whether the catch-up would fall
within the "precision threshold" by year-end. If the results of that analysis
indicated that catch-up would not be within the threshold, management made
periodic on-top adjustments to bring the catch-up within the threshold.(356)
1. Management Used a Variety of Tools To Manage Catch-Up
Management used a variety of methods not articulated in the
Amortization Policy to manage Fannie Mae's catch-up position.
For example, on occasion, management changed the base interest rate
path used to calculate the catch-up. Juliane described at least two occasions,
once in the second quarter of 2003 and once in the first quarter of 2004, when
management used a base interest rate path to calculate catch-up other than the
base interest rate path employed throughout the Company. In the OCA letter, the
Company asserted that using a different interest rate was necessary "at times
when interest rates ha[d] moved materially between the date when interest rates
[were] set for the corporate business forecast and the end of the quarter."(357)
The Policy, however, did not provide for such an exception.
Management also booked on-top adjustments for reasons other than those
described in the Policy. Juliane stated that management booked on-top
adjustments when it appeared that the catch-up number was going to be outside of
the plus or minus one percent range at year-end. For example, Juliane recalled
that management booked a $10 million on-top adjustment in November 2002 after
conducting an interim run of its year-end catch-up position and discovering that
it was significantly out of compliance with the
- ----------
(356) Management also engaged in a variety of other unrelated practices to
mitigate the impact of the catch-up amount on the financial statements,
such as including in the catch-up calculation an estimate that was
generated in connection with system realignments, and adjusting the
amortization end-date for its callable debt, which resulted in an
adjustment to the amortization of deferred debt issue costs that
substantially offset the calculated catch-up amount. We address these
practices in Chapter VI, Parts M, V, and O below.
(357) OCA Letter at FNMSEC 154.
85
precision threshold.(358) According to Juliane, Spencer and Pennewell were
responsible for the decisions to book these on-top adjustments.
We have also seen instances when management made edits to CPRs that
fed into the modeling system, which in turn affected the catch-up calculation.
Juliane explained that he would propose CPR edits from time to time based on his
market analysis. The Controller's Office would obtain prepayment data from the
Bloomberg website and create a CPR range representing the high and low market
estimates based on that data. The Controller's Office would then compare the
internally-generated CPRs from Portfolio Analytics to this market range and make
adjustments to the selected CPRs based on what Controller's Office staff deemed
appropriate.(359) Juliane stated that he would suggest CPR edits to Lawler, who
would sign off on the adjustment.(360) A document dated March 15, 2003
demonstrated CPR edits that were made in this fashion.(361) Such CPR edits were
only made for the use of the Controller's Office in calculating catch-up, and
were neither fed back to Portfolio Analytics, nor applied elsewhere in the
Company.(362)
Finally, an incident that occurred in the third quarter of 2002
clearly demonstrated management's primary motivation behind managing the
catch-up. At this time, management faced a positive catch-up of $80 million in
order to remain in compliance with the Policy. Rather than recording the amount,
management changed the methodology by which it had previously calculated
catch-up, which had the effect of reducing the amount of catch-up from $80
million to $43 million. To reach this result, management included catch-up
related to current quarter loan acquisitions, which it had never done in the
past. Management's previous position had been that the calculation of catch-up
on current quarter acquisitions was unnecessary because the rate environment
during the quarter remained relatively stable. However, in the third quarter of
2002,
- ----------
(358) As discussed infra in Subsection IV.B.3, we have confirmed that management
booked a $10 million on-top adjustment in November 2002. However, the
catch-up position by year-end was only $64.8 million, which was within the
policy range of $93.3 million. Undated Catch-Up Analysis (Including
Realignments), FMSE-IR 265826; 2002 Q4 Catch-up Sensitivities, FNMSEC 2869;
Journal Entry, dated Dec. 9, 2002, FNMSEC 2870.
(359) Juliane OFHEO Testimony at 45:20-46:6.
(360) Id. at 45:20-46:10. Lawler claimed that he was not the final
decision-maker as to the CPRs that were used to calculate catch-up. Lawler
stated that he was never asked "what to book," only whether he believed a
particular prepayment rate looked reasonable.
(361) CPR Analysis, Mar. 15, 2003, FMSE-SP 2936.
(362) A more detailed discussion of and our conclusions regarding management's
practice of editing CPRs can be found in Chapter IX.
86
citing the large amount of premiums purchased in the quarter and a volatile rate
environment, management changed its methodology to include current quarter
acquisitions in its catch-up calculation.(363) Management claimed that this
change in methodology was necessary in order to "provide a complete picture of
the impact of interest rate/prepayment speed volatility on recorded
amortization."(364)
While we agree that the change would appear to make the catch-up
calculation more accurate since it allowed the Company to take into account
current quarter acquisitions, we conclude that management was motivated to do so
primarily by the desire to avoid recording the $80 million catch-up adjustment
for the third quarter of 2002. This conclusion is based on, among other things,
the timing of this change. In other words, while this was not the first quarter
in which interest rates were volatile, it was the first time since the
implementation of the Policy in December 2000 that management faced having to
record a significant amount of catch-up.(365)
Further, management resisted recording even the reduced $43 million of
catch-up income in the third quarter of 2002. Management stated to KPMG that it
would reduce the catch-up to be in compliance with the Policy by year-end.
According to then KPMG engagement partner, Mark Serock, he took up this issue
with both Pennewell and Spencer, and also advised Howard that if management did
not adjust interest income to be in accordance with the Policy by quarter-end,
the difference would be included in the audit difference workpapers that would
be reviewed with the Audit Committee. After Serock so advised Howard, he was
informed by Spencer and Pennewell that management planned to record a $43
million increase to interest income, but that it would also be making an
amortization end-date change for the Company's callable debt that would increase
interest expense by approximately $35 million,(366) which would, in effect,
offset a significant portion of the $43 million of income.
In summary, rather than record the $80 million adjustment calculated
by its own Policy, management first changed its methodology for calculating
catch-up, resisted KPMG's recommendation to record $43 million, and, ultimately,
made an end-date change for certain callable debt that resulted in an offsetting
adjustment. The sum total of these efforts by management was the elimination of
almost the entire $80 million
- ----------
(363) FAS 91 Workpaper, dated Oct. 2002.
(364) Id.
(365) Undated Catch-Up Analysis (Including Realignments), FMSE-IR 265826. KPMG
required that Fannie Mae, going forward, continue to include catch-up
related to current quarter acquisitions in its catch-up calculation "at
least until prevailing market conditions [were] stabilized," FAS 91
Workpaper, dated Oct. 2002, and evidence showed that management did so, at
least through the second quarter of 2004. Q2-2004 Forecast Update.
(366) See E-mail from Cheryl DeFlorimonte, dated Oct. 10, 2002, FMSE-IR
437919-76.
87
in calculated catch-up income for the third quarter of 2002. This example
clearly demonstrates that management's primary motivation with respect to
catch-up was to avoid or to minimize its impact on the financial
statements.(367)
2. Catch-Up Was Initially Calculated for Year-End
From December 2000, when the Policy was first implemented, through the
end of 2002, management used an estimate of what the year-end catch-up balance
would be to determine whether to record adjustments to its interim period
earnings to bring the projected year-end catch-up back within the precision
thresholds.(368)
In the OCA letter, the Company acknowledged that calculating the
catch-up in this manner was not in accordance with GAAP.(369) According to
management, it changed this practice in 2003 based on KPMG's instruction and
began calculating the catch-up for each interim reporting period.(370)
No explanations were offered by the Controller's Office staff as to
the reason for this practice, and the recollections also differed as to when and
whether KPMG had been aware of this practice. According to Pennewell, Serock
advised in 2003 that booking entries as of year-end was no longer appropriate
because Enron and Sarbanes-Oxley had changed the environment, and accounting
standards were tightening. According to Spencer, at some point in 2002, KPMG
told management that it would be a "better practice" to use a quarter-end
measurement, but KPMG did not say that the year-end method was not GAAP
compliant.
Serock stated that he was not aware that management had been using
year-end income estimates to determine whether it needed to make adjustments at
each quarterly period. Serock stated that he was aware that management was
calculating the catch-up on a quarterly basis, but was unaware that it was not
recording the catch-up amount at each interim balance sheet date. In addition,
Serock could not recall whether anyone at KPMG informed management that it
needed to calculate the catch-up as of each balance sheet date and was unaware
of any modification management made to the Policy in this regard in the first
quarter of 2003.
- ----------
(367) Management's reluctance to book catch-up adjustments is also evidenced by
their actions in the first three quarters of 2003, when they included in
their catch-up analysis the unrecognized portion of the cumulative
realignment differences and estimates of future realignments differences,
which had the effect of eliminating or reducing the size of the on-top
adjustments booked in these quarters. An in-depth discussion of this
treatment is discussed in Chapter VI, Part O.
(368) OCA Letter at FNMSEC 155.
(369) Id.
(370) Id.
88
3. Management Made Adjustments Even When Catch-Up Fell Within the
Predetermined Threshold
The fact that casts the greatest doubt on management's good faith and
motive in establishing the Amortization Policy was that management recorded
catch-up adjustments even when it was not required to do so under the Policy. On
several occasions, management recorded catch-up adjustments despite the fact
that the calculated catch-up amount fell within the precision thresholds, which
was the "functional equivalent of zero." For example, in 2001, management booked
an additional $10 million of catch-up income even though the catch-up was within
the predetermined range.(371) An April 12, 2001 memorandum from Juliane and
LeRouzes stated that Juliane and LeRouzes determined that the $10 million on-top
should be booked "to hedge our exposure if rates continue to decline."(372)
In addition, Juliane recalled recording catch-up within the range on
at least three other occasions, once in the amount of $19.8 million, which
occurred during the fourth quarter of 2001.(373) Juliane understood that this
on-top was also booked as a "hedge" and that he was told that the decision to
book this amount was made due to a disproportionate exposure in the down-rate
environment and in anticipation of future declining rates. The $19.8 million
entry was made on January 6, 2002, shortly before Fannie Mae closed its books.
Including this entry, Fannie Mae's EPS for the fourth quarter of 2001 was $1.40,
which exceeded then Wall Street expectations of $1.39.(374) Fannie Mae's actual
EPS was $1.3955.(375) The after-tax impact of the $19.8 million entry on the
quarterly EPS for 2001 was approximately $0.0128.(376) In the absence of any
other adjustments, had Fannie Mae not booked the $19.8 million on-top
adjustment, the fourth
- ----------
(371) Mem. from J. Juliane and R. LeRouzes, dated Apr. 12, 2001, FMSE-IR
227051-54, at FMSE-IR 227051; 2001 Q2 Catch-up Sensitivities, FNMSEC 2826;
Journal Entry, dated June 6, 2001, FNMSEC 2827.
(372) Mem. from J. Juliane and R. LeRouzes, dated Apr. 12, 2001, FMSE-IR
227051-55, at FMSE-IR 227051.
(373) See Q4 Catch-up Sensitivities, FNMSEC 2848; Journal Entry, dated Jan. 6,
2002, FNMSEC 2854.
(374) Fannie Mae 4th Quarter Profit Rises 23% on Lending Boom, Bloomberg News,
Jan. 14, 2002, at 2.
(375) Fannie Mae, Selected Financial Information as of Dec. 31, 2001, available
at http://www.fanniemae.com/global/pdf/ir/financial/earnings/2001/
iap123101.pdf.
(376) Assuming a thirty-five percent statutory tax rate, the after-tax income
impact of the $19.8 million adjustment was $12.9 million. When divided by
the Company's 1,005.2 million diluted average shares outstanding in the
fourth quarter of 2001, the after-tax impact on EPS is calculated to be
$0.0128. Id.
89
quarter EPS for 2001 would have been $1.3827 ($1.3955 minus $0.0128), meaning
that Fannie Mae would have missed analysts' expectations.(377) Evidence showed
that KPMG was aware of the $19.8 million adjustment, and while it noted that the
entry was not required under the Amortization Policy, KPMG concluded that the
amount was immaterial. Serock stated that KPMG considered SAB 99 in making this
determination, but he acknowledged that he did not recall the specific reason
for the adjustment.
There are additional instances of management making adjustments when
the calculated catch-up was within the targeted range. In November 2002, a $10
million on-top adjustment was recorded even though the catch-up position by
year-end was only $64.8 million, which was within the Policy range of $93.3
million.(378) Also, there were numerous occurrences of adjustments related to
guaranty fees being booked even though the catch-up was within the range through
the first quarter of 2002.(379)
We have found no credible contemporaneous analysis or explanations
that would support management's decisions to record catch-up amounts within the
Policy range.
According to Pennewell, management stopped recording catch-up that was
within the precision threshold in the third quarter of 2002 because KPMG advised
that management should record adjustments only to bring the catch-up number to
the outside of the range, and not record anything if the catch-up calculation
was within the range. Notwithstanding this advice from KPMG, the Company's OCA
letter acknowledged that management made yet another $10 million adjustment in
the fourth quarter of 2002, even though the catch-up calculation was within the
range.(380)
4. KPMG's Awareness of the Manner in Which the Amortization Policy
Was Implemented
As reflected above, at least certain individuals at KPMG were aware of
the ways in which management implemented the Policy. Pennewell stated that the
Company
- ----------
(377) We note that the $19.8 million adjustment did not seem to affect the
Company's ability to reach AIP goals since Fannie Mae comfortably exceeded
its maximum AIP goal of 14.9% annual EPS growth by achieving a 21.2% annual
EPS growth for 2001 and would have reached that EPS growth without this
adjustment. Annual Incentive Plan 2001 Plan Year, FMSE-IR 17500.
(378) Undated Catch-Up Analysis (Including Realignments), FMSE-IR 265826; 2002
Q4 Catch-up Sensitivities, FNMSEC 2869; Journal Entry, dated Dec. 9, 2002,
FNMSEC 2870.
(379) Undated Catch-Up Analysis (Including Realignments), FMSE-IR 265827.
(380) OCA Letter at FNMSEC 155. Neither Serock nor Argires from KPMG were aware
prior to the OCA letter that management made this adjustment.
90
sent to KPMG documents that showed quarterly catch-up sensitivities that
summarized the catch-up results and indicated management's year-end projections,
and that management met with KPMG to explain these analyses.
KPMG's workpapers indicate, and KPMG staff have confirmed, that
Howard, Spencer, Pennewell and Juliane met with Russell, Theobald and Harry
Argires of KPMG on December 12, 2000 to discuss the Amortization Policy.(381)
The KPMG workpapers noted that at this meeting, management "articulated" its
planned purchase premium and discount amortization policy, but there was no
indication that management showed KPMG a copy of the written Policy.(382) The
KPMG workpapers indicated that management wanted to implement the Policy
"because of the sensitivity to PSA rates (which would all be in a band of
reasonableness)," and to "allow[__________] for the level of imprecision within
the marketplace."(383) The document described the first two provisions of the
Policy - the use of an average of five interest rate scenarios and a "dollar
threshold of precision" - in some detail; however, the KPMG workpapers contained
no reference to reducing catch-up balances in excess of the "dollar threshold of
precision" over a longer period.(384)
Evidence also showed that KPMG was somewhat familiar with the manner
in which the Amortization Policy was implemented. For example, as described
supra in Subsection IV.B.1., Serock demonstrated that he was familiar with the
Policy's precision threshold when he advised management in the third quarter of
2002 that the Company needed to make an adjustment to interest income to be in
compliance with the plus or minus one percent provision of the Policy. Serock
and Argires were also aware that management made adjustments even when the
catch-up fell within the range - including the $19.8 million adjustment to
income made in the fourth quarter of 2001 - but determined that the adjustments
were immaterial.
On the other hand, Serock stated that the first time he learned that
management was applying the Policy by looking only to year-end catch-up
estimates, was when he reviewed drafts of the OCA letter in the Fall of 2004.
Serock also stated that he was unaware that the Company had been using various
tools, such as changing CPRs, that affected the catch-up calculation. In
addition, it was not until late 2004 that David C. Britt, KPMG's then new
engagement partner, became aware of the practices of recording catch-up within
the range and looking to year-end estimates to determine quarterly catch-up
numbers. Apparently, Britt learned of these practices only through
- ----------
(381) Fannie Mae Accounting for FAS 91, dated Dec. 31, 2000.
(382) Id.
(383) Id.
(384) Id.
91
reviewing the drafts of the OCA letter and promptly informed management that
KPMG did not agree with these practices.(385)
C. Inadequate Disclosures to the Board About the Amortization Policy and
Its Application
We have not seen any evidence that management disclosed the Policy or
its application to the Board prior to late 2003.(386) In November 2003, Spencer
made a presentation entitled "Critical Accounting Policy Deferred Price
Adjustments" to the Audit Committee.(387)
The minutes of the November 2003 Audit Committee meeting, at which
Serock, Britt and Argires of KPMG were present, reflect that, in response to a
question from Anne M. Mulcahy, a then member of the Audit Committee, about the
Company's FAS 91 policy, "Spencer responded that management could not pick any
interest rate path to predict prepayments but instead used an average of rates
that is standardized in many processes across the company."(388) Spencer's
statement was misleading - we are aware of no other process employed at Fannie
Mae at the time that used an average of interest rates or an average of results
derived from these interest rates. To the extent that Spencer meant that the
interest rates are used in other areas across Fannie Mae, that statement too was
inaccurate, as management did not always use the base interest rate that was
used in other areas of the Company for catch-up calculation purposes. We
conclude that in response to Mulcahy's direct question that reflected her
concern that management's discretion was properly constrained by objective
measures, Spencer provided a misleading answer that was entirely inconsistent
with management's motive for developing the Policy in the first place, and
inconsistent with the actual implementation of the Policy.
- ----------
(385) While Britt objected to management's practices of booking within the range
and looking to year-end estimates to determine quarterly catch-up numbers,
he only required the Company to assess the impact on prior periods of the
latter practice. See Fannie Mae, Notification of Late Filing (Form 12b-25),
at 4 (Nov. 15, 2004), available at
http://www.fanniemae.com/ir/sec/index.jhtml?s=SEC+Filings (follow "All SEC
Filings" hyperlink; then follow "NT 10-Q, Nov. 15, 2004" hyperlink for PDF
format).
(386) Spencer acknowledged that prior to November 2003, the Amortization Policy
was not disclosed to the Board.
(387) Audit Committee Update, Critical Accounting Policy, Deferred Price
Adjustments, dated Nov. 17, 2003, FMSE-IR 55456-71; Minutes of the Meeting
of the Audit Committee of the Board of Directors of Fannie Mae, dated Nov.
17, 2003, FMSE 221342-51, at FMSE 221346.
(388) Minutes of the Meeting of the Audit Committee of the Board of Directors of
Fannie Mae, dated Nov. 17, 2003, FMSE 221342-51, at FMSE 221347.
92
The minutes also reflected that "Ms. Spencer and Fannie Mae management
present at the meeting agreed that they would inform the Board of any future
changes made to the deferred price adjustment methodology or events where there
was a failure to make an adjustment."(389) We saw no evidence in the minutes of
any Board Meeting that Spencer followed through on her promise to the Audit
Committee.(390) In short, at the November 2003 Audit Committee meeting, Spencer
misleadingly painted a picture for the Board that suggested that the Company's
Policy was, in fact, objective and that management did not exercise undue
discretion with respect to calculating and recording catch-up.
Finally, both Spencer and Howard were present at the July 2004 joint
Audit and Special Review Committee where the accountants retained by the lawyers
for the Company for the Special Examination discussed the propriety of the
Company's FAS 91 policy and what OFHEO may allege with respect to the Policy.
One of the anticipated criticisms of OFHEO discussed by the accountants was
whether the Policy had been implemented inconsistently and to manage
earnings.(391) Neither Spencer nor Howard spoke up at this meeting to inform the
Board that OFHEO's allegations would be well-founded in the facts, that is, the
Policy had been adopted precisely to give maximum discretion to management in
managing catch-up, and that since the adoption of the Policy, the Controller's
Office staff had routinely applied the Policy inconsistently, to avoid the
catch-up's impact on the Company's financial statements.
D. 2004 Revisions to the Amortization Policy
In August 2004, prior to the issuance of the OFHEO Report, management
undertook to change its practices for accounting under FAS 91 and updated its
written Amortization Policy. Pennewell was primarily responsible for updating
the policy and received assistance from Juliane, among others. Like the December
2000 Policy, the August 2004 Policy permitted calculating the catch-up using an
average of the results of the catch-up calculation with five interest rate
scenarios and a threshold within which the
- ----------
(389) Id.
(390) The only other presentation made to the Board relating to the Policy that
we reviewed was for a Board meeting in November 2004, which was after the
issuance of the OFHEO Report. Financial Performance Update, Fannie Mae
Board of Directors, dated Nov. 16, 2004. This presentation indicates that
management may have told the Board about a change in the Policy related to
the threshold range used to determine whether adjustments needed to be
recorded for the guaranty fee component of the catch-up. See id. However,
the minutes from this meeting do not reflect that management made this
disclosure. Minutes of the Meeting of the Board of Directors of Fannie Mae,
dated Nov. 16, 2004, FMSE 504488-94.
(391) The discussions that took place at the July 2004 joint Audit and Special
Review Committee meeting are discussed further in Chapter X below.
93
catch-up would be considered to be the functional equivalent of zero.(392) The
threshold in the August 2004 version of the Policy for both net interest income
and guaranty fees was plus or minus one percent.(393) The August 2004 Policy did
not contain a provision that allowed management to reduce the catch-up over a
three-year period and, instead, explicitly required management to bring the
catch-up within the range by quarter-end.(394) The August 2004 policy was silent
about whether management could use its judgment to make adjustments when the
catch-up was within the range.
The Company is in the process of establishing a new Amortization
Policy as part of the restatement process.(395)
E. Findings Regarding the Amortization Policy
Our conclusions concerning the Amortization Policy are as follows:
- - The Amortization Policy was designed to give management the maximum amount
of discretion to mitigate the income statement effect of recognizing
catch-up. Such a purpose has no support in FAS 91.
- - The Amortization Policy was also created with the goal of documenting the
Company's practice to avoid audit differences, which would have highlighted
this
- ----------
(392) Amortization Operational Policy, dated Aug. 31, 2004, FMSE-IR 405894-97 at
FMSE-IR 405895.
(393) Id.
(394) Id.
(395) After the issuance of the OFHEO Report and prior to the commencement of
the restatement process, Janet Pennewell began a SAB 99 analysis to see
whether certain ways that management applied the Policy historically -
including its use of the precision threshold and year-end estimates, rather
than estimates as of interim balance sheet dates, to calculate the catch-up
- had a material impact on the Company's financial statements for any given
period. However, Pennewell stated that she never completed the analysis
because she was not able to recreate all of the data, and thus the analysis
was unreliable. In addition, Pennewell stated that the Company had been
unable to restore all of the prior PDAMS runs. Huron has sought to
re-create the PDAMS runs for 1998, without success. Moreover, we could not
determine the interest rate paths management actually used to book
amortization because the amortization factors used by the Company to record
amortization were not based exclusively on a given interest rate path, but
instead also reflected other adjustments made by management. For this
reason, and the fact that the Company is currently working with Deloitte &
Touch LLP to restate prior period financial results, which will include an
assessment of the Company's accounting pursuant to FAS 91, we did not
pursue this task.
94
practice to the Audit Committee. An accounting policy such as this should
have focused on accounting for purchase premium and discount amortization
in accordance with GAAP, rather than focusing on avoiding audit
differences.
- - We also conclude that management continued to exercise discretion for
recognizing catch-up, and disregarded the terms of the Policy when it did
not suit its purpose. There is no legitimate explanation for, among other
things, management's recording adjustments when the catch-up fell within
its predetermined threshold. Management's exercise of discretion to book
amounts as a reserve against future interest rate changes was not
consistent with FAS 91 and also contradicted management's stated rationale
for the Amortization Policy.
- Finally, we conclude that Spencer and Howard concealed the true
purpose of the Amortization Policy and the manner in which it was
implemented from the Board.
95
CHAPTER IV APPENDIX: FANNIE MAE'S FAS 91-RELATED SYSTEMS
The systems that Fannie Mae used to calculate FAS 91 amortization and
amortization catch-up can be separated into three groups: source, modeling, and
amortization systems.(396)
I. SOURCE SYSTEMS
The source systems have two main functions for FAS 91 amortization
accounting. First, they provide loan and security data such as the coupon rate,
time to maturity, unpaid principal balance, and original premium and discount
amounts to the modeling systems for the purposes of modeling prepayment speeds
and ultimately generating amortization factors. In addition, the source systems
provide original premium and discount data to the amortization systems for the
purpose of calculating amortization income or expense. The five principal source
systems used at Fannie Mae during the relevant period through the present are
known as "Delivery,"(397) "LASER,"(398) "Strategy,"(399) "STAMPS"(400) and
"STATS."(401)
- ----------
(396) See Undated AIMS: Data Flow and Aggregation and iPDI: Context Diagram for
comprehensive system flowcharts that diagram the amortization process.
(397) Delivery is a client-server system used by lenders to submit loans to
Fannie Mae. Delivery transfers the data related to Fannie Mae acquisitions
to the LASER and Strategy systems. In addition, Delivery also provides
single-family original premium and discount data to the amortization
system. Data Analysis Specification, AIMS Project, dated Oct. 8, 2003, FMSE
193105-42, at FMSE 193112; Fannie Mae FAS 91 Amortization Process (AIMS
Data Aggregation), dated Nov. 12, 2004, FMSE-IR 9370-72.
(398) LASER is a mainframe system that tracks single-family loans in the Fannie
Mae portfolio. LASER receives data from the Delivery system and tracks
loan-level data such as the coupon rate, time to maturity, unpaid principal
balance, and premium and discount amounts. For amortization purposes, LASER
passes this data to the modeling systems. Data Analysis Specification, AIMS
Project, dated Oct. 8, 2003, FMSE 193105-42, at FMSE 193113.
(399) Strategy is the system that tracks multifamily loans in the Fannie Mae
portfolio. Strategy receives data from the Delivery system and tracks
loan-level data similar to that of LASER. Fannie Mae FAS 91 Amortization
Process (AIMS Data Aggregation), dated Nov. 12, 2004, FMSE-IR 9370-72. For
amortization purposes, Strategy passes this data to the modeling systems
and provides multifamily original premium and discount data to the
amortization system. Data Analysis Specification, AIMS Project, dated Oct.
8, 2003, FMSE 193105-42, at FMSE 193113.
96
II. MODELING SYSTEMS
The modeling systems aggregate loan and security level data into pools
based on certain characteristics including asset type (referred to at the
Company as "the FAS 91 type"), month, and year of acquisition and coupon rate.
This information and the selected interest rate path is then applied to
prepayment models to generate estimates of conditional prepayment rates
("CPRs"),(402) cashflows, and updated amortization factors(403) that are
ultimately used in the calculation of what Fannie Mae referred to as the
"catch-up" estimate.
Data received from the source systems is aggregated at two levels.
Currently, data is first aggregated by FMIS(404) and then by ALEX(405) before
model-ready records - that is, data for similar loans aggregated into a series
of FAS 91 "buckets"
- ----------
(400) STAMPS, or the Securities Trading and MBS Processing System, is the system
that records MBS transactions related to the Fannie Mae portfolio. For
amortization purposes, among others, STAMPS provides security data to the
STATS system. Id.
(401) STATS, or the Securities Trading Accounting Transactional System, is the
system that tracks all securities acquired by Fannie Mae. STATS receives
data from the STAMPS system and tracks securities at the CUSIP number
level. For amortization purposes, STATS provides data to both the modeling
and amortization systems. Id.
(402) Conditional Prepayment Rates (or "CPRs") are measurements of prepayments
expressed as a percentage of the remaining principal balance at the
beginning of the measurement period (hence, they are "conditional" on the
principal balance). Linda Lowell, Mortgage Pass-Through Securities, in THE
HANDBOOK OF MORTGAGE-BACKED SECURITIES 25, 41 (Frank J. Fabozzi ed., 5th
ed. 2001).
(403) Amortization factors are percentages applied to original premium and
discount amounts in order to calculate amortization.
(404) FMIS, or the Financial Management Information System, is a "data
warehouse" currently used by Fannie Mae, that receives and aggregates
information downloaded from the LASER, Strategy, and STATS. Data Analysis
Specification, AIMS Project, dated Oct. 8, 2003, FMSE 193105-42, at FMSE
193114.
(405) ALEX, or the Asset Liability Extractor, is the system currently used by
Fannie Mae that provides data for similar loans that have been aggregated
into a series of FAS 91 buckets reflecting the characteristics of those
similar loans for all portfolio analytical systems, and includes data such
as CUSIP, FAS 91 Type, Acquisition Date, Original Unamortized balance,
Current Unamortized balance, Original Face, and Current Face. Data Analysis
Specification, AIMS Project, dated Oct. 8, 2003, FMSE 193105-42, at FMSE
193113-15.
97
containing loans with similar characteristics - are passed to AIMS.(406) AIMS
then passes this data to Valuation Net ("VN"),(407) which applies an interest
rate path to its library of prepayment models in order to calculate CPRs.(408)
Portfolio Strategy creates interest rate paths based on the forward
interest rates derived from the yield curve. These rates, along with "shocks" to
the interest rate paths, are compiled into an interest rate projection file,
which contains the interest rate information used throughout Fannie Mae, and is
made available within VN. The CPRs generated by VN are then passed back to AIMS,
which, in turn, calculates the constant effective yield and creates updated
amortization factors.
AIMS then applies the updated amortization factors to the original
unamortized premium and discount amounts to determine how much should have been
amortized based on the current data, assumptions, and modeling. AIMS compares
this amount to the amount of amortization actually recorded to the financial
statements, which it receives from the amortization system. The resulting
difference is the catch-up estimate. Based on the catch-up estimate, and when
deemed appropriate, the Company adjusts the actual amortization factors that are
then provided to the amortization system.
In 1998, the modeling system used by the Company was PDAMS.(409) In
1999, Fannie Mae supplemented PDAMS with a software called BancWare Convergence
- ----------
(406) AIMS, or the Amortization Integration Modeling System, is the application
currently used by Fannie Mae that is responsible for the calculation of the
constant effective yields and amortization factors used to amortize the
premiums, discounts, and other deferred price adjustments into income. Data
Analysis Specification, AIMS Project, dated Oct. 8, 2003, FMSE 193105-42,
at FMSE 193105-08.
(407) VN is a portfolio analytics system. It houses two data libraries, the
Mortgage Cash Flow Library (MCFL) and the Portfolio Analytics Library
(PAL), which work together to calculate CPRs, which AIMS ultimately uses to
generate amortization factors. For REMIC amortization, VN interacts with a
third party library called INTEX, which provides historical and prospective
cash flows for all REMICs. Fannie Mae began using INTEX when it started
modeling REMICs in 1998. Mem. from Jeffrey Juliane to File, dated Apr. 5,
2004, FMSE-E 147666-69.
(408) At present, there is an added step for modeling REMICs since cash flows
require allocation among the different tranches of the REMIC. The process
for modeling REMICs involves the same systems described above in the same
capacity, with the addition of INTEX. INTEX is a data library licensed by a
third party that contains tranche-level REMIC characteristics. INTEX
applies these characteristics to estimated cash flow data, for the
underlying collateral for the REMICs, received from VN to generate
tranche-level cash flows. These tranche-level cash flows are then passed
back to VN. Fannie Mae began using INTEX when it started modeling REMICs in
1998. Id.
98
("BancWare").(410) The primary benefit of BancWare appears to have been its
ability to run different scenarios more quickly than PDAMS.(411) Management
ultimately discontinued BancWare and sought instead to develop a new modeling
system to replace PDAMS.(412)
PDAMS was ultimately replaced by AIMS in the fourth quarter of
2001.(413) The transition to AIMS appears to have improved the process of
generating amortization factors by consolidating system responsibilities,
modeling all assets in Fannie Mae's "core" and "non-core" books,(414)
incorporating a potentially unlimited number of rate environments, increasing
the stratification of generated cash flows, grouping CPRs by month as opposed to
longer intervals, and explicitly modeling guaranty fee collateral.(415)
- ----------
(409) PDAMS, or the Purchase Discount Amortization Management System, was the
application responsible for the calculation of the constant effective
yields and amortization factors used to amortize the premiums, discounts,
and other deferred price adjustments into income. PDAMS User Documentation,
dated Apr. 7, 1994, FMSE-IR 2833-48. PDAMS was used from 1994 to 2001. Tr.
of Aug. 31, 2004 OFHEO Dep. of J. Juliane at 216:11-218:23.
(410) Mem. from J. Juliane to Distribution, dated Mar. 12, 1999, FMSE-SP 364-67,
at FMSE-SP 364.
(411) Id. at FMSE-SP 364.
(412) Tr. of Aug. 31, 2004 OFHEO Dep. of J. Juliane at 216:11-218:23.
(413) Mem. from J. Juliane and Rene LeRouzes to Distribution, dated Oct. 28,
2001, FMSE 217674-76, at FMSE 217675; Mem. from R. LeRouzes to File, dated
Apr. 9, 2004, FMSE-E 1851058-59, at FMSE-E 1851058.
(414) In the context of FAS 91 amortization, Fannie Mae refers to premium and
discount on whole loans and MBS (excluding REMICs) as well as buy-ups and
buy-downs on guaranty fees as its "core" book and refers to premium and
discount on its REMICs and synthetic REMICs as its "non-core" book.
(415) AIMS Requirements Documentation, dated Dec. 22, 2000, FMSE-E 1166285-300;
Mem. from J. Juliane to File, dated Oct. 9, 2001, FMSE 56578-80, at FMSE
56578. Documents and witnesses indicate that in 2004, management decided to
develop a new amortization system known as MARS (Modeling, Amortization,
and Reporting System). Agenda for AIMS Re-engineering Status Meeting, dated
June 9, 2004, FMSE-E 155732-33. The primary objective of MARS was to
replicate the functionality of AIMS while providing updates for emerging
accounting standards, improving audit, control, and reporting
responsibilities in addition to reducing processing time. See MARS System
Requirements Specifications, dated June 26, 2004, FMSE-E 2128276-302, at
FMSE-E 2128279-80. We understand that the
99
From 1989 until 1996, Rick DePetris, then Director--Financial
Standards, was responsible for the operation of the PDAMS system. In 1997,
Jonathan Boyles replaced DePetris as head of Financial Standards and took over
the responsibilities for PDAMS. In 1999, Leanne G. Spencer, then Senior Vice
President and Controller, transferred the PDAMS responsibility out of Financial
Standards and into the Financial Planning area of the Controller's Office. In
1999, Janet L. Pennewell put Jeffrey Juliane, a Manager in the Controller's
Office, in charge of operating PDAMS. Juliane was responsible for PDAMS and
AIMS, as well as BancWare, until his departure in the summer of 2005.
III. AMORTIZATION SYSTEM
From 1998 until 2003, the Premium and Discount Integration ("PDI")
system was the amortization system that applied amortization factors received
from the modeling systems to original premium and discount in order to calculate
amortization expense or income and post amortization entries to the general
ledger. In 2003, the PDI system was upgraded and the new system is referred to
as the Improved Premium and Discount Integration ("iPDI") system.(416)
To calculate amortization income or expense, iPDI applies the
amortization factors it receives from the modeling system to the original
premium and discount balances reflected in various source systems. iPDI then
generates amortization journal entries that are posted to the general ledger. In
addition, as described above, iPDI also provides original and current
unamortized balances to AIMS for the purpose of calculating the catch-up.
Roger Barnes, who was the Manager of Premium/Discount Amortization,
was responsible for running the PDI and iPDI systems until July 2003.
- ----------
MARS system was never implemented and the project to develop the system was
abandoned. Currently, in connection with its restatement, the Company is
developing a system referred to as the "Amortization Engine" which will
perform premium and discount amortization.
(416) The transition from iPDI to PDI was a system upgrade, not a system
replacement. iPDI maintains the functionality of PDI, while improving the
efficiency of the process.
100
CHAPTER V: ACCOUNT FOR DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES
In this Chapter, we set forth our findings on Fannie Mae's
implementation and application of FAS 133,(417) which governs accounting for
derivative instruments and hedge transactions. Hedge transactions were an
important part of Fannie Mae's portfolio management strategy, and, of the issues
raised by the OFHEO Report, those involving FAS 133 were the most significant in
terms of their impact on the Company's financial statements.
We begin with a summary of our conclusions regarding FAS 133. Then, in
order to place our discussion of the FAS 133 issues into context, we discuss
Fannie Mae's debt portfolio and relevant concepts concerning FAS 133 and hedge
accounting. Finally, we discuss the Company's implementation of FAS 133 and the
objectives that motivated that effort, and our findings.
I. INTRODUCTION
As noted above, hedge transactions were an important part of Fannie
Mae's portfolio management strategy. The Company's outstanding debt grew
tremendously during the 1990s (commensurate with the growth in its portfolio),
and the ability to hedge that debt against interest-rate risk was a substantial
component of the Company's overall risk-management strategy. The Company used
derivatives to hedge the interest-rate risk associated with its debt, and the
notional amount of the Company's derivative portfolio also grew tremendously
during the 1990s and into the 2000s.
FAS 133 was issued in 1998 and required that companies record changes
in the fair value of their derivative portfolio through earnings. Companies
could avoid the earnings volatility associated with FAS 133 by entering into
"effective hedges." FAS 133 refers to this as "special accounting," and the
rules contain explicit guidelines on how to achieve and account for effective
hedges.
Fannie Mae undertook a two-year effort to implement FAS 133 prior to
the standard's effective date on January 1, 2001. There is substantial evidence
that the Company's effort was focused on avoiding the earnings volatility
associated with the implementation of FAS 133 by entering into what the Company
deemed to be "perfect hedges," or perfectly effective hedges.
We are aware that there has been substantial criticism of FAS 133; in
particular, we are aware of the view that FAS 133 injects inappropriate
volatility into earnings. Apparently, some companies took the view, as Fannie
Mae did, that FAS 133 would not be interpreted literally, and that FAS 133 was
open to practical interpretation
- ----------
(417) ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES, Statement of
Fin. Accounting Standards No. 133 (Fin. Accounting Standards Bd. 1998)
(hereinafter "FAS 133").
101
and application based on the principles involved, even if the interpretation or
application deviated from a strict reading of the standard. We are also aware
that, in the wake of the SEC's announcement concerning errors in Fannie Mae's
accounting under FAS 133 in November 2004, other companies have announced
restatements of their own for FAS 133.
However, in our view, Fannie Mae did not engage in innocuous practical
interpretations or modest deviations from a strict reading of the standard. The
Company's implementation of FAS 133 was motivated, not only by a desire to avoid
earnings volatility, but also by a desire to avoid the substantial changes to
the Company's business methods, and/or the development of new and complex
accounting systems, that would have been required to satisfy FAS 133's special
accounting requirements. These considerations led the Company, with the
knowledge of senior managers in the Controller's Office, to adopt an approach to
hedge accounting that relied too heavily on the assumption that its hedges were
"perfectly effective."
The Company's approach deviated from FAS 133 requirements in numerous
and important respects. Indeed, the record of our review shows that the
Company's method of hedge accounting conflicted with clear and specific
provisions of FAS 133. As one example, the Company disregarded amendments to FAS
133 that the FASB had adopted over a year before the standard took effect. The
FASB's amendments were directed specifically to limit the application of hedge
accounting with respect to a type of transaction that Fannie Mae had raised with
the FASB, and which was referred to within the Company as the "Fannie Mae
carve-out." Notwithstanding the amendment, the Company did not change its
approach to hedge accounting for these transactions.
The Company's accountants relied on an assessment that any deviations
from a "strict application" of FAS 133 that were embodied in the Company's
approach to hedge accounting were immaterial. However, the fact that the Company
even undertook such assessments is inconsistent with its blanket assumption that
its hedge transactions were perfectly effective. Moreover, the Company did not
engage in a systematic or comprehensive effort to test the proposition that its
deviations from a strict reading of the standard were immaterial, and the tests
that it did undertake provided little support for its conclusions.
The Company's implementation of FAS 133, however, was undertaken in
consultation with Fannie Mae's outside auditor, KPMG. The record shows that the
Company took steps throughout the FAS 133 implementation process to keep its
outside auditor informed of the important decisions. Management engaged KPMG to
perform a special review of its Derivatives Accounting Guidelines prior to the
effective date of FAS 133 to ensure the principal features of its guidelines
complied with the standard. Statements in KPMG's audit workpapers reveal that
the auditors knew of and accepted the Company's major accounting policies in
this area on the grounds that deviations from GAAP reflected in Fannie Mae's
hedge accounting policies were immaterial.
In addition, there is evidence that the Company's hedge accounting
guidelines were open to and were reviewed by OFHEO in 2001, the year in which
FAS
102
133 took effect. As late as June 2002, when OFHEO issued its reports on Fannie
Mae's first year of operation under FAS 133, OFHEO reported to Congress and the
Company that Fannie Mae's implementation of FAS 133 had a sound footing.
There is evidence that Timothy Howard set the tone for the FAS 133
implementation effort, and the evidence indicates that, from the outset and
throughout the process, he focused the implementation team's efforts on avoiding
the volatility associated with FAS 133 and not changing the Company's business
practices to a significant degree. There is no indication, however, that he
specifically directed anyone to violate GAAP or to take any specific measures in
that direction.
Frank Raines's involvement in the implementation effort was minimal.
Although he was familiar with the Company's interest in avoiding the income
statement volatility and complex systems-development effort associated with
hedge accounting under FAS 133, we see no indication that Raines was aware of
the Company's departure from GAAP.
The Board received assurances on several occasions that the Company's
implementation of FAS 133 was correct. In addition, the Board was aware of, and
relied on, assurance from KPMG and in OFHEO's report described above.
II. BACKGROUND
A. Fannie Mae's Debt Policies and Practices
Fannie Mae finances its mortgage and securities acquisitions in part
by raising funds in the debt market.(418) Fannie Mae issues debt with a variety
of terms and features, including fixed and variable interest rates, call
options, and terms ranging from a few days to ten years or more. According to
Fannie Mae, the most common debt instruments it issues are:(419)
NONCALLABLE BENCHMARK NOTES -- Noncallable benchmark notes are
securities with maturities ranging from two to ten years. Noncallable benchmark
notes are issued on a schedule set at the beginning of each year. This debt may
specify payment of interest at a fixed rate or at a variable rate that resets
periodically.
- ----------
(418) Derivatives Accounting Guidelines, dated Jan. 2001, FMSE-IR 12825-3295, at
FMSE-IR 12873 (hereinafter "DAG").
(419) This information is drawn from Fannie Mae's website. See Fannie Mae,
Understanding Fannie Mae's Debt, at
http://www.fanniemae.com/markets/debt/understanding_fm_debt/funding_
programs.jhtml. It is consistent with other documents we have reviewed.
See, e.g., DAG at FMSE-IR 12874-75
103
CALLABLE BENCHMARK NOTES -- Callable benchmark notes are securities
with characteristics similar to noncallable benchmark notes, with two important
differences. First, they are issued in response to market demands and portfolio
considerations, rather than on a pre-determined schedule. Second, callable
benchmark notes allow Fannie Mae to exercise a call option and pre-pay the debt.
Like noncallable debt, callable debt may have fixed or variable interest rates.
DISCOUNT NOTES/BENCHMARK BILLS -- Discount notes and benchmark bills
are short-term borrowings with maturities ranging from overnight to one year.
Benchmark bills and discount notes with maturities of three and six months are
issued at a weekly auction, while benchmark bills and discount notes with
maturities of one year are issued at a monthly auction. Discount notes of other
maturities are issued through a dealer network.
Often, Fannie Mae will repay maturing discount notes or benchmark
bills using the proceeds from newly issued discount notes or benchmark bills
(referred to herein as "re-issuing" or "rolling over" the maturing discount
notes or benchmark bills). When the Company rolls over its debt in this fashion,
these streams of debt collectively mimic longer-term callable debt having a
variable interest rate.(420)
The amount and characteristics of the debt that Fannie Mae issues are
important elements in the Company's overall commercial strategy. Generally, the
Company's objective is to maintain a spread between the interest it receives
from its mortgage and securities portfolios and the interest it pays on its
debt. The Portfolio Investment Committee sets the Company's debt strategy on a
weekly basis with an eye toward maintaining this spread. The Treasurer's Office
is responsible for the issuance and management of the Company's debt. The
Controller's Office is responsible for debt accounting.
The Company's outstanding debt increased substantially during the
period relevant to our review, commensurate with the increase in the size of the
Company's retained mortgage portfolio. Fannie Mae reported total debt of $123.4
billion at year-end 1990.(421) By 2000, the Company's total debt had more than
quintupled, and it continued to increase thereafter:
- ----------
(420) DAG at FMSE-IR 012874.
(421) OFHEO Report to Congress, dated June 15, 2004, Appendix at 8, available at
http://www.ofheo.gov/media/pdf/finalreport61504.pdf (hereinafter "2004
OFHEO Report to Congress").
104
Outstanding
Total Assets Debt
Period(422) ($ in millions) ($ in millions)
- ----------- --------------- ---------------
2000 675,224 642,682
2001 799,948 763,467
2002 887,515 850,982
2003 1,009,569 961,732
Fannie Mae's use of short-term discount notes, benchmark bills, and
long-term noncallable benchmark notes to finance the acquisition of generally
fixed-rate mortgage assets exposes it to substantial interest-rate risk. As a
general principle, an increase in interest rates will result in an increase in
the interest costs associated with variable rate debt and with the rollover of
discount notes and short-term benchmark bills. Because Fannie Mae's mortgage and
securities portfolios consist primarily of fixed-rate mortgages, the spread
between portfolio income and debt costs will decrease as interest costs increase
and interest revenues remain relatively constant.
A decrease in interest rates also can affect Fannie Mae's spread. As
interest rates decrease, prepayments of mortgages with higher fixed interest
rates usually accelerate. Because higher-yielding mortgages are replaced by
mortgages with lower interest rates, prepayments reduce the spread between the
Company's interest income and fixed debt payments. In addition, interest income
on adjustable-rate mortgages that the Company holds in its portfolio will fall
as those mortgages reprice to the lower rate. The net impact of these
developments, other things being equal, is a decrease in the spread.
B. Derivatives and Hedging
In order to reduce its vulnerability to interest rate fluctuations,
Fannie Mae devotes considerable effort to managing its interest-rate risk. For
present purposes, the most important aspect of the Company's program is its use
of derivatives to hedge the interest-rate risk associated with its debt.(423) A
derivative is an agreement between two parties to exchange a payment based on
one set of variables for a payment based on another set of related variables.
Broadly speaking, Fannie Mae buys derivative
- ----------
(422) Id.
(423) As noted in its 2001 Annual Report, Fannie Mae "typically uses derivative
instruments . . . to hedge against the impact of interest rate movements on
its debt costs to preserve its mortgage-to-debt spreads." Fannie Mae 2001
Annual Report at 64, available at
http://www.fanniemae.com/global/pdf/ir/annualreport/2001/fullreport.pdf.
105
instruments that will offset the impact of interest rate movements on Fannie
Mae's debt obligations and thereby maintain its spread.
As defined in FAS 133, a derivative is a financial instrument that
meets all of the following criteria:
- It has one or more "underlyings" (i.e., a specified index, such
as an interest rate, security or commodity price, or currency)
and one or more notional amounts (i.e., a specified number, such
as currency units, shares, bushels, or other quantity) used to
determine the amount of any payment to be exchanged between the
parties to the contract.
- It requires no (or a nominal) initial net investment.
- Its terms require or permit net settlement, or it can be readily
settled net by a means outside the contract (i.e., by entering
into an offsetting position on an exchange that results in the
party being relieved of its rights and obligations under the
contract), or it requires the delivery of an asset that is
readily convertible to cash.(424)
Most of the derivatives relevant to Fannie Mae's FAS 133 accounting
are: (1) interest-rate swaps (pay-fixed, receive-variable swaps; pay-variable,
receive-fixed swaps; basis swaps; and forward-starting swaps); (2) options on
interest-rate swaps (also known as "swaptions"); and (3) interest-rate caps
(agreements in which payments begin if interest rates cross a certain
threshold).(425) These derivatives counter the changes in either the cash flows
on, or the fair value of, debt that result from changes in interest rates.(426)
Given Fannie Mae's use of derivatives to hedge the interest-rate risk associated
with its debt, the Company's derivative portfolio is dominated by instruments in
which the notional amounts and the underlyings relate to the face amounts and
interest-rate features of Fannie Mae's debt.(427)
In a typical hedge transaction, Fannie Mae will acquire a derivative
(in the following example, a pay-fixed, receive-variable interest-rate swap)
that requires it to make a fixed monthly payment based on the application of a
rate of interest (e.g., six
- ----------
(424) FAS 133 PP 6-9; see also DAG at FMSE-IR 12847.
(425) DAG at FMSE-IR 12876.
(426) Id. at FMSE-IR 12877.
(427) See id. at FMSE-IR 12876. Fannie Mae also maintains a relatively small
portfolio of derivatives that hedge foreign exchange rate risk. We do not
address these derivatives in our report.
106
percent) to a notional amount (e.g., $100 million); in exchange, the
counterparty agrees to make a variable payment based on the application of the
London Inter-Bank Offered Rate ("LIBOR") for a specified term (e.g., three-month
LIBOR) to the same notional amount and designates that interest-rate swap as a
hedge of its variable rate debt. Fannie Mae makes fixed payments on the
derivative and uses the variable payments it receives from the counterparty to
offset payments it is required to make to holders of its variable-rate debt. To
the extent that the interest-rate indices, maturities, repricing dates (dates on
which the variable interest rates reset), and other relevant features of the
debt and the derivative are the same, the payments received from the
counterparty on the derivative would be expected to offset the interest-rate
variability associated with the debt. Economically, Fannie Mae has converted its
variable-rate debt into fixed-rate debt for the term of the swap. Because this
"pay-fixed swap" affects the variability in Fannie Mae's future debt payments on
a dollar for dollar basis, this type of hedge is called a "cash-flow
hedge."(428)
A significant amount of Fannie Mae's derivative portfolio has the
reverse effect: economically converting the Company's fixed-rate debt into
variable-rate obligations. In a "receive-fixed" swap, the Company agrees to make
payments based on the application of a variable interest rate to a notional
amount; the counterparty agrees to pay Fannie Mae an amount based on a fixed
interest rate applied to the same notional amount. To the extent that the debt
and the derivative have appropriately corresponding features, the Company has
hedged against the effect of a decline in interest rates on its net interest
margin. Because a decline in interest rates results in a decline in the fair
value of fixed-rate debt, this type of hedge is referred to as a "fair-value
hedge."(429)
A basis swap involves a derivative that has the effect of converting
the interest rate on a debt instrument from one index to another. For example,
Fannie Mae might enter into cash-flow hedge of a LIBOR-based borrowing by
linking the debt to a pay-fixed swap under which it receives payments based on
LIBOR and makes fixed payments. If Fannie Mae subsequently replaces that
LIBOR-based borrowing with debt indexed to the prime rate, the original
interest-rate swap would not by itself be effective as a hedge against changes
in the variable rate because the debt and the interest-rate swap have different
bases. Accordingly, Fannie Mae might enter into a second interest-rate swap
under which it would receive a payment based on the prime rate and make a
payment based on LIBOR. The Company could then designate the two interest-rate
swaps in combination as a cash-flow hedge of the new prime-rate borrowing.
- ----------
(428) Paragraph 28 of FAS 133 provides: "An entity may designate a derivative
instrument as hedging the exposure to variability in expected future cash
flows that is attributable to a particular risk."
(429) Paragraph 20 of FAS 133 states: "An entity may designate a derivative
instrument as hedging the exposure to changes in the fair value of an asset
or a liability or an identified portion thereof . . . that is attributable
to a particular risk."
107
C. Significant Hedge Transactions
The notional amount of Fannie Mae's derivative portfolio has expanded
tremendously in recent years. In 1990, the total outstanding notional amount of
Fannie Mae's derivative portfolio was just over $6.5 billion.(430) In 1995, that
figure had grown to $128 billion.(431) The growth continued thereafter, and
passed the $1 trillion mark in 2003:
Notional Amount of
Financial Derivatives
Outstanding ($ in
Period(432) millions)
- ----------- ---------------------
1998 187,557
1999 274,970
2000 324,740
2001 533,139
2002 656,595
2003 1,079,088
Fannie Mae enters into a number of different hedging transactions
using derivatives in different combinations and in association with different
types of debt. Over time, Fannie Mae's "menu" of hedge transactions has
increased to approximately seventy different combinations of debt and
derivatives. Five transactions are particularly significant for present
purposes. Although this list is not comprehensive, it is illustrative, and many
of the more complex transactions are combinations of, or variations on, these
basic models.(433)
SWAPS ON MEDIUM- AND LONG-TERM DEBT -- As described above, Fannie Mae
issues medium- and long-term debt. If this is variable-rate debt, Fannie Mae
hedges the variability in its future interest payments by entering into a
pay-fixed swap
- ----------
(430) 2004 OFHEO Report to Congress, Appendix at 16.
(431) Id.
(432) Id.
(433) This list does not include the important concept of "all-in-one hedges"
associated with commitments to purchase or sell mortgages or
mortgage-backed securities. This concept is discussed in Chapter VI, Part C
of our Report, dealing with FAS 149.
108
(i.e., a cash-flow hedge). With respect to fixed-rate debt, Fannie Mae hedges
the changes in the fair value of that debt by entering into a receive-fixed swap
(i.e., a fair-value hedge).
HEDGES OF DISCOUNT NOTE ROLLOVERS -- Fannie Mae hedges the risk of
variability in interest rates associated with the rollover of discount notes. To
the extent that the Company anticipates rolling over discount notes at periodic
intervals, then this program is similar to the issuance of variable-rate debt
with repricing dates at intervals equal to the maturity of the discount notes. A
suitable pay-fixed swap, therefore, operates as a cash-flow hedge against the
variability in interest rates at the rollover dates.(434)
SWAPTIONS -- Fannie Mae has accumulated a significant volume of
swaptions - that is, options to enter into an interest-rate swap at a future
date.(435) The significance of these instruments for present purposes is
associated with their treatment under FAS 133, which made it difficult for a
company to include changes in the time-value component of an option's fair value
in its assessment of the effectiveness of the hedge (discussed below). This
difficulty led most companies to include the change in the time-value element of
an option's fair value in earnings.(436) Fannie Mae lobbied the FASB to change
this aspect of FAS 133 but was not successful. Since 2001, therefore, Fannie Mae
has included in its financial statements two measures of earnings: GAAP
earnings, which includes changes in the fair value of the option's time value,
and "core earnings," which differed from GAAP earnings only in that the changes
in the fair value of the option's time value was excluded, with the amount paid
for the option amortized to earnings on a straight-line basis over the term of
the option.
TERM-OUTS -- Fannie Mae dubs certain transactions "term-outs." A
term-out transaction involves multiple instruments that are intended in the
aggregate to result in a hedging relationship.(437) The following example
illustrates a typical term-out
- ----------
(434) A diagram from the DAG showing a hedged transaction involving the rollover
of discount notes may be found at Tab C of the Appendix to this Report.
(435) DAG at FMSE-IR 12879.
(436) The FASB staff, in Statement 133 Implementation Issue G20, agreed that,
with respect to options meeting certain conditions, changes in the
time-value element of an option's fair value could be deferred on a
company's balance sheet in other comprehensive income prior to exercise of
the option. See ASSESSING AND MEASURING THE EFFECTIVENESS OF A PURCHASED
OPTION USED IN A CASH FLOW HEDGE, Statement 133 Implementation Issue No.
G20 (Fin. Accounting Standards Bd. 2001). Because the majority of Fannie
Mae's swaptions were for use in fair-value hedges, however, the guidance in
Implementation Issue G20 was not of significant help to Company management
in attempting to reduce earnings volatility.
(437) See, e.g., DAG at FMSE-IR 12882.
109
transaction: Fannie Mae issues 90-day discount notes; Fannie Mae anticipates
rolling over the notes for five years, and therefore enters into a five year,
pay-fixed, receive-LIBOR interest-rate swap with a notional amount equal to the
face value of the discount note. The derivative operates as a cash-flow hedge of
the interest-rate risk associated with the rollover of the discount notes. After
two years, however, the Company discontinues the rollover of the discount notes
and instead issues a fixed-rate, two-year note in the same principal amount. The
Company therefore has two pay-fixed obligations: the original pay-fixed swap,
and the new debt. The Company hedges the fair value of the fixed-rate note by
entering into a two-year, pay-LIBOR, receive-fixed interest-rate swap. The
Company then designates the original pay-fixed, receive-LIBOR interest-rate
swap, in combination with the new pay-LIBOR, receive-fixed interest-rate swap,
as a cash-flow hedge of the anticipated issuance of discount notes covering the
remainder of the original interest-rate swap. As the payment provisions on the
derivatives cancel out, the Company's obligation remains fixed.(438)
ANTICIPATORY OR FORECASTED DEBT ISSUANCE -- Fannie Mae developed a
program for hedging its exposure to interest-rate changes that are associated
with debt that the Company expected to issue in the future. Specifically, the
Company sought to mitigate the risk associated with interest-rate changes
between the date on which the Company established its plan to issue the debt
(and determined the expected interest rate on the debt) and the date on which it
actually issued the debt. Depending on the nature of the debt, changes in the
interest rate would affect either Fannie Mae's debt payments in the future or
(if the debt was a discount instrument) the proceeds it would receive on the
debt. To hedge that risk, the Company generally would enter into a cash-settled
"short sale" of a financial asset (such as U.S. Treasury securities).(439)
Changes in the fair value of these short-sale contracts would be expected to
counter any change in the fair value of the anticipated debt issuance as a
result of changes in interest rates.(440)
Hedging activity associated with forecasted or anticipated debt
transactions arose in two different contexts. Fannie Mae's Hedge Desk was
responsible for hedge transactions involving the issuance of large debt
instruments, such as benchmark notes. Fannie Mae's Funding Desk was responsible
for the issuance of discount notes; to the extent that Fannie Mae's strategy
involved hedging the rollover of discount notes, that strategy also involved the
hedging of an anticipated debt issuance.
- ----------
(438) A diagram showing a term-out transaction is included in the Appendix under
Tab C ("Term-Out Transaction #4").
(439) DAG at FMSE-IR 12878.
(440) Such arrangements, however, would not hedge against changes in the credit
component of Fannie Mae's debt costs.
110
III. AN OVERVIEW OF FAS 133
The FASB first considered the development of accounting principles for
derivatives in 1983. Following over a decade of study, the issuance of several
preliminary studies and reports, public hearings, and an exposure draft in 1996,
the FASB issued FAS 133 in June 1998. Under the original provisions of the
standard, the Company would have been required to comply with FAS 133 by January
1, 2000.
The FASB amended FAS 133 twice before its effective date. In FAS 137,
issued in June 1999, the FASB extended the effective date of FAS 133 by one
year, to January 1, 2001, for companies (like Fannie Mae) that reported their
financial results on a calendar-year basis.(441) In FAS 138, issued in June
2000, the FASB made substantive changes to FAS 133 that are discussed
below.(442) In April 2003, following FAS 133's effective date, the FASB issued
FAS 149, which clarified that firm commitments to purchase mortgage loans and
purchase or sell mortgage-backed securities should be treated as derivatives
under FAS 133. FAS 149 is addressed in a separate section of our report.
Prior to FAS 133, the accounting literature covering hedge
transactions was a patchwork. For example, FAS 80 addressed futures contracts
and, by analogy, forward contracts; FAS 52 concerned foreign currency
transactions; AICPA Issues Paper 86-2 dealt with options; and a variety of EITF
consensuses covered interest-rate swaps. For interest-rate swaps, the general
pre-FAS 133 principle was known as "synthetic instrument accounting," under
which an interest-rate swap was linked (for accounting purposes) to a debt
instrument, with the combined arrangement treated as if the debt had the
interest-rate characteristics of the interest-rate swap. For example, a company
with a pay-fixed, receive-variable interest-rate swap designated as a hedge of a
variable-rate debt instrument would account for the arrangement as a fixed-rate
debt instrument. To the extent the interest-rate swap involved in a hedge
relationship qualified for hedge accounting, it was not separately recognized as
an asset or liability on a company's balance sheet, and changes in its fair
value had no direct impact on earnings.
FAS 133 introduced three fundamental principles into accounting for
derivatives. First, under FAS 133, derivatives "represent rights or obligations
that meet the definitions of assets or liabilities and should be reported in the
financial statements."(443) Second, "[f]air value is . . . the only relevant
measure for derivative
- ----------
(441) ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES - DEFERRAL OF
EFFECTIVE DATE OF FASB STATEMENT NO. 133, Statement of Fin. Accounting
Standards No. 137 PP 7-8 (Fin. Standards Accounting Bd. 1999)
(hereinafter "FAS 137").
(442) ACCOUNTING FOR CERTAIN DERIVATIVE INSTRUMENTS AND CERTAIN HEDGING
ACTIVITIES, Statement of Fin. Accounting Standards No. 138 (Fin. Standards
Accounting Bd. 2000) (hereinafter "FAS 138").
(443) FAS 133 P 3(a).
111
instruments," and therefore derivatives "should be measured at fair value, and
adjustments to the carrying amount of hedged items should reflect changes in
their fair value (that is, gains or losses) that are attributable to the risk
being hedged and that arise while the hedge is in effect."(444) Third,
"[s]pecial accounting for items designated as being hedged should be provided
only for qualifying items."(445)
In sum, in the absence of a hedge relationship, changes in fair value
of a derivative should be recognized in income. Indeed, FAS 133 can be seen as a
relatively brief statement requiring that changes in the fair value of
derivatives be reflected in earnings, followed by a detailed set of requirements
for limiting the impact of that principle by means of hedge accounting, with the
caveat that hedge accounting is "special accounting" that may be used only in
specified circumstances.
Given this new standard, hedge accounting acquired even greater
importance for Fannie Mae and other public companies with large derivative
portfolios. The FAS 133 requirement that derivatives be recorded at their fair
value as assets or liabilities, and that changes in fair value be recognized in
earnings to the extent they are not linked in a completely effective hedge, had
the potential to inject tremendous volatility into a company's financial
statements. Fannie Mae was a vocal adherent of the popular view that this
volatility was artificial and could be misleading to investors. During the
months leading up to FAS 133's effective date, business journals and periodicals
carried articles critical of FAS 133's treatment of derivatives; the articles
highlighted the standard's complexity and its implications for injecting
volatility into financial reporting.(446) Despite this criticism, FAS 133 took
effect on January 1, 2001.
1. Requirements for Hedge Accounting
Under FAS 133, "[o]ne aspect of qualification [for hedge accounting]
should be an assessment of effective offsetting changes in fair values or cash
flows during
- ----------
(444) Id. P 3(b).
(445) Id. P 3(d).
(446) See, e.g., Simon Boughey, U.S. Issuers in Euromarket Are Snakebit by FAS
133, INVESTMENT DEALERS DIGEST, Feb. 22, 1999, at 13 ("Although it's too
soon to tell exactly how FASB will interpret the new rules, it is already
clear that FAS 133 is a major headache for American issuers in the
international debt markets, and that some companies would rather pay
greater funding costs than face balance sheet and income volatilities.");
Paula Froelich, U.S. Companies Find New Accounting Rule Costly,
Inefficient, DOW JONES NEWS SERVICE, Mar. 2, 1999 ("[A] lot of clients have
been grumbling about the increased volatility - which could have
increasingly negative consequences for the industry."); Joe Niedzielski,
Firms Alter Derivatives Use As Rule Change Looms, WALL STREET JOURNAL
EUROPE, Nov. 30, 2000, at 20 ("Some big U.S. corporations are altering
their use of derivatives in the run-up to a new accounting rule that goes
on the books next year.").
112
the term of the hedge for the risk being hedged."(447) The concept of
"effectiveness," therefore, is critical to an understanding of hedge accounting
and Fannie Mae's application of the standard. "Effectiveness" for these purposes
means the extent to which changes in the fair value (or cash flows) associated
with a derivative offset the changes in the fair value (or cash flows)
associated with the hedged item (e.g., a debt instrument). If the offset is
complete, then the hedge transaction is completely effective, and the derivative
and hedged item can be said to form a "perfect hedge." The extent to which the
changes in the fair value (or cash flows) of the derivative do not offset the
changes in the fair value (or cash flows) of the hedged item is referred to as
the "ineffectiveness" of the hedge.
With this concept in mind, FAS 133 established criteria that must be
satisfied to be eligible for the "special accounting" exception for qualifying
hedge transactions. The rules regarding fair value and cash-flow hedges differ
slightly, but in each case three elements are of particular importance:
DOCUMENTATION -- At the inception of the hedge, a company must
document the hedge relationship. The documentation must identify "the entity's
risk management objective and strategy for undertaking the hedge, including the
identification of the hedging instrument, the hedged item, the nature of the
risk being hedged, and how the hedging instrument's effectiveness in offsetting
the exposure to changes in the hedged item's fair value [or, in the case of a
cash flow hedge, variability in cash flows] attributable to the hedged risk will
be assessed."(448) It is generally understood that the documentation may be in
any form (that is, electronic or paper media), and need not be in one location,
so long as it is generated contemporaneously at the inception of the hedge
relationship and includes all of the necessary elements.(449)
ASSESSMENT OF EFFECTIVENESS -- Both at the inception of the hedge and
on an ongoing basis, the hedging relationship must be determined to be "highly
effective" in offsetting changes in the fair value (or cash flows) of the hedged
instrument. The periodic assessments are required "whenever financial statements
or earnings are
- ----------
(447) Id. (emphasis added).
(448) Id. PP 20 (fair-value hedge), 28 (cash-flow hedge).
(449) Other accounting literature elaborates on this requirement. DOCUMENTATION
OF THE METHOD USED TO MEASURE HEDGE INEFFECTIVENESS UNDER FASB STATEMENT
NO. 133, EITF Topic No. D-102 (Fin. Accounting Standards Bd. Nov. 14-15,
2001), lists five elements that a company must include in its hedge
documentation: (1) The hedging instrument; (2) the hedged item or
transaction; (3) the nature of the risk being hedged; (4) the method that
will be used to assess retrospectively and prospectively the hedging
instrument's effectiveness; and (5) the method that will be used to measure
hedge ineffectiveness.
113
reported, and at least every three months."(450) FAS 133 does not define "highly
effective," but acknowledges that the "highly effective" requirement is
satisfied if the similar, pre-FAS 133 "high correlation" requirement hedge
accounting was met.(451) Under this principle, a hedge is "highly effective"
when changes in the fair value (or cash flows) of the derivative and the fair
value (or cash flows) of the hedged instrument offset within a range of 80 to
125 percent.
MEASUREMENT AND RECOGNITION OF INEFFECTIVENESS -- As noted above, the
documentation required at the inception of a hedge relationship must include the
methodology by which the effectiveness of the hedge will be measured. The
methodology specified at the outset of the hedge must be used for the duration
of the hedge to determine whether the hedge relationship remains highly
effective prospectively, and to measure any ineffectiveness associated with the
hedge retrospectively. If the entity establishing a hedge relationship
identifies an improved method for assessing or measuring effectiveness and wants
to apply that method in the future, then it must discontinue the existing hedge
relationship and designate a new relationship with new documentation.(452)
Additional rules apply to accounting for anticipatory or forecasted
transactions. Two rules of particular importance to these kinds of transactions
are that the forecasted transaction be probable of occurring and that the
documentation identify the hedged transaction with sufficient specificity so it
is readily apparent when the hedged transaction has occurred.(453)
2. Accounting for Ineffectiveness
As noted above, FAS 133 requires documentation at the outset of a
hedge relationship that includes identification of (1) the method that will be
used to assess that the hedge remains highly effective, and (2) the method that
will be used to measure any ineffectiveness in the hedge transaction. Hedge
accounting under FAS 133 is permitted only to the extent of the hedge's
effectiveness. Ineffectiveness (measured as the excess of the cumulative change
in the fair value of the derivative over the cumulative change in the fair value
of the hedged item) is reflected in earnings.
The accounting for the effective portion of a hedge depends on the
type of hedge involved. In a fair-value hedge, the changes in the fair value of
the derivative and the hedged item are both recognized in income: to the extent
the hedge is perfectly effective, the changes in the fair values of the
derivative and the hedged item will offset
- ----------
(450) FAS 133 P 20(b).
(451) Id. P 389.
(452) Id. P 62.
(453) Id. PP 29(b), 28(a)(2).
114
each other. Any ineffectiveness in the hedge - that is, the extent to which the
changes in fair values do not offset each other - will result in an increase or
decrease in reported income for the relevant period.
In a cash-flow hedge, the accounting involves a deferral of changes in
the fair value of the derivative for the effective portion of the hedge. To the
extent that the hedge is effective, the change in the fair value of the
derivative is recognized as a component of other comprehensive income ("OCI").
As with hedge accounting for fair-value hedges, any ineffectiveness is reported
in earnings.
The process of assessing the effectiveness of a hedge relationship,
measuring the ineffectiveness of a hedge transaction, and recognizing any
ineffectiveness in income is referred to popularly (but not in the text of FAS
133 itself) as the "long-haul" method of hedge accounting. To the extent that
long-haul accounting results in either (1) disqualification of hedge
transactions for further hedge accounting because they no longer satisfy the
"highly effective" test, or (2) ineffectiveness, regardless of whether hedge
accounting continues, then it will inject volatility into a company's income
statements from accounting period to accounting period. This volatility can be
eliminated entirely only if proper analysis supports the conclusion that the
transactions are perfect hedges. It is widely acknowledged that the long-haul
method of hedge accounting is cumbersome and complex.
FAS 133 permits two alternatives to the long-haul method that may be
used to account for certain types of hedge transactions, and these alternatives
can simplify the accounting for these transactions. These methods permit an
assumption that, in one case, a hedge will be highly effective at the outset
(but subject to periodic re-assessment), and in the other case, that a hedge
will be perfectly effective throughout its life. These two methods thus permit a
company to avoid both the burden and complexity of long-haul accounting and the
income-statement volatility associated with the recognition of ineffectiveness.
The first alternative is referred to popularly as the "matched-terms
method" of hedge accounting, although once again this term does not appear in
the text of FAS 133 itself. This method, described in paragraph 65 of the
standard, is based on the recognition that "[w]hether a hedge relationship
qualifies as highly effective sometimes will be easy to assess, and there will
be no ineffectiveness to recognize in earnings during the term of the
hedge."(454) The matched-terms method is permitted when "the critical terms of
the hedging instrument and of the entire hedged asset or liability . . . or
hedged forecasted transaction are the same"; in that circumstance, the Company
"could conclude that changes in fair value or cash flows attributable to the
risk being hedged are expected to completely offset at inception and on an
ongoing basis."(455) As an example of a transaction that would qualify for this
matched-terms approach, FAS 133 describes
- ----------
(454) Id. P 65.
(455) Id. (emphasis added).
115
a hedge of a forecasted purchase of a commodity forward purchase contract that
is for the same quantity of the same commodity as the forecasted purchase and
that has a fair value of zero at inception.
FAS 133 does not define "critical terms" for purposes of implementing
the matched-terms method of hedge accounting. It does state, however, that
ineffectiveness will result from differences between the derivative and the
hedged item in such terms as notional amounts, maturities, quantity, location,
or delivery dates.(456) The language of the standard leaves no doubt that this
list was intended to be exemplary of a larger set of possible critical terms and
was not meant to be all-inclusive. To the extent that the terms of a derivative
and a hedged item are not "the same," the transaction does not qualify for
matched-terms accounting.
The matched-terms method is based on the recognition that
ineffectiveness is likely to be minimal or nonexistent when the terms of a
derivative and a hedged item are "the same." That observation, however, does not
excuse the entity from the hedge documentation requirements described above or
from monitoring the hedge relationship for ineffectiveness on a periodic basis.
The standard requires, for example, that an entity assess on at least a
quarterly basis that there has been no change to the criteria on which the
initial matched-terms assessment was made; that is, the entity must "continue to
assess whether the hedge meets the effectiveness test and also would measure any
ineffectiveness during the hedge period."(457) If at any time the terms of the
instruments in the hedge relationship are no longer "the same," then the
matched-terms method no longer applies. Further, even if a company employs the
matched-terms method, it still is required to specify in its documentation at
the outset of the hedge how it will measure the ineffectiveness in a hedge
transaction, should that be necessary.(458)
The second alternative to long-haul accounting is known popularly as
the "shortcut" method. This exception, described in paragraph 68 of FAS 133,
applies only to hedge transactions involving interest-rate swaps and recognized
assets or liabilities (that is, it applies only to hedges of existing
instruments, and not to hedges of anticipated or forecasted debt issuances). To
qualify for the shortcut method, among other criteria, the notional amount of
the swap must "match" the principal amount of the hedged item, the expiration
date of the swap must "match" the maturity date of the hedged item (for
fair-value hedges), and the repricing dates on the interest-rate swap and the
hedged asset or liability must "match" (for cash-flow hedges). FAS 133
Implementation Issue E4 confirms that the word "match" for purposes of the
shortcut method means "exactly the
- ----------
(456) Id. P 66.
(457) Id. P 67.
(458) Id. PP 28, 30, 67; see also CASH FLOW HEDGES: MEASURING THE
INEFFECTIVENESS OF A CASH FLOW HEDGE UNDER PARAGRAPH 30(B) WHEN THE
SHORTCUT METHOD IS NOT APPLIED, Statement 133 Implementation Issue No. G7
(Fin. Accounting Standards Bd. May 17, 2000) (revised July 11, 2000).
116
same."(459) If all of the requirements of the shortcut method are satisfied,
then the entity is not required to assess effectiveness or measure
ineffectiveness during the life of the hedge transaction.(460) Like the
matched-terms approach, the shortcut method does not affect the requirement that
the entity prepare appropriate documentation at the outset of the hedge.
Both the matched-terms method and the shortcut method are available
only when the fair value of the derivative is zero at the outset of the hedge
relationship. This concept is important with respect to term-outs because the
hedge transaction involves an existing derivative that is unlikely to have a
fair value equal to zero at the inception of that hedge relationship. The
concept is also important for derivatives that hedge callable debt: after debt
is called, a derivative may be re-linked in another hedge transaction, but its
fair value would not be expected to be equal to zero.
3. Term-Out Transactions and the "Fannie Mae Carve-Out"
FAS 133 includes a number of examples that illustrate the proper
application of hedge accounting principles. One example relates directly to
Fannie Mae's term-out transactions. In fact, this example was included in FAS
133 in response to Fannie Mae's comment letter on the standard's exposure
draft.(461) The example, therefore, has been referred to within Fannie Mae as
"the Fannie Mae carve-out."
The Fannie Mae term-out transactions are addressed in Example 8,
"Changes in a Cash Flow Hedge of Forecasted Interest Payments with an Interest
Rate Swap."(462) In the example, derived from a Fannie Mae term-out transaction
similar to that described above, the hypothetical entity links the rollover of
discount notes to a pay-fixed, receive-variable swap. Both the discount notes
and the variable leg of the swap are set at LIBOR. The dates on which the
interest rates are established for the variable leg of the swap and for the
discount notes (the repricing dates) are the same. The example concludes that
the entity may assume that there will be no ineffectiveness in this first hedge
relationship.
At the end of the second year, the entity discontinues its discount
note program and "terms out" the rollover of discount notes by issuing a
three-year, $5 million
- ----------
(459) APPLICATION OF THE SHORTCUT METHOD, Statement 133 Implementation Issue No.
E4 (Fin. Accounting Standards Bd. 1999) (revised 2003).
(460) These descriptions provide a general overview of the recognized hedge
accounting methodologies. Both the matched-terms and shortcut methodology
have other requirements that are discussed below.
(461) Letter from Sam. Rajappa to Director of Research and Technical Activities,
Fin. Accounting Standards Bd., dated Oct. 6, 1997, FMSE-IR 217015-26.
(462) FAS 133 PP 153-161.
117
debt instrument with interest payable every ninety days at the prime interest
rate. The entity is no longer entitled to assume no ineffectiveness because the
interest rate indices of the derivative and the debt instrument differ. The
entity then enters into a basis swap with a $5 million notional amount and a
three-year term, in which it pays LIBOR and receives interest payments at the
prime rate. The entity documents a new hedging relationship, designating the two
swaps in combination as hedging payments on the newly-issued debt. According to
FAS 133, this transaction qualifies for hedge accounting: "Together, the cash
flow from the two derivatives are effective at offsetting changes in the
interest payments on the three-year note."(463)
As initially released in 1998, FAS 133 also stated that this
transaction qualified for the shortcut method of hedge accounting. However, the
FASB deleted that sentence when it issued FAS 138. In its explanation for this
change, the FASB stated that "the hedging instrument in Example 8 does not meet
the criterion in paragraph 68(b) to qualify for the shortcut method. The hedging
instrument does not have a fair value of zero at the inception of the hedge
relationship."(464) The implication of this amendment is that the transaction
would not qualify for matched-terms accounting either, as that method also
requires that the instruments in the hedge relationship have a fair value equal
to zero at the outset. Because the linked instruments would be effective at
offsetting interest payments, the transaction would qualify for hedge
accounting, but only under the long-haul method.
IV. FINDINGS REGARDING FANNIE MAE'S IMPLEMENTATION OF FAS 133
During the years 1998 through 2000, Fannie Mae devoted considerable
time and resources to the analysis of FAS 133 and to the formulation of policies
and systems to implement the standard. Ultimately, the undertaking involved
personnel from Financial Standards and Financial Reporting within the
Controller's Office, as well as representatives of the Treasurer's Office,
Portfolio, and others.
The implementation activities did not end on the January 1, 2001
effective date, and Fannie Mae addressed a number of accounting and operational
issues in 2002 and 2003 (separate from the implementation of FAS 149 in 2003).
In 2003, for example, the Company considered a substantial overhaul of its
derivative accounting systems, with the ultimate objective of developing the
capability to account for hedge transactions under the long-haul method. That
effort, however, was postponed with the commencement of OFHEO's Special
Examination.
The substantial record that we have developed of the Company's FAS 133
efforts leads to several significant conclusions regarding Fannie Mae's
implementation of FAS 133. The objective, or at least a principal focus, of the
FAS 133 implementation
- ----------
(463) Id. P 161.
(464) FAS 138 P 38.
118
project was to treat Fannie Mae's hedge transactions as "perfect hedges," and
thereby to utilize the shortcut method of hedge accounting so as to avoid both
the volatility in earnings that would result from the recognition of
ineffectiveness and the need to implement complex changes either to the
Company's business model and its accounting and financial reporting systems. In
order to achieve this result, the Company adopted policies that deviated from
the requirements of FAS 133. These policies were established with the knowledge
and, in some cases, active involvement of Howard, Leanne Spencer, Jonathan
Boyles, and others.
A. The Three Tenets
As discussed in more detail below, Boyles would recount in 2003 that
Fannie Mae's implementation of FAS 133 had been driven by three tenets: avoiding
earnings volatility; leveraging existing accounting systems; and ensuring that
Fannie Mae's operating earnings were simple and understandable. (465) While
these objectives were not per se extraordinary, and almost certainly were shared
by other companies with substantial derivative portfolios, we believe the
Company took excessive measures to achieve them. In this section, we discuss the
development of these tenets, particularly the first.
Because Fannie Mae tracked FASB activities routinely, the Company was
aware of FAS 133 in concept at least as early as 1996. In 1997, Fannie Mae sent
a letter to the FASB commenting on certain aspects of the FASB's approach to
hedge accounting,(466) and in 1999 sent another letter requesting an extension
of the effective date of January 1, 2000.(467) In requesting the extension,
Fannie Mae cited the complexity of the accounting changes FAS 133 would require
and the fact that the effective date would require implementation of new hedge
accounting systems at the same time that companies were addressing Y2K
issues.(468) Fannie Mae's submission was one of many that the FASB received
raising similar concerns.
The effort to implement FAS 133 began soon after the FASB's release of
the final standard in June 1998. Initially, in mid-1998, a small group of
individuals, including individuals from the Controller's Office and the
Treasurer's Office, participated in an off-site meeting to study the standard
and develop an initial understanding of how it would affect Fannie Mae's
transactions, accounting, and
- ----------
(465) Mem. from Boyles to Distribution, dated Mar. 2, 2003, FMSE 78540-42
(hereinafter "Boyles March 2003 Memo").
(466) Letter from S. Rajappa to Director of Research and Technical Activities,
Fin. Accounting Standards Bd., dated Oct. 6, 1997, FMSE-IR 217015-26.
(467) Letter from Timothy Howard to Edmund Jenkins, dated Apr. 12, 1999, FMSE-IR
193011-13.
(468) Id. at FMSE-IR 193012.
119
systems. The process has been described as an exchange in which Treasurer's
Office personnel explained the Company's debt and hedge transactions to the
accountants, and the accountants considered the application and implications of
FAS 133 to those transactions.
Boyles described the off-site meetings in a draft memorandum he
prepared early in the process.(469) After describing the meeting, Boyles
explained the benefits that the Company would enjoy if its hedge transactions
qualified as "perfect hedges":
The final standard includes language regarding the concept of a
`perfect hedge' that we believe will prove beneficial in the adoption
of the standard with a minimum of core accounting system changes. If
Fannie Mae's derivative transactions can qualify under the `perfect
hedge' criteria, then we should be able to maintain our current
`accrual accounting' systems and there would be little impact on our
income statement. In instances where we do not qualify for `perfect
hedge' accounting treatment there would be some income volatility in
earnings from the new standard. The basic premise I am using to
evaluate the standard's impact on Fannie Mae is the effect on
income.(470)
Boyles then reported that Fannie Mae uses "several `term-out' transactions that
don't fit neatly into the carve-out the FASB gave us back in December
1997."(471) On this issue, Boyles proposed returning to the FASB for more
guidance or altering Fannie Mae's term-out transactions to match the guidance in
FAS 133 more closely.(472) Boyles also noted concerns about the treatment of
anticipated debt issuances and reported that FAS 133 "could have a significant
effect on earnings, particularly in periods where spreads are volatile."(473)
Boyles concluded, among other things, that "[w]e anticipate a major systems
effort to strengthen the controls associated with this standard so that we meet
the necessary criteria to apply the `perfect hedge' rules for our derivative
instruments."(474)
- ----------
(469) Mem. from Boyles to Rajappa, Linda Knight, Leanne Spencer, Mary Lewers,
Mehmood Nathani, Donald Sinclair, and KPMG, et al., dated Sept. 14, 1998,
FMSE-IR 217361-64.
(470) Id. at FMSE-IR 217361.
(471) Id.
(472) See id. at FMSE-IR 217363.
(473) Id.
(474) Id. at FMSE-IR 212364.
120
These early efforts to address FAS 133 were discussed at a meeting
with Howard in early December 1998, as reflected in a December 4, 1998
memorandum and associated talking points prepared by Spencer.(475) According to
the talking points, Spencer's main objectives at the meeting were:
- To provide Howard with a tutorial on basic FAS 133 concepts;
- To describe for Howard the work completed up to that time;
- To explain that the Company had identified certain transactions
that would not qualify for the "perfect hedge" exception; that
the term-out transactions "are the culprit" in this respect; and
that "we either must adjust our funding on the transactions or
get out prior to implementation in order to eliminate earnings
volatility";
- To explain further that, with respect to anticipated debt
issuances, the "inefficient [ineffective] portion of the hedge
will run through current earnings," which will "result in much
more earnings volatility";
- To describe for Howard the implementation group's work plan,
which included a general description of systems development
efforts, along with a detailed project plan to be completed by
January 31, 1999.(476)
In describing the work completed up to that time, the talking points
noted that:
- The working group had "developed a working draft describing all
affected transactions and what the accounting should be";
- The Company had met with KPMG and had described each transaction
and what the proposed accounting would be; and
- "The key tenet we are working towards is that we want to fit all
of our transactions into the FASB's `perfect hedge'
exception."(477)
Spencer's memorandum documenting this meeting describes Howard's
reactions on these points and his instructions for going forward. According to
Spencer,
- ----------
(475) Mem. from L. Spencer to T. Howard, et al., dated Dec. 4, 1998, FMSE-IR
192988-992.
(476) See id. at FMSE-IR 192991-92.
(477) Id. at FMSE-IR 192990.
121
Howard's "first point was that we have not stopped doing some of the
transactions for which we have not found an accounting solution that would keep
the income statement neutral."(478) Howard also observed that "the new standard
will affect so many different aspects of our business" and that Spencer should
"make sure [she] got other departments involved in the implementation
group."(479) A separate set of talking points, which Spencer appears to have
used for her briefing to her colleagues following the meeting with Howard,
refers to Howard's "vision that all departments should be working together and
that all will be held responsible for ensuring that we adopt the standard."(480)
Based on these principles, in 1999 and 2000 the Company engaged in an
extensive and systematic effort to implement FAS 133. The inter-departmental
working group assigned to the project (per Howard's instructions) considered a
number of technical issues, reported periodically to senior management (at the
senior vice president level, including Spencer and Knight, the Company's
Treasurer), and consulted with Howard (albeit less frequently).
A common thread that runs throughout this work, as during the planning
meetings in 1998, is the objective to avoid, or at least limit, earnings
volatility by fitting all of Fannie Mae's hedge transactions into the "perfect
hedge" category. For example, notes handwritten on stationery from a Fannie Mae
officers' meeting held on December 8-11, 1998, state, under the heading "FAS
133," "`Perfect hedge' is the goal for FNM accounting."(481) An outline
describing the Company's implementation effort prepared in 1999 by Kimberly
Stone,(482) one of the principal participants involved in the implementation
effort, stresses the involvement of senior officers in the project and states
that "one of our main goals is to implement this very complex standard and to
continue our robust hedging program but at the same time minimize our earnings
and equity volatility."(483)
- ----------
(478) Id. at FMSE-IR 192989.
(479) Id.
(480) Undated Leanne Talking Points, FMSE-IR 193003.
(481) Undated handwritten notes, FMSE-SP 70111. No one we had the opportunity to
interview recognized the document or recalled the meeting, and it is
possible that the document was prepared at a later date. A document with
similar handwriting is signed "Tim," raising at least the possibility that
the document was prepared by Howard.
(482) Kimberly Stone is referred to in some documents as Kimberly Rawls, her
maiden name.
(483) Undated outline, FMSE-SP 84562-66, at FMSE-SP 84566.
122
The team involved in the FAS 133 implementation effort regularly
briefed senior executives. A recurring topic at these meetings was earnings
volatility. A topic on the agenda at the June 23, 1999 meeting, for example, was
"Ownership of Volatility."(484) An "Update on FAS 133 Project," dated July 1,
2000, lists under "Critical Next Steps": "Determine threshold for earnings and
equity volatility (As Soon As Possible)."(485) At the July 26, 2000 meeting, the
discussion concerned the education of investors and others on FAS 133's impact;
a handwritten note by that agenda items reads: "Tim thinks we could explain $30
mm per qtr of earnings volatility."(486)
In an e-mail dated July 21, 2000, Mehmood Nathani, a participant in
the FAS 133 efforts from the Treasurer's Office, reported that he and others had
met with Howard to discuss the FAS 133 implementation. Nathani announced:
We will continue to explore delta hedging as a potentially important
way to reduce FAS 133 related earnings volatility. Tim is more
interested in Delta Hedging now because of the market's adverse and
unreasonable reaction to our latest earnings release. He can no longer
feel even somewhat assured that the analysts and external folks will
not misinterpret FAS 133's impact when we go live. Therefore,
reduction of earnings volatility is still our numero uno
objective.(487)
- ----------
(484) Agenda, dated June 23, 1999, FMSE-SP 70416.
(485) Update on FAS 133 Project, dated July 1, 2000, FMSE 436304.
(486) Agenda, dated July 26, 2000, FMSE 86508.
(487) E-mail from M. Nathani to Nadine Bates, dated July 21, 2000, FMSE 436303.
It appears from the e-mail that the other attendees included Knight,
Spencer, and Boyles. Nathani's reference to "the market's adverse and
unreasonable reaction" appears to refer to the decrease in the Company's
stock price in mid-2000. An earnings release dated July 13, 2000, just
eight days before Nathani's e-mail, included the following statement:
"Howard also said that the Company had a $46.3 million reduction in fee and
other income, net compared with the first quarter, resulting largely from
the recognition of a loss on a Benchmark Note hedge early in the second
quarter. Howard noted that the dislocation in the agency debt markets that
caused the hedge to go out of correlation and triggered immediate
recognition of the loss also presented opportunities to repurchase debt on
highly attractive terms. Such debt repurchases led to an extraordinary gain
of $50.3 million ($32.7 million after tax) in the second quarter." Fannie
Mae press release, dated July 13, 2000, Zantaz document 3785175, at 2.
123
Nathani concluded: "Separately, I believe we need to examine all possible ways
to reducing [sic] earnings volatility."(488)
During the implementation process, Fannie Mae adopted a procedure for
the approval of transactions that would not meet the Company's "perfect hedge"
guidelines. Any transaction that would not qualify as a "perfect hedge" required
the approval of three Company Senior Vice Presidents: the Treasurer; the Senior
Vice President--Portfolio Strategy; and the Senior Vice President--Portfolio
Management. The signatures acknowledged the officers' "acceptance of
accountability for earnings volatility" associated with long-haul
accounting.(489) Several interviewees explained that the concern underlying the
form was not the earnings volatility per se, but the burdens associated with
long-haul calculations. The language of the form does not comport with that
explanation, and a memorandum accompanying a similar form (relating to
transactions that would not qualify for hedge accounting at all) explains that
the approving official "must assume responsibility for any changes in the market
value that will flow through earnings."(490) In any event, the proposition that
senior officers had to acknowledge, and take responsibility for, the burdens
associated with a transaction that did not meet the Company's "perfect hedge"
criteria reflects Fannie Mae's overall approach to implementation of the
standard, i.e., that Fannie Mae sought to avoid transactions that, in its view,
required any assessment or recognition of ineffectiveness.
On September 5, 2000, the team responsible for the implementation of
FAS 133 made a presentation to the Office of the Chairman.(491) After a brief
overview of FAS 133's basic principles, the presentation focused on "business
options under FAS 133." This topic included several possible actions to address
the earnings volatility associated with FAS 133, such as reducing the Company's
use of derivatives, explaining earnings volatility to investors and Wall Street
analysts, or using different portfolio strategies to minimize volatility.(492)
Under the heading "Challenges Presented by FAS 133," the presentation raises
five points: (1) the time value of options would be marked to fair value through
earnings; (2) significant volatility in earnings would result from the large
volume of cash-flow hedges in the Company's portfolio; (3) any hedge
ineffectiveness would be recorded to earnings; (4) some cash-flow hedges still
would not
- ----------
(488) E-mail from M. Nathani to N. Bates, dated July 21, 2000, FMSE 436303.
(489) Derivatives Accounting Guidelines, Dec. 2003, FMSE 112657-113142, at FMSE
112936.
(490) Mem. from J. Boyles to Distribution, dated June 21, 2001, FMSE 79004.
(491) See FAS 133 Briefing, dated Sept. 5, 2000, FMSE-IR 195328-46.
(492) Id. It appears that, by this time, the Company recognized that FAS 133
would result in some volatility in earnings as a consequence of the
Company's inability to include changes in the time value of options in
measuring and assessing the effectiveness of a hedge relationship.
124
qualify for hedge accounting; and (5) there would be a large, one-time earnings
impact in the first quarter of 2001 due to the change in accounting
principle.(493)
According to a report on this meeting that Stone distributed two days
later, the proposals offered at the meeting to address the volatility issue were
not well-received. "It appears that a number of the strategies that we were
pursuing did not sit will with the executives (i.e., large AFS portfolio, large
swings in equity and political risk, breaking out operating versus other
earnings, etc.)."(494) Ultimately, Fannie Mae adopted the two-pronged approach
to its financial reporting mentioned in Stone's report. Beginning in 2001,
Fannie Mae reported GAAP earnings based on its application of FAS 133 and a
separate earnings measure called "core earnings," which was the GAAP earnings
measure adjusted to eliminate the impact of the change in the time value of
purchased options and include amortization of the cost of the purchased options.
Although analysts accepted Fannie Mae's alternative reporting approach and
discounted swings in earnings that resulted from FAS 133, it is noteworthy, for
reasons discussed below, that as late as September 2000 senior management was
concerned that this approach would not be well-received.
The Company's ability to adopt FAS 133 with minimal interference to
the Company's business operations or impact on earnings was important to
individual employees involved in the process. Several documents - including a
summary, prepared by Stone with Boyles's assistance, of the process by which
Fannie Mae implemented FAS 133 - note that the implementation was incorporated
into the personal bonus plans of the Fannie Mae executives. In October 2000,
several senior executives involved in the FAS 133 project - including Knight and
Spencer - nominated a number of the other individuals involved in the FAS 133
implementation effort for a special Chairman's Award. The executives stated:
"Never before has the adoption of a new accounting standard had such a
significant impact on Fannie Mae's business practices. Had it not been for the
hard work and ingenuity of this team, FAS 133 would have created billions of
dollars in annual earnings volatility. As a result of their extraordinary
efforts, Fannie Mae is now in a position to adopt FAS 133 on January 1, 2001
with a significantly reduced impact to its bottom line."(495)
The major goals in the implementation effort were summarized in a 2003
retrospective that Boyles prepared as part of a more general review of the
Company's hedge strategies. In the course of (or in anticipation of) that
review, Boyles wrote a draft
- ----------
(493) See id. at FMSE-IR 195335.
(494) E-mail from K. Stone to M. Nathani, dated Sept. 7, 2000, FMSE 436284.
Interviewees differed on their interpretation of "political risk," although
the predominant view was that the swings in Fannie Mae's reported equity
from period to period would draw unwelcome attention to, and possibly
misinterpretation of, Fannie Mae's financial statements by the Company's
critics in Congress.
(495) Undated Chairman's Award Nomination Form, FMSE-SP 89437.
125
memorandum in which he described the Company's implementation of FAS 133. He
explained that the implementation effort was guided by the three "tenets"
mentioned previously: (1) "Earnings volatility was to be minimized and if there
were earnings volatility it should be as predictable as possible"; (2) "We were
to leverage off existing systems as much as possible"; and (3) "Operating
earnings needed to be simple and easily understood."(496) Boyles explained that
the Company "minimize[d] the potential for earnings volatility" by "divest[ing]
itself of any derivative that either did not qualify for the `short-cut' method
or was not in a hedging relationship where we could assume no
ineffectiveness."(497) Further, this principle "was deemed to be very important
because by adopting this policy we were able to maintain our existing systems
for accruing interest income and interest expense."(498)
Boyles noted that "[t]he cornerstone of [the] system was that only
transactions where there would be no ineffectiveness would flow into the system.
This decision was key because the most important piece of the systems
implementation effort was that we would continue to use our existing systems to
record interest income and expense."(499) Remarking that the Company already had
controls in place with regard to the recording of interest income and expense,
he stated: "Had we allowed for ineffectiveness to be included in income/expense
we would have severely complicated the implementation effort and the month end
close of our financial records."(500)
Although it is not clear that Boyles ever completed or distributed his
memorandum, the salient points were incorporated into a presentation to the
Office of the Chair in May 2003.(501) One of the slides included in the
presentation materials repeats the three goals that the Company followed when it
implemented FAS 133: "Minimize earnings volatility"; "Leverage existing
systems"; "Keep operating earnings simple."(502) According to the presentation,
one of the issues on the table for discussion was "Could we design effective
hedge strategies that would deliver stable and predictable performance and would
allow us to move to a GAAP only presentation?"(503)
- ----------
(496) Boyles March 2003 Memo at FMSE 78540.
(497) Id.
(498) Id.
(499) Id.
(500) Id. at FMSE 78541
(501) See Examining Our Hedging Strategies - Post FAS 133, A Progress Report,
dated May 9, 2003, FMSE 27242-65.
(502) Id. at FMSE 27243.
(503) Id. at FMSE 27244.
126
Boyles's 2003 memorandum includes the observation that the "three
tenets caused the implementation group to make several key decisions that, given
today's environment, we may not have made with 20-20 hindsight."(504) Boyles
explained during an interview that he believes the Company would have accepted
more volatility into earnings had it appreciated in advance how readily the
market would accept the Company's "core earnings" as an alternative to the more
volatile GAAP income measure that included the volatility associated with
options.
That explanation, however, does not address the impact of the tenets
on those involved in the implementation process prior to 2001. Prior to 2001,
the Company did not know whether investors and analysts would accept the
Company's core earnings measure and disregard the volatility that remained in
the Company's reported GAAP earnings as a result of FAS 133. In our view, the
record strongly supports the conclusion that the Company's interpretation of FAS
133 - which, as we explain below, disregarded or "interpreted away" unambiguous
language in the statement - was designed to avoid earnings volatility. The goals
established at the outset of the process, and confirmed at various times from
the Spencer-Howard meeting in December 1998 up to and including Boyles's 2003
memorandum, resulted in more than one departure from the requirements of FAS
133.
No one that we interviewed acknowledged this point explicitly,
although several acknowledged the three tenets, at least in concept. Even those
who recognized the three tenets, however, could not point to an express
instruction from a senior officer to follow them.(505) Because Howard declined
to cooperate with our investigation, we did not have the opportunity to question
him regarding these documents or his views on FAS 133 implementation generally.
Several interviewees reported that Howard's overarching instruction was "Get it
right," and there is evidence that Howard intended that all of those involved
would `be held responsible for ensuring that we adopt the standard."(506) That
directive was belied (or at least colored), however, by other guidance regarding
the approach he apparently expected the Company to take when implementing the
standard (for example, Nathani's instruction after a meeting with Howard that
"reduction of earnings volatility is still our numero uno objective").(507)
In addition, several documents reflect Howard's personal view that the
concepts underlying FAS 133 were ill-conceived. In a July 4, 2002 e-mail, for
example, Howard explained: "These wild and unpredictable swings in our GAAP net
income--
- ----------
(504) Boyles March 2003 Memo at FMSE 78540.
(505) Boyles suggested that the tenets formed in his mind through trial and
error. He explained that, as certain ideas were considered and rejected for
particular reasons, he developed a sense of what was unacceptable and what
was expected.
(506) Undated Leanne Talking Points, FMSE-IR 193003.
(507) E-mail from M. Nathani to N. Bates, dated July 21, 2005, FMSE 436303.
127
that are completely artificial and convey no real information about the economic
substance of our business-- make our GAAP net income useless to investors and
security analysts. Analysts and investors uniformly agree that this is
true."(508) In his talking points for remarks to the Fannie Mae Board in
February 2001, Howard explained that FAS 133's accounting requirements are "not
particularly meaningful" because "net income and EPS numbers that move around
this much based on changes in the market values of our purchased options - and
nothing else on the balance sheet - don't give an accurate picture of our
financial performance."(509) To the extent that this opinion of the accounting
standard was conveyed to the individuals who were responsible for implementation
of the standard, it undoubtedly affected any message that might have been
conveyed about "getting it right."(510)
In sum, the record indicates that Fannie Mae's principal objective in
its implementation of FAS 133 was to avoid earnings volatility (other than with
respect to the time value of purchased options) by ensuring that all of the
hedge transactions it entered into after the standard's effective date qualified
as "perfect hedges." There is substantial evidence as well that Howard
established this goal and that many of the individuals responsible for the
project, including at least Spencer and Boyles, were aware of Howard's concerns.
B. Development Efforts During 1999 and 2000
By 1999, following Howard's December 1998 instructions to Spencer, the
group of Company employees who were spending a substantial amount of their time
on FAS 133 issues had expanded significantly to include additional personnel
from the principal offices affected, as well as representatives of other
disciplines (legal, tax, etc.). The principal Controller's Office personnel
involved in the development of Fannie Mae's accounting policies under FAS 133
were Boyles and Stone from Financial Standards and Lewers from Financial
Reporting. Nathani was the principal representative of the Treasurer's Office
and participated primarily by describing the affected transactions and
performing analyses. (Others involved in particular aspects of the FAS 133
implementation effort are identified below in connection with the developments
in which
- ----------
(508) E-mail from T. Howard to L. Spencer, dated July 4, 2002, FMSE-SP 35056-57.
(509) E-mail from T. Howard to L. Spencer, dated Feb. 20, 2001, FMSE 429280-86,
at FMSE 429281.
(510) Certain statements - such as Spencer's December 1998 talking points in
which she referred to Howard's instruction that "all will be held
responsible for ensuring that we adopt the standard" - might be read to
support a conclusion that Howard said "get it right"; overall, however,
these statements are too cryptic and infrequent (and belied by other
evidence, such as Spencer's point from December 1998 that "[t]he key tenet
we are working towards is . . . the FASB's `perfect hedge' exception") to
support the conclusion that strict compliance with GAAP was Howard's main
concern.
128
they were involved.) Although Stone and Nathani left the Company for personal
reasons in 2001 and 2002, respectively, we interviewed them and the other
principal participants in the effort during this period.
Fannie Mae's FAS 133 working group met regularly throughout 1999 and
2000 to discuss various issues and to make decisions on accounting, financial
reporting, and systems matters. The documentary record of our review is replete
with agendas, action item lists, internal correspondence (e-mails and memoranda)
and similar documents reflecting the time and attention that the personnel
involved devoted to this effort. The implementation team addressed a variety of
issues at a considerable level of detail. Although the working group regularly
briefed senior officers, including Spencer and Knight, interviewees involved in
the process were unable to identify a decision-maker with respect to the
Company's hedge accounting policies, except perhaps Boyles.
Beginning in 1999, the Company began the detailed development of its
FAS 133 accounting policies. This resulted in the preparation of a volume,
drafted largely by Stone under Boyles's direction, known as the Derivatives
Accounting Guidelines (the "DAG").(511) The DAG contains a statement of the
Company's approach to (among other things) hedge documentation, assessment of
hedge effectiveness at the outset of the transaction and on an ongoing basis,
and other aspects of the accounting for hedge transactions in Fannie Mae's books
and records.
The DAG also contains a "menu" of permitted hedge transactions and the
accounting associated with the transactions, many of which were deemed to
qualify for treatment as "perfect hedges" under the "shortcut" method. As noted
above, any transaction that the Company entered into that did not qualify for
shortcut treatment per the DAG required the approval of senior officers.
The DAG, and not the text of FAS 133 itself, became the standard for
hedge accounting at Fannie Mae. Interviewees routinely stated that Company
personnel looked to the DAG, rather than FAS 133, for guidance on hedge
accounting matters. Even Controller's Office personnel who were accountants or
who were otherwise familiar with FAS 133 stated that they did not consider the
language of FAS 133 in determining the appropriate accounting for Fannie Mae's
hedge transactions. They explained that Financial Standards had adopted the DAG
as an interpretation of FAS 133 for Fannie Mae's purposes, and the DAG therefore
was authoritative within the Company. They also noted that the DAG had been
"approved" by KPMG.
- ----------
(511) DAG at FMSE-IR 12825-13295. The DAG was revised as of December 2003. See
Derivatives Accounting Guidelines, dated Dec. 2003, FMSE 112657-3142. All
citations in this section of our Report are to the 2001 edition of the DAG.
129
The Company implemented changes in its accounting systems. A document
labeled "FAS 133 Accounting Project Kick-Off Meeting," dated January 1999,
describes this activity.(512) A central paragraph states:
Qualifying for one of FASB's hedge designations is paramount for
Fannie Mae in applying the accounting standard. A critical component
in qualifying for a hedge designation is demonstrating a linkage
between the derivative and its related debt. The present accounting
systems do not provide a sufficiently rigorous link. A key component
of the FAS133 [sic] project will be to supplement STAR [an existing
accounting system that tracked debt instruments and derivatives] data
with the required linkage information. The linkage will be derived
using data provided by a Fannie Mae Treasury maintained management
information system.(513)
Essentially, the process as outlined would: (1) establish a system to specify
the debt and derivative instruments to be linked in a hedge relationship; (2)
identify each link as establishing a cash flow or fair-value hedge (or identify
a transaction as "does not qualify" for hedge accounting); (3) calculate fair
values of the relevant instruments; and (4) create subledgers, journal entries
and analytic reports.
The Company devised two systems to implement its FAS 133 accounting
and reporting functions. An existing system maintained in the Treasurer's
Office, called DEBTS, was modified to establish an automatic link between a
derivative and a debt instrument. DEBTS tracked benchmark notes and longer-term
debt instruments. (The Short-Term Notes ("STN") application tracked discount
notes, and the information in STN was transmitted nightly to DEBTS.) The DEBTS
system would establish linkages between the derivatives the Company acquired and
its portfolio of debt instruments to form hedge relationships. Initial linkages
usually were established when the Company acquired the derivative. However, the
DEBTS system would relink debt and derivatives if an initial link were severed
(for example, by the discontinuance of discount note rollovers or the call of a
debt instrument). The system contained a protocol for assigning derivatives to
debt by which term-out transactions and long-term debt would be linked to
available derivatives before discount notes.
On a monthly basis, information regarding the linkages in the DEBTS
system would be delivered to a system known as the FAS 133 Accounting System,
which was created for the purpose of complying with FAS 133. Maintained in the
Controller's
- ----------
(512) See FAS 133 Accounting Project Kick-Off Meeting, dated Jan. 1999, FMSE-E
415603-05. Although this document is labeled a draft, its contents are
reflected in other documents and are consistent with interviewees'
statements.
(513) Id. at FMSE-E 415603.
130
Office, the FAS 133 Accounting System would corroborate the linkage established
in DEBTS and identify the hedge accounting designation. The FAS 133 system would
draw the designation from the menu of permitted transactions listed in the DAG.
For example, a pay-fixed swap linked to the anticipated rollover of discount
notes would be designated by the system as a "Cash Flow #1" - the title of that
transaction in the DAG. The system would post necessary entries to the Company's
general ledger and issue a report on any improper linkages, which would be
addressed manually. Separately, procedures were developed for the Company's
Hedge Desk, which was responsible for transactions involving hedges of the
anticipated issuances of debt (excluding the rollover of discount notes).
We have uncovered no evidence that Fannie Mae seriously considered
during this period developing and implementing a system capable of long-haul
accounting for hedge transactions. Several interviewees confirmed that no
serious consideration was ever given to this idea. At one point, the Company did
investigate the possibility of obtaining "off-the-shelf" hedge accounting
software but abandoned that effort when it became apparent that no such software
was available.
Instead, the evidence indicates that Fannie Mae was concerned about
preserving "perfect hedges." A document dated March 30, 2001, captioned "FAS 133
Implementation," provides a retrospective outline of the FAS 133 implementation
project: it states under the heading "Accounting Operations" that "Systems
[were] built to implement the short-cut method."(514) A similar document, titled
"Derivative Accounting," reports under the heading "Operational Principles"
that: "[a]ccounting process [was] designed to avoid any earnings volatility
(except for time value pertaining to options)."(515) These points are consistent
with two of the basic tenets discussed in the previous section, i.e., minimizing
volatility by ensuring that all transactions were treated as "perfect hedges"
and utilizing the Company's existing accounting systems (which did not have a
long-haul capability) to the extent possible.
In 1998, the target date for the implementation of FAS 133 accounting
was January 1, 2000. In May 1999, the FASB released an exposure draft of FAS
137, which proposed deferring the effective date of FAS 133 by one year. The
FASB acknowledged the challenges that FAS 133 presented and the fact that
adherence to the initial effective date (January 1, 2000) would require
companies to implement FAS 133 systems at the same time they were addressing any
operational issues associated with "Y2K." The addition of a year to prepare,
however, did not alter the Company's approach to FAS 133 in any significant way.
Lewers, in fact, recalled that the FAS 133 working group made a conscious
decision not to use the additional year to refine its approach to FAS 133 by
improving its systems capabilities or otherwise.
- ----------
(514) See FAS 133 Implementation, dated Mar. 30, 2001, FMSE 415107-09.
(515) See Undated Derivative Accounting, FMSE 415372.
131
C. FAS 138
One of the most significant developments during the FAS 133
implementation period was the release in March 2000 of an exposure draft of FAS
138, in which the FASB proposed to amend FAS 133 prior to its effective date. In
FAS 138, the FASB addressed a series of issues that had been raised in
connection with FAS 133 and made certain clarifying amendments. One of those
amendments affected the so-called "Fannie Mae carve-out" for term-out
transactions. The FASB removed from FAS 133 a sentence that had provided that
the term-out transaction could be treated under the shortcut method of paragraph
68. In its explanation for the change, the FASB stated: "The hedging instrument
does not have a fair value of zero at inception of the hedging relationship" and
thus "the hedging instrument . . . does not meet the criterion in paragraph
68(b) to qualify for the shortcut method."(516)
The FASB also addressed in FAS 138 the treatment of another common
Fannie Mae transaction: the rollover of discount notes hedged by a pay-fixed
swap. The FASB explained that this transaction, too, did not qualify for hedge
accounting using the shortcut method:
The swap is designated in a hedge of a series of forecasted interest
payments, only one of which relates to a recognized interest-bearing
liability [that is, the initial discount note]; the remainder relate
to a forecasted borrowing. The shortcut method is limited to either a
fair value or cash flow hedging relationship of interest rate risk
involving an existing recognized interest-bearing asset or liability
and an interest rate swap. Thus, a cash flow hedge of the variability
in interest on a probable forecasted lending or borrowing [that is,
the future rollover of the discount notes] is not eligible for the
shortcut method.(517)
Fannie Mae recognized the importance of these changes. Stone's
handwritten notes captioned "133 Amendment Issues" stated, among other things,
"P 161 [part of the Fannie Mae carve-out in Example 8] - No longer qualify for
shortcut method" and "Takes away our argument to apply shortcut method in other
places."(518) In a memorandum Stone prepared dated March 8, 2000, she stated:
"Another surprise in the Exposure Draft release was that the FASB deleted the
ability to qualify for the shortcut
- ----------
(516) FAS 138 P 38.
(517) Id. P 39.
(518) Undated handwritten notes, FMSE 366653. Boyles told us that the amendment
did not affect the accounting for term-outs because Fannie Mae was not
applying the shortcut method. We address that issue below.
132
method in the Fannie Mae 'carve-out' in the standard. Jonathan will be following
up with Leanne re: the implications this may cause."(519)
Notwithstanding these observations, Financial Standards concluded that
there would be no implications associated with these changes. Stone's notes
state, "as long as critical terms are the same, assume no ineffectiveness."(520)
The issuance of FAS 138, in sum, did not alter the Company's approach to FAS 133
insofar as the treatment of term-out transactions or hedging the rollover of
discount notes were concerned.
D. Post-Effective Date Developments
Fannie Mae's policies with respect to the implementation of FAS 133
remained relatively static during 2001 and 2002. Several developments in 2003
and 2004, however, are worthy of note.
In 2003, at Raines's direction, Fannie Mae undertook an examination of
its hedging practices and its overall approach to interest-rate risk. Although
this effort did not focus on hedge accounting issues, or FAS 133 specifically,
Boyles took this opportunity to review the Company's implementation of FAS 133
during 1998-2000. Apparently, this project prompted Boyles to write the draft
March 2003 memorandum that described the three tenets that the Company followed
in its implementation of FAS 133 and to incorporate these points into the May
2003 presentation used during a meeting with Raines and others. Both Raines and
Boyles stated during interviews that Raines objected to the proposition that the
Company was reviewing its hedging policies at that time in an effort to avoid
earnings volatility. According to both men, Raines stated that his focus was on
effective economic hedging and the maximum avoidance of interest-rate risk as an
economic matter rather than for accounting purposes.
It does not appear, however, that senior management made those views
known prior to 2001, when Howard and others had substantial concerns about
volatility in GAAP earnings and the extent to which investors and analysts would
accept the Company's alternative "core earnings" measure of performance.
Moreover, according to Stone's report of the September 5, 2000 meeting with the
Office of the Chair, senior management was concerned that investors and market
analysts would disregard the Company's alternative measure of income, and focus
instead on the volatile GAAP income statistics.(521) Although Raines may not
have been concerned about volatility in Fannie Mae's GAAP earnings in 2003 (by
which time the market had accepted the
- ----------
(519) Mem. from K. Rawls to Yolanda Green, dated Mar. 8, 2000, FMSE 436300.
(520) Undated handwritten notes, FMSE 366653.
(521) E-mail from K. Stone to M. Nathani, dated Sept. 7, 2000, FMSE 436284.
133
Company's core earnings alternative), it appears that senior executives were
concerned about volatility, and expressed those concerns, right up to FAS 133's
effective date.(522)
Also in 2003, the Company initiated a program to upgrade its hedge
accounting systems with a view toward incorporating into the systems an
automated capability to perform long-haul accounting. This effort was prompted
by concerns, apparently voiced in the Treasurer's Office, that the menu of
transactions approved for hedge accounting because they resulted in "perfect
hedges" was too restrictive. This project was not completed, as Fannie Mae's
resources later were devoted to the OFHEO Special Examination and other matters.
In the first half of 2004, Fannie Mae engaged KPMG to conduct a review
of the Company's FAS 133 policies. In the course of this engagement, KPMG
reviewed the Company's accounting for fourteen different types of hedge
transactions, which account for over ninety-five percent of the Company's hedge
transactions. Most of the review was conducted by KPMG's audit team, although
certain questions were referred to KPMG's Department of Professional Practice.
KPMG confirmed the correctness of the Company's accounting for all of the
transactions but one. The Company raised that transaction with the FASB. In a
telephone call, which was later confirmed in a letter, Fannie Mae described the
term-out transaction at issue.(523) According to the letter confirming the
discussion, the FASB agreed that the transaction was eligible for hedge
accounting. Notably, the letter does not disclose whether the parties discussed
the type of accounting that would be required - that is, whether the Company
could rely on the shortcut method for this transaction, or whether it would be
required to apply the long-haul method of accounting.(524)
Finally, in early 2004, Boyles issued an accounting policy memorandum
amending certain aspects of Fannie Mae's FAS 133 accounting policies.(525) The
two most significant changes were a prohibition on further use of a duration
matching test for the hedging of anticipated debt issuances, and the elimination
of a de minimis test to
- ----------
(522) Raines did not recall attending the September 5, 2000 briefing.
(523) In the transaction, Fannie Mae issued a callable, fixed-rate medium-term
note to replace the rollover of discount notes and entered into a
receive-fixed, pay-floating interest-rate swap that was cancelable by the
counterparty. Fannie Mae then designated the new interest-rate swap in
combination with an existing pay-fixed, receive-floating interest-rate swap
as a hedge of the issuance of discount notes beyond the maturity date of
the medium-term note. The issue Fannie Mae discussed with the FASB staff
related to whether the cancelable interest-rate swap could qualify as a
hedge of the callable medium-term note because of the option embedded in
the interest-rate swap.
(524) Letter from J. Boyles to Robert Wilkins, dated July 21, 2004, FMSE
216625-28.
(525) Mem. from J. Boyles to File, dated Mar. 13, 2004, FMSE 113686-90.
134
determine whether hedges are expected to be highly effective. As a result of
these changes, the Company discontinued its hedging program with respect to
anticipated debt issuances (except for the anticipated rollover of discount
notes). These amendments are addressed in greater detail below in our discussion
of Fannie Mae's hedge accounting policies.
V. FINDINGS REGARDING FANNIE MAE'S ACCOUNTING FOR HEDGE TRANSACTIONS
The SEC announced on December 15, 2004 that Fannie Mae's hedge
accounting policies and procedures did not comply with GAAP. The SEC's press
release stated as follows:
Regarding Statement No. 133, one of the principles underlying the
statement is that derivative instruments are to be recorded at their
fair value with changes in fair value reported in earnings. If certain
hedge criteria are met, however, Statement No. 133 affords special
accounting for the hedge relationship. If the specific hedging
requirements are not met, then special hedge accounting is not
appropriate.
Fannie Mae internally developed its own unique methodology to assess
whether hedge accounting was appropriate. Fannie Mae's methodology,
however, did not qualify for hedge accounting because of deficiencies
in its application of Statement No. 133. Among other things, Fannie
Mae's methodology of assessing, measuring, and documenting hedge
ineffectiveness was inadequate and was not supported by the
Statement.(526)
The SEC's decision followed Fannie Mae's submission of a letter
describing and defending its hedge accounting policies, and we assume that the
SEC's conclusions were based on the presentation in that letter.(527) Certain
aspects of Fannie Mae's accounting under FAS 133 discussed in the letter apply
broadly to all hedge transactions, and certain aspects apply only to a more or
less narrow subset of those transactions. The broadest issues addressed in the
Company's letter, and which are
- ----------
(526) Office of the Chief Accountant, U.S. Securities and Exchange Commission,
press release, dated Dec. 15, 2004,
http://www.sec.gov/news/press/2004-172.htm (last visited Feb. 17, 2006).
(527) Letter from J. Boyles to Stephen Cutler and Paul Berger, dated Oct. 19,
2004, FMSEC 2215-64 (hereinafter "October 2004 SEC Letter"). Company
representatives also met with the SEC, and KPMG provided a separate
submission supporting the Company's accounting.
135
discussed in the SEC's press release, concern the type of hedge accounting the
Company was using, the requirement that all hedge transactions be documented at
inception, and that the documentation clearly identify certain aspects of the
hedge relationship. Other aspects of FAS 133 addressed in the SEC letter were
especially significant to Fannie Mae given its business practices, including the
hedging of the rollover of discount notes, the hedging of forecasted debt
issuance, and term-out transactions.
Our review focused on these areas and on other issues that we believed
would provide the most direct and extensive insight into the Company's
accounting policies and procedures. We address below: (1) the hedge accounting
methodology Fannie Mae adopted when it implemented FAS 133; (2) aspects of
Fannie Mae's accounting that are inconsistent with this chosen methodology; (3)
the Company's documentation; and (4) other aspects of the Company's accounting
under FAS 133 that we believe reflect on the Company's approach to the standard.
In our view, this evidence, viewed as a whole, demonstrates that Fannie Mae
departed from clear FAS 133 requirements in order to avoid the income statement
volatility and administrative complexity associated with strict adherence to the
standard.
A. Hedge Accounting Methodology
It bears repeating that FAS 133 describes certain permitted methods of
hedge accounting that differ in the extent to which they require the periodic
calculation and recognition of ineffectiveness. Those methods are referred to in
practice as the long-haul, matched-terms, and shortcut methods. In this section,
we consider the methods that Fannie Mae applied.
The question of whether Fannie Mae intended to follow a particular
method of hedge accounting described in FAS 133 is complicated by what appears
to be a change in the Company's nomenclature over the period in question and
some conflict among those involved in the implementation of FAS 133 as to what
the Company's intentions were in this regard. The Company's 2004 submission to
the SEC refers to the Company's use of a concept that is "similar to the matched
terms method in paragraph 65 of FAS 133 and DIG Issue G9."(528) Individuals
involved in the development of the DAG and the implementation of the Company's
hedge accounting stated that Fannie Mae's intention was to use the matched-terms
method from the outset. Certain references in some documents to "critical terms"
- - a phrase used in paragraph 65 of FAS 133 - lend some support to this view.
The strong weight of the evidence, however, is that the Company
intended to rely on a version of the shortcut method. That is, Fannie Mae would
treat certain transactions as perfect hedges, retrospectively and prospectively,
if certain "critical
- ----------
(528) October 2004 SEC Letter at FMSEC 2234. Another portion of the letter
includes the statement: "Our FAS 133 accounting policies relied heavily on
ensuring that key terms (notional amounts, indices, repricing dates,
maturity, and currencies) of the derivative and the hedge item matched."
Id. at FMSEC 2226.
136
terms" of the derivative and the hedged item were aligned in accordance with
parameters that the Company devised and prescribed in the DAG and incorporated
into its FAS 133 Accounting System. Although some Company employees whom we
interviewed referred to this approach as the "Fannie Mae shortcut," rather than
as a method derived directly from the text of paragraph 68 of FAS 133, the
overall approach was to enter into hedge transactions that, in the Company's
view, would result in "no or inconsequential ineffectiveness," with no
assessment or measurement of ineffectiveness required.(529)
Beginning in 2001, discussions of the Company's hedge transactions
referred to the Company's reliance on the shortcut method. The DAG itself refers
to the application of the shortcut method for many transactions.(530) The DAG
also states that "[t]he term sheet will be the source of documentation on the
hedging relationship."(531) Term sheets that the Company issued when it entered
into derivative transactions at that time stated that the transaction "will
qualify for the shortcut method." Because these documents reflect managements's
intentions both at the time it established its policies and when it entered into
individual derivative transactions, the repeated reference to the shortcut
method in these documents appears to be deliberate and is persuasive evidence of
the management's intent.(532)
- ----------
(529) Id. at FMSEC 2229.
(530) The DAG states:
Fannie Mae can use a shortcut method to apply FAS 133 provisions to an
interest rate swap in a fair value hedge when it is assumed that there
will be no hedge ineffectiveness. Assuming no ineffectiveness is
especially important in a hedging relationship involving an
interest-bearing hedged item and an interest rate swap because it
significantly simplifies the computations necessary for making the
hedge accounting journal entries required under FAS 133.
DAG at FMSE-IR 13014-15. The DAG contains virtually identical language with
respect to cash-flow hedges. See id. at FMSE-IR 12907-08. Other sections of
the DAG explicitly refer to applying "the shortcut method." Id. at FMSE-IR
12924.
(531) Id. at FMSE-IR 12965, 13023.
(532) Sample form term sheets are included in the Appendix at Tab C. The Company
would later take the position that the term sheets were not a part of the
Company's documentation for its hedge transactions.
137
E-mails, memoranda, and correspondence drawn from Fannie Mae's files
during the period 1998 through 2004 also refer repeatedly to the shortcut
method.(533) These documents include correspondence - such as correspondence
between Fannie Mae and the FASB - in which the receiving party would have
understood the phrase "shortcut method" to refer to the method spelled out in
paragraph 68 of FAS 133. Stone's notes and memorandum following the release of
the exposure draft of FAS 138 mention the deletion of the reference to the
shortcut method in the "Fannie Mae carve-out" and consider the implications of
that amendment for Fannie Mae's hedge accounting. The authorization forms for
transactions that required long-haul treatment required that the forms be
completed when a transaction did not qualify for the "shortcut method." Other
internal documents, including memoranda prepared by Financial Standards,
describe Fannie Mae's hedge accounting by reference to paragraph 68 and the
shortcut method.(534) An Internal Audit document prepared in October 2000, for
example, states that "Fannie Mae has determined that funding swaps will meet the
FAS 133 short cut method criteria to qualify for hedge accounting."(535)
Also significant are documents that refer to possible changes to the
shortcut method and discuss the implications for Fannie Mae. On September 24,
2002, for example, Boyles sent an e-mail reporting that the FASB was considering
an amendment to FAS 133 that would make certain transactions "ineligible for the
shortcut."(536) According to Boyles, "[t]his rule does not mean that they would
not qualify for hedge accounting but only that they must go through the
long-haul method that could create some ineffectiveness."(537) It is not
credible that Fannie Mae would have been concerned about changes to FAS 133 that
affected the shortcut method if the Company had not intended to apply that
method as its documentation indicated.
In December 2003, Financial Standards issued a directive that Company
personnel should no longer refer to the method of hedge accounting described in
the DAG as the shortcut method. The e-mail states: "Please note that we are no
longer referring to use of the 'shortcut method' in our FAS 133 documentation
(i.e.
- ----------
(533) We understand that individuals at the Company sometimes referred to "a"
shortcut method, suggesting that it was not referring to the method
described in paragraph 68. Given the plethora of other references to "the"
shortcut method, that interpretation is unconvincing.
(534) See, e.g., Mem. from P. Salfi and I. Sussan to File, dated Oct. 15, 2003,
FMSE-IR 650223-26, at FMSE-IR 650224 n.3.
(535) Undated Fannie Mae Office of Auditing, FAS 133 - Test 3A - Funding Swaps,
Review Performed During October 2000, Zantaz document 2913273.
(536) E-mail from J. Boyles to P. Salfi, I. Sussan, and L. Spencer, et al.,
dated Sept. 24, 2002, FMSE-E 1049251.
(537) Id.
138
termsheets/hsm [hedge strategy memoranda]/reports). Instead, consistent with the
revised term sheets . . . we state that we 'assume perfect effectiveness' or
'assume no hedge ineffectiveness.'"(538) Boyles explained during an interview
that he believed the use of the term "shortcut" was an incorrect
characterization of Fannie Mae's methodology and that he thought it necessary to
clarify the Company's nomenclature. It is not clear, however, whether the new
nomenclature actually reflected a change in methodology. Indeed, an October 2003
memorandum prepared by members of Financial Standards concerning the accounting
treatment of certain term-out transactions refers to the requirements of
paragraph 68 - the paragraph that describes the conditions to applying the
shortcut method - as the basis for the Company's treatment of the hedge as
"perfectly effective."(539) At least until late 2003, therefore, the Company's
internal documentation and justification for its hedge accounting practices
rested on the shortcut method and paragraph 68.
Two documents that refer to Fannie Mae's use of the shortcut method
are both exemplary and significant because they bracket the period in which
Fannie Mae was using hedge accounting and because of the audiences to which they
were directed. First, a letter from Fannie Mae to the FASB in April 2000 states,
"Fannie Mae, along with many other entities, intends to rely on the 'shortcut'
method provided for in the Statement to ease the implementation effort of
adopting FAS 133. The shortcut method not only makes implementation easier but
also reduces income volatility associated with common hedge relationships."(540)
Second, talking points prepared in connection with a July 2004 presentation to
the Audit Committee of Fannie Mae's Board of Directors refer to the Company's
use of the shortcut method, citing paragraph 68 of FAS 133 specifically.(541)
These documents were directed to entities in a context in which one presumes
that the authors would have been especially concerned about precision in
language and accuracy in description. Accordingly, these references to the
shortcut method cannot credibly be
- ----------
(538) E-mail from I. Sussan to C. DeFlorimonte, M. Lewers, and M. Patel, dated
Dec. 18, 2003, FMSE-E 473762.
(539) Mem. from P. Salfi and I. Sussan to Distribution, dated July 31, 2003,
FMSE 51390. The memorandum addresses a particular transaction in which the
maturities of the relevant instruments did not match. Notwithstanding this
"stub period," the authors concluded, "this transaction qualifies for the
shortcut method of accounting after the stub period ends." Id. The
memorandum refers to an interpretation of FAS 133, Implementation Issue No.
E12, which discusses the treatment of stub periods under the shortcut
method of paragraph 68. See HOW PARAGRAPH 68(C) APPLIES TO AN INTEREST RATE
SWAP THAT TRADES AT AN INTERIM DATE, Statement 133 Implementation Issue E12
(Fin. Accounting Standards Bd. Dec. 6, 2000).
(540) Unsigned letter from T. Howard to Director of Research and Technical
Activities, Fin. Accounting Standards Bd., dated Apr. 3, 2000, FMSE
48027-30.
(541) E-mail from D. Luigs to A. Kappler, copy to R. Bruemmer, dated July 15,
2004, FMSE-E 2239079-114.
139
explained (as some interviewees suggested) as a company-specific shorthand for
another acceptable approach.(542)
B. Significant Aspects of Fannie Mae's Hedge Accounting
1. Fair Value Equal to Zero
FAS 133 provides that the shortcut (and matched-terms) method of hedge
accounting can be used only if the fair value of the derivative at the inception
of the hedge relationship is equal to zero. Thus, hedge accounting for a
transaction in which the derivative has a fair value other than zero at
inception requires the long-haul method. Fannie Mae has acknowledged it did not
meet this requirement for one of the exceptions to long-haul accounting and that
it took another approach.(543)
One cause of the repeated violations of the "zero fair value" rule was
the automatic relinkage by the Company's DEBTS system of derivatives to debt
instruments other than the original hedged item.(544) As noted above, one of
Fannie Mae's objectives when it implemented FAS 133 was to leverage its existing
accounting systems as much as possible. The DEBTS system, which was the
responsibility of the Treasurer's Office, determined which derivatives would be
linked to which debt instruments. The process can be summarized as having in
essence three steps:
(1) When the Treasurer's Office entered into a hedge transaction, Treasurer's
personnel would enter the terms of the derivative into the DEBTS system,
which would electronically "link" the derivative to a particular debt
instrument (in some circumstances, a single derivative, because of its
notional amount, would be linked to several different debt instruments);
(2) The system would then produce a term sheet describing the transaction,
including the derivative and the debt being hedged; and
- ----------
(542) The confusion over nomenclature may result from the fact that Fannie Mae
adopted an approach to hedge accounting in which it would use a form of the
shortcut methodology if the "critical terms" of the transaction matched. A
workpaper from the files of KPMG states, for example, that for certain
transactions, "If critical terms match, shortcut method can be used if it
is an interest-rate swap." KPMG, Process Analysis Document, dated Aug. 2002
(hereinafter "KPMG Process Analysis Document").
(543) October 2004 SEC Letter at FMSEC 002236.
(544) The DEBTS system was used for hedge transactions involving issued debt,
including discount notes (which were tracked by the STN application),
medium-term notes and long-term debt. It was not used for the less
frequent, but very important, practice of hedging the anticipated issuance
of debt.
140
(3) On a monthly basis, the FAS 133 Accounting System, which was the
responsibility of the Controller's Office, would receive linkage
information from the DEBTS system and confirm that the linkages met the
criteria contained in the DAG for hedge accounting.
Parts, but not all, of the Company's guidance in the DAG was
incorporated into DEBTS and the FAS 133 Accounting System; however, only the FAS
133 Accounting System incorporated the DAG's numbering system for identifying a
particular hedge transaction. Any linkages that did not meet the DAG
requirements for the shortcut method would generate an error report in the FAS
133 Accounting System that could be analyzed and addressed by linking the
derivative to a different debt instrument that would allow the relationship to
qualify for the use of the shortcut method as defined in the DAG.
One feature embedded into the DEBTS system was a protocol that would
reassess the derivative-debt linkages periodically. Under the protocol, for
example, a derivative linked to the rollover of discount notes might be relinked
on its repricing date to another derivative in a term-out transaction or to a
medium- or long-term debt instrument. Other than for new term-out transactions,
it does not appear that the system created term sheets for new linkages, raising
a question as to whether the documentation for these transactions existed at all
or, if it did, whether it was appropriate.(545)
Regardless of whether the new hedge relationships were appropriately
documented, these new relationships resulted in new hedge relationships at times
when it would not be expected that the derivatives would have a fair value equal
to zero.(546) These transactions would therefore require hedge accounting under
the long-haul method. The Company did not apply the long-haul method to these
transactions and it did not reflect on its income statements any ineffectiveness
associated with these transactions. Therefore, Fannie Mae did not account for
these transactions properly.
The evidence does not permit a definitive conclusion on whether the
accountants in Financial Standards or elsewhere in the Controller's Office
understood that the DEBTS system routinely relinked derivatives, creating a
different hedge relationship than existed previously. Interviewees, including
Boyles, claimed that they
- ----------
(545) This question depends on whether the documentation for the Company's hedge
transactions was contained in the term sheets that were prepared at the
outset of a new hedge transaction or was contained in the DEBTS system
itself. The answer to that question is not clear: interviewees suggested
that DEBTS and the FAS 133 Accounting System, combined with the DAG,
comprised the documentation; the DAG, however, refers to the term sheets as
the relevant documentation.
(546) This conclusion does not apply to circumstances in which the DEBTS system
relinked a derivative that was entered into as a hedge of the rollover of
discount notes to another discount note. Those "relinkages," as long as
they continued unbroken, would be considered continuations of the original
hedge relationship.
141
were not familiar with the operation of DEBTS and the documentary evidence on
this issue is scanty.(547) The FAS 133 Accounting System, which did reside in
the Controller's Office, merely determined whether linkages existing at the end
of the month were of the type permitted by the DAG. The fact that these
transactions might reflect relinkages, therefore, would not have been apparent
through this system because it was not set up to check whether a linkage
established in DEBTS resulted in a new hedge relationship. In our view, it does
not appear that the lack of such a check was part of a conscious decision to
bypass key provisions of FAS 133; instead, it was a failure of communication and
follow-through between those responsible for compliance with GAAP and those with
a detailed understanding of how the systems operated.
Other relinkages, however, were intentional and not embedded within
systems. Relinkages would arise, for example, when the Company called
outstanding debt that had been part of a hedge relationship. Because the debt
instrument no longer existed, the derivative would be designated in a new hedge
relationship. Although the derivative would likely have a fair value other than
zero, which would preclude the new hedge relationship from qualifying for the
shortcut (or matched-terms) method, Fannie Mae continued to apply the shortcut
method for the new hedge relationship.
Evidence compiled during our review does address the problem of
accounting for intentional relinkages of derivatives and hedged instruments.
Notably, discussions between the Company and its outside auditor, KPMG,
addressed the issue. According to internal e-mail exchanges, the issue raised
was the amount of time that could elapse between the end of one hedge
transaction and the relinkage of the derivative in another hedge and still have
the derivative qualify for the use of the shortcut method. After some discussion
in which the Company sought approval for a seven-day period between the two
hedge transactions, Fannie Mae adopted a policy (1) that the Company would have
three days to link the derivative to the new hedged item in DEBTs, but (2) that
it would be required to document its intention to create such a link within one
day of the termination of the previous hedge transaction.(548) The available
documentation does not reflect any consideration of whether the relinkages
should be accounted for under the long-haul method.
- ----------
(547) One document that does appear to address this issue is an e-mail, dated
December 12, 2000, sent to Stone, with a copy to Boyles and others. The
e-mail states (among other things) that "a single Debt Swap may be linked,
automatically, to different funding instruments for different periods
during its life." Stone expressed concern "about documentation issues."
E-mail from Prasad Chintamaneni to K. Stone, dated Dec. 12, 2000, FMSE-E
1691116-18. The response noted that "[t]here were questions regarding
documenting these changed links that are yet to be addressed." E-mail from
K. Stone to P. Chintamaneni, dated Jan. 2, 2001, FMSE-E 1691115.
(548) See E-mail from M. Patel to P. Salfi, et al., dated July 15, 2003, FMSE-E
166732-33; E-mail from P. Salfi to Katarina Skladony, et al., dated Aug.
21, 2003, FMSE-E 166455-56.
142
The same issue arose in connection with the Company's term-out
transactions.(549) To the extent that a term-out involves the relinkage of a
derivative in a new hedge relationship, FAS 133, as amended by FAS 138, requires
that the fair value of the derivative be assessed. Assuming the fair value is
other than zero, the Company would be required to measure and recognize any
ineffectiveness in the transaction under the long-haul method. FAS 133 thus
precluded hedge accounting for these transactions under either the shortcut or
matched-terms method.(550)
We received various explanations for the Company's position on this
issue. The most common explanation, offered by Boyles, was that the Company
believed that the transaction would not result in ineffectiveness or that the
ineffectiveness would be inconsequential, even if the fair value of the
derivative were not equal to zero.(551) However, there is no evidence that the
Company conducted any tests prior to the summer of 2004 (discussed below) to
determine whether its assumption that the ineffectiveness would be
inconsequential was accurate, and even the tests it did conduct during 2004 were
not comprehensive.
2. Seven-Day Tolerance for Matching Repricing Dates
Under the shortcut method of hedge accounting for cash-flow hedges,
the "repricing dates [of the variable rate leg of the derivative] must match
those of the variable rate asset or liability."(552) To the extent that the
meaning of "match" was unclear, Implementation Issue E4, an interpretation of
paragraph 68 issued on July 28, 1999, states that "[t]he verb match is used in
the specified conditions in paragraph 68 to mean be exactly the same or
correspond exactly."(553) More than a year before the effective date
- ----------
(549) It does not appear that the Company raised this issue with KPMG
specifically.
(550) Further, in a majority of Fannie Mae's term-out transactions, the maturity
dates of the offsetting derivatives were not the same; the example in FAS
133 that originally permitted the application of the shortcut method
involved derivatives with matching maturity dates. Paragraph 68, in fact,
mentions differences in maturity dates as a source of ineffectiveness in a
hedge transaction.
(551) Boyles also explained that he believed the fair-value provision would only
apply to those companies that structured their derivative transactions to
contain a financing element (i.e., a fair value of other than zero at
inception).
(552) FAS 133 P 68(k).
(553) APPLICATION OF THE SHORTCUT METHOD, Statement 133 Implementation Issue No.
E4 (Fin. Accounting Standards Bd. 1999) (revised Mar. 26, 2003).
143
of FAS 133, therefore, the fact that the shortcut method permitted no
flexibility on the maturing of repricing dates was amply confirmed.(554)
Nonetheless, Fannie Mae adopted a policy that permitted the repricing
dates of variable-rate instruments (or the rollover dates of discount notes) to
differ from the repricing dates on the interest-rate swap by up to seven days.
That is, the DAG required that "the repricing dates match, within 7 calendar
days (plus or minus), the rollover dates of the Discount Notes or the repricing
dates of the variable-rate asset or liability."(555) This reflects a deviation
from the requirement in FAS 133 that long-haul accounting be applied to any
transaction in which the repricing dates did not coincide.(556)
The Company's explanation for this policy rested on practicality and
materiality. As to practicality, for reasons of market efficiency, Fannie Mae
issues benchmark bills on Wednesdays. Fannie Mae did not wish to change this
practice and concluded it would not be feasible, in the ordinary course, to
obtain derivatives to hedge the debt instruments issued on a given day so that
all of the derivatives reprice on the same date.
As to materiality, although the Company took the position that any
ineffectiveness associated with this practice was inconsequential, we have seen
no evidence that the Company tested that proposition prior to the implementation
of the rule.(557) The analysis that the Company did conduct before 2001 did not
test the
- ----------
(554) Similarly, under the matched-terms method of hedge accounting, the Company
could conclude that "changes in fair value or cash flows attributable to
the risk being hedged are expected to completely offset at inception and on
an ongoing basis" if "the critical terms of the hedging instrument and of
the entire hedged asset or liability (as opposed to selected cash flows) or
hedged forecasted transaction are the same." FAS 133 P 65.
(555) DAG at FMSE-IR 12909.
(556) Initially, the permitted deviation was plus-or-minus five business days.
This formulation, however, proved difficult for the systems involved in the
hedge transactions to accommodate because the effect of holidays could not
be programmed into the system. Holidays in the United States and other
markets, for example, could affect whether the repricing dates were within
five business days of each other. The Company therefore amended the policy
to permit a deviation in repricing dates of plus-or-minus seven calendar
days, making it easier for Fannie Mae to apply its guidelines.
(557) One interviewee noted that a seven-calendar-day rule covered the entire
week between Wednesday debt offerings, and therefore permitted the Company
to link all derivatives to some debt no matter when the derivatives were
acquired. This may be overstated, but the rule permitted the Company a
certain flexibility to enter into derivative transactions around the time
of the debt issuances.
144
ineffectiveness associated with the seven-day repricing date mismatch in a way
that would have mirrored the results of applying the long-haul method. According
to documents describing the analysis:
To estimate the income statement impact of applying this policy (e.g.,
the ineffectiveness we do not book because the repricing dates
"match"), we performed two sets of quantitative analysis looking at
the daily movements in 3M LIBOR since 1993 and applied these average
differences to our average pay-fixed swap book for the last three
years.
The first set of quantitative analysis ("average approach")
incorporates the idea that there is offset between movements in LIBOR
associated with pay-fixed swap funding needs which occur before a
Benchmark Bill issuance and movements in LIBOR associated with
pay-fixed swap funding needs which occur after a Benchmark Bill
issuance. The second set of quantitative analysis ("absolute value
approach") does not incorporate this idea of offset and assumes that
changes in LIBOR always move against us, which we believe represents a
"worst case" scenario and is highly unlikely.(558)
The Company's analysis showed that, on average, the mismatch was less than seven
days and was clustered fairly evenly around the date of the debt issuance. It
quantified the amount of ineffectiveness at between $0.4 million and $5.4
million for each $1 billion of notional amount. However, this range may be
understated because the analysis did not compute the ineffectiveness on each
hedge relationship outstanding during the period and may have resulted in
netting under-hedges (that would not result in the recognition of
ineffectiveness) with over-hedges (that would result in the recognition of
ineffectiveness). Finally, this issue once again draws the Company's approach
into question: by offering that the ineffectiveness associated with this aspect
of the Company's hedge accounting was immaterial, the Company presumes to have
considered this issue from the perspective of a long-haul methodology, but that
perspective was not reflected in the Company's hedge accounting policies or
practices at any time.
3. Forecasted Transactions
As explained above, special rules apply to the hedging of forecasted
or anticipated debt issuances. These transactions include the Company's
anticipated rollover of discount notes and the issuance of longer-term debt
instruments. Forecasted transactions do not qualify for shortcut treatment.
- ----------
(558) Mem. from I. Sussan to File, dated Dec. 17, 2003, FMSE 32657-58, at FMSE
32657.
145
(a) Duration Matching
A hedge of a forecasted transaction, like other hedges, has two parts.
The first part is the hedged item, or the debt instrument to be issued at some
anticipated future date on certain terms. The second part is the derivative
designed to offset the impact of changes in market conditions on the proceeds
received on the date the debt is issued (or the interest rate on that debt). If,
for example, the Company were to forecast that it will issue medium-term debt in
fourteen days, the Company might enter into a short sale of another instrument
(typically U.S. Treasury instruments) to hedge changes in the cash flows on the
anticipated debt issuance attributable to changes in the risk-free interest rate
over the fourteen-day period. Any change in interest rates would affect the
forecasted debt issuance and the short sale in opposite directions, although not
necessarily in the same magnitude. If the critical terms of the hedging
instrument and the forecasted transaction are the same, FAS 133 (specifically,
the matched-terms method) permits a company to assume there will be no
ineffectiveness.(559) If the critical terms are not the same, long-haul
accounting would be required.
The DAG permitted a shortcut approach to forecasted debt transactions
when certain critical terms of the derivative and the debt instrument
"matched."(560) The criteria established for applying this shortcut method were:
(1) that the risk being hedged be the risk-free (U.S. Treasury) rate, the LIBOR
swap rate, or the agency rate; and (2) that the duration of the derivative fall
within a specified range of the hedged debt.(561) The policy did not require
that the durations match; instead, the hedge qualified for this duration
shortcut approach if the durations fell within the ranges shown in the following
table:
- ----------
(559) Forecasted transactions may be accounted for using the matched-terms
method described in paragraph 65, if "[t]he critical terms of the hedging
instrument and of the... hedged forecasted transaction are the same."
Paragraph 66 of FAS 133 makes clear, however, that "hedge ineffectiveness
would result from the following circumstances, among others: ... b.
Differences in critical terms of the hedging instrument and hedged item or
hedged transaction, such as differences in... maturities..."
(560) See DAG at FMSE-IR 12924. Fannie Mae referred to this approach as the
"duration shortcut" of hedge accounting for anticipated debt issuances.
(561) Id. at FMSE-IR 12925. For these purposes, "duration" refers to the
sensitivity of an instrument's price to changes in interest rates. Although
duration is measured in months, it is not the same as the maturity of the
instrument.
146
Hedged Debt Maturity Duration Range
- -------------------- --------------
0-36 months +/- 6 months
37-60 months +/- 9 months
61-120 months +/- 12 months
121+ months +/- 18 months
Although FAS 133 states specifically that ineffectiveness would result
from mismatched maturities, Fannie Mae's policy did not require that the
maturities of the instruments linked in a hedge transaction match. Therefore, to
the extent the maturity dates of the hedged anticipated transaction and the
hedging instrument did not match, the Company's forecasted transactions did not
qualify for hedge accounting under the matched-terms method. Consequently, these
transactions should have been accounted for under the long-haul method.(562)
In a March 2004 memorandum discontinuing the duration-matching rule,
Boyles acknowledged that this policy "has been a known departure from strict
compliance with GAAP," but that the Company permitted the approach "because,
from an economic standpoint, the correlation from matching of durations between
the anticipated debt and the actual debt to be issued is better than just
matching notional and payment/reset dates."(563) Interviewees explained that the
Company adopted the duration-matching rule for two reasons. First, the
Treasurer's Office personnel responsible for hedge transactions focused on
duration, not on maturity, as an important feature of the debt that office
issued. Second, the Company took the view that matching durations resulted in a
more effective hedge than matching maturities and notional amounts.(564)
- ----------
(562) The training materials published by the FASB after the issuance of FAS 133
illustrate the use of a duration approach to hedging.
(563) Mem. from J. Boyles to File, dated Mar. 13, 2004, FMSE 113686-90, at FMSE
113686.
(564) In addition to the duration rule that was applied to the hedge of a
forecasted transaction, the Company had a duration rule that provided
flexibility in the terms of the debt to be issued. A memo from Stone, dated
February 18, 2000, states, "[t]o add managed flexibility to the type of
debt that is issued versus the type of debt that is hedged, Fannie Mae
developed the duration rule." Memorandum from K. Rawls to Distribution,
dated Feb. 18, 2000, Zantaz document 1925375, at 1. The memo goes on to
note, "as market conditions change, the Treasurer's Office can sometimes
obtain better execution (lower costs) by substituting (cross-delivering) a
type of debt other than what we [sic] being hedged. The current duration
rule, however, does not allow adequate flexibility in cross-delivering debt
issuances on the long end of the yield curve." The memo then concludes:
147
Contemporaneous documents reflect a somewhat different motive for
adopting a policy of permitting the application of the shortcut method when
durations were within the defined ranges. The duration range appeared in a
November 22, 2000 memorandum from the Hedging Desk to Nathani, Boyles, and
Stone.(565) The memorandum states:
The proposed duration windows take into account the probability that
Fannie Mae will need to hedge both new issue and reopened debt with
current or reopened securities which will result at times in larger
than normal mismatch of duration. If market conditions change, there
will be a need to re-asses [sic] these duration windows.
Finally, given the fact that hedging Fannie Mae debt with Fannie Mae
benchmark securities results in as perfect a hedge as we can achieve,
we suggest using the short cut treatment for such agency hedges that
fall within the proposed duration windows.(566)
The following month, Stone announced that "KPMG has agreed to our proposal to
use a 'shortcut' method on anticipatory debt issuances" within the specified
duration parameters.(567)
To support the duration-matching rule, the Company prepared an
analysis that purported to compare the calculated ineffectiveness in a hedge
transaction involving closely-matching durations (but different notional and
principal amounts) to the amount
- ----------
If the original duration of the anticipated debt is 84 months or less,
the Hedge Desk can cross-deliver that does not differ by more than 18
months from the original duration of the anticipated debt.
Alternatively, if the original duration of the anticipated debt is
greater than 84 months, the Hedge Desk can cross-deliver debt that
does not differ by more than 30 months from the original duration of
the anticipated debt.
This approach calls into question the Company's hedge accounting for
forecasted debt issuances on other grounds - specifically, that the
documentation did not specify the hedged item and the forecasted
transaction described in the documentation may not have been probable.
(565) Mem. from U. O'Donnell to Distribution, dated Nov. 22, 2000, FMSE
365840-43.
(566) Id. at FMSE 365840.
(567) E-mail from K. Stone to Mary Trzeciak, dated Dec. 20, 2000, FMSE-E 845330.
148
of ineffectiveness in a hedge transaction involving identical dollar amounts.
The results of this analysis were that the use of the duration method might
result in less ineffectiveness than the ineffectiveness that arises when the
amounts match.(568) This analysis is not persuasive. According to Ursula
Schaeffer, who drafted the analysis, the Company did not test the
duration-matching rule in differing market conditions or at various points
within the duration window. The Company's analysis was, therefore, a series of
examples and not a proof or demonstration that duration matching is necessarily
a "better" approach other than for reasons of operational convenience.
At KPMG's insistence, Fannie Mae monitored the impact of the
duration-matching policy. At the end of 2001 and 2002, Financial Standards
selected a sample of the relevant transactions and Treasurer's Office personnel
measured the ineffectiveness associated with those transactions. Based on this
analysis, the Company concluded in each year that the total ineffectiveness
associated with the duration matching rule was immaterial (less than $3
million). At the end of 2003, Financial Standards conducted a more comprehensive
assessment and determined that the ineffectiveness associated with these
transactions was approximately $12 million ($21 million pre-tax). At that time,
the Company recorded the $12 million in earnings and discontinued hedge
accounting for anticipated debt issuances.
4. The De Minimis Test
To qualify for hedge accounting, it must be established that the hedge
of a forecasted debt issuance is highly effective. Accounting literature prior
to FAS 133 described a "dollar offset" test in which a company would determine
the fair values of the two instruments; if the change in the fair value of one
instrument offset the change in the fair value of the other instrument within a
band of 80-125 percent, the derivative was deemed sufficiently effective.
Although FAS 133 expressly permits this approach, it allows an entity to adopt
another suitable "statistical analysis."
FAS 133 requires that the methodology used for assessing effectiveness
be consistent. Paragraph 62 of FAS 133 requires that the Company designate at
the outset of the transaction "the method it will use to assess the hedge's
effectiveness . . . ." Moreover, "[o]rdinarily, . . . an entity should assess
effectiveness for similar hedges in a similar manner; use of different methods
for similar hedges should be justified."
Fannie Mae adopted an approach to the assessment of hedge
effectiveness for forecasted transactions that was not consistent with this
requirement. The Company adopted the dollar-offset methodology, but supplemented
it with an alternative methodology. Not only did this approach violate the
consistency requirement, but the alternative test was not an acceptable
statistical approach.
- ----------
(568) Mem. from U. O'Donnell to Distribution, dated Nov. 22, 2000, FMSE
365840-43; Undated analysis, FMSE 365877-79.
149
This alternative method for testing effectiveness - known as the "de
minimis" method - would permit hedge accounting if the dollar-offset criterion
was not met as long as the interest rate on the issued debt, adjusted for the
results of the hedge, was within fifteen basis points ("bps") of the target rate
established on the date of the original forecast. Given the magnitude of Fannie
Mae's debt issuances, and because the amount of ineffectiveness required to
cause the actual rate to differ by more than fifteen bps from the target rate
would be significant, the de minimis test allowed the Company to treat
derivatives as hedges even when the extent of the dollar-offset was
significantly outside the 80-125 percent range.
The de minimis test was employed at Fannie Mae prior to FAS 133, and
appears to have been incorporated into the DAG without a systematic analysis
regarding the consistency of the test with FAS 133's requirements. The DAG
introduces the de minimis test as follows:
Dollar correlation alone has proven to be an unsatisfactory measure of
hedge performance when there is very little interest rate movement
over a hedge period. The Deminimus [sic] rule was developed as an
alternative means of evaluating the effectiveness of a hedge. To
overcome such inequities in the correlation measurement, we have
established an alternative for measuring the effectiveness of a
hedge.(569)
The rule, therefore, appears to be a Company-originated alternative to the
dollar-offset approach recognized in FAS 133 and prior accounting literature.
Interviewees, including Boyles, acknowledged that the de minimis test
was not a statistical method. Moreover, when asked how this approach was
appropriate given FAS 133's reference to "the method" for assessing
effectiveness, and the requirement that the methodology be consistent for
similar transactions, Boyles responded that the Company's approach consisted of
a single method with two parts. That formulation, however, is not consistent
with other documents on this subject.(570)
In addition, this test has not been applied consistently. Prior to the
adoption of FAS 133, the Company's de minimis test permitted a window between
the actual and target interest rates of ten bps. At the time the Company was
developing its approach to FAS 133, individuals in the Treasurer's Office were
concerned that increased
- ----------
(569) DAG at FMSE-IR 12930.
(570) An undated presentation entitled "FASB Statement No. 133: Accounting for
Derivative Investments and Hedging Activities - Fannie Mae: Policies and
Procedures for FAS 133," FMSE-IR 534549-534697, states: "The Hedge Desk
employs two acceptable method of measuring hedge effectiveness: 1.
Correlation[;] 2. Deminimus [sic]." Id. at FMSE-IR 534559.
150
market volatility would push hedge transactions outside the permitted ten bps
margin. The Company conducted an analysis of the historic volatility in its debt
issuances, and concluded (among other things) that Fannie Mae's five- and
ten-year debt, which traditionally had experienced spreads of approximately
thirty bps, had more recently experienced spreads of approximately sixty-five
bps: "The percentage volatility in spreads between time periods virtually
doubled going from 26% to 50% in fives and from 15% to 32% in tens."(571) Based
on this analysis, the Company considered (and, it appears, encouraged its
outside auditor to approve) an increase in the range covered by the de minimis
rule to twenty bps. Ultimately, the Company established a new de minimis test
with a margin of fifteen bps. The de minimis rule was incorporated into the DAG
with this change.
Internal correspondence confirms that the rule was expanded to enhance
the Treasurer's Office's flexibility to enter into transactions that might not
have qualified for hedge accounting under the old, ten bps rule. In an e-mail
dated November 24, 1999, from Nathani to Howard, Spencer, and Boyles, et al.,
Nathani reported "that the de minimis parameters have been extended to fifteen
bps from the current ten bps rule."(572) He recounted that, at an earlier
planning meeting, "we discussed the importance of getting more flexibility
around the de minimis rule. . . . We presented statistics around increased
spread volatility and requested twenty bps. Jonathan [Boyles] has agreed to
fifteen bps." Nathani concluded by noting that the new rule "allows us to
weather more volatile times without having to mark to market through earnings,"
but he indicated that Fannie Mae would "be careful not to use the fifteen bps as
a license for greater hedge inefficiencies - we will continue to attempt to get
as high dollar correlation as we can." Howard's response to Nathani is telling
as to his view of the hedge accounting rules, "That's great news and excellent
work. Congratulations to all involved. I agree with your conclusion not to take
the expanded de minimis latitude as a basis for increasing our hedge risk - we
should instead view it as an added margin of safety to ensure the applicability
of hedge accounting in volatile markets."(573)
The accounting policy memorandum that announced the change in the de
minimis rule formally linked the change to the Company's convenience and
business interests: "Market volatility has increased dramatically since the
implementation of the original de minimus measure . . . Meanwhile, there has
been no adjustment to the gauges
- ----------
(571) De Minimus Research Highlights, dated Oct. 26, 1999, FMSE 514327.
(572) E-mail from M. Nathani to T. Howard, L. Spencer, and J. Boyles, et al.,
dated Nov. 24, 1999, FMSE 514324.
(573) Id. A separate e-mail conveys the substance of an exchange with a KPMG
partner, Ken Russell, in which Russell expresses the concern that the need
to extend the de minimis parameters might reflect the fact that the hedges
are simply not effective in the more volatile environment. E-mail from K.
Rawls to M. Trzeciak, final e-mail in chain dated Jan. 6, 2000, FMSE
365019. As noted, a subsequent e-mail reports on KPMG's "approval" of the
change.
151
used in measuring the effectiveness of hedges. This raises the likelihood that a
hedge may lose hedge accounting due to an extreme, although temporary, move in
spreads."(574) The policy concludes, "the current ten basis point de minimus
requirement is no longer an appropriate measure of a hedge's effectiveness given
the historical change in volatilities based on a review of spread volatility . .
.. we determined that a 15 basis point requirement is a more appropriate measure
of a hedge's effectiveness."
In connection with its efforts to increase the de minimis threshold,
the Company prepared an analysis showing the percentage of the forecasted debt
issuance transactions in which the Company relied on the de minimis approach to
qualify the transaction for hedge accounting. In 1998, nearly half of the
Company's transactions (forty-eight percent) would not have qualified for hedge
accounting under the dollar-offset method, but were accounted for as hedges
under the de minimis rule.(575) In 1999 that proportion increased to sixty-six
percent. Assuming that these data reflect the tendency in Fannie Mae's hedge
transactions after FAS 133's effective date, then at least half of the Company's
hedge transactions involving forecasted debt issuances would not have qualified
for hedge accounting.
The Company discontinued its use of the de minimis test as of January
1, 2004, following an SEC staff speech emphasizing the importance of using only
one method to test whether a transaction would be highly effective.(576) The
Company did not consider whether its approach had been proper prior to that
date. The speech does not alter the conclusion, however, that Fannie Mae's use
of the de minimis rule was inappropriate and designed to inject greater
flexibility into the Company's approach to hedge accounting so as to avoid the
consequences of more volatile markets.
5. Identification and Probability of Forecasted Transactions
In discussing hedges of forecasted transactions, FAS 133 states that
the "hedged forecasted transaction shall be described with sufficient
specificity so that when a transaction occurs, it is clear whether that
transaction is or is not the hedged transaction."(577) Further, FAS 133 makes
clear that the forecasted transaction must be probable of occurring.(578) The
issues of identification and probability raise concerns with
- ----------
(574) Undated Mem. from K. Stone to Distribution, FMSE-E 1044982-83.
(575) E-mail from M. Trzeciak to K. Rawls, dated Jan. 6, 2000, FMSE 365019.
(576) The speech did not mention the de minimis test per se. Accordingly, we
have no way of knowing whether the hedge transactions at issue would in
fact have qualified for hedge accounting under one acceptable test, which
Fannie Mae's did not.
(577) FAS 133 P 28(a)(2).
(578) FAS 133 P 29(b).
152
respect to Fannie Mae's hedges of its rollover of discount notes and its
issuance of benchmark notes.
(a) Forecasted Issuance of Discount Notes
The Company's documentation of its hedges of the forecasted issuance
of discount notes states "Fannie Mae expects to issue Discount Notes for a
period of (insert term of swap). As a result, Fannie Mae is exposed to
variability in cash flows related to the forecasted issuance of the Discount
Notes."(579) Similarly, the hedge relationship diagrammed in the DAG notes that
the hedged item is "Discount Note Rollover 90-day."(580)
During our investigation, interviewees acknowledged that the Company
had a strategy of replacing its discount notes with longer-term debt (e.g., in
term-out transactions). As stated in the Company's October 19, 2004, letter to
the SEC staff, "Fannie Mae often will choose to 'term-out' the Discount Note
issuances described above by entering into a fixed-rate, medium term note to
raise the necessary funding. . . . "(581)
Because the Company had a pattern of redesignating its interest-rate
swaps as a hedge of longer-term debt, it does not appear that it had a basis for
asserting that its forecasted transactions (i.e., the rollover of discount
notes) were probable, calling into question the Company's basis for applying
hedge accounting in these instances.(582) Moreover, the protocol in the DEBTS
system gave priority to term-out transactions and unswapped variable-rate
long-term debt before considering a linkage with discount notes. It is likely,
therefore, that many interest-rate swaps originally designated as hedging the
rollover of discount notes were redesignated as a hedge of another instrument.
(b) Forecasted Issuance of Benchmark Notes
Similar issues arise in connection with the Company's treatment of the
anticipated issuances of benchmark notes and long-term debt. FAS 133 requires
that the hedged forecasted transaction be described with sufficient specificity
so it is clear when the hedged transaction occurs.(583) If the terms of the debt
issued differ significantly from
- ----------
(579) DAG at FMSE-IR 13120.
(580) DAG at FMSE-IR 13168.
(581) October 2004 SEC Letter at FMSEC 2222.
(582) As the FASB noted in FAS 133, "A pattern of determining that hedged
forecasted transactions probably will not occur would call into question
both an entity's ability to accurately predict forecasted transactions and
the propriety of using hedge accounting in the future for similar
forecasted transactions."
(583) FAS 133 P 28(a)(2).
153
the terms of the forecasted transaction described in the Company's
documentation, the application of hedge accounting would not be appropriate.
It appears that the Company at least considered adopting documentation
that would disguise its intent with respect to forecasted transaction hedges so
as to avoid the need to measure and record ineffectiveness. In a memorandum
dated April 25, 2000, Stone discussed Fannie Mae's preference for funding its
mortgage purchases with ten-year debt.(584) According to Stone, "Portfolio and
Treasurer's is [sic] exploring alternatives to provide ten-year funding when
needed as well as reducing the Hedge Desk's exposure to earnings volatility from
shifts in the market when anticipated debt issuances are hedged. One alternative
being explored is the purchase of a ten-year funding swap that is funded with
Discount Notes as product is delivered and unwind the swap when the ten-year
Benchmark is issued." In other words, rather than hedge the anticipated debt
issuance, the Company would acquire a ten-year swap, link that swap to the
rollover of discount notes pending issuance of a ten-year note, and then
(following issuance of the note) re-link the derivative in a new hedge
relationship. A handwritten note at the top of the memo states "Documentation
not to mention (expect to end relationship in 2 months) can end relationship in
2 months & fund w/ ten year Benchmark."(585)
Stone explained that the contemplated transaction had the benefit of
allowing Fannie Mae to "lock in a ten-year rate as mortgage products are
purchased and it does not have to hedge the issuance of an anticipated Benchmark
note. This reduces the Hedge Desk's exposure to earnings volatility arising from
hedging instruments not correlating with the anticipated debt issuance when
markets are volatile."(586) It appears the handwritten note addresses a concern
that hedge accounting for the ten-year interest-rate swap would not be
appropriate because it was not probable that the initial hedged anticipated
transaction (i.e., the rollover of discount notes for a ten-year period) would
occur.
In each of these instances, the Company adopted an approach to FAS
133's requirements for forecasted debt issuances that departed from principles
set forth in the standard. The evidence is persuasive that the Company took this
approach because it offered greater flexibility, while the approach that the
standard required in these circumstances - long-haul accounting - was
incompatible with the Company's business objectives.
- ----------
(584) Mem. from K. Rawls to Distribution, dated Apr. 25, 2000, FMSE 365266-68,
at FMSE 365266.
(585) Id.
(586) Id.
154
6. Term-Outs
As noted above, the Company's term-outs did not qualify for treatment
under the shortcut method or the matched-terms method because there was no
demonstration or likelihood that the fair value of the pre-existing derivative
was zero. Moreover, the shortcut method was foreclosed by the amendments in FAS
138. The Company has taken the view, however, that its treatment of term-outs
was permissible. In support of this proposition, the Company has pointed to its
exchanges with the FASB regarding the term-out transactions, including the
correspondence that led to the "Fannie Mae carve-out."(587) Although we
acknowledge that FAS 133 could be clearer in certain respects, we do not believe
that Fannie Mae's position was well-grounded.
As a factual matter, term-out transactions begin with the issuance and
rollover of discount notes hedged by a receive-fixed swap. As an anticipatory
hedge transaction, the rollover of discount notes does not qualify for the
shortcut method. FAS 133 does raise the possibility that the rollover of
discount notes might qualify for treatment under the matched-terms method, if
the critical terms of the discount notes and the derivative are the same. Fannie
Mae's correspondence with the FASB on this subject proposes such a transaction
and specifies in particular that the reset dates of the derivative and the
rollover of the discount notes were the same.(588) The adoption of the "+/-
seven-day rule," however, was inconsistent with this statement and, so far as we
are aware, was not otherwise disclosed to the FASB. Any prediction as to how the
FASB would have responded had it been aware of Fannie Mae's intention to allow
for differences in repricing dates would be speculative. We recognize that
Fannie Mae wanted to present a specific question to the FASB regarding the
rollover of discount notes, and therefore presented a simple scenario; it would
be extending this exchange too far, however, to conclude that the FASB approved
Fannie Mae's accounting for these transactions.
Fannie Mae's correspondence with the FASB regarding the term-out
portion of the discount notes is likewise not comprehensive and therefore does
not support Fannie Mae's position. The correspondence posited a situation in
which the debt instrument, the original derivative, and the new derivative all
end on the same date. That is, measured from the date of the term-out, all of
the instruments involved in the transaction have the same maturity date. In
fact, in many of Fannie Mae's term-out transactions, both by design and in
practice, the maturities of the instruments differed substantially. Differences
in the maturities could mean that changes in market conditions would affect the
fair values of the instruments differently - that is, a change in interest rates
might affect the fair value of a four-year instrument differently than it
affects the fair value of a two- or three-year instrument. Paragraphs 66 and 68
of FAS 133, moreover, make plain that differences in maturity yield
ineffectiveness.
- ----------
(587) Letter from S. Rajappa to Director of Research and Technical Activities,
Fin. Accounting Standards Bd., dated Oct. 6, 1997, FMSE-IR 217015-26.
(588) Letter from J. Boyles to R. Wilkins, dated Jan. 20, 1999, FMSE-IR
192985-86..
155
Insofar as the specific issues related to term-outs is concerned,
Boyles pointed to the language in Example 8 of FAS 133 that remained after the
FASB (in FAS 138) had deleted the reference to shortcut accounting: "Together,
the cash flows from the two derivatives are effective at offsetting changes in
the interest payments on the three-year note. Changes in fair values of the two
swaps are recognized in other comprehensive income and are reclassified to
earnings when the hedged forecasted transaction . . . affect[s]
earnings[.]"(589) Boyles's view was that the FASB recognized that the amount of
ineffectiveness would not be significant in the fact pattern used in the example
and therefore did not indicate that ineffectiveness should be recognized in
earnings. The acknowledgment that the derivatives are "effective at offsetting
changes in the interest payments," however, merely restates a requirement for
special accounting of all hedge transactions. In our view, this language does
not mean that the shortcut (or matched-terms) methodology is appropriate in
accounting for Fannie Mae's term-out transactions. Finally, there is no
contemporaneous documentation to suggest that the Company considered this issue
prior to our review; on the contrary, contemporaneous documents (notably Stone's
notes and memorandum discussed above) reflect a recognition that the FASB had
removed the authorization to treat term-out transactions under the shortcut
method but that the Company did not wish to reconsider its accounting.
C. Hedge Documentation
For the reasons described above, a significant number of Fannie Mae's
hedge transactions did not qualify for the hedge accounting under the shortcut
(or matched-terms) method. It bears repeating that, for many of the Company's
hedge transactions, the documentation stated that "the critical terms of [the
derivative] and [the debt instrument] are the same (as defined in Fannie Mae's
Derivative Accounting Guidelines)," and the Company therefore concluded "both at
inception and on an ongoing basis . . . that the hedging relationship is
expected to be highly effective in achieving offsetting cash flows attributable
to changes in the benchmark interest rate . . . and will qualify for the
shortcut method."(590)
The Company's hedge documentation is insufficient to meet the
requirements of FAS 133 and, in some instances, is incorrect. The form of hedge
documentation that the Company used beginning in January 2001 posits that "[t]he
critical terms of the swap and the debt obligation are identical. . . .
Therefore, both at inception and on an ongoing basis, Fannie Mae concludes that
the hedging relationship is expected to be highly effective in achieving
offsetting changes in fair value attributable to the hedged risk and will
qualify for the shortcut method."(591) The hedge transactions
- ----------
(589) FAS 133 P 161.
(590) DAG at FMSE-IR 13120. This language is taken from the template for
documentation of a hedge transaction involving the rollover of discount
notes.
(591) Mem. Cash Flow Hedge 2001-XX, dated Jan. 1, 2001, PW-PR 816172-78.
156
themselves, however, did not satisfy the conditions described in the
documentation or as prescribed in FAS 133: The terms of the derivative and
hedged instrument were not "identical." Accordingly, the documentation did not
accurately describe the transaction it purported to address or offer a proper
basis for hedge accounting.
Moreover, there is no evidence that the Company undertook to meet the
other requirements of FAS 133, such as the assessment of ineffectiveness on a
periodic basis and the designation of a methodology for measuring and recording
any ineffectiveness that might arise in its hedge transactions. Transactions
that qualified for neither the shortcut nor the matched-terms method require a
company to assess, on at least a quarterly basis, the effectiveness of the hedge
(both retrospectively and prospectively) and to measure and recognize any
ineffectiveness in earnings. Fannie Mae did not have systems in place to assess
whether a hedge met the effectiveness test on an ongoing basis. Although the
systems "matched" the terms of the hedged item with the terms of the derivative
within the band of tolerance specified in the DAG - which appears to have been
the mechanism on which the Company relied - that would not be sufficient because
the Company did not measure the effects of certain factors, such as the
ineffectiveness caused by a derivative with a fair value other than zero at the
inception of the hedge relationship. Further, with the exception of a very few
transactions,(592) the Company would not accept the earnings volatility
associated with ineffectiveness, nor did
- ----------
(592) Periodically, the Company would come across a transaction that would not
qualify for hedge accounting because of an error in the execution of the
transaction. In some cases, the Company decided to treat these transactions
as "DNQ" - meaning that they do not qualify for hedge accounting at all. A
meeting report dated March 25, 1999 from Nathani to Spencer, Knight, Boyles
et al., states that one of the objectives for a subsequent meeting is "a
final list of DNQ transactions/impact and recommended solutions." FMSE-IR
193008. A 2004 report on hedge accounting activity relates that "[t]he
Treasury Department attempts to manage the DNQ position such that there is
no P&L exposure resulting from the position in changing market conditions."
E-mail from P. Barbera to L. Spencer, J. Pennewell, and M. Lewers, dated
Apr. 29, 2004, FMSE-E 37590-93, at FMSE-E 37591.
In other cases, the Company undertook efforts to avoid either the DNQ
approach or long-haul accounting. For example, in one case, the Company
booked a $5.6 million loss on a transaction because (under the Company's
criteria) the transaction did not qualify for hedge accounting based on the
fair value resulting from the use of the yield curve at the end of the day.
The Company later decided that the transaction would qualify for hedge
accounting if it determined the derivatives' fair value using the intra-day
yield curve at the time of the transaction itself. The Company reversed the
$5.6 million loss the following month. At the same time, the Company
decided as a matter of policy that it would apply the yield curve at the
end of the day. When the director of Financial Reporting in the
Controller's Office responsible for booking these entries noted the
inconsistency of this treatment, her concerns were dismissed.
157
it design or install systems to implement that portion of the matched-terms
methodology that admits ineffectiveness into the accounting.(593) The fact that
the FAS 133 Accounting System tested the linkages between the derivatives and
the hedged items on a monthly basis is not the same as measuring the amount of
hedge ineffectiveness. The FAS 133 Accounting System was designed only to
corroborate on a monthly basis that the linkages between the debt instrument and
the derivative were still valid in accordance with the DAG, not to measure
ineffectiveness.(594)
The Company's hedge documentation rests almost entirely on an
assumption that any ineffectiveness associated with its hedge transactions would
be inconsequential. Not only does this approach presuppose that the Company was
prepared to identify ineffectiveness, but the documentation failed to address
how any ineffectiveness in the hedge relationship would be measured if the
ineffectiveness were no longer inconsequential.
Although the DAG indicates that Fannie Mae would rely on the
"Hypothetical Derivative" method to measure and record ineffectiveness when the
critical terms of the derivative and the hedged item no longer are the same, its
documentation (whether it be the term sheets or the diagrams in the Appendix to
the DAG) states that the hedge will be perfectly effective. However, because the
critical terms of the derivative and the hedged item were not the same,
management did not have adequate documentation of the hedge relationship and
therefore was prohibited from applying hedge accounting for those
transactions.(595)
Moreover, management did not establish a foundation for the assumption
that any ineffectiveness in its portfolio of hedge transactions was
inconsequential. On the contrary, Fannie Mae's assessments of ineffectiveness in
a population of hedge transactions points to the opposite conclusion. For
example, according to a February 2001 analysis prepared by Sinclair and sent to
Stone, "[t]he average ineffectiveness for
- ----------
(593) Even if we were to draw the conclusion that Fannie Mae's intention was to
implement the matched-terms method, its hedge accounting still would not
have complied with FAS 133 for a number of reasons, including the fact that
the critical terms were not the same and the Company's failure to provide
the proper documentation regarding the measurement of ineffectiveness on an
ongoing basis.
(594) Because the original linkages, as well as relinkages, were created in the
DEBTS system, corroboration was a necessary control to confirm that these
linkages were consistent with the criteria for the "shortcut method"
contained in the DAG.
(595) It should be noted that the DAG indicates the Company would use the
hypothetical derivative method for measuring and recognizing
ineffectiveness when the terms no longer match. However, its documentation
and policies state that, in most cases, the transaction was either
perfectly effective (using the DAG as the Company's documentation) or
qualified for the shortcut method (using the termsheets as the Company's
documentation).
158
most scenarios is no more than $20,000 per period for each $100 million notional
of swap. This implies that on average a long haul book of $1 billion would have
ineffectiveness of less than $200,000."(596) In an e-mail exchange referring to
the analysis, Sinclair confirmed Stone's assumption that the "period" referred
to is a month.(597) Although the analysis concerned transactions that would not
qualify for the shortcut method under the DAG,(598) the results show that the
ineffectiveness associated with Fannie Mae's hedges might have been as high as
$2.4 million per year on a $1 billion hedge. Applying this average
ineffectiveness to the notional amount Fannie Mae's interest-rate swap portfolio
as of December 31, 2003, and assuming that the fair values of pay-fixed and
receive-fixed swaps would move in opposite directions, the ineffectiveness might
have reached more than $10 million per month.
That amount might be understated. Fannie Mae undertook a second
analysis of ineffectiveness in a portion of its portfolio in 2004. At that time,
at KPMG's insistence, the Company tested the ineffectiveness associated with a
series of term-out transactions. As a result of that analysis, Fannie Mae booked
$67 million of ineffectiveness. (Concurrently, Fannie Mae also attempted to
evaluate the total ineffectiveness it would have booked during prior years under
the long-haul method. The effort proved too complex and was abandoned.)(599)
- ----------
(596) Undated Analysis of Ineffectiveness in Long Haul Swaps, FMSE 365970-73, at
FMSE 365972.
(597) Id.
(598) The hedge instruments were presumed to reprice outside of the
plus-or-minus seven-day window around the repricing date of the debt
instrument. Although the analysis concerned transactions for which
long-haul accounting would be required under Fannie Mae's system, it shows
the magnitude of ineffectiveness that can be generated when the terms of
the instruments linked in a hedge do not match, and it demonstrates the
extent to which Fannie Mae was willing to tolerate ineffectiveness as
immaterial.
(599) The Company's analysis of the $67 million ineffectiveness in its term-out
transactions was not a substitute for ongoing ineffectiveness assessments,
nor are the results necessarily reflective of ineffectiveness throughout
this period. The analysis was based on a computation of ineffectiveness as
of a point in time for a series of randomly selected derivatives. The
results of that random selection were applied to the remaining portfolio of
"similar" transactions. However, it is unclear how the Company determined
that the selected derivatives were representative of those that were not
selected, which it would have been required to do in order to extrapolate
the results of its testing of the sample to the population. Further, it
appears that the Company adjusted the results for one transaction,
concluding that the selected derivative was not representative of the
remaining population. That adjustment lowered the amount of the
ineffectiveness when the results of the sample were extrapolated to the
population.
159
Finally, Fannie Mae's periodic assessments of the ineffectiveness
associated with its duration-matching approach to hedges of forecasted debt
issuances also uncovered ineffectiveness. As noted above, according to the
Company's analysis, the ineffectiveness associated with that relatively small
portion of Fannie Mae's derivative portfolio reached $12 million ($21 million
pre-tax). Fannie Mae booked that ineffectiveness and discontinued its hedging
program for those transactions.
Based on this evidence, and given the size of Fannie Mae's derivative
portfolio overall, it appears that the ineffectiveness in Fannie Mae's portfolio
was substantial. Management's own analyses - even when directed to only a
portion of the portfolio - undermine the Company's view that the ineffectiveness
at any given time necessarily or predictably would have been inconsequential.
Nonetheless, Fannie Mae's hedge accounting documentation rested on this premise.
We see no evidence, therefore, that Fannie Mae had established the foundation
for the hedge accounting described in its documentation.
D. Other Hedge Accounting Policies
Our overall views regarding the Company's implementation of FAS 133
are influenced as well by decisions made on questions that arose after the
standard's effective date. These decisions reflect an intention to inject
flexibility into the Company's procedures to avoid strict application of
accounting standards based on an assumption, often without analysis, that the
deviations had an immaterial effect on the Company's financial statements.
The first example concerns the situation in which a swap used in a
term-out had a stub period that extended beyond the term of the debt instrument.
Stone drafted a memorandum addressing the treatment of this issue in which she
posited two alternative resolutions: the first alternative involved the adoption
of the long-haul method, at least for the stub period; the second alternative
was to "[t]reat the basis swap as a DNQ [does not qualify for hedge accounting]
with the changes in fair value (from the last date the basis swap qualified for
the shortcut method) running through earnings."(600) In her draft, Stone
concluded that the second option "is the most viable solution as it is unlikely
that option 1 will qualify for the long haul method."
Two notes appear on the draft in Stone's handwriting. One says "M -
operationally [sic] policy." The second says:
Jonathan,
Please review. Mary [Lewers] would like to know if we could apply an
immateriality argument for these type[s] of transaction. Right now,
we know of 1 w/ a mkt value of ~ 400K. Is this a policy you want to
make?
- ----------
(600) Mem. from K. Stone to Distribution, dated Apr. 13, 2001, FMSE 366485.
160
Kim(601)
A second draft of the memorandum, with the same date as the original
draft, includes the language noted above regarding the two resolutions, and the
preference for the second option.(602) However, the memorandum includes a new
concluding paragraph which states:
Because the term of the stub period is always less than three months,
the amount of ineffectiveness generated from applying the procedures
documented above are [sic] likely to be immaterial. Therefore, we will
continue to apply the shortcut method in situations where the basis
swap has a stub and the basis swap is used in a cash flow hedge
termout.
Below this new paragraph appears the handwritten note: "Jonathan - Are you OK w/
this statement? K" The final version of the memorandum which was dated May 15,
2001 and issued as a new accounting policy, includes this final paragraph.(603)
A similar series of events arose in connection with the analysis of an
EITF Issue(604) that concerned, in part, the proper accounting for hedge gains
or losses deferred on cash-flow hedges when the underlying debt has been
extinguished and those deferred gains or losses are required to be reclassified
into earnings. A draft memorandum prepared by Stone and dated April 12, 2001,
contains the handwritten note, "Version 1 Follow the EITF [Emerging Issues Task
Force]."(605) The memorandum addresses three issues raised by the EITF and
concludes in two instances that certain amounts previously recorded as
extraordinary items "should be recognized immediately in the Fee and Other
Income (Expense) line of the income statement[.]" In the final version of the
memorandum, dated May 7, 2001,(606) the memorandum repeats the conclusions
regarding the accounting that would apply if the Company were to follow the
EITF's guidance; the text of the memorandum was amended, however, to state that
these conclusions would result if one were "Applying the EITF" or "Following the
EITF." As to those issues, the memorandum contains a new conclusion that
reverses the intention to follow or apply the EITF guidance: "However, due to
the immateriality of these amounts, Fannie Mae's
- ----------
(601) Id.
(602) Mem. from K. Stone to Distribution, dated Apr. 13, 2001, FMSE 366483.
(603) See Mem. from K. Stone to Distribution, dated May 15, 2001, FMSE 366575.
(604) CLASSIFICATION OF A GAIN OR LOSS FROM A HEDGE OF DEBT THAT IS
EXTINGUISHED, EITF Issue No. 00-9 (Fin. Accounting Standards Bd. 2000).
(605) Mem. from K. Stone to Distribution, dated Apr. 12, 2001, FMSE 365130.
(606) Mem. from K. Stone to Distribution, dated May 7, 2001, FMSE 365121.
161
policy will be to continue to record these hedge gains and losses as
extraordinary items." The memorandum ends: "Fannie Mae will readdress the
policies outlined above if the amounts become material.
Another example of Fannie Mae's adoption of rules that bypass
recognized accounting precepts is reflected in an e-mail exchange concerning a
discrepancy between the instruments linked in a hedge transaction.(607) The
e-mail reads:
OK. We met with Peter at 4 and Jonathan joined us. I am sure much to
his regret. It became apparent that between our 9:30 meeting with
Jonathan and our 4, Jonathan had given additional consideration to the
6 mos rule on the forward starting RF swaps. For so long as we put on
forward starting receive fixed swaps on an occasional basis, his 6
mos. guidance works. The key here is on an occasional basis. Jonathan
readily admits he made up the 6 mos. rule. If we were to do this on a
programmatic basis - for example 15 to 20 billion in a week for
rebalancing purposes, he is NOT comfortable with the 6 mos. rule he
devised. His view is there must be substance behind linking
derivatives needed to hedge a piece of debt. He did not intend to make
a hard and fast rule out of the 6 months.
The e-mail concludes: "By the way, today the desk did 3 trades where there is 6
mos. or great [sic] payer mismatch (what we thought we knew at 9:30). Ursula is
checking to see if this qualifies as 'occasional' or it is part of a program. I
believe her rationale is we put this under this am's guidance." Boyles did not
recall this incident.
Although these examples stand out, we believe they reflect and confirm
an overall tone in Fannie Mae's implementation of FAS 133 that rested heavily on
assumptions of immateriality to justify avoidance of applicable accounting rules
in deference to minimizing earnings volatility, reliance on existing accounting
systems, and avoiding the need to alter the Company's business practices.
VI. FINDINGS REGARDING OVERSIGHT OF FANNIE MAE'S HEDGE ACCOUNTING
Company records and interviewees' recollections show that five
different groups were involved to a greater or lesser degree in Fannie Mae's
implementation of FAS 133. These were: Fannie Mae's senior management, its Board
of Directors, the FASB, KPMG, OFHEO and Fannie Mae's Office of Audit. Each
played a different role and had a different level of involvement in the process.
- ----------
(607) E-mail from Laura Simmons to K. Skladony, dated Mar. 8, 2004, FMSE-E
520178.
162
A. Senior Management
We have incorporated into our discussion the involvement in the
Company's FAS 133 implementation process of Howard, Spencer, and Boyles. In our
view, each of these individuals knew or should have known the concepts that
motivated the Company's approach to hedge accounting. Spencer and Boyles, as the
senior accountants involved, knew or should have appreciated that the Company's
accounting did not meet the requirements of FAS 133 in important respects. As
will be seen, however, for the most part, they took steps to ensure that KPMG
was informed of the Company's policies, and they relied on KPMG's acceptance of
the Company's approach.
The September 2000 briefing to the Office of the Chair is the only
documented occasion prior to 2001 in which Raines was briefed on FAS 133 issues
insofar as they affected Fannie Mae.(608) There is no report of any other
occasion in which FAS 133 issues were discussed with Raines prior to 2003, and
no other interviewee reported any involvement by Raines in these matters. During
his interview, Raines disclaimed any involvement with the implementation of FAS
133. Raines's disclaimer in this respect is credible and supported by the lack
of significant documentary or anecdotal evidence linking him to these accounting
decisions.
B. The Board and the Audit Committee
Management's reports to the Board on FAS 133 developments were
sporadic and, for the most part, management withheld significant information
regarding the Company's implementation efforts and objectives. In November 1998,
the Audit Committee received a briefing paper on new accounting developments
that noted the FASB's release of its "long awaited standard on the accounting
for derivative financial instruments."(609) The Company described the standard
in five sentences and reported that "Fannie Mae does not expect the adoption of
the new standard to significantly affect earnings, however the new standard will
require a large portion of our derivatives to be marked to market through
equity."(610) The report describes management's emphasis on the fact that "a
number of operations and systems changes will need to be made."(611)
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(608) A document prepared by Boyles, dated June 23, 2000, and a draft
transmittal memorandum to Raines captioned "Preliminary Report on How FAS
133 May Affect Our Customers," address the possible impact of FAS 133 on
third parties (primarily mortgage bankers). See Undated Preliminary Report
on How FAS 133 May Affect Our Customers, Zantaz document 2207964. Raines
was also involved in efforts to lobby the FASB and the SEC to eliminate
impact of the accounting for the time value of options on income
statements.
(609) FMSE-SP 87043-047.
(610) Id.
(611) Id.
163
A year later, in November 1999, management reported to the Audit
Committee on the impact of FAS 133. Management stated, among other things:
Fannie Mae has completed its project to identify and classify all our
derivatives according to the criteria specified in the new standard.
In addition, we have substantially completed the development of a
system that will capture and record our derivatives and hedging
activities in our financial statements. We have been conducting shadow
processing activities for these activities since the first quarter of
1999 to evaluate how our derivatives behave in different environments
and to prepare operationally for the implementation of the standard.
We plan to use the information gathered in our shadow processing phase
to develop strategies, if necessary, to offset earnings or equity
volatility.(612)
This report appears to confirm that, although the FASB had extended the
effective date of FAS 133 by one year, the Company did not take advantage of the
extension to improve its processes and instead viewed its implementation effort
as substantially complete by the end of 1999.(613)
The minutes of the Audit Committee's meetings in November 1999 and
April 2000 also reflect these status updates. In November, according to the
minutes of an Audit Committee meeting, "Ms. Spencer reported that, even though
the effective date for FAS 133 . . . has been deferred to January 1, 2001,
Fannie Mae has made it a priority to develop the systems necessary to implement
and analyze the impact of the new standard, particularly its effect on
volatility in shareholder equity."(614) The minutes of the April meeting reflect
the comments of a KPMG partner, who "noted that KPMG would perform a significant
amount of testing of financial reporting and planning during the
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(612) Id. at FMSE 367238. The report expressed some concern for Fannie Mae's
customers: "[S]ince it is almost impossible to obtain a perfect hedge of
loans or mortgage servicing rights, mortgage bankers will likely experience
significant volatility in earnings." Id.
(613) In a document entitled "Audit Committee Talking Points" dated November 16,
1999, there is reference to the extension and a statement that "[t]his will
give us enough time to adequately develop the necessary accounting and
reporting systems." Zantaz document 694338, at 1. As noted above, it does
not appear that substantial efforts were made in this regard during 2000.
The talking points also report that management "expect[s] this standard to
cause significant volatility in our equity but that it should have only a
minor impact on our earnings." Id.
(614) Minutes of the Meeting of the Audit Committee of the Board of Directors of
Fannie Mae, dated Nov. 16, 1999, FMSE-IR 322676-82, at FMSE-IR 322679.
164
year 2000. She stated that KPMG's test work would emphasize the system and
accounting changes required to account for hedges under the new FAS 133
standard."(615)
Howard's report to the Board in February 2001, following the effective
date of FAS 133, was critical of the standard itself, and focused on the impact
of the standard on the Company's financial statements. At least insofar as the
minutes of this meeting and Howard's talking points reflect, at no time did
management report to the Board on the tenets that the Company had used to
implement FAS 133 or the critical decisions that the Company had made with
respect to systems development or accounting policy.(616)
C. FASB
The Company's interactions with the FASB focused on narrow questions.
The most important of these related to (1) the time value of options; (2) the
term-out transactions and the Fannie Mae "carve-out"; and (3) transactions
involving hedges of the risk-free rate. On the first issue, the FASB did not
accommodate Fannie Mae's concerns. On the second issue, the FASB initially
considered the shortcut method a possibility for term-outs, but unequivocally
rejected that approach in FAS 138. As to the third issue, Fannie Mae prevailed
on FASB to change the standard.
Based on our interviews and the documentary record, it would be
incorrect to assume that the FASB had a significant appreciation of the facts
behind the Company's accounting policies surrounding FAS 133, or that the FASB
in any way approved the Company's accounting. On the contrary, in several
significant respects, the FASB's views regarding particular transactions were
based on insufficient information regarding the Company's approach to hedge
accounting, and therefore should not be considered probative.
The Company's first letter to the FASB in October 1997 addressed both
basis swaps and term-outs.(617) The letter described these transactions in
general terms. The letter asked the FASB to assume that there would be minimal
ineffectiveness in the term-out transactions and that the transactions would
therefore qualify for hedge accounting. As to the basis swaps, it simply asked
the FASB to "allow basis swaps to qualify for hedge accounting and to be marked
to market through equity subject to the transaction meeting the same qualifying
criteria as a cash flow hedge."(618) As to the latter
- ----------
(615) Minutes of the Meeting of the Audit Committee of the Board of Directors of
Fannie Mae, dated Apr. 18, 2000, FMSE-IR 396847-53, at FMSE-IR 396851.
(616) Minutes of the Meeting of the Board of Directors of Fannie Mae, dated Feb.
20, 2001, FMSE 504046-058, at FMSE 504054-55.
(617) Letter from S. Rajappa to Director of Research and Technical Activities,
Fin. Accounting Standards Bd., dated Oct. 6, 1997, FMSE-IR 217015-26.
(618) Id. at FMSE-IR 217017.
165
transaction, the Company suggested that the transaction is "perfectly
effective."(619) It did not discuss any differences in the terms of the
instruments that might have injected ineffectiveness into the transaction.
Moreover, the FASB did not agree with the Company's suggestion that changes in
the fair value of the offsetting interest-rate swaps be included in equity,
requiring instead that the fair value of the offsetting swaps be recognized in
income.
The Company sent a letter to the FASB in January 1999 addressing an
issue concerning differences between the effective interest rate on Discount
Notes and LIBOR.(620) The letter specified that the "reset dates on the floating
leg of the swap match the rollover date of the Discount Notes." The letter did
not indicate that, according to Company policy, the reset dates could fall
within seven calendar days of each other.
Also in 1999, the Company drafted a letter to the FASB regarding the
FASB staff's tentative decision that would have precluded the use of the
shortcut method under paragraph 68 of FAS 133 for derivatives existing at the
date of adoption of the standard. The letter stated: "We have already begun our
systems development under the assumption that the majority of our swaps qualify
for the shortcut method and we have plans to terminate most of the hedging
relationships that do not qualify for the shortcut method prior to our adoption
of FAS 133."(621) In a letter dated April 3, 2000, when the Company's accounting
policies and systems were largely in place, the Company reported to the FASB
that it "intends to rely on the 'shortcut' method provided for in the Statement
to ease the implementation effort of adopting FAS 133."(622) Yet, when the FASB,
in its adoption of FAS 138, rejected reliance on the shortcut method for
term-out transactions, Fannie Mae did not change its accounting treatment.
Fannie Mae approached the FASB again in 2004 regarding a specific term-out
transaction that KPMG questioned; the FASB confirmed that the transaction could
qualify for hedge accounting generally but, again, there is no indication that
Fannie Mae explained its accounting for the transaction in any detail.
Based on the information that Fannie Mae provided to the FASB, we have
no basis to conclude that the FASB was sufficiently familiar with Fannie Mae's
approach to FAS 133 such that the FASB can be held to have approved the
Company's accounting. The correspondence suggests that Fannie Mae's
presentations to the FASB were directed
- ----------
(619) Id. at FMSE-IR 217018.
(620) Letter from J. Boyles to R. Wilkins, dated Jan. 20, 1999, FMSE 57580-81.
(621) Letter from T. Howard to Derivatives Implementation Group, dated Sept. 29,
1999, FMSE 366044-45, at FMSE 366044.
(622) Unsigned letter from T. Howard to Director of Research and Technical
Activities, Fin. Accounting Standards Bd., dated Apr. 3, 2000, FMSE
48027-30. Talking points dated March 29, 2000, prepared for a conference
call with the FASB, use similar language. FMSE 61130.
166
to narrow questions, and did not address important issues (such as differences
in the repricing dates) to which the FASB might have reacted negatively. The
FASB's responses to Fannie Mae's letters go only so far as the information in
the Company's inquiries allow. In our view, reliance on the FASB's views to
support Fannie Mae's accounting treatment, except as to narrow issues, has no
basis in the record.(623)
D. KPMG
Fannie Mae encouraged KPMG's involvement in the implementation of FAS
133 and provided KPMG with relevant information. The record shows that KPMG had
access to Fannie Mae's written hedge accounting policies, including the DAG, and
did not raise significant objections to those policies. Both documents and
recollections of those involved confirm that KPMG was a part of the
implementation process from the outset.
A number of Fannie Mae documents refer to the importance the Company
placed on receiving KPMG's approval of the Company's approach to hedge
accounting even before FAS 133's effective date. Several interviewees referred
to the Company's "special engagement" of KPMG to review the DAG and other issues
relating to hedge accounting. Additional evidence appears to confirm that the
Company paid KPMG an additional fee in 2000 for the work associated with the FAS
133 implementation effort. We have no reason to doubt the statement in Spencer's
December 1998 memorandum that those involved in the FAS 133 implementation
process had "met with KPMG and walked them through each type of transaction and
what our recommended accounting treatment would be. We explained how we didn't
want to start systems work without KPMG's sign-off on our accounting
proposals."(624) As noted above, KPMG reported to the Audit Committee in early
2000 that it intended to pay significant attention to Fannie Mae's
implementation of FAS 133, and KPMG's audit workpapers for 2000 discuss many of
the Company's most significant policies in this area.(625)
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(623) A representative of Huron approached the FASB with a request that they
discuss with us the FASB's involvement with Fannie Mae's accounting
generally, and its implementation of FAS 133 specifically. The FASB
declined to participate.
(624) Mem. from L. Spencer to T. Howard et al., dated Dec. 4, 1998, FMSE-IR
192988-992, at FMSE-IR 192988.
(625) The one significant exception we have identified relates to a feature of
the DEBTS system, which links the derivatives to debt. A feature of DEBTS
is that these links are not necessarily maintained, at least for Discount
Notes. Rather, pay-fixed interest-rate swaps are relinked automatically to
hedge (in order of priority) term-out transactions, medium- or long-term
variable rate debt, and the rollover of discount notes. As a consequence, a
pay-fixed swap linked to the rollover of Discount Notes might automatically
be relinked at a later point to hedge a term-out transaction. It appears
that this aspect of the DEBTS system was not well
167
This is not to say that KPMG necessarily viewed the Company's
application of FAS 133 as correct in all respects. A preponderance of the
evidence suggests that KPMG did not object to the Company's application of FAS
133 in several important respects because the auditors came to believe that any
departures from a proper application of the standard would be immaterial.
KPMG workpapers reveal a significant amount of attention to various
aspects of the Company's FAS 133 accounting policies and systems in the months
leading up to the effective date.(626) Among other things, the workpapers
confirm that KPMG "[r]eviewed the 67 transactions identified in the [Derivatives
Accounting Guidelines] and determined that the accounting treatment for the
transactions . . . are [sic] reasonable based on the information
presented."(627)
A KPMG workpaper prepared in 2002 describes the audit work conducted
during that year.(628) The document states: "It is important for Fannie Mae to
receive hedge accounting treatment because hedge accounting treatment results in
only the ineffective portion of a hedge being reflected in earnings. Otherwise,
the entire gain or loss related to the derivative is reflected in earnings,
resulting in earnings volatility."(629) The workpaper then describes and
discusses various aspects of Fannie Mae's hedge accounting.
The workpaper discusses the hedge of anticipated issuances of
benchmark notes and the rollover of discount notes together. As to the
anticipated debt issuance, the workpaper states:
Under FAS 133, if the critical terms of the hedging instrument and the hedged
item are the same, an entity can assume that a hedge will be perfectly effective
at offsetting the hedged transaction's variability in cash flows, which is
referred to as the "short-cut" method. Additional criteria necessary for
applying the short-cut method include eligible risk and duration parameter.(630)
- ----------
understood within the Company, and neither Financial Standards nor KPMG
appears to have been aware of it at the time the Company adopted FAS 133.
(626) KPMG, Derivatives and Hedging Process and FAS 133 Audit Program, dated
Dec. 31, 2000.
(627) KPMG, Completion Memorandum, dated Dec. 31, 2000.
(628) KPMG, Process Analysis Document.
(629) Id. Similar language also appears in the DAG at FMSE-IR 12847.
(630) Id.
168
The workpaper then describes an acceptable "duration range" for these purposes
- -- that is, the extent to which the duration of the hedging and hedged
instrument must match to qualify for Fannie Mae's shortcut treatment. The report
states further that Fannie Mae "prove[s] out each year . . . that using the
shortcut method based on this prescribed duration range is proper by selecting a
sample of anticipatory hedge transactions and measuring hedge
ineffectiveness."(631) A handwritten note in the workpaper reports that "KPMG
requested that Fannie Mae complete long-haul calculations for selected
transactions associated with employing the duration check to verify that any
ineffectiveness would be immaterial."(632)
KPMG's workpapers also acknowledge that "Fannie Mae can use a shortcut
method to apply FAS 133 provisions to an interest rate swap in a cash flow hedge
when it is assumed that there will be no hedge ineffectiveness."(633) A
handwritten note following that statement refers to the rollover of discount
notes:
Fannie Mae Derivative Accounting Guidelines Section IV (pages .20 and
.21) discuss the policy for assuming no ineffectiveness for the
issuance and rollover of discount notes. Discount notes are considered
forecasted fixed rate debt instruments, and Fannie Mae hedges the risk
of changes in interest payments attributable to changes in the
benchmark rate related to the forecasted issuance of discount notes.
Fannie Mae assumes no ineffectiveness and applies the shortcut method
if the rollover date of the disc. notes and the reset on the interest
rate swap are w/in +/- 7 days of each other. (A maximum of five
business days.) Although the policy is not in strict compliance with
FAS 133 and DIG, KPMG reviewed and agreed to this policy at the time
when Fannie Mae was preparing their accounting guidelines and
implementing FAS 133.
Any ineffectiveness would result from near-term movements in rates as
the yield curve at 90 days vs. 95 days (5 business day difference) or
longer periods would
- ----------
(631) Id.
(632) Id. A separate, handwritten statement in that same document appears to
say: "These parameters are included in Fannie Mae Derivative Accounting
Guidelines and calculations are prepared to prove out effectiveness and
ineffectiveness employing a long-haul approach." Id.
(633) Id.
169
not be different. Any ineffectiveness would flow through the financial
statements within a given quarter.(634)
At another part of the workpaper, KPMG states: "if the critical terms of the
Discount Note and the swap are the same, no hedge ineffectiveness is assumed
using short-cut method."(635)
The KPMG workpapers also address the Company's use of the de minimis
test for assessing hedge effectiveness. KPMG stated in its workpaper that it had
"indicated we would approve a ten bps threshold" and that the use of the test
"will still result in earnings impact because the market values of the hedging
instrument and the hedged item will still be compared using the dollar offset
method."(636) A handwritten note in the paper states: "The 'de minimus'[sic]
measure is used only for anticipated issuance of debt. The time being hedged is
minimal [illegible - possibly a discussion of the short time period between the
planned debt issuance and the actual debt issuance] and therefore it is
reasonable to conclude that given the short term of the hedge [illegible] and
the historical movements in rates w/in a couple day period --> It is reasonable
to conclude that the hedge will be highly effective and qualify for hedge
accounting."(637)
With respect to existing debt obligations, the workpaper notes:
"Fannie Mae assumes no hedge ineffectiveness if the critical terms of the debt
obligation and the swap are the same." For these transactions (as well as for
anticipated debt issuances and discount not rollovers), the workpaper provides
that "if the critical terms of the hedging instrument and of the hedged item do
not match, the Hedge Desk [or Funding Desk as the case may be] must assess the
effectiveness of the hedges via the long haul method."(638)
These workpapers establish that KPMG had access to Fannie Mae's
principal hedge accounting policies and was aware of the principal features of
Fannie Mae's approach to hedge accounting. KPMG accepted certain aspects of
Fannie Mae's approach that were not consistent with a strict reading of FAS 133,
and that acceptance was based largely on an understanding that the impact of
those deviations would be immaterial.
- ----------
(634) Id.
(635) Id.
(636) Id.
(637) Id.
(638) Id. (emphasis in original).
170
E. OFHEO
Interviewees indicated that Fannie Mae's implementation of FAS 133 was
open to OFHEO as well. Several interviewees recalled at least one briefing
during which they explained Fannie Mae's approach to hedge accounting to OFHEO
personnel and provided OFHEO with copies of relevant materials, including the
DAG.
In its annual report to Congress in 2002, regarding examination work
conducted during calendar year 2001, OFHEO reported that it had "proctor[ed] the
implementation of FAS 133 and ongoing compliance."(639) Although OFHEO was
careful to avoid a categorical statement to the effect that it had conducted an
audit of Fannie Mae's FAS 133 accounting, it acknowledged in its report that it
had "evaluated the appropriateness of GAAP accounting for derivatives." In this
respect, OFHEO reported that "FAS 133 implementation has been deliberate and
well-documented with the necessary investments made to provide systems needed to
ensure ongoing compliance."(640) This report appears to confirm that OFHEO had
access to Fannie Mae's accounting policies and other information relevant to the
implementation of FAS 133, and that OFHEO initially found no weaknesses in
Fannie Mae's approach.
In our conversations with OFHEO regarding this report, agency
officials acknowledged that it had reported no deficiencies in Fannie Mae's
application of FAS 133 as of 2002. The officials noted, however, that they are
not the Company's auditor and they (like the Company's Board) are entitled to
rely on the auditor for a thorough assessment of the Company's accounting. OFHEO
also was very candid in its assessment of the weaknesses in its own examination
processes prior to 2003.(641)
- ----------
(639) OFHEO Report to Congress, dated June 14, 2002, at 25, available at
http://www.ofheo.gov/Media/Archive/reports/ar61402.pdf.
(640) Id. at 29.
(641) Among other things, OFHEO pointed us to the July 2003 testimony of its
then-Director Armando Falcon, before the Senate Banking, Housing and Urban
Affairs Committee. In response to a question from Senator Sarbanes as to
"how we get at the fact that it [referring to Freddie Mac's accounting
problems] was all happening unbeknownst to the regulator," Falcon stated:
"That's a good question, Senator Sarbanes. And what we are working to do at
OFHEO is to build an in-house team of accountants that can take a look at
issues like this." Falcon suggested that OFHEO "should have a lower
threshold of what gets included in this annual report." In response to a
question from Senator Sununu, Falcon stated: "In addition, it has been
clear for a long time now to me that the Agency needed to build the depth
in at least the examination program, and we are working to try to do that."
See Hearing Before the Committee on Banking, Housing and Urban Affairs, S.
Hrg. 108-833, July 17, 2003, at 18, 26.
171
F. Internal Audit
Fannie Mae's Internal Audit personnel conducted an audit of the FAS
133 implementation effort in the fall of 2000. According to the December 2000
report of that effort, the audit "was conducted to determine whether internal
controls over derivatives transactions are adequate and functioning effectively
to ensure compliance with FAS 133."(642) The report states that Internal Audit
had (among other things) "validated FAS 133 system criteria for classifying
derivatives as cash flow, fair value and DNQ (does not qualify) hedges" and
"verified that processes and controls had been implemented to meet the FAS 133
documentation requirements for hedging relationships." Internal Audit had no
criticisms to report, and concluded that "transactions are accounted for and
reported in accordance with FAS 133 requirements."
Interviews with several of the audit personnel involved in the FAS 133
audit confirm that, in fact, this statement was incorrect. Internal Audit did
not conduct an audit of the Company's compliance with the requirements of FAS
133, as its conclusion might suggest. Internal Audit conducted a controls audit
of the Company's systems for implementing hedge accounting. In addition, the
controls audit was not based on FAS 133, but on the Company's implementation of
FAS 133 as reflected in the Derivative Accounting Guidelines.
* * *
In sum, several entities were involved in the development of Fannie
Mae's FAS 133 accounting policies as they took shape in 1999 and 2000. Although
Fannie Mae would later come to rely on its communications with the FASB to
support its positions, we find little in the record to support the view that the
FASB had a sufficiently clear or complete picture to approve the Company's hedge
accounting, or that it did more than respond to the narrow questions that Fannie
Mae posed based on hypothetical scenarios that did not explain aspects of the
Company's transactions that the FASB might have found troubling.
Both OFHEO and the Company's internal auditors had the opportunity to
review Fannie Mae's FAS 133 program in detail and both issued reports that
praised the Company's implementation efforts without qualification. Indeed, both
the OFHEO and Internal Audit reports contain language that is so broad it could
have misled readers into believing that the conclusions say more than was
intended, particularly with respect to the Company's compliance with GAAP.
OFHEO's review is particularly noteworthy given the fact that, a year after
OFHEO issued its 2002 report, it would begin its Special Examination of Fannie
Mae and conclude that the errors in Fannie Mae's hedge accounting were numerous
and fundamental.
- ----------
(642) Draft Audit Report, Office of Auditing, FAS 133 Audit, dated Dec. 22,
2000, FMSE-E 47997-8000, at FMSE-E 47999-8000.
172
KPMG had a comprehensive view of the most significant features of the
Company's FAS 133 policies. It accepted the proposition that FAS 133 was subject
to a materiality standard, and maintained throughout that any departure from FAS
133's requirements reflected in the Company's policies would not distort the
Company's financial statements. Having reported to the Board that it would
review the Company's implementation efforts in 2000, it then reported that the
Company's financial statements were fairly stated. It did not deviate from that
view.
Finally, the Board was entitled to rely -- and by all accounts did
rely -- on the representations and conclusions it received. Management's
consistent message to the Board was that the Company was prepared for any
challenges that FAS 133 presented, and the reports that the Board received from
KPMG, OFHEO and Internal Audit until 2004 confirmed that view.
173
CHAPTER VI: OTHER ACCOUNTING ISSUES
PART A: ACCOUNTING FOR THE ALLOWANCE FOR LOAN LOSSES
I. INTRODUCTION
In this Part, we address the propriety of the Company's accounting for
the allowance for losses on loans in its mortgage portfolio and the liability
for losses associated with its guaranty of the loans underlying its MBS
(collectively referred to as the "Allowance").
The facts showed that management's methodology for setting the
Allowance in the period from 1997 through 2003 was not based upon a detailed
assessment of the loss exposure inherent in the portfolio, as required by GAAP,
and did not reflect the continued trend of improved credit quality that the
Company reported in its public statements. Accordingly, all evidence would
indicate that the Allowance was overstated as early as 1997. However, we saw no
evidence that management intentionally utilized the Allowance to manipulate
earnings or to offset unrelated one-time events. Of course, by not reducing the
reserve when they knew, or should have known, that it was overstated, management
had a potential "war chest" for meeting earnings targets, and the evidence
showed that management periodically did consider drawing down the reserve to
offset unrelated expenses. Furthermore, had the excess reserve been reversed
when management first knew, or should have known, the reserves were overstated,
the reduction in income and its "non-recurring" nature would have made the
subsequent year's earnings growth goals that much more difficult to achieve.
Finally, a downturn in the economy or other adverse changes in credit quality
would have required the Company to add to the reserve, further reducing earnings
and making it difficult to meet year over year earnings targets in a given
period.
In summary, we have the following conclusions about management's
historical accounting for the Allowance:
- - As early as 1997, management believed that the Allowance was in excess of
what was required and viewed such excess as a "war chest" to mitigate the
impact of unrelated financial events; however, we saw no evidence that
management did, in fact, use the Allowance to offset unrelated expenses or
to manage earnings to meet EPS targets in a given period.
- - The Allowance was essentially unchanged at approximately $800 million
throughout the seven-year period from 1997 to 2003, despite improved credit
quality and improved credit administration by the Company. Credit
losses(643) as a
- ----------
(643) Credit losses or "credit-related losses" are defined by Fannie Mae as the
sum of foreclosed property expenses plus charge-offs. Fannie Mae 2002
Annual Report (Form 10-K), at 126 (Mar. 31, 2003) (hereinafter "2002 Form
10-K"), available at http://fanniemae.com/ir/pdf/sec/2003/f10k3312003.pdf.
174
percentage of the average book of business declined from 0.027% in 1998 to
0.006% in 2003; because management did not adjust the Allowance based on
this experience, the number of years of losses covered by the Allowance
increased from 3.3 years of losses in 1998 to 7.2 years of losses in 2003.
- - The methodologies used by management to set the Allowance during the period
from 1997 through 2003 were not based upon a detailed assessment of the
loss exposure inherent in the portfolio, as required by GAAP, and did not
measure or reflect the effects of improved credit quality that the Company
reported during the period. Management essentially derived the Allowance
level by setting the provision for losses (i.e., expense) equal to
charge-offs. GAAP requires the Allowance to be assessed and adjusted to
reflect management's documented estimate of losses inherent in the
portfolio on a periodic basis (e.g., quarterly) with any necessary
adjustment to the level of the Allowance reflected as an increase or
decrease to the provision for losses.
- - During the period, management failed to develop a detailed bottom-up
methodology to estimate losses inherent in the portfolio as of the balance
sheet date as required by GAAP. SEC Staff Accounting Bulletin No. 102 ("SAB
102") applied to Fannie Mae's Allowance accounting practices as of December
31, 2002, when Fannie Mae became a registrant. Management did not begin
working on a detailed Allowance model until some time in 2002, despite
KPMG's inquiries as early as 1998 about a detailed Allowance model to
support the level of the Allowance, and the model was not deemed complete
until the third quarter of 2003.(644)
Management has reduced the Allowance by approximately $300 million in
2004, and will restate historical periods as part of the restatement.
II. BACKGROUND
A. Identification of the Allowance as a Potential Issue
Our investigation into Fannie Mae's accounting for the Allowance was
the result of three specific areas of work. First, during our review of the 1998
catch-up adjustment,(645) we found a 1999 planning document from the files of
Shaun Ross, then a Project Manager in the Controller's Office, which had
significant implications for
- ----------
(644) Allowance for Loan Losses Audit Report, dated Dec. 15, 2003, Zantaz
document 2229258, at 1, 2; Single Family (SF) Allowances for Loan Losses
(ALL) Process During Restatement Period 2001 - through 2004, dated Aug. 1,
2005, Zantaz document 2228409.
(645) See discussion supra Chapter IV.
175
management's use of the Allowance.(646) As detailed above, the document was a
set of schedules dated January 7, 1999 and labeled "Earnings Alternatives," and
presented three alternative scenarios for recognizing the 1998 catch-up
expense.(647) This document was prepared by Ross at the request of Leanne G.
Spencer, then Controller, in connection with the finalization of year-end
results for 1998. The third alternative of this schedule appeared to reflect
management's consideration of an adjustment to the fourth quarter 1998 results
to decrease the provision for losses by $100 million, which would have had the
effect of reducing the Allowance by the same amount. The document suggested, at
a minimum, the possibility that then management believed that there was a
surplus in the Allowance sufficient to absorb a $100 million reduction while
maintaining adequate protection against losses.(648)
Second, during our review of KPMG's audit workpapers for fiscal years
1998 through 2002, we noted an absence of support prepared by management for the
"build up" of the Allowance. Additionally, we found an internal KPMG memorandum
that described a meeting on August 11, 1998 with Timothy Howard, then Fannie
Mae's CFO, which reflected Howard's expectation that an allowance model would be
completed by the end of 1998. The memorandum also stated that Howard "hopes to
have the analysis that will provide a solid basis to determine if the
[A]llowance needs to be increased, decreased or is at an approprite [sic]
level."(649) Ken Russell, the author of this KPMG memorandum, wrote in the
memorandum that he did not expect that an increase to the Allowance would be
required. (650) Shortly following the date of this memorandum, a document that
contained KPMG's notes from a December 31, 1998 Fannie Mae conference call
stated the following: "Allowance may be conservative. Are waiting to adjust when
they have a sense on long term trends."(651)
While the KPMG audit workpapers for 2003 referred to and included a
Fannie Mae model supporting a majority of its Allowance, we could not locate
similar information in the prior years' audit workpapers. We also noted in the
KPMG workpapers other documents that suggested that the components of the 2003
Allowance
- ----------
(646) Fannie Mae 1999 Income Statement schedules, dated Jan. 7, 1999, FMSE-IR
21476-79, at FMSE-IR 21477-79.
(647) See discussion supra Chapter IV.
(648) Compare Fannie Mae 1999 Income Statement schedules, dated Jan. 7, 1999,
FMSE-IR 21476, at FMSE-IR 21479, with Fannie Mae 2000 Annual Report, at 43,
available at
http://www.fanniemae.com/global/pdf/ir/annualreport/2000/financials.pdf.
(649) Mem. from Ken Russell to Julie Theobald and Eric Smith, dated Aug. 25,
1998.
(650) Id.
(651) Fannie Mae Conference Call Notes December 31, 1998, dated Jan. 14, 1999.
176
continued to contain a general reserve category known as "other projected
risks," which contained amounts not associated with modeled risks or any
particular pool of loans.(652)
We subsequently learned that management's process of setting the
Allowance balance in the late 1990s through 2003 consisted of quarterly meetings
whereby single-family and multifamily loan activity and related credit loss
metrics were reviewed. The result of these meetings was to set the provision for
loan losses equal to charge-offs.(653) This practice was in contrast to GAAP,
which requires the level of the Allowance to reflect an estimate of losses
inherent in the portfolio as of the balance sheet date with any required
adjustment flowing through the income statement.
The third and final reason for our focus on the Allowance was a review
of Fannie Mae's published financial statements. We observed that the Allowance
balance was essentially unchanged at approximately $800 million throughout the
seven-year period from 1997 through 2003. We also noted the following disclosure
regarding the Allowance from 1998 to 2002 in Fannie Mae's 2002 Form 10-K: "Over
the past five years, our combined allowance for loan losses and guaranty
liability for MBS have remained relatively stable although our book of business
has expanded. This trend reflects improvements in the credit performance of our
book of business."(654) This statement suggested that while the risk grew along
with the book of business, the Allowance remained constant due to improved
credit performance.
However, our own analysis showed that credit performance improved
significantly more than the increase in size of the book of business. That is,
the credit losses as a percentage of the average book of business declined from
0.027% in 1998 to 0.006% in 2003, which equated to a seventy-eight percent
decrease in the percentage of credit losses. In contrast, the size of the book
grew from approximately $1.1 trillion in
- ----------
(652) Draft Fannie Mae Allowance for Loan Loss Methodology, dated Dec. 29, 2003.
The 2003 Allowance contained $51.3 million for "other projected risks"; in
2002, the amount was $149.8 million. The total Allowance balance in 2002
and 2003 was $808.2 million and $796.9 million, respectively. See Q4 2004
Allowance for Loan Losses Summary, dated Jan. 26, 2005, FMSE-IR 283353.
(653) Although Fannie Mae's documentation for the Allowance in 2003 does not
explicitly indicate a policy of setting the provision for loan losses equal
to charge-offs, the Allowance balance continued to remain static throughout
2003. The Allowance did not change significantly from the fourth quarter of
1997 through the fourth quarter of 2002. See, e.g., Undated Notes to the
File Quarterly Loss Review Fourth Quarter 1997 Review, FMSE-IR 280137-39,
at FMSE-IR 280139; Undated Notes to the File Quarterly Loss Review Fourth
Quarter 2002 Review, FMSE-IR 281079-80, at FMSE-IR 281080.
(654) 2002 Form 10-K at 56.
177
1998 to approximately $2.2 trillion in 2003.(655) The combined effect of
declining credit losses and the policy of provision that equaled charge-offs,
led to a substantial increase in the number of years of loss coverage provided
for in the Allowance:(656)
TABLE 1.
DOLLARS IN MILLIONS 1998 1999 2000 2001 2002 2003 2004
- ------------------- ------- ------- ------- ------ ------- ------- -------
Allowance $ 799.0 $ 801.0 $ 806.0 $803.0 $ 808.0 $ 797.0 $ 510.4
Charge-offs (245.0) (149.0) (117.0) (97.0) (123.0) (111.0) (290.9)
Coverage Ratio 3.3 5.4 6.9 8.3 6.6 7.2 1.8
======= ======= ======= ====== ======= ======= =======
These facts raised several questions about the propriety of the
Company's historical accounting for the Allowance, including: (1) whether
management intentionally maintained an excessive Allowance to manage current
and/or future earnings volatility; (2) what was the Company's methodology for
supporting its Allowance balance, and how was the methodology documented; (3)
what were the reasons for the Company's failure to adjust the Allowance; and (4)
whether the Allowance was at an adequate but not excessive level to cover such
losses for the period between 1998 and 2004. We determined that these questions
merited further investigation.
B. Relevant Accounting Principles
The accounting principles that apply to an allowance for loan loss is
well summarized in remarks by Lynn E. Turner, then Chief Accountant of the SEC,
in a speech dated November 6, 1998:(657)
GAAP for loans and the allowance for loan losses can be found in FASB
Statements No. 5 and 114 and in the AICPA Audit Guide for Banks and
Savings Institutions (Audit Guide). The basic premise in this guidance
is best summarized in paragraph 7.29 of the Audit Guide which
- ----------
(655) Loss Accounting Summary, dated April 2004, Zantaz document 2226776, at 3;
Q4 2004 Allowance for Loan Losses Summary, dated Jan. 26, 2005; 2002 Form
10-K at 56; Fannie Mae, 2003 Annual Report (Form 10-K), at 41 (Mar. 15,
2004) (hereinafter "2003 Form 10-K"), available at
http://www.fanniemae.com/ir/pdf/sec/2004/f10k03152004.pdf.
(656) 2002 Form 10-K at 56; 2003 Form 10-K at 41; Q4 2004 Allowance for Loan
Losses Summary, dated Jan. 26, 2005, FMSE-IR 283353; Loss Accounting
Summary, dated May 2005, Zantaz document 1945386, at 3.
(657) Lynn E. Turner, Chief Accountant, SEC, Remarks to the AICPA Bank and
Savings Institution Annual Conference: Continuing High Traditions (Nov. 6,
1998).
178
states: "The allowance for loan losses should be adequate to cover
probable credit losses related to specifically identified loans as
well as probable credit losses inherent in the remainder of the loan
portfolio that have been incurred as of the balance sheet date" . . .
GAAP does not permit providing losses for future events.
Guidance in this area is [also] provided by the banking regulators.
For example, OCC ADVISORY LETTER 97-8 states that "Unallocated
reserves . . . must not be used to obfuscate the determination of the
overall allowance adequacy, mask significant deteriorating trends in
asset quality, or 'manage' earnings." Additionally, Financial
Reporting Release ("FRR") No. 28 requires the application of a
systematic methodology and rationale in determining the allowance for
loan losses.
The GAAP principles that Turner described apply to both public and
non-public companies. In addition, SAB 102, applied to public
companies as of the 2002 financial statements. SAB 102 did not create
a new standard, but only served to reinforce the existing accounting
literature and GAAP requirements for determining and documenting the
amount of the allowance for loan losses.(658)
III. FINDINGS CONCERNING FANNIE MAE'S ACCOUNTING FOR THE ALLOWANCE
A. Fannie Mae's Historical Practice for Setting the Allowance
1. Overview of the Components of Fannie Mae's Allowance
Fannie Mae's Allowance covers both single-family and multifamily loans
held in its loan portfolio. The guaranty liability relates to Fannie Mae's
guaranty of MBS held by Fannie Mae in its portfolio as well as outstanding MBS
held by third party investors. Because management determined that the credit
risks are identical, management used the same methodology to set the Allowance
for loan losses and guaranty liability for MBS.(659)
- ----------
(658) SELECTED LOAN LOSS ALLOWANCE METHODOLOGY AND DOCUMENTATION ISSUES, SEC
Staff Accounting Bulletin No. 102, at 1, 3 (July 6, 2001), "draws upon
existing guidance, in Commission rules and interpretations, generally
accepted accounting principles, and generally accepted auditing standards,
and explains certain views of the staff in applying existing guidance
related to loan loss allowance methodologies and supporting documentation."
(659) 2002 Form 10-K at 55; 2003 Form 10-K at 40.
179
The following diagram illustrates the components of Fannie Mae's
Allowance:
(FLOW CHART)
According to the Company's financial statements, the Allowance
components were calculated based on the credit quality of the portfolio.(660)
Management analyzed several risk factors when assessing credit quality. As
depicted in the diagram above, these risks were analyzed based on the
single-family and multifamily loan types. Risk factors that the Company analyzed
for both single-family and multifamily loans included delinquency levels,
historical loss experience, current economic conditions, and mortgage
characteristics.(661)
2. Management's Process for Setting the Allowance
Management did not employ a model or a well-documented detailed
process to estimate the Allowance from 1997 through 2002. During this period,
both the single-family and multifamily portions of the Allowance were based on
the Company's "provision equal to charge-offs" policy, which resulted in the
Allowance balance being maintained at a relatively static level. Even after
implementing a more analytical approach for setting the Allowance in 2003,
management maintained the Allowance balance at the existing level.
(a) Early 1990s
At one point in the early to mid-1990s, the Company apparently had
maintained the Allowance at a level approximating two to three times trailing
charge-
- ----------
(660) Id.
(661) Id.
180
offs. We did not find a document written contemporaneously that reflected this
approach, but instead, a document from 2000, after the policy changed, that
reflected it.(662) Jonathan Boyles described the policy from that time period as
being "a laundry list of things to consider."(663)
J. Morgan Whitacre, then Director-Business Planning, became
responsible from sometime in late 1997 or early 1998 through the fourth quarter
of 2003 for creating the presentations that the Controller's Office would use in
connection with the Allowance setting process. Whitacre stated that when he
first became responsible for this process, he used a "spreadsheet" he had
"inherited" from his predecessor to calculate a range of two to three times
trailing charge-offs that he would give to Spencer and Janet L. Pennewell for
their presentation.(664) We have not located any contemporaneous information or
specific documents that management relied upon to set the Allowance level during
this period.
(b) 1997 through 2002
From at least 1997 to 2002, the provision was set to be equal to
charge-offs during a series of quarterly loss review meetings.(665) Information
about the single-family and multifamily businesses was gathered and compiled by
the Controller's Office, which was responsible for recommending an Allowance
level. The collected information was discussed by management teams including the
Controller's Office, Credit Policy, Single-family, and Multifamily. The process
culminated with a CFO level meeting and a subsequent Chairman's loss meeting
involving the CEO.(666)
The CFO and CEO level meetings were typically attended by senior
management including the Chief Operating Officer, Chief Credit Officer,
Controller, as well as Single-family and Multifamily executives. However,
attendees recalled that the
- ----------
(662) Recommendation to Change Loss Accounting Methodology, dated Nov. 2000,
FMSE-E 44694-714, at FMSE-E 44707.
(663) Accord Allowance for Losses, dated July 1996, FMSE 31523-31.
(664) At some point between 1998 and 2000, he created a "trend model," the
output of which he also handed off to Janet L. Pennewell and Leanne G.
Spencer.
(665) See discussion supra at note 653.
(666) These meetings were commonly referred to as either the "Review with Chief
Financial Officer" or the "Loss Allowance Review Meeting with Chair" or
"Chairman's Loss Meeting."
181
discussion at such meetings focused on credit losses and portfolio performance,
rather than discussing specific Allowance requirements and related provision
amounts.(667)
The documents related to these CFO and CEO meetings confirm that the
focus was primarily on credit losses.(668) Documents also show that management
discussed data and statistics such as current delinquency levels, historical
loss experience, changes in economic conditions, payment performance in areas of
geographic concentration, loan purpose, product type, original loan-to-value
ratio, and loan age or "seasoning." (669) Whitacre and others acknowledged that
the Company did not keep documentation of the Allowance setting process other
than the "Chairman's package," prior to 2002.
(1) Change in Policy in 1997
At the end of 1997, management changed the Allowance policy to simply
provide an amount equal to charge-offs, from the previous trailing two to three
years of trailing charge-offs.(670) While not conclusive, this change in
provisioning policy may be related to a memorandum written by Michael Quinn to
Howard, among others, in late 1997, in which Quinn suggested that the provision
be calculated at a level that "will approximate charge-offs."(671) In addition,
other contemporaneous documents reflect a recommendation in 1998 to maintain the
Allowance at a constant level.(672)
- ----------
(667) Adolfo Marzol (then Chief Credit Officer), Robert J. Levin (then Head of
Housing and Community Development), and Michael Quinn (then Senior Vice
President for the Single-family Business), regularly attended the
Chairman's Loss Meetings during this time.
(668) Quarterly Loss Review documentation from 1998 through 2002, FMSE-IR
280194-96; FMSE-IR 280159-61; FMSE-IR 280317-19; FMSE-IR 280377-79; FMSE-IR
280424-26; FMSE-IR 280476-47; FMSE-IR 280535-36; FMSE-IR 280579-80; FMSE-IR
280636-37; FMSE-IR 280673-74; Zantaz document 3913800; FMSE-IR 280747-48;
FMSE-IR 280783-84; FMSE-IR 280839-40; FMSE-IR 280904-95; FMSE-IR 280960-61;
FMSE-IR 281019-20; FMSE-IR 281046-47; FMSE-IR 281079-80.
(669) Id.
(670) Undated Notes to File Quarterly Loss Review Fourth Quarter 1997 Review,
FMSE-IR 280137-39, at FMSE-IR 280139.
(671) Mem. from M. Quinn to Timothy Howard, R. Levin, Ann Logan, and Sam
Rajappa, dated Dec. 5, 1997, FMSE-IR 338619-21, at FMSE-IR 338620. This and
other examples of documents relevant to the discussion in Chapter VI, Part
A can be found in the accompanying Appendix, at Tab A.1.
(672) 1998 Loss Provisioning Strategies, Zantaz document 1512035, at 1.
182
Management highlighted this change to the Board and to the investing
public in 1998 and in 1999.(673) In particular, Howard stated that: "At the
present time our intent is to continue to have our quarterly loan loss provision
be roughly in line with charge-offs, so as to maintain our loss allowance
approximately level. We recognize that our $800 million loss allowance looks
conservative in the current environment. But we believe it is prudent to hold it
there, at least until we can get a better sense as to where the longer-term loss
trends may settle out."(674)
The decision to hold the Allowance constant, and to change the
provisioning policy to equal charge-offs, also may be related to the fact that
beginning sometime in 1997, the Company began experiencing charge-off gains,
instead of losses on foreclosures.(675) By late 2000, management was aware that
its accounting for "charge-offs" was not "optimal."(676) In a presentation to
Howard, Pennewell and Whitacre proposed a change in how Fannie Mae would
recognize losses and gains on foreclosures.(677) Under the proposed methodology,
which was referred to as "waterfall accounting,"(678) the Company would allocate
gains "on a loan by loan basis to first
- ----------
(673) Notes for January 1998 Board of Directors Meeting, Zantaz document
1505640, at 6 ("Our projected provision for losses tracks our expected
chargeoffs. Our intention this year is to have our provision equal our
chargeoffs, so if we continue to do as well on chargeoffs as we did in the
second half of last year our provision would be even lower."); Notes for
January 14, 1998 Conference Call, Zantaz document 1349789, at 3 ("Our
current intent for this year is to have our loss provisions equal our
chargeoffs - with only small differences each quarter such as we had last
quarter. That would keep our loss allowance at around $800 million. Once we
get a little more experience with where our chargeoffs are setting out -
and a sense of what may drive them in the future on a trend basis - we will
revisit this provisioning approach."); Tr. Notes for Jan.14, 1999
Conference Call, FMSE-IR 278342-49, at FMSE-IR 278345.
(674) Tr. Notes for Jan. 14, 1999 Conference Call, FMSE-IR 278342-49, at FMSE-IR
278345.
(675) Recommendation to Change Loss Accounting Methodology, dated Nov. 2000,
FMSE-E 44694-714, at FMSE-E 44698; accord Mem. from M. Quinn to T. Howard,
R. Levin, A. Logan, and S. Rajappa, dated Dec. 5, 1997, FMSE-IR 338619-21,
at FMSE-IR 338620.
(676) E-mail from J. Morgan Whitacre to J. Pennewell, dated Dec. 28, 2000,
FMSE-E 1819010-11, at FMSE-E 1819010.
(677) Recommendation to Change Loss Accounting Methodology, dated Nov. 2000,
FMSE-E 44694-714.
(678) See also E-mail from J. Pennewell to L. Spencer, Jonathan Boyles, Paul
Salfi, et al., dated Dec. 2, 2002, Zantaz documents 792470, 792476, at
Zantaz document 792476, at 4.
183
recover UPB [unpaid principal balance], then recover accrued interest, and then
cover other expenses."(679)
However, management did not implement this "waterfall accounting"
until 2002. The delay may have been due to Howard's reluctance to implement the
change. Howard described his concerns in Spencer's Annual Review for 2000:
[M]y main concern on this issue is that we not get into a situation
where, when losses start rising, our proposed policy results in our
needing to add large amounts to our loss allowance in addition to
covering our credit losses. Yet the proposal [Janet Pennewell]
presented to me a few weeks ago would, in my view, have done exactly
that.(680)
Nearly two years later, in June 2002, the Controller's Office made
another presentation to Howard stressing the "[n]eed to [c]hange" rather than
merely proposing a change.(681) The following month, Boyles, then head of
Financial Standards, described the issue in a "white paper" as follows:
We do not believe our current method of accounting [for the Allowance]
is the preferable method . . . . Under our current methodology we are
increasing the [Allowance] by recording gains from the disposition of
properties and reducing it through negative provisions.(682)
Boyles continued in the "white paper" that the current methodology made it
"increasingly difficult for us to produce analytical support for our current
allowance balance."(683) Further, Boyles added:
With the current public debate regarding whether or not we should
register with the SEC we believe it has become
- ----------
(679) Recommendation to Change Loss Accounting Methodology, dated Nov. 2000,
FMSE-E 44694-714, at FMSE-E 44698.
(680) Mem. from T. Howard to L. Spencer, dated Dec. 9, 2000, FMSE-IR 28779-81,
at FMSE-IR 28780-81.
(681) E-mail from J.M. Whitacre to A. Marzol, Brian Graham, and Laura Kenney,
dated Aug. 19, 2002, FMSE-E 1091499-513, at FMSE-E 1091501.
(682) E-mail from J. Boyles to L. Spencer, J. Pennewell, P. Salfi, and J.M.
Whitacre, dated July 1, 2002, FMSE 413416-19, at FMSE 413417.
(683) Id. at FMSE 413417-18.
184
imperative that we begin to put into place the analysis and support
for the balance in our allowance for loan losses.(684)
Plainly, during the period from 2000 through 2002, management
recognized that the Company's methodology made it increasingly difficult to
produce analytical support for the allowance balance in accordance with GAAP and
needed to be changed. Yet, the person who appeared to have had the authority to
do so, Howard, did not act upon the recommendation until late 2002.
Boyles's concern in the "white paper" was consistent with concerns
raised by KPMG. Mark Serock, who became the engagement partner for KPMG in 2001,
stated that the Company's Allowance practices prior to 2002 were "not
preferable." The issue, according to Serock, was the "recording [of] recoveries
in excess of the unpaid principal balance written off," which the Company
committed to change by year-end 2002. Serock said that KPMG had felt that Fannie
Mae's Allowance during these years was adequate, but that Fannie Mae needed to
improve its documentation that showed how management determined that the level
of the Allowance was reasonable.
Ultimately, management implemented its "waterfall accounting" at
year-end 2002.(685)
(2) Introduction of a Model into the Allowance Setting
Process(686)
In 2002, management began developing the Loss Allowance Model ("LAM")
to estimate the allowance attributable to the single-family book of business.
The timing and other evidence suggest that the decision was prompted by the
Company's decision to become an SEC registrant and the need to comply with SAB
102.(687)
- ----------
(684) Id. at FMSE 413418.
(685) Mem. from P. Salfi to L. Spencer, dated Jan. 31, 2003, FMSE 26642-44; 2002
Form 10-K at 30; see also E-mail from J. Boyles to L. Spencer, J.
Pennewell, P. Salfi, and J.M. Whitacre, dated July 1, 2002, FMSE 413416-19,
at FMSE 413417-19; E-mail from J.M. Whitacre to A. Marzol, B. Graham, and
L. Kenney, dated Aug. 19, 2002, FMSE-E 1091499-513.
(686) While Controller's Office staff used various spreadsheets in its
calculation of Allowance recommendations prior to 2002, it did not consider
those spreadsheets to be a modeled approach. Allowance for Loan Losses
(ALL) & Liability for MBS Guaranty - Briefing to OFHEO, dated June 14,
2005, FMSE-IR 438739-44, at FMSE-IR 438742-43; SF Allowance for Loan Losses
- Status Update and Report on Interim Findings, dated Aug. 25, 2005, Zantaz
document 2290112, at 4.
(687) Credit Loss Accounting Update, dated June 2002, Zantaz document 272788, at
2 ("Must Implement in 2002 SEC Guidance SAB 102 . . . requires detailed
analytical
185
The LAM was implemented during the fourth quarter of 2002.(688)
However, management chose to retain discretion over the Allowance rather than
follow the results of the model. That is, according to Adolfo Marzol, then head
of Credit Policy, at the quarterly Chairman's Loss Review meeting, management
decided that the difference between the previous quarter's Allowance and the
amount the LAM calculated, which was approximately $100 million, would be
described as the "unallocated portion" of the Allowance.(689) Richard DePetris,
then Controller for Multifamily, confirmed that an unallocated amount was added
to the LAM modeled amount for the multifamily portion of the Allowance in the
fourth quarter of 2002 to arrive at a level consistent with the previous
quarter.(690) We have found no evidence that management sought to substantiate
the amount to be set aside for the "unallocated portion."
(c) Policy in 2003
The process for setting the Allowance in 2003 continued to involve a
series of quarterly loss review meetings, but now the Allowance was calculated
using, in part, the results of the LAM. However, it was not until the third
quarter of 2003 when a version of the model was determined by Fannie Mae and its
internal auditors to be
- ----------
support behind loan loss allowance methods and application, including
procedures to adjust methodology to reduce any differences between
estimated and actual losses that occur. Most companies adopted upon
issuance in 2001: we need to comply by year end."); see also E-mail from J.
Boyles to L. Spencer, J. Pennewell, P. Salfi, and J.M. Whitacre, dated July
1, 2002, FMSE 413416-19.
(688) Although it had been implemented, Fannie Mae did not consider the LAM
complete until later, in the third quarter of 2003. Allowance for Loan
Losses Audit Report, dated Dec. 15, 2003, Zantaz document 2229258, at 1, 2;
Single Family (SF) Allowances for Loan Losses (ALL) Process During
Restatement Period 2001 - through 2004 mem., dated Aug. 1, 2005, Zantaz
document 2228409.
(689) See also Undated Proposed Loss Allowance Methodology: Model Allocated with
Unallocated Judgment, FMSE-IR 549499-512, at FMSE-IR 549511.
(690) Richard DePetris stated his belief that GAAP allows for an unallocated
reserve up to twenty-five percent of the prior period's total balance. In
support, DePetris cited SAB 102 and an AICPA exposure draft of a proposed
Statement of Position ("SOP"), "Allowance for Credit Losses," but
subsequently acknowledged that he could not recall ever reading either SAB
102 or the AICPA's proposed SOP.
Whitacre stated that the LAM was seen as confirmation of management's
judgment rather than as an analytical tool that would calculate the
Allowance in place of judgment.
186
completed.(691) It appears that, throughout 2003, the LAM results continued to
be discussed in the context of various loss statistics and a forecasted credit
outlook, and not as the result that was modeled for setting the Allowance.
Accordingly, notwithstanding the implementation of the LAM and the waterfall
accounting, the Allowance was kept static by management at approximately $800
million throughout 2003.
(d) Changes in 2004
In 2004, significant changes were made to the single-family portion of
the allowance,(692) which resulted in a reduction to the total Allowance balance
as shown in the following table:(693)
TABLE 2.
INCREASE/
DOLLARS IN MILLIONS 2003 2004 (DECREASE)
------------------- ------ ------ ----------
Analysis of Combined Allowance:
Single-family
Modeled $600.8 $370.1 ($230.7)
Other Projected Risks 36.8 (41.9) (78.7)
------ ------ ------
Total Single-family Portion of Combined Allowance $637.6 $328.2 ($309.4)
------ ------ ------
Multifamily
Specific $ 20.5 $ 16.3 ($4.2)
Modeled 124.3 151.8 27.5
Other Projected Risks 14.5 14.1 (0.4)
------ ------ ------
- ----------
(691) Allowance for Loan Losses Audit Report, dated Dec. 15, 2003, Zantaz
document 2229258, at 1, 2; Single Family (SF) Allowances for Loan Losses
(ALL) Process During Restatement Period 2001 - through 2004, dated Aug. 1,
2005, Zantaz document 2228409.
(692) A similar review of the Multifamily portion of the Allowance did not occur
until later, in 2005. Allowance for Loan Losses (ALL) & Liability for MBS
Guaranty - Briefing to OFHEO, dated June 14, 2005, FMSE-IR 438739-44; Mem.
from Gregory Garner to David Hisey and Carol Connelly, dated Mar. 30, 2005,
FMSE-IR 612149-54.
(693) Q4 2004 Allowance for Loan Losses Summary, dated Jan. 26, 2005, FMSE-IR
283353. The "Specific" multifamily portion refers to loans individually
evaluated by Fannie Mae that are considered impaired. Fannie Mae applies
Financial Accounting Standard No. 114, Accounting by Creditors for
Impairment of a Loan ("FAS 114"), to estimate the amount of impairment. See
2003 Form 10-K at 41; Allowance for Loan Losses (ALL) & Liability for MBS
Guaranty - Briefing to OFHEO, dated June 14, 2005 at FMSE-IR 438742.
187
Total Multifamily Portion of Combined Allowance $159.3 $182.2 $ 22.9
------ ------ -------
Total Combined Allowance
Specific $ 20.5 $ 16.3 ($4.2)
Modeled 725.1 521.9 (203.2)
Other Projected Risks 51.3 (27.8) (79.1)
------ ------ -------
Total Combined Allowance $796.9 $510.4 ($286.5)
------ ------ -------
Management's reason for reducing the Allowance in 2004 by $286.5 million was
"because prior estimates are determined to be beyond the range of
reasonableness."(694)
Among other things, the work done on the single-family portion of the
Allowance in 2004, which resulted in the material reduction, included: improving
the documentation for the Allowance in the first quarter of 2004;(695)
"discovering" more information about lender make-whole recoveries in the second
and third quarters of 2004, which were causing Fannie Mae's losses to be lower
than forecasted; and reducing the number of years of historical severity data
included in the LAM calculation in the fourth quarter of 2004.(696)
Additionally, at Marzol's behest, Fannie Mae increased the number of defaults
predicted by the LAM.(697) Based principally on the net effect of these changes,
management reduced the total Allowance by approximately $231 million in the
fourth quarter of 2004 alone.
- ----------
(694) Based on documents reviewed, the single-family portion of the Allowance
will be subject to restatement for 2001 through 2004. The multifamily
portion of the Allowance does not appear to be included in the pending
restatement. See Allowance for Loan Losses (ALL) & Liability for MBS
Guaranty - Briefing to OFHEO, dated June 14, 2005, FMSE-IR 438739-44, at
FMSE-IR 438742; SF Allowance for Loan Losses - Status Update and Report on
Interim Findings, dated Aug. 25, 2005, Zantaz document 2290112.
(695) In the first quarter of 2004, Shaun Ross took over responsibility for the
LAM from Whitacre.
(696) Mem. from S. Ross, Hemant Pradhan and Shelley Klein to File, dated May 4,
2005, Zantaz document 2291383, at 4. This change eliminated from the
calculation the high severities Fannie Mae experienced in 1990 through 1992
and made the calculation more responsive to recent experiences. Allowance
for Loan Losses (ALL) & Liability for MBS Guaranty - Briefing to OFHEO,
dated June 14, 2005, FMSE-IR 438739-44, at FMSE-IR 438744.
(697) See also E-mail from A. Marzol to S. Ross, dated Mar. 22, 2004, Zantaz
document 107166, at 1. Allowance for Loan Losses, dated Jan. 25, 2005,
FMSE-IR 283388-99, at FMSE-IR 283393. The increased number of defaults was
derived from the Loss Forecast Model ("LFM"), which Fannie Mae considered
to be a "more robust" econometric model created by Credit Policy. Id.
188
According to Ross, the changes in the first three quarters of 2004
were motivated in large part by the change in staffing and his attempt to
improve the process. But the changes in the fourth quarter of 2004 were the
result of observations that OFHEO had made in the fall of 2004, which were
echoed by KPMG in November of 2004. Among other things, OFHEO observed that the
Allowance did not "behave directionally consistent with the book of business"
and questioned whether the Company was including in its severity estimate too
much historical data.(698) Management later determined that the historical loss
severity data dating back to 1990 used in the LAM was up to ten times higher
than the Company's current experience.(699)
In January 2005, under the direction of Robert J. Levin, Fannie Mae's
Chief Business Officer and Interim CFO,(700) Fannie Mae determined that its
Allowance had been set at too high a level. Interim Chief Risk Officer Marzol
stated that he and other senior accounting employees returned to "first
principles" concerning the Allowance in order to establish a supportable
Allowance that the new Accounting Policy staff would accept under GAAP. The
fourth quarter reduction was discussed with the Fannie Mae Audit Committee.(701)
B. Evidence Reflecting Management's View of the Allowance
As we stated at the outset, we have found no evidence showing that
management used the Allowance to offset unrelated expenses or to manage earnings
to meet EPS targets in a given period. However, documents showed management's
awareness that the Allowance may be overstated, or not in accordance with GAAP,
and showed that certain members of management viewed the Allowance as a "war
chest" for use in connection with unrelated or unexpected costs.
1. Management's Awareness that the Allowance May Be Overstated
Documents showed awareness within management that the Allowance was
set at a level in excess of credit loss experience. In Spencer's draft notes to
Howard for a September 1997 presentation regarding the Accounting Policies for
Foreclosed Assets,(702)
- ----------
(698) See also Mem. from S. Ross, H. Pradhan, and S. Klein to File, dated Mar.
15, 2005, FMSE-IR 283444-47.
(699) Allowance for Loan Losses (ALL) & Liability for MBS Guaranty - Briefing to
OFHEO, dated June 14, 2005, FMSE-IR 438739-44, at FMSE-IR 438743.
(700) Levin stated that once he learned the requirements, it was "clear to him"
that Fannie Mae's Allowance was set at too high a level.
(701) Minutes of the Meeting of the Audit Committee of the Board of Directors of
Fannie Mae, dated Jan. 17, 2005, Zantaz document 555388, at 6-7.
(702) Draft Notes to T. Howard, dated Sept. 24, 1997, FMSE-IR 338605-612.
189
she wrote regarding the implementation of FAS 114: "A Big Pro: It gives us a
vehicle to draw down our loss allowance" and "Consider drawing down provision
allowance?"(703) In the same document, under the heading "Prepare an IR Story,"
the document states:
Likewise, we feel a more appropriate measure to assess the adequacy of
our reserves would be to insure that we had an allowance sufficient to
cover two years of TOTAL CREDIT LOSSES.
Using this more conservative approach, we are still overprovided.
As such, we will be bringing down our provision for a time until we
approach our desired ratio.(704)
In addition, in a December 5, 1997 memorandum from Quinn, then Senior
Vice President--Credit Loss Management, to Howard, Levin, Ann Logan, and Sam
Rajappa, Quinn wrote:
At the end of 1999 when most of the portfolio is past its peak default
period and if the credit picture continues to improve or stay stable,
I believe we would be justified in booking a one-time reversal of the
reserve of $300 million.(705)
In addition, James A. Johnson, the CEO of Fannie Mae in 1998, recalled
being aware of a dialogue about the Company being over-reserved in 1998 because
of improvement in credit risk. Although Johnson said he thought the potential
over-reserved amount was immaterial, he did vaguely recall KPMG suggesting that
the Company reduce its loan loss reserve.
Marzol, then head of Credit Policy, stated that he had opposed a
reduction of the Allowance based solely on the Company's improved credit
experience. Although Marzol disclaimed any participation in setting the
Allowance prior to 2004, he nonetheless stated that he considered it overly
simplistic for the Allowance to vary based on improved loss experience alone.
Marzol believed that other factors, such as the Company's rapid book of business
growth and increased participation in sub-prime business all should be
considered when setting the Allowance.
- ----------
(703) Id. at FMSE-IR 338607.
(704) Id. at FMSE-IR 338611.
(705) Mem. from M. Quinn to T. Howard, dated Dec. 5, 1997, FMSE-IR 338619-21, at
FMSE-IR 338620.
190
As late as 2001, management considered reducing the Allowance and
mitigating the one-time positive impact to income created by such a reduction
through a finite risk insurance product. In April 2001, personnel from Credit
Portfolio Strategies met with personnel from certain Marsh & McLennan companies
("MMC") to discuss the use of finite risk insurance to replace a portion of the
Allowance. According to Robert Schaefer, then Director--Credit Portfolio
Strategies, Brian Graham, who was then Senior Vice President--Credit Portfolio
Strategies, outlined the following objectives for the MMC meeting: Controller's
Office personnel were looking to reduce the Allowance, and if such a reduction
were to occur, Graham wanted an insurance policy that would (1) allow the
Company to expense the premium and thus offset the spike in income that would
result from reducing the Allowance, and (2) have a high degree of certainty of
"paying off" in future periods (i.e., that Fannie Mae was certain of recovering
its premium payment through future claims reimbursements). Documents relating to
these discussions with MMC show that management was considering reducing the
Allowance by as much as $200 million at the time.(706)
As discussed in further detail in Chapter VI, Part J, infra, Credit
Portfolio Strategies discussed a number of potential structures with MMC to
accomplish this objective, but ultimately, was unable to obtain Financial
Standards' agreement that the structures would qualify for accounting as
insurance arrangements.(707)
2. Evidence Reflecting Management's Consideration of Using the
Allowance to Offset Unrelated Expenses
Documents also showed that management considered using the excess
amount in the Allowance to offset unrelated events. An example was Spencer's
notes from a September 22, 1998 meeting described as a "Risk Review with
CFO."(708) The Spencer notes suggested that in order to offset the impact of
recording a large year-end catch-up expense, "We would source those earnings
from a reduction to our loss reserves."(709) However, we saw no evidence that
Spencer did, in fact, source the earnings from the Allowance.
- ----------
(706) Handwritten Notes from Robert Schaefer, dated May 19, 2001, Zantaz
document 2207005 ("$800M current reserve take it down to $600 . . .
transfer $200 m to XL . . . for $300 m in coverage").
(707) Schaefer stated that Financial Standards' stated that the proposal would
not receive insurance accounting because the timing of cash flows were set
by the contract. KPMG workpapers reflect that it opined that the
transaction would not qualify for insurance accounting. Mem. from Harry
Argires to Fannie Mae File, dated Mar. 2002.
(708) Risk Review with CFO, dated Sept. 22, 1998, FMSE-IR 321564-68.
(709) See discussion supra Chapter IV.
191
Another example was the January 7, 1999 earnings alternatives
schedules that were prepared under Spencer's direction.(710) The "Alternative
III" scenario from these schedules reflected that management considered
offsetting the large amount of negative catch-up expense that would be recorded
for 1998 by taking $100 million from the provision for losses.(711) Management
ultimately did not choose this alternative.(712)
In yet another example, Spencer wrote to Howard concerning a 1997
presentation regarding the Accounting Policies for Foreclosed Assets: "Consider
drawing down provision allowance? Over the planning horizon, we would have 'war
chest' to draw down if necessary. Could do a one time draw, a big event, to
cover ideas as restructuring the portfolio, infusing capital into Foundation,
settling a tax event (if one occurred), other ideas . . . . This would be linked
to an even[t] that we would publicly talk about and the analysts would view
positively."(713) In addition to acknowledging an excess Allowance, these notes
suggested Spencer's belief of the Allowance as a "war chest." Nevertheless, we
saw no evidence that Spencer did draw down the Allowance at this time for the
stated purpose.
Finally, in what appears to be a September 2000 PowerPoint
presentation - which was found in Ross's files and identified then Controller
Spencer as the presenter - the "Loss Allowance" was listed as an item under
"Possible Ways to Fill the Shortfall" in the EPS. Another slide in the same
presentation, titled "Loss Allowance," read: "Potential to draw down a portion
of the allowance for loan losses (currently at $809 million), resulting in
income recognition."(714) Again, notwithstanding this document, our
investigation has not uncovered any instances of an actual use of the Allowance
to offset unrelated expenses or to fill earnings shortfalls in a given period.
3. Management's Safety and Soundness Perspective on the Allowance
Pennewell stated that some members of senior management, particularly
Howard, agreed with many bank regulators that it was prudent to build up the
loan loss reserves in case credit performance deteriorated. Indeed, we note that
in the 1990s there
- ----------
(710) See id.
(711) The fourth quarter 1998 "Adjustments" for "Net interest income" and
"Guaranty fees" were negative amounts, or reductions of $280 million and
$60 million, respectively. The sum of these contemplated adjustments totals
$340 million. Fannie Mae 1999 Income Statement schedules, dated Jan. 7,
1999, FMSE-IR 21476-79, at FMSE-IR 21479.
(712) See discussion supra Chapter IV.
(713) Draft Notes to T. Howard, dated Sept. 24, 1997, FMSE-IR 338605-612, at
FMSE-IR 338607.
(714) Getting Back on Track Agenda, dated Sept. 2000, Zantaz 1512665, at 25.
192
was a general debate among banking regulators, the SEC, and the accounting
profession about the proper level of a loan loss reserve. The bank and thrift
failures of the 1980s and early 1990s influenced the bank regulators' "safety
and soundness" view, which emphasized a conservative approach towards recording
loan loss reserves at levels management can reasonably justify within the
confines of GAAP. This view was perceived by many in the industry to be in
conflict with the SEC's primary mandate of investor protection and concerns
about earnings management. This led to the November 1998 press release
announcing the formation of the Joint Interagency project to "better ensure the
consistent application of loan loss accounting policy and to improve the
transparency of financial statements,"(715) and resulted in congressional
hearings and a number of speeches, testimony, and articles by the SEC, the
regulators, and the accounting profession expressing their positions on loan
loss accounting.
The agencies agreed to the following aspects of loan loss allowance
practices in the July 1999 Joint Interagency Letter to Financial Institutions:
- Arriving at an appropriate allowance involves a high degree of
management judgment and results in a range of estimated losses;
- Prudent, conservative, but not excessive, loan loss allowances
that fall within an acceptable range of estimated losses are
appropriate. In accordance with GAAP, an institution should
record its best estimate within the range of credit losses,
including when management's best estimate is at the high end of
the range;
- Determining the allowance for loan losses is inevitably
imprecise, and an appropriate allowance falls within a range of
estimated losses;
- An "unallocated" loan loss allowance is appropriate when it
reflects an estimate of probable losses, determined in accordance
with GAAP, and is properly supported;
- Allowance estimates should be based on a comprehensive,
well-documented, and consistently applied analysis of the loan
portfolio; and
- The loan loss allowance should take into consideration all
available information existing as of the financial statement
date,
- ----------
(715) November 24, 1998 Joint Interagency Statement by SEC, Federal Deposit
Insurance Corporation ("FDIC"), Federal Reserve Board, Office of the
Comptroller of the Currency ("OCC"), and Office of Thrift Supervision.
193
including environmental factors such as industry, geographical,
economic, and political factors.(716)
Then, in July 2001, the SEC issued SAB 102, which provided further guidance for
determining and documenting the level of an allowance for loan losses in
accordance with GAAP.
Certain members of Fannie Mae management may have believed that the
"safety and soundness view" or conservatism "trumped" a literal application of
GAAP in this area.(717) Because Howard declined our interview requests, we have
not confirmed whether Howard subscribed to this view, as suggested by witnesses
and documents. Boyles acknowledged such a point of view in his 2002 white paper,
when he wrote, "[w]e recognize that there is a natural tension between the need
for an allowance large enough to ensure safety and soundness and the limiting
nature of GAAP. We will keep this in mind and will try to balance the two as we
move forward during the year putting the framework in place."(718) Additionally,
OFHEO reviewed but did not criticize the Allowance methodology or balance from
2000 through 2003.
C. Transparency of the Allowance Setting Process to OFHEO
Since 2000, OFHEO examined Fannie Mae's Allowance (referred to by
OFHEO as the "Loan Loss Allowance") on at least three occasions, issuing reports
on December 31, 2001 (the "2001 review"), December 8, 2003 (the "2003 review"),
and March 30, 2005 (the "2004 review").(719) Although OFHEO did not complete an
examination in 2002, the Company did brief OFHEO about the accounting and
methodology changes that occurred during that year.(720)
- ----------
(716) Joint Interagency Letter to Financial Institutions by the SEC, FDIC,
Federal Reserve Board, OCC, and the Office of Thrift Supervision, dated
July 12, 1999.
(717) According to Pennewell, Howard believed it was prudent to build up loan
loss reserves in conjunction with the safety and soundness view. Pennewell,
however, shared the view expressed by the SEC and AICPA that an allowance
should move in tandem with credit losses.
(718) E-mail from J. Boyles to L. Spencer, J. Pennewell, P. Salfi, J.M.
Whitacre, dated July 1, 2002, FMSE 413416-19, at FMSE 413419.
(719) OFHEO Examination Worksheet Observation and Follow-Up, dated Dec. 31,
2001, Zantaz document 1282365; OFHEO Examination Worksheet Observation and
Follow-Up, dated Dec. 8, 2003, Zantaz document 1282369; Mem. from G.
Grarner to D. Hisey and C. Connelly, dated Mar. 30, 2005, FMSE-IR 612149-54
at FMSE-IR 612150.
(720) OFHEO Briefing: Loss Allowance, dated Dec. 31, 2002, Zantaz document
3543416.
194
In the 2001 review, although opportunities for improvement were cited,
OFHEO noted that Fannie Mae's allowance process was effective and that
"Management complies with accounting standards and Fannie Mae's allowance
policy."(721) Once again, in the 2003 review, OFHEO noted that Fannie Mae's
reserve determination process was acceptable and that "[t]he allowance
determination process is in line with professional standards."(722) OFHEO
concluded in both of these reviews that the Company's processes "exceed[ed]
safety and soundness standards."(723)
In August 2004, OFHEO began its exam of Fannie Mae's Allowance. As
already discussed, Fannie Mae made changes during the fourth quarter of 2004
that were meant to address OFHEO's comments. In January 2005, Fannie Mae made a
presentation to OFHEO describing how its methodology changes addressed OFHEO's
commentary regarding directional consistency, responsiveness, back testing and
third party review.(724) Also included in this presentation was a response to
KPMG's comments regarding severity and defaults, as well as the impact on the
Company's Allowance at year-end 2004 as a result of its methodology
changes.(725)
Thereafter, on March 9, 2005, OFHEO issued a report related to a
Sarbanes-Oxley examination, which identified internal control deficiencies and
"poor methodologies for determining the loan loss allowance levels."(726) OFHEO
issued its 2004 review, but lowered its overall rating from "exceeds" safety and
soundness standards to "meets."(727)
- ----------
(721) OFHEO Examination Worksheet Observation and Follow-Up, dated Dec. 31,
2001, Zantaz document 1282365, at 4.
(722) OFHEO Examination Worksheet Observation and Follow-Up, dated Dec. 8, 2003,
Zantaz document 1282369, at 8.
(723) OFHEO Examination Worksheet Observation and Follow-Up, dated Dec. 31,
2001, Zantaz document 1282365, at 6; OFHEO Examination Worksheet
Observation and Follow-Up, dated Dec. 8, 2003, Zantaz document 1282369, at
1.
(724) Allowance for Loan Losses Discussion with OFHEO, dated Jan. 28, 2005,
Zantaz document 1651744, at 5.
(725) Id. at 7-10.
(726) Mem. from Daniel Berkland to A. Marzol, dated Mar. 9, 2005, Zantaz
document 2291541, at 3.
(727) Misc. Communication to an Enterprise, dated Mar. 30, 2005, Zantaz document
1931394, at 1.
195
D. Conclusions Regarding Fannie Mae's Accounting for the Allowance
The Company did not maintain a consistent or an appropriate accounting
policy concerning the Allowance, and also failed to develop in a timely manner a
methodology to support the Allowance balance under GAAP. We have not seen any
documented analysis of the Allowance to support the accounting decisions to
calculate an Allowance that approximates two to three times trailing charge-offs
pre-1997, or to support a change in methodology to the provision for losses
equal to charge-offs beginning in 1997.(728)
In spite of the acknowledgement of the need to as early as 1998,
Fannie Mae apparently did not begin working on a detailed Allowance model until
fiscal year 2002. And, it was not until the third quarter of 2003 when a version
of the model was determined by Fannie Mae and its internal auditors to be
completed.(729) The development of the model appears to have been driven by
Fannie Mae's voluntary decision to become an SEC registrant in 2002. Beyond
that, however, there does not appear to have been any urgency in bringing the
Company's accounting methodology for the Allowance in compliance with GAAP.(730)
Also, Boyles's white paper suggested that the Company was aware that
it was not in compliance and had not made much progress in complying with SAB
102 as of that time.(731) Documents showed that management was either complacent
or ignorant
- ----------
(728) According to Pennewell, Whitacre, and contemporaneous documents, Howard
exercised decision-making authority over the Allowance methodology from
1998 onward, apparently until he left the Company. See, e.g., Year 2000
Performance Evaluation, from T. Howard to L. Spencer, dated Dec. 9, 2000,
FMSE-IR 28779-81; Mem. from K. Russell to J. Theobald and E. Smith, dated
Aug. 25, 1998; E-mail from J.M. Whitacre to A. Marzol, B. Graham, L.
Kenney, dated Aug. 19, 2002, FMSE-E 1091499-513, at FMSE-E 1091499.
Further, we have been unable to interview Howard about his rationale for
these accounting judgments. Similarly, Spencer declined further interviews
after the discovery of a file of documents in which, among other things,
she described using the Allowance to offset a catch-up adjustment in a note
to Howard for a Sept. 22, 1998 "Risk Review Meeting with CFO" meeting.
Buy-up File, FMSE-IR 321541-78, at FMSE-IR 321567.
(729) Allowance for Loan Losses Audit - Audit Report, dated Dec. 15, 2003.
(730) We note that Fannie Mae began developing the LAM more than three years
after KPMG first requested that the Company do so. Mem. from K. Russell to
J. Theobald and E. Smith, dated August 25, 1998.
(731) E-mail from J. Boyles to L. Spencer, J. Pennewell, P. Salfi, and J.M.
Whitacre, dated July 1, 2002, FMSE 413416-19, at FMSE 413417-18.
196
about the need to comply with GAAP. For instance, a document from Mary Lewers's
files, titled "Q2 2003 Allowance for Loan Losses Summary," contained the
following handwritten notations on the margins about the unallocated portion of
the Allowance: "Why? There is a permissible range - but is there a floor or a
ceiling on the unallocated? W/O the better modeling, we are reluctant to
[change] the 808 [total allowance balance] - but we are working toward the
better model by the end of 2003."(732) Even after implementing a model as of
2003, based on the fact that the Allowance remained constant until 2004, it does
not appear that the changes in methodology or policy seriously affected
management's decision-making until 2004.
Moreover, several employees - namely, DePetris, Marzol, and Whitacre -
stated their belief that it was permissible to have an "unallocated" portion in
the Allowance, which required no further analysis or support so long as the
amount did not exceed a certain percentage of the total Allowance amount.(733)
There was no support for such belief in the authoritative literature, and these
employees have not pointed to any.(734)
In summary, Fannie Mae's policy prior to 2004, which was based on a
provision for losses equal to charge-offs, was not consistent with GAAP and
Fannie Mae's methodology did not adequately support the Allowance.
PART B: ACCOUNTING FOR DOLLAR ROLLS
I. INTRODUCTION
The February 11, 2005 OFHEO Letter identified concerns about Fannie
Mae's accounting treatment for transactions known as dollar rolls.(735) In light
of OFHEO's concerns, we undertook a review of Fannie Mae's dollar roll policies
and procedures.
In a typical dollar roll transaction, Fannie Mae borrowed funds from a
counterparty for a specified period of time, using a security from its portfolio
as collateral. From an execution perspective, the borrowing was effected by
Fannie Mae's "selling" the collateral and simultaneously entering into an
agreement to repurchase a similar security at a future date. Assuming that
certain criteria in the accounting standards were met, Fannie Mae would account
for the simultaneous sale/repurchase
- ----------
(732) Undated Key Allowance Accounting Concepts, FMSE 60753-58, at FMSE 60755.
(733) Loss Allowance Methodology, dated November 2002, Zantaz document 2225939,
at 3 ("KPMG - SEC rule of thumb that unallocated allowance cannot be more
than 26% of total allowance"); Loss Accounting Change and New Loss
Allowance Methodology, dated March 18, 2003, FMSE-IR 549627-41, at FMSE-IR
549636.
(734) See Supplementary Information - Background to SAB 102, dated July 6, 2001.
(735) See February 11, 2005 OFHEO Letter at FMSE-IR 547320-22.
197
arrangement as a financing (i.e., a short-term loan) rather than as a sale of
the collateral and a purchase of a new security. If the counterparty did not
meet its commitment to deliver a similar security at the maturity date, the
dollar roll would be treated as a "fail." If the Company then could not obtain a
similar security in the market, the "fail" would result in accounting for the
transfer of the collateral as a sale.
Dollar rolls offered Fannie Mae a ready source of short-term
liquidity, similar to its benchmark bills or discount notes. Execution of a
dollar roll that did not comply with accounting requirements, or that resulted
in a fail for which the Company could not purchase a substantially similar
security, however, had two potential consequences for the Company. First, Fannie
Mae would have to account for the transfer of collateral as a sale and the
receipt of the security as a repurchase, with consequent recognition of gain or
loss. Second, because Fannie Mae used securities from its held-to-maturity
("HTM") portfolio as collateral, treatment of the transfer of the collateral as
a sale would have resulted in the tainting of the Company's HTM portfolio.(736)
We conclude that Fannie Mae's accounting for dollar roll transactions
did not follow GAAP for a significant portion of the time period covered by this
Report. The Company's policies did not address all of the requirements set forth
in the accounting standards and there were significant gaps in the Company's
systems for assessing whether treatment of the transactions as financings was
appropriate. Coordination among the offices responsible for dollar roll
transactions - particularly Financial Standards in the Controller's Office, the
Securities Trading Operations ("STO") group in the Treasurer's Office, and
Portfolio - was weak.(737)
Based on all of the evidence, we further conclude that the failure to
follow GAAP in this instance was not intentional or motivated by an effort to
achieve a pre-determined financial outcome. Rather, this situation stemmed from
a lack of rigor in Fannie Mae's accounting policies and systems, including a
failure to communicate clearly what each group's responsibilities were with
respect to these transactions. In our view, this circumstance reflects primarily
on the senior management in the Controller's Office, including Leanne G.
Spencer, her predecessors, and those in charge of Financial Standards.
- ----------
(736) Chapter VI, Part D of this Report discusses the designation of securities
as HTM and the consequences of a subsequent sale (or change of designation)
of that security.
(737) We did not determine whether individual transactions were or were not
properly accounted for as financings. We understand that this issue is
being addressed as part of the restatement process.
198
We have seen no evidence that KPMG undertook a review of the Company's
dollar roll policies or practices. According to KPMG, it did not view dollar
rolls as a significant aspect of Fannie Mae's business.(738)
II. BACKGROUND
A. FAS 140 and Other Accounting Literature
FAS 140 addresses accounting for the transfer of financial
assets.(739) Under FAS 140, a simultaneous sale/repurchase agreement may qualify
as a financing if the transaction satisfies all of the following conditions:
1. The assets to be repurchased or redeemed are the same or
substantially the same as those transferred.
2. The transferor is able to repurchase or redeem them on
substantially the agreed terms, even in the event of default by
the transferee.
3. The agreement is to repurchase or redeem them before maturity, at
a fixed or determinable price.
4. The agreement is entered into concurrently with the
transfer.(740)
In order to satisfy the requirement that the transferor be able to
redeem the security (subparagraph (b)), FAS 140 requires that the transferor
(borrower) "must at all times during the contract term have obtained cash or
other collateral sufficient to fund substantially all of the cost of purchasing
replacement assets from others."(741) In effect, this provision requires that
either the transferor establish a mechanism to monitor the value of the
collateral or that there be market practices that function to ensure the
adequacy of collateral.
- ----------
(738) Based on data contained in the Company's general ledger accounts available
on its Homesite system, Huron determined that the average end-of-month
dollar roll balance in 2003 was $2.8 billion. In October 2003, the balance
reached $7.8 billion. See Homesite General Ledger for account 211021.
(739) See ACCOUNTING FOR TRANSFERS AND SERVICING OF FINANCIAL ASSETS AND
EXTINGUISHMENTS OF LIABILITIES (A REPLACEMENT OF FAS STATEMENT NO. 125),
Statement of Fin. Accounting Standards No. 140 (Fin. Accounting Standards
Bd. 2000) (hereinafter "FAS 140").
(740) See id. P 47.
(741) See id. P 49.
199
If the parties' agreement does not require the delivery of the same
security to the transferor, then the returned security must be "substantially
the same" as the transferred security.(742) FAS 140 provides that the collateral
returned is "substantially the same" as the transferred collateral if the
securities share all of the following characteristics:
1. The same primary obligor (except for debt guaranteed by a
sovereign government, central bank, government-sponsored
enterprise or agency thereof, in which case the guarantor and the
terms of the guarantee must be the same);
2. Identical form and type so as to provide the same risks and
rights;
3. The same maturity (or in the case of mortgage-backed pass-through
and pay-through securities, similar remaining weighted-average
maturities that result in approximately the same market yield);
4. Identical contractual interest rates;
5. Similar assets as collateral; [and]
6. The same aggregate unpaid principal amount or principal amounts
within accepted "good delivery" standards for the type of
security involved.(743)
FAS 140 does not address the duration of a dollar roll, except to note
that financing treatment would not be appropriate if the transferor (borrower)
does not have the right to "repurchase or redeem [the collateral] before
maturity."(744) Nothing in the standard precludes extension of the dollar roll
during the term of the collateral prior to maturity, so long as the other
requirements of the standard are satisfied.
Because FAS 140 permits the transaction to be treated as a financing
rather than a sale, nothing in the literature precludes the use of HTM
securities as dollar roll collateral. However, as noted above, by using HTM
securities as collateral, the borrower risks a taint of its portfolio if a
transaction is treated as a sale.
FAS 140 was not the first accounting standard to address dollar rolls.
SOP 90-3, which is referenced in FAS 140, originally set forth the requirement
that the returned collateral be substantially the same as the transferred
collateral, and described
- ----------
(742) See id. P 47.
(743) See id. P 48.
(744) See id. P 47(c).
200
the parameters for making that assessment.(745) FAS 125, which was issued in
June 1996, specified substantially-the-same test in the language that would be
incorporated into FAS 140.(746) FAS 125 also introduced the requirement that the
transferor "have obtained cash or other collateral sufficient to fund
substantially all of the cost of purchasing replacement assets from
others."(747) Thus, all of the critical requirements for treatment of dollar
rolls as financings have been in place at least since 1996.
B. OFHEO'S Concerns
The February 11 OFHEO Letter questioned whether Fannie Mae was
adequately testing to ensure that the security that Fannie Mae received at the
end of a dollar roll was substantially the same as the security Fannie Mae
transferred to the counterparty.(748) OFHEO expressed doubt that Fannie Mae was
complying with the requirement that the weighted average maturity ("WAM") and
yield of the returned collateral were similar to the securities that Fannie Mae
"rolled out."(749) The agency also challenged the Company's practice of testing
the WAM at the level of an overall trade, rather than at the individual security
level; the Company's assumption that if the WAMs were similar, the yields would
also be similar; and the Company's failure to perform WAM and yield tests for
any period prior to 2003.(750)
In addition, OFHEO raised a number of operational issues associated
with Fannie Mae's treatment of dollar rolls. OFHEO stated that Fannie Mae did
not appear to have a monitoring system in place to ensure that it was adequately
collateralized at all times during the term of the repurchase agreement.(751)
Finally, OFHEO questioned whether Fannie Mae's policy for dealing with
dollar roll fails was overly flexible. According to OFHEO, Fannie Mae would not
- ----------
(745) See id. P 48 n.18; see also DEFINITION OF THE TERM SUBSTANTIALLY THE SAME
FOR HOLDERS OF DEBT INSTRUMENTS, AS USED IN CERTAIN AUDIT GUIDES AND A
STATEMENT OF POSITION, Statement of Position No. 90-3 (Am. Inst. of
Certified Pub. Accountants 1990).
(746) See ACCOUNTING FOR TRANSFERS AND SERVICING OF FINANCIAL ASSETS AND
EXTINGUISHMENTS OF LIABILITIES, Statement of Fin. Accounting Standards No.
125 (Fin. Accounting Standards Bd. 1996), at PP 27-28 (hereinafter "FAS
125").
(747) See id. P 28.
(748) See February 11, 2005 OFHEO Letter at FMSE-IR 547321.
(749) Id.
(750) Id.
(751) Id.
201
consider a dollar roll to have failed unless Fannie Mae had not received, or
purchased in the marketplace, a substantially similar security within four
months, whereas market convention requires that a securities trade be considered
a fail if delivery is late by even one day.(752) OFHEO noted that, because
Fannie Mae's dollar rolls involved securities classified as HTM, a failed dollar
roll could have resulted in a tainting event that triggered the reclassification
of all securities classified as HTM to available-for-sale ("AFS").(753)
C. Fannie Mae's Accounting Policy
Fannie Mae adopted an accounting policy for dollar rolls in the 1994
and 1996 versions of its Financial Accounting Policy Manuals.(754) These
policies reflected the Company's interpretation of the criteria in SOP 90-3 for
determining whether returned collateral was substantially the same as the
transferred collateral.
Fannie Mae did not revise this policy for, or otherwise incorporate
into its internal accounting policies, the additional requirements in FAS 125
and FAS 140 regarding dollar rolls until 2003.(755) Specifically, the policy did
not mention the need to monitor the collateral to ensure that the Company
received cash or other collateral sufficient to buy it back if the lender failed
to deliver. Thus, for several years after that requirement initially became
effective, the Company's policy did not reflect the applicable accounting
literature. Jonathan Boyles stated that revamping the Company's accounting
policies generally (and not just with respect to dollar rolls) had been on his
"to do" list, but other obligations had required that he put that effort off
until 2003.
The 2003 dollar roll policy generally tracked the language of FAS 140
insofar as the conditions for treating dollar rolls as financings are concerned.
In language drawn from the standard, the Company's policy required (among other
things) that "assets to be repurchased or redeemed are the same or
'substantially the same' as those transferred," and listed specific criteria for
making that assessment.(756) It also specified
- ----------
(752) Id.
(753) Id. at FMSE-IR 547320-21.
(754) Reverse Repurchase Agreements and Dollar Rolls, Financial Accounting
Policy Manual, dated Oct. 20, 1994, FMSE-SP 79123-239, at FMSE-SP 79185-87
(hereinafter "1994 Policy"); Reverse Repurchase Agreements and Dollar
Rolls, Financial Accounting Policy Manual, dated July, 1996, Zantaz
document 420510, at 51-53 (hereinafter "1996 Policy").
(755) See Reverse Repurchase Agreements and Dollar Rolls, Financial Accounting
Policy Guide, dated Oct. 2003, FMSE-SP 78953-9118, at FMSE-SP 79041-46
(hereinafter "2003 Policy").
(756) See 2003 Policy at FMSE-SP 79041-42.
202
that: "Fannie Mae, at all times during the contract term, must have obtained
cash or other collateral sufficient to fund substantially all of the cost of
repurchasing replacement assets from others."(757)
Several features of the Company's policy apparently sought to fill in
certain gaps or ambiguities in the authoritative literature. For example, FAS
140 is silent on the threshold WAM and yield for determining whether the
returned security is "substantially the same." Fannie Mae's policy, in addition
to requiring that the WAMs of the two securities "be similar," specified that
the difference in the WAM of the transferred and returned collateral be within
twenty-four months.(758) Likewise, whereas FAS 140 stated only that the returned
collateral must have "approximately the same market yield," Fannie Mae's policy
specified a difference in yield of up to ten basis points.(759) Although the
standard did not provide specific guidance on whether these parameters should be
evaluated on the basis of the entire bundle of collateral returned or on a
security-by-security basis, Fannie Mae's policy required that the WAM and yield
calculations be performed on a weighted-average basis on an entire trade, rather
than on the individual securities within that trade.(760) In each of these
instances, the 2003 policy draws on earlier Company policies without
amendment.(761)
As noted, the Company's 2003 policy also addressed "fails" - i.e., the
counterparty's failure to deliver the required collateral on the contractual
delivery date. The policy stated that, "[i]f the counterparty to a dollar roll
transaction fails to redeliver the security(ies) within 3 months of the end of
the original contract date, this transaction is considered to have failed."(762)
Under the policy, Fannie Mae still would not account for the transaction as a
sale, however, so long as, within one additional month, the Company could "use
the cash proceeds originally received in the secured financing to repurchase a
security from a third party that meets the 'substantially similar' criteria," or
to "receive the collateral from the original counterparty."(763) If Fannie Mae
was unable to acquire the security from the counterparty or the market within
that four month span, then the Company was to record the gain or loss resulting
from the sale.(764)
- ----------
(757) Id.
(758) Id. at FMSE-SP 79042.
(759) Id.
(760) Id.
(761) See 1994 Policy at FMSE-SP 79185; 1996 Policy, Zantaz document 420510, at
51.
(762) See 2003 Policy at FMSE-SP 79043.
(763) Id.
(764) Id. at FMSE-SP 79044.
203
Fannie Mae's policy stated, without explanation, that treating a
dollar roll as a sale would not taint the Company's portfolio, even if the
collateral involved was an HTM security.(765) The policy did prohibit securities
with characteristics similar to those of securities involved in the fail from
being used for dollar rolls in the future, however, on the ground that, if
re-acquisition of appropriate collateral was impossible, then Fannie Mae was
incorrect in its original assumption that a substantially similar security could
be acquired from a third party.(766)
Our questions regarding Fannie Mae's policy related to timing and
substance. As to timing, we have received no clear explanation for why the
Company's policy prior to 2003 did not reflect the requirement that the Company
obtain and maintain adequate cash to repurchase collateral - seven years after
that requirement appeared in FAS 125 and three years after it was incorporated
in FAS 140. As to substance, there were several areas in which the 2003 Policy
did not track the FAS 140 requirements. In particular, the 2003 Policy
considered the securities to be substantially the same if their WAMs were within
twenty-four months; while a twenty-four month WAM difference might not result in
substantially different yields when comparing two securities with remaining WAMs
of 340 and 316 months, the analysis might well yield different results if the
mortgage pools had a short remaining term to maturity (that is, if the
twenty-four months reflected a greater portion of the loans' remaining terms).
Although the criteria in the Company's policy that the yield of the two
securities be within ten basis points might have mitigated any concerns with the
WAM threshold, the Company did not test the yields.
Fannie Mae is not currently engaging in dollar roll transactions.
Interviewees stated that this is a result of both changed market conditions and
continuing uncertainty over Fannie Mae's dollar roll policy and procedures.
- ----------
(765) Id. at FMSE-SP 79043.
(766) See also Mem. from Jonathan Boyles to File, FMSE 54164-67, at FMSE 54166.
We asked Boyles to explain why a sale resulting from a failed HTM dollar
roll would not be considered a portfolio tainting event. Boyles stated that
he would not consider a dollar roll fail to be an "intentional" sale from
the HTM portfolio. Without an intent to sell out of HTM, Boyles contended,
it made no sense to recognize a tainting event. Paul Salfi disagreed with
this characterization. He reasoned that sales out of the HTM portfolio were
permissible under FAS 115 only in limited circumstances, and, in his view,
a failed dollar roll transaction would not qualify as a permissible HTM
sale. Salfi questioned whether the "intent" of the sale made any difference
for purposes of determining whether portfolio tainting had occurred.
204
D. Fannie Mae's Dollar Roll Transactions.
1. Mechanics of the Dollar Roll Transaction
Functionally, dollar rolls were processed much like any other MBS
trade. A Fannie Mae trader and the counterparty would agree to terms by which
the counterparty would purchase a security from Fannie Mae's portfolio. At the
same time, the trader and the counterparty would enter into a purchase agreement
under which Fannie Mae would acquire a security that was substantially the same
as the security "sold" from the counterparty at a specified future date. The
decision to dollar roll a particular security in this fashion would be made by
the trading desk personnel. The master agreement under which Fannie Mae and its
counterparties structured a dollar roll, in fact, was the same agreement that
applied to any other securities trade.
The responsibility for carrying out the different tasks associated
with a dollar roll transaction fell on different organizations within the
Company. As noted, traders within the Treasurer's Office executed dollar roll
transactions. STO monitored the settlement date for the return of the collateral
and received the collateral back into the Company's portfolio. A group within
Portfolio was responsible for maintaining an inventory of securities eligible
for use as dollar roll collateral. The Company had no automated systems that
were dedicated to testing the returned collateral in accordance with either the
criteria in the authoritative accounting literature, or the Company's own policy
on dollar rolls.
2. Dollar Roll Fails
Although the Company's dollar roll accounting policy specifies a
three-month grace period in which a counterparty is required to return adequate
collateral and that the transaction will be treated as a "fail" one month later,
the accounting literature does not impose such deadlines. These deadlines,
therefore, appear to constitute internal guidelines, rather than requirements
mandated by GAAP.
Boyles stated that he included these provisions in the policy to
impose discipline on the dollar roll process. He said that it would be rare or
exceptional for Fannie Mae not to have received its security back eventually,
and that, in any event, the assets that Fannie Mae used for dollar rolls were
standard, highly liquid MBS, so a true fail was highly unlikely. Al Barbieri,
the Vice President responsible for the STO, confirmed that he knew of no dollar
roll transaction in which the Company ultimately did not reacquire collateral
from the counterparty or purchase replacement securities from a third party.
Barbieri described a process in which, at or around the Company's designated
"fail" date, the STO would contact the counterparty in an effort to resolve the
fail. If that was unsuccessful, the matter would be referred to the traders for
further resolution.
Moreover, we were told by employees that the STO was aware of the
possibility that a fail could taint the Company's HTM portfolio, and that they
were careful not to act in a way that could be construed to cause a taint. For
example, Ilene
205
Topper stated that Fannie Mae employees were always trying to follow the policy
of getting collateral back within ninety days and to avoid tainting the
portfolio with a sale out of HTM. She said that individuals involved in the
process were sensitized to the HTM and taint issues.
In this respect, we do not share OFHEO's concern that the Company's
dollar roll policy with respect to extensions was too lenient. The extension of
a dollar roll beyond the contractual redelivery date does not preclude treatment
of the transaction as a financing, so long as the transaction does not extend to
the collateral's maturity date. Accordingly, we do not question this aspect of
Fannie Mae's policy or its failure to account for transactions as sales solely
because they were extended for more than three months beyond the contractual
deadline.
3. Return of Substantially the Same Collateral
(a) Implementation of the Company's Policy
Even after the adoption of a new accounting policy in 2003, the
Company did not have a system in place to ensure that the collateral returned at
the end of the dollar roll was "substantially similar" to the collateral the
Company had posted. None of our interviewees thought that his or her group was
responsible for administering this policy, and there was substantial confusion
regarding the need to assess returned collateral, the standards that would be
applied, and the group responsible for performing that task. The lack of a
mechanism to assess the collateral position during the term of the dollar roll
raises concerns as to whether that collateral met the requirements of FAS 140.
Typically, only the trading desk personnel at Fannie Mae were aware at
the outset that these two transactions (the "sale" and the "repurchase") were
related. From the perspective of Fannie Mae's securities tracking system
("STAMPS"), and from the perspective of the back office personnel responsible
for trade verification and securities settlement, the two legs of the Company's
dollar roll transactions were entirely independent. Although securities trade
tickets had a code that identified the trade as a dollar roll, it appears that
there was no indication (e.g., a flag, or some other signal) within STAMPS to
indicate that the "sale" and "repurchase" were linked; the two transactions
could be identified as being part of the same dollar roll only through the "deal
number" assigned to the transaction, and only the trading desk personnel would
have access to the records that would make this linkage decipherable. As
Barbieri noted, STO - the office that received the returned collateral - would
have no way of knowing that the transaction was part of a dollar roll as opposed
to an outright purchase of the security.
Nonetheless, except for Barbieri, all of our interviewees from
Portfolio assumed that STO was responsible for this task.(767) The rationale for
assigning this task to
- ----------
(767) Financial Reporting also believed that Al Barbieri's group played the key
role in testing returned collateral. See E-mail from J. Boyles to Janet L.
Pennewell, Mary Lewers, and Leanne G. Spencer, dated Jul. 14, 2003, FMSE-E
24256-57. In that e-
206
STO was that this group was the first to process the collateral as it came to
Fannie Mae from the counterparty. According to Andrew McCormick, for example,
the first check would be to ensure that the counterparty made "good delivery"
under Bond Market Association ("BMA") guidelines,(768) and then STO would review
the collateral for compliance with the criteria for dollar rolls.
Barbieri stated that his group evaluated the WAM of securities
returned to the Company for a period of time; however, the task was performed
manually, and only when and if it was requested. In fact, Barbieri stated that
he had voiced his concern over his group's rejecting a trade based on an
accounting standard rather than a market convention, since such criteria were
not standard practice in the marketplace or part of the BMA guidelines. Barbieri
indicated that he would feel uncomfortable telling a counterparty that their
securities "fell out" of a trade because they failed a test that was not a part
of normal "good delivery." Barbieri also said that it would have been more
logical for Fannie Mae to use the BMA guidelines to test for the adequacy of
collateral, rather than the WAM/yield tests reflected in Company policy.(769)
While there was some dispute, then, over who was responsible for
conducting the "substantially similar" test on returned collateral, it is clear
that this task was not performed systematically. This weakness was acknowledged
in the Company's Portfolio Transactions Guide:
Portfolio Transactions management identified a control weakness
surrounding the dollar rolls process. Per the Fannie Mae accounting
standards, there should be controls in place to perform
characteristics checks on the collateral that is returned back.
Currently average WAM
- ----------
mail, Lewers writes that "[r]egarding dollar rolls, STO (Al Barbieri's
group) is manually controlling the redelivered pools to insure that the
securities meet the dollar roll accounting guidance." Id. at FMSE-E 24256.
Andrew McCormick suggested that the process was handled by a combination of
people, including Stephen Bartolini, Lynda Maggio, and Matthew Douthit from
his group, Barbieri from the Treasurer Department's back office, and either
Pennewell or Ilene Topper from the Controller's Office.
(768) The BMA establishes and publishes the market consensus regarding certain
terms and parameters of transactions involving different types of
securities, including Fannie Mae MBS (http://www.bondmarkets.com/).
(769) Barbieri acknowledged, however, that his team was responsible for
evaluating whether a dollar roll transaction extended past the ninety-day
"fail" period. Barbieri said that this was a collaborative effort across
department lines. According to Barbieri, the ninety-day analysis was a
manual query within the STAMPS system used to capture that particular fail
information. To Barbieri's knowledge, no systems enhancements were planned
to automate that process.
207
yield change tests are not currently enforced by the back-office.
Portfolio back-office included implementing functionality to perform
these two tests into their 2004 budget. This weakness does not cause
any material impact to balance sheet or earnings.(770)
Even this information was not well known throughout the Company. Ilene
Topper, who was responsible for securities accounting within the Controller's
Office, said that she thought that the Company was performing a WAM test, but
that she did not know for sure. She thought that it might have started in 2004.
Matthew Douthit, Vice President--Portfolio Transactions stated that he was aware
of this WAM/yield test requirement as early as 2002. As noted, Barbieri stated
that his group would perform the WAM test on an as-requested basis.
Because the Company's systems were designed to handle all MBS
transactions generally, the systems focused on identification of incoming
securities that did not fall within the BMA's "good delivery" guidelines. The
Company viewed the BMA good delivery guidelines as "analogous" to the
requirements of the "substantially the same" accounting standard.(771) According
to analyses performed by the STO, these guidelines require that the following
conditions be met:
The agency name and program description (pool prefix or suffix)
including short name and maturity (FNMA 30 yr) are the same.
The same coupon.
The same bid or offer price.
- ----------
(770) Portfolio Transactions Policy and Procedures Guide, dated May 11, 2004,
FMSE 219734-81, at FMSE 219768. With respect to the statement in the
Portfolio Transactions Guide that the identified control weakness "does not
cause any material impact to balance sheet or earnings," most interviewees
were not familiar with this statement and did not know what analysis had
been performed to support that conclusion. Among those who recalled the
statement, there was concern as to whether Portfolio should be opining
about something that was the responsibility of the Controller's Office to
determine. McCormick believed that his group worked with STO to assist in
some analysis on this point. He specifically remembered that the
twenty-four-month WAM test in the Company's policy had been examined.
McCormick said that, in his view, the passage in the transactions guide
regarding materiality was intended more as an instruction that dollar rolls
should not be done until the issue was resolved, rather than as a true
opinion of materiality.
(771) See The MBS TBA Market, Andrew McCormick, dated Sept. 10, 2002, FMSE
367272-90, at FMSE 367282.
208
The same settlement month.(772)
On their face, these good delivery principles do not track all of the
requirements of the accounting standard for treating the returned securities as
substantially the same as the transferred collateral. Barbieri confirmed that he
would not have viewed a WAM test as part of the BMA good delivery
guidelines.(773)
Among the interviewees, there appears to have been some general
awareness that Fannie Mae's dollar roll procedures were inadequate. McCormick,
for example, acknowledged that the policy added layers of analysis for which the
Company never established adequate procedures. Topper said that she had concerns
about the adequacy of the policy back in 2003, and she felt that this area
needed tightening. Anthony Lloyd said that it was well understood that the
dollar roll system needed improvement. In his view, the extra work that the
inadequate system created was causing frustration for many. Douthit expressed
the view that the BMA good delivery guidelines and market discipline were an
adequate mechanism to ensure that counterparties did not deviate from standard
practice.
(b) Reactions to Fannie Mae's Dollar Roll Policy
The question as to whether Fannie Mae was following FAS 140
requirements arose following the issuance of the Company's accounting policy in
2003. It appears that, around that time, the Company implemented an analysis of
its prior transactions to determine whether they could be treated as financings.
That effort, however, resulted in tension between Financial Standards and
Portfolio, which was responsible for managing these transactions.
STO analyzed the practical impact of Fannie Mae's policy on the
Company's ability to conduct dollar roll transactions. In a series of undated
documents captioned "Dollar Roll Validation by STO" that appear to have been
successive iterations of a single analysis,(774) several consequences of the
dollar roll policy were identified. The most significant of these appears to be
that, "[w]hen we do a dollar roll, the street does not distinguish between a
dollar roll and a standard buy/sell TBA. Therefore, the
- ----------
(772) Undated Dollar Roll Validation by STO, FMSE 387142-43, at FMSE 387143
(hereinafter "Dollar Roll Validation").
(773) We have not undertaken an independent assessment of the BMA good delivery
guidelines except to note the apparent lack of requirements that follow the
FAS 140 standard, either in language or in substance.
(774) None of the interviewees we spoke to could identify who had prepared the
documents or for what specific purpose. Nonetheless, it seems likely that
the documents were created around the time that Financial Standards
reconsidered the dollar roll policy in 2004.
209
counterparty is going to only redeliver securities based upon standard TBA
requirements as defined by the BMA."(775)
Nonetheless, the STO analysis reported that Fannie Mae had been
evaluating the WAM of returned collateral since January 2003, and that, in that
time, no collateral received from a counterparty had a WAM difference in excess
of the accounting policy's twenty-four month limitation.(776) The analysis
stated that "[m]ost of the WAM are within a few months of each other" and that
"[t]he requirement that the yield change must not be greater than plus or minus
10 basis points was decided to be futile because it is such a small range."(777)
According to the analysis, the STO had conducted an analysis "to determine which
inputs affect yield," and several factors - including the TBA assumptions, the
yield curve, and the weighted average coupon - were determined not to be
factors.(778) The analysis concluded that "WAM could affect yield if the change
in WAM was greater than 15 months, but we have not seen this scenario at all
this year - the difference in WAM has only been within a few months."(779)
Finally, "this yield requirement has been determined to be fairly difficult to
automate because of limitations in STAMPS [the Company's system for recording
securities transactions] and it would be a major undertaking - most likely not
worth the cost."(780)
The STO document that we believe to be the latest version of this
analysis ends with a number of recommendations concerning Fannie Mae's dollar
roll practices going forward. Most significantly, the analysis recommended that
the WAM and yield requirements not be used.(781) The recommendation pointed out
that FAS 140 does not specify a particular WAM or yield - only that the WAMs be
sufficiently similar to "result in approximately the same market yield."(782)
The recommendation then stated that the securities trading desk had determined
that a dramatic change in WAM would be required to have a significant impact on
yield (e.g., ten basis points).(783) The STO analysis recommended that Fannie
Mae continue to monitor WAM and "dk" (i.e., reject)
- ----------
(775) Dollar Roll Validation at FMSE 387142-43.
(776) Id. at FMSE 387143.
(777) Id.
(778) Id.
(779) Id.
(780) Id.
(781) Id. at FMSE 387126.
(782) Id.
(783) Id. at FMSE 387127.
210
any pools "that will cause a change in WAM on the deal level to be greater than
15 months."(784)
The analysis pointed out the problems that could be created by
"dk'ing" securities that fall outside of this fifteen-month window. The STO
stated that the TBA good delivery guidelines "do not take into account the same
WAM and yield requirements that we have for dollar rolls."(785) As a result,
counterparties may not accept Fannie Mae's rejection of collateral and might
force Fannie Mae to accept the security.(786) If that were to occur, the
document concluded, Fannie Mae would either have to swap the "bad" security with
another one in Fannie Mae's portfolio, or the Company would have to sell the
returned collateral and buy a new security as a replacement.(787)
The origins of STO's assessment of the dollar roll policy are not
clear. It does appear that the release of the 2003 accounting policy instigated
a discussion between Financial Standards and Portfolio, later involving KPMG, as
to whether it was adequate to assess dollar rolls against market conventions.
There was substantial concern among people within Portfolio, however, that the
proposed tightening of dollar roll requirements would effectively shut down the
dollar roll program.(788) In a series of e-mails from September 2004, Douthit
engaged Financial Standards staff concerning the "substantially the same"
criteria contained in the dollar roll policy. Douthit noted that the accounting
group was likely to "hear significant dissent from business folks if your
decision rests primarily on our own policy interpretation of the accounting
literature without giving due consideration to whether a significant number of
accounting firms at banks permit BMA definition of 'substantially the
same.'"(789) Douthit stated that, as of the date of that e-mail, Financial
Standards had been unable to determine what industry practice was, and, in his
view, this was critical in order to "challenge an otherwise impractical and
conservative reading of the accounting rule."(790)
- ----------
(784) Id.
(785) Id.
(786) Id.
(787) Id.
(788) See, e.g., E-mail from M. Douthit to Mukul Gupta, dated Sept. 17, 2004,
FNMSEC-E 279958-59.
(789) E-mail from M. Douthit to Gregory Ramsey, dated Sept. 1, 2004,
PW-PR-700062 (hereinafter "Sept. 1 Douthit E-Mail").
(790) Id. Douthit stated that he had heard at one point that Financial Standards
was considering requiring that the WAM values for the outgoing and incoming
collateral be exact.
221
A later e-mail message suggests that KPMG subsequently provided
industry practice information.(791) According to the e-mail, industry practice
had an even stricter standard than Fannie Mae's.(792) Portfolio representatives
stated that they were not aware of other parties' using this standard and that,
if the Company adopted it, other parties might no longer be interested in
engaging in dollar rolls with Fannie Mae.(793) The e-mail also identified a
number of other areas in which Financial Standards was considering tightening
the policy, including ensuring that dollar roll counterparties were also
accounting for the transaction as financings, rather than as sales; researching
whether margin calls would be necessary to account for changes in value of the
"rolled" securities; and discussing the level (e.g., CUSIP or product/coupon
level) at which a fail should be evaluated.(794) Of particular note on this list
was the reference to margin calls; we have seen no indication prior to that
communication that Fannie Mae acknowledged the requirement that it monitor its
collateral during the dollar roll term.
The e-mail concluded that "[t]here have been no known [dollar roll]
violations, but since we are reviewing our policies and procedures, we might
want to stop doing [dollar roll] transactions temporarily. Higher ups will send
out a memo if this decision is made."(795) As noted, Fannie Mae discontinued its
dollar roll program soon thereafter.
In sum, despite the reference to a "substantially the same" test in
Fannie Mae policies as early as 1994, the Company had no mechanism in place for
ensuring that the policies were implemented. Fannie Mae did not undertake to
consider those requirements of FAS 140 and its own accounting policy until it
revised its accounting policy for other reasons in 2003. As a consequence of
this failure, the Company never had an adequate means for assuring itself that
each piece of returned collateral qualified under the standard, and that the
transaction qualified as a financing rather than a sale.(796)
- ----------
(791) See E-mail from L. Maggio to S. Bartolini and M. Douthtit, dated Sept. 13,
2004, PW-PR-700065-66.
(792) Id. at PW-PR 700065.
(793) Id.
(794) Id. at PW-PR 700065-66.
(795) Id. at PW-PR 700066.
(796) The accounting literature does not address whether the "substantially the
same" analysis should be conducted with respect to the entire trade or with
respect to individual securities included in the collateral. We understand
that, as part of its restatement, the Company is reviewing every aspect of
its dollar roll procedure to ensure consistency with the relevant
standards.
212
(c) Monitoring Collateral
FAS 140, like FAS 125 before it, required that the Company at all
times have obtained sufficient cash or other assets to acquire substantially
similar assets.(797) As noted above, this required a mechanism to determine
whether a change in the value of the collateral requires an adjustment to the
transaction's terms. There is no evidence that the Company addressed this
requirement by identifying a system or practice to ensure that the cash received
in the transaction was adequate to fund the repurchase of replacement collateral
in the cost the counterparty defaulted. Prior to 2003, the Company's accounting
policy did not discuss the issue and the reference to the need to address this
issue in the 2004 e-mail discussed above bolsters the conclusion that Fannie Mae
did not ensure that it had an appropriate mechanism in place.
Interviewees confirm this point. Douthit was not aware of a mechanism.
Boyles pointed out that the requirement is specified in the 2003 policy, but he
had no insight into how it was implemented.(798) Barbieri in STO was unaware of
the requirement. We have seen no documentary reference to a mechanism for
dealing with this issue.
The question of whether the Company actually complied in part with
this provision is more complex and, ultimately, not amenable to resolution as
part of our review. In our interview with Barbieri, he noted that the Company
has used the trade confirmation services of the Depository Trust & Clearing
Corporation ("DTCC").(799) Although the particular DTCC services Fannie Mae used
has changed over time, Barbieri reported that, at least beginning sometime after
2000, the DTCC services Fannie Mae used required that the Company and its
counterparties make available to the DTCC assets sufficient to cover a party's
inability to perform its obligations.(800) According to Barbieri, the DTCC
contacted Fannie Mae periodically regarding adjustments to this "margin."(801)
- ----------
(797) See FAS 125 P 29; FAS 140 P 49.
(798) See 2003 Policy at FMSE-SP 79043.
(799) Barbieri recalled that prior to about 2000 or so, the Company used only
the DTCC's Electronic Pool Notification service, which involves the
transmission of pool information. After that date, the Company used some of
the DTCC's other services, such as trade comparison, netting and risk
management. As a government-sponsored enterprise, Fannie Mae's transactions
are cleared through the Federal Reserve Bank.
(800) Id.
(801) Id.
213
However, this requirement was not linked in any way to compliance with
applicable accounting requirements or, before 2003, the Company's own
policies.(802)
III. FINDINGS
We conclude that the Company's treatment of dollar rolls reflected a
lack of specific attention to the accounting requirements established by SOP
90-3, FAS 125, and FAS 140, at least prior to 2003, and a lack of coordination
between the various groups within the Company that had a role in the accounting
for and implementation of the transactions. Even after Financial Standards
issued a revised policy in 2003, it does not appear that the Company adopted
procedures to ensure compliance with the requirements for treating the
transactions as financings. The result was a lack of appropriate systems and
understanding and agreement on what standards should be applied, no allocation
of responsibility for applying relevant standards, and a failure to track the
transactions adequately.
However, we have seen no evidence that the Company's approach to
dollar rolls stemmed from an intent to manipulate earnings or other financial
results. Rather, the record viewed as a whole appears to confirm the conclusion
that the issues raised with respect to the Company's dollar roll transactions
are the result of a lack of appropriate systems and resources and, prior to the
advent of potential fails in 2003, a lack of consideration of the practical
issues surrounding dollar roll accounting and the potential consequences of the
Company's failure to account for the transactions properly.
PART C: ACCOUNTING FOR FORWARD COMMITMENTS
I. INTRODUCTION
In this Part, we address Fannie Mae's accounting for firm commitments
to purchase or sell mortgage loans or MBS following the FASB's adoption of
Statement of Financial Accounting No. 149.(803) FAS 149, which had an effective
date of July 1, 2003, amended FAS 133(804) to clarify that firm commitments to
purchase or sell mortgage loans and MBS should be treated as derivatives.
Accordingly, FAS 149 required that firm commitments (like other derivatives
covered by FAS 133) be recorded on the company's
- ----------
(802) As noted above, we did not determine whether individual dollar rolls were
properly accounted for as financings. That issue is being addressed as part
of the Company's restatement.
(803) AMENDMENT OF STATEMENT 133 ON DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITY,
Statement of Fin. Accounting Standards No. 149 (Fin. Accounting Standards
Bd. 2003) (hereinafter "FAS 149").
(804) ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES, Statement of
Fin. Accounting Standards No. 133 (Fin. Accounting Standards Bd. 1998)
(hereinafter "FAS 133"). The Company's accounting under FAS 133 is
considered in Chapter V of this Report.
214
balance sheet at fair value and subsequently marked to fair value at the end of
each reporting period until the settlement date. Changes in the fair value of
the commitments would be reflected in the Company's earnings unless the
derivative qualified as part of a hedging relationship.
Fannie Mae designated many of its firm commitments as hedges of the
risk resulting from changes in the price of the mortgage loans or MBS the
Company would acquire or deliver when the commitment settled. The rules that
govern these hedge relationships are the same rules that govern the hedges of
variable-rate debt. Consequently, the provisions of FAS 133 regarding the hedge
of a forecasted or anticipated transaction apply, including the requirements
that the forecasted transaction be identified in the hedge documentation with
sufficient specificity to identify when the hedged transaction occurs and that
the forecasted transaction be probable of occurring.
The February 11, 2005 OFHEO Letter raised several issues regarding
Fannie Mae's implementation of FAS 149.(805) First, OFHEO raised concerns
regarding the Company's policy for assessing whether the forecasted transaction
(that is, settlement of the commitment) was probable of occurring. Second, OFHEO
questioned whether Fannie Mae's documentation of hedges involving commitments
satisfied the requirements for hedge accounting. Third, OFHEO noted that "Fannie
Mae was unable to fully implement [FAS] 149 in the allotted time, which resulted
in changes in accounting for transactions subject to [FAS 149] after
adoption."(806) OFHEO raised additional questions regarding the Company's
application of other aspects of FAS 133 to hedged transactions involving
commitments. In sum, OFHEO "question[ed] whether Fannie Mae has properly and
consistently applied [FAS] 149 since it[s] adoption."(807)
During our review, we considered the history of the Company's
implementation of FAS 149 and the policies and procedures the Company adopted
with regard to hedged transactions involving firm commitments. As to the
history, the evidence we have compiled, including documents and interviews of
those involved in the implementation of FAS 149, shows that the effort to
implement the new standard stretched the Company's resources in both of the
departments that were most immediately affected by it: Financial Standards and
Portfolio. The resources were strained by a lack of systems and staffing to the
point where it became difficult, if not impossible, for Fannie Mae to implement
the standard correctly and in a timely fashion. Thus, Fannie Mae did not have a
final accounting policy regarding FAS 149 in place until October 2003, nearly
four months after the standard's effective date. Likewise, the Company's
procedures to address several of the important issues raised by FAS 149 were not
completed until months after the standard took effect. Hedge documentation was
revised several times after the standard's effective date and, as late as
mid-2004, the
- ----------
(805) See February 11, 2005 OFHEO Letter at FMSE-IR 547324-26.
(806) Id.
(807) Id.
215
specifications for the systems necessary to account for the hedged transactions
were still in the discussion stage.
We conclude that the policies and procedures Fannie Mae adopted to
implement FAS 149 were not consistent with GAAP. The record overall reveals that
Fannie Mae's hedge documentation did not adequately identify the hedged
forecasted transaction as FAS 133 requires. Most importantly, the Company's
hedge documentation did not describe the hedged transaction with specificity to
determine whether a transaction that occurred was the hedged transaction. For
similar reasons, Company management did not and could not assess at the outset
of the hedge whether the hedged transaction was probable of occurring.
It does not appear that the Company was driven by an effort to affect
the Company's financial statements (that is, to avoid earnings volatility) to
the same extent as we have found with its adoption of FAS 133 (except insofar as
the Company sought to treat its commitments as perfectly effective hedges).
Based on the evidence compiled during our review, we conclude that the
departures from GAAP were the result of three related factors: (1) the lack of
advance preparation for the changes that FAS 149 required; (2) the incorrect
assumption at the outset of the implementation that, with only minor exceptions,
all commitments - including commitments that resulted in "fails to ourselves" -
would be eligible for hedge accounting; and (3) the unexpected complexity
involved in the application of FAS 149 to the variety of Fannie Mae's commitment
and forward trade transactions.
Weakness in the Company's implementation of FAS 149 became apparent
when the first close of the Company's books after FAS 149's effective date
resulted in a $1 billion error on the Company's balance sheet. Although the
error was brought to the immediate attention of the Board, Leanne G. Spencer
told the Board that the implementation process was well in hand.(808) The Board
was not told, then or later, of the problems associated with the implementation
effort, including the problems Spencer acknowledged she had in communications
with her staff.(809)
This omission was especially significant as the balance sheet error
triggered special review by OFHEO of Fannie Mae's FAS 149 implementation process
and its end-user accounting systems. OFHEO's criticism further strained already
tense relations between Fannie Mae and its regulator at an especially important
period at the outset of OFHEO's Special Examination.
- ----------
(808) Mem. from Franklin D. Raines to the Board of Directors, dated Oct. 29,
2003, Zantaz document 3528788, at 2; Minutes of the Meeting of the Board of
Directors of Fannie Mae, dated Oct. 30, 2003, FMSE 10449-51, at FMSE 10450.
(809) See, e.g., 2003 Performance Review, Jonathan Boyles, dated Feb. 25, 2004,
FMSE-SP 102951-53 (hereinafter "Boyles 2003 Performance Review").
216
II. BACKGROUND ON FAS 149
A. Commitments under FAS 133 Prior to FAS 149
FAS 133 defines a "firm commitment" as a binding agreement between
unrelated parties that (1) specifies all significant terms, including the
quantity to be exchanged, the price, and the timing of the transaction and (2)
has "a disincentive for nonperformance that is sufficiently large to make
performance probable."(810) In certain circumstances, a firm commitment met FAS
133's definition of a derivative even before the FAS 149 amendments took
effect.(811) Such a commitment would be subject to FAS 133's accounting rules,
including the requirement that the commitment be recorded at fair value, unless
it qualified for one of FAS 133's scope exceptions.
FAS 133 recognized from the outset that a commitment, like other
derivatives, could be linked to another instrument in a hedged transaction.
Moreover, the FASB staff concluded in Statement 133 Implementation Issue No. G2,
dated March 31, 1999 (more than eighteen months before FAS 133's effective
date), that a commitment could serve as both the hedging instrument and the
hedged transaction in an "all-in-one hedge."(812) In an "all-in-one" hedge, a
commitment is linked in a hedge relationship with the asset underlying the
commitment: The commitment to purchase (or sell) the relevant asset on specified
terms serves as a hedge of the amount that the purchaser (or seller) will pay
(or receive) when the forward contract for that asset settles.(813)
FAS 133, as it took effect on January 1, 2001, arguably excluded
certain commitments from its scope. The standard provided that contracts for the
purchase or
- ----------
(810) FAS 133 P 540. A firm commitment is analogous to a futures contract that
can settle net - that is, instead of delivering the asset in question
(settling "gross"), the party can make a cash payment equal to the change
in the value of the asset during the contract term.
(811) FAS 133 defines a derivative as an instrument or contract (1) with one or
more underlyings and notional amounts, (2) that requires no (or minimal)
net investment, and (3) that requires or permits net settlement as opposed
to delivery of the underlying asset. See FAS 133 P P 6-9. The definition of
a derivative is discussed in Chapter V of this Report.
(812) CASH FLOW HEDGES: HEDGED TRANSACTIONS THAT ARISE FROM GROSS SETTLEMENT OF
A DERIVATIVE ("ALL-IN-ONE" HEDGES), Statement 133 Implementation Issue No.
G2 (Fin. Accounting Standards Bd. 1999).
(813) For example, if Fannie Mae enters into a commitment to purchase securities
at par with a settlement date in thirty days, the commitment (if
appropriately designated as a hedge of the security to be purchased) serves
as a hedge of the fluctuations in the price of the security during the
period between the commitment date and the date on which the forward
contract settles.
217
sale of when-issued securities or other securities that do not yet exist are
"excluded from the requirements of this Statement . . . only if (1) there is no
other way to purchase or sell that security, [and] (2) delivery of that security
will occur within the shortest period possible for that type of security."(814)
Concisely stated, FAS 133 contained language to the effect that the standard did
not apply to certain commitments to purchase or sell MBS on a "to-be-announced"
("TBA") basis.
As clarified by Statement 133 Implementation Issue No. C13, FAS 133
also excluded commitments to acquire mortgage loans from its scope.(815) As
originally released, Implementation Issue C13 provided an exemption for "loan
commitments that relate to the origination or acquisition of mortgage
loans."(816)
Consequently, when Fannie Mae adopted its Derivatives Accounting
Guidelines (hereinafter "DAG") in 2001, it did not treat commitments associated
with TBA trades or the purchase of mortgage loans as derivatives.(817) Fannie
Mae's interpretation was not unique, and the published materials surrounding the
FASB's consideration and implementation of FAS 149 confirm that the DAG did not
specify clearly the treatment of these commitments under FAS 133.
B. Adoption of FAS 149
The FASB released an exposure draft of FAS 149 in May 2002.(818) The
exposure draft modified FAS 133's exemption for commitments with respect to TBA
securities trades. Under the terms of the exposure draft, if there existed the
possibility that the commitment would settle net through the payment of a
pair-off fee (i.e., a fee paid by a nonperforming party to make the other party
whole based on changes in the fair value of the commitment), or if the entity
did not prepare the proper documentation to show that the commitment would not
settle net, then the commitment would fall within
- ----------
(814) FAS 133 P 59a.
(815) SCOPE EXCEPTION: WHEN A LOAN COMMITMENT IS INCLUDED IN THE SCOPE OF
STATEMENT 133, Statement 133 Implementation Issue No. C13 (Fin. Accounting
Standards Bd. 2000) (hereinafter "Implementation Issue C13").
(816) Id. (emphasis added).
(817) Derivatives Accounting Guidelines Section II.4-.5, dated Jan. 2001,
FMSE-IR 12825-13295, at FMSE-IR 12850-51. The DAG appears to rely on
Implementation Issue C13 to justify the exemption for commitments involving
both whole loans and TBA trades.
(818) PROPOSED STATEMENT OF FINANCIAL ACCOUNTING STANDARDS AMENDMENT OF
STATEMENT 133 ON DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES, Exposure
Draft R24(a) (Fin. Accounting Standards Bd. 2002).
218
the definition of a derivative and would be subject to accounting as such under
FAS 133.(819)
The initial exposure draft did not address commitments for the
purchase of mortgage loans. After further discussion, however, on October 9,
2002, the FASB voted unanimously that "only loan commitments that relate to
originating loans with potential borrowers" would qualify for the FAS 133
exemption.(820) As of that date, therefore, it was clear that all of Fannie
Mae's forward commitments to purchase mortgage loans would have to be accounted
for as derivatives.
The implication of FAS 149 was that firm commitments for the purchase
of mortgage loans and MBS would be required to comply with all of the FAS 133
requirements for hedge accounting, including those concerning documentation and
hedges of forecasted transactions.
The 2002 exposure draft stated that the new rules would apply to all
commitments entered into as of April 1, 2003. On March 12, 2003, the FASB
delayed the effective date by three months, to July 1, 2003.(821)
III. BACKGROUND ON FANNIE MAE'S FIRM COMMITMENT PRACTICES
In the ordinary course of its business, Fannie Mae purchases and sells
mortgage loans and MBS. Many of these transactions entail at the outset a firm
commitment by Fannie Mae to buy (or sell) the asset at a future date, followed
by settlement of the forward contract and delivery of the underlying asset to
(or by) Fannie Mae.
- ----------
(819) The exposure draft narrowed the exemption by requiring that, for the
exemption to apply, the parties to the firm commitment had to conclude and
document that, with respect to each trade, "it is probable at inception and
throughout the term of that individual contract that the contract will not
settle net and will result in physical delivery of a security when it is
issued." Id. Thus, FAS 149 still contains an exemption for commitments that
are unlikely to settle net. Fannie Mae did not attempt to take advantage of
this provision, instead treating its commitments as hedges.
(820) FASB ACTION ALERT NO. 02-39, dated Oct. 16, 2002,
http://www.fasb.org/action/aa101602.shtml (last visited Feb. 17, 2006).
(821) See FASB DERIVATIVES IMPLEMENTATION GROUP SUMMARY OF MARCH 12, 2003 BOARD
MEETING DISCUSSION ON THE PROPOSED AMENDMENT TO STATEMENT 133,
http://www.fasb.org/derivatives/bdmtg031203.shtml (last visited Feb. 17,
2006); FASB ACTION ALERT NO. 03-11, (Fin. Accounting Standards Bd. 2003),
http://www.fasb.org/action/aa031903.shtml (last visited Feb. 17, 2006).
219
A commitment to purchase or sell MBS might involve a "specified" trade
or a TBA trade. In a specified trade, Fannie Mae agrees to purchase or sell an
existing and identified security. In a TBA trade, the security does not yet
exist and the composition of the underlying mortgage pool is unknown. Instead,
the seller anticipates acquiring securities with certain features (for example,
Fannie Mae MBS reflecting securitization of a pool of thirty-year, fixed-rate,
six percent mortgages); the seller commits to sell, and the buyer commits to
purchase, the to-be-created security at a specified price on a specified date.
By entering into the commitment, the parties establish the price for and the
nature of the asset, regardless of any market fluctuations between the
commitment date and the settlement date.(822)
A commitment to purchase a pool of mortgage loans operates in a
similar fashion. The commitment specifies the parameters of the loans (interest
rate, term, etc.) and the price of the pool. At the settlement date, the seller
is obligated to deliver the loans or pay (or receive) a pair-off fee. Although
Fannie Mae buys and sells MBS, it typically does not sell whole loans due to
systems limitations.
Often, the parties to a commitment have an alternative: Instead of
delivering the asset, they may substitute a cash payment equal in amount to the
difference between the price specified in the commitment and the market value of
the asset on the settlement date.(823) This payment is referred to as a
"pair-off" fee.
These transactions often take on additional features that made
implementation of FAS 149 more complex. For example, in an "as soon as pooled"
("ASAP") trade, the mortgage lender (seller) has the option to deliver a pool of
loans to Fannie Mae in advance of the specified settlement date in exchange for
an adjustment to the purchase price for the loans. Fannie Mae might choose to
retain these loans in its portfolio or securitize the loans and sell the MBS. In
certain cases, Fannie Mae would also assume the lender's forward commitment to
sell the MBS created from the pool of loans to a third party.
Another transaction that had implications for the Company's
implementation of FAS 149 is referred to as a matched-terms buy-sell ("MTBS")
trade. In an MTBS trade, Fannie Mae enters into simultaneous commitments to
purchase a security from one party and to sell that security to another. Prior
to November 2003, however, using an automated process called "sorting and
sifting," Fannie Mae could compare the security it received under the "buy"
commitment in the MTBS to similar securities the Company acquired from other
parties. Based on that comparison, Fannie Mae might decide to keep a security it
had originally designated to be used to satisfy an
- ----------
(822) See generally Mem. from Paul Salfi to Distribution, dated Oct. 22, 2003,
FMSE-IR 482061-82 (establishing Company's financial accounting policy for
commitments).
(823) These terms are set forth in a standard Master Securities Agreement
between Fannie Mae and its counterparties. See Undated Master Securities
Forward Transaction Agreement P 7, FMSE-IR 694602-10, at FMSE-IR 694604.
220
MTBS trade and satisfy its MTBS sell obligation instead with a security acquired
from another party in settlement of another commitment. In other instances, if
the seller failed to deliver the security that Fannie Mae was expecting to
deliver under an MTBS trade, the Company typically would deliver a security that
had been intended for its portfolio to satisfy the MTBS trade. Because Fannie
Mae did not take the security into its portfolio, the Company dubbed that
transaction as a "fail to ourselves."(824)
Other transactions - such as pair-offs, cancel and corrects,(825) and
TBA value swaps - also had implications for Fannie Mae's application of FAS 149.
The important aspect of each of these transactions for present purposes is that
the commitments did not settle at the time, on the terms, and/or with the
counterparty the Company originally had anticipated.
IV. FINDINGS REGARDING FANNIE MAE'S IMPLEMENTATION OF FAS 149
Fannie Mae decided early in 2003 that, following the issuance of FAS
149, it would implement a program to designate its firm commitments as hedges of
the sale or purchase of TBA securities and mortgage loans.(826)
Despite the release of an exposure draft proposing changes in the
rules for TBA securities trades in May 2002, and the FASB's vote in October 2002
concerning commitments to acquire mortgage loans, the Company did not begin to
prepare for the issuance of FAS 149 until early 2003. Paul Salfi, an accountant
in Financial Standards who was involved in the Company's FAS 149 implementation
efforts, stated that he raised with Jonathan Boyles the potential that FAS 149
could have a significant effect on Fannie Mae. Boyles either did not expect that
FAS 149 would have a significant impact on Fannie Mae's operations, or, as we
explain below, he was distracted by other matters. In either event, the
implementation effort was delayed.
- ----------
(824) The ability to sort-and-sift and deliver securities intended for the
portfolio to third parties to fulfill the Company's forward sale
commitments was viewed by personnel in Portfolio as providing significant
economic value to Fannie Mae. When the ability to sort-and-sift was lost,
Portfolio management attempted to quantify the lost economic value. See
Undated Accounting Issues and Impact on Portfolio Business, FMSE-E
278831-42.
(825) A "cancel and correct" occurs when the original trade is canceled and a
new trade, with different terms, is executed.
(826) E-mail from J. Boyles to Timothy Howard, dated June 23, 2003, FMSE-E
5639-41 ("FAS 149 amends FAS 133 and reverses the DIG issue regarding
purchases held for investment and limits it to origination. As a result, we
will start treating these contracts as derivatives effective July 1,
2003.").
221
A document captioned "Timeline describing the development of FAS 149
implementation policy" (the "Timeline") records that the initial meeting among
the accountants in Financial Standards to discuss FAS 149 occurred on January
17, 2003.(827) An initial meeting with the managers in Portfolio to "discuss
potential population of commitments impacted" occurred ten days later.
Additional meetings over the next year, primarily involving Lynda Maggio in the
Portfolio Middle Office and Salfi, but including others as necessary, addressed
various issues surrounding the interpretation and implementation of FAS
149.(828) According to Salfi, by mid-2003, the FAS 149 implementation effort was
occupying a significant portion of his time.
According to Boyles and Salfi, implementation of FAS 149 was an
iterative or "peel the onion" process. Financial Standards worked with Portfolio
representatives to understand the Company's various commitment transactions and
formulate the accounting for those transactions. This process took several
months, especially as the Financial Standards and Portfolio teams considered
more varied and complex transactions (such as ASAP and "fails to ourselves"
transactions discussed above).
A presentation dated October 31, 2003, listed the steps in the FAS 149
implementation process up to the Company's third-quarter earnings release in
2003 (the first release affected by the new standard) and confirmed Boyles's
characterization of the Company's approach.(829) The five steps were: (1)
"Identified relevant transactions and inventory states"; (2) "Isolated data and
developed reports"; (3) "Long discovery period resulted in multiple amendments
to data sets and reports requested from portfolio Middle Office"; (4) "Marked to
market (M2M) transactions and inventories"; and (5) "Developed automated M2M
proposal for whole loans in CORE [systems] release I."(830) Among the items left
to be accomplished were: "Expedite review of transactions and inventory states
where accounting guidance is pending"; and "Materiality guidance from
Controller's office to prioritize list and work flow."(831)
It is apparent that, at the outset, Financial Standards was unfamiliar
with many of the commitment transactions about which it was required to provide
accounting
- ----------
(827) The document was prepared by Salfi in late 2003 in response to OFHEO's
request for information concerning the FAS 149 implementation process.
Salfi based the timeline on his diaries and records. See Undated timeline,
Zantaz document 272705 (hereinafter "Timeline").
(828) E-mail from Lynda Maggio to P. Salfi et al., dated Sept. 24, 2003, FMSE-E
165732-37.
(829) FAS 149 Checkpoint, dated Oct. 21, 2003, FMSE-E 38344-69, at FMSE-E
383451.
(830) Id. at FMSE-E 383453.
(831) Id.
222
advice. A presentation to OFHEO that Fannie Mae prepared in November 2003
regarding the implementation process confirmed that it took "several months to
understand all the commitment types and to define [the standard's]
scope[.]"(832) The presentation noted the standard's complexity and that the
FASB provided "[l]ess than four months from issuance to implementation."(833)
That iterative and protracted nature of the implementation process is
reflected in other documents as well. In a September 2003 e-mail exchange among
Salfi, Janet L. Pennewell, and Matthew Douthit in Portfolio, Pennewell listed
the commitments that had yet to be addressed in order of priority.(834)
Pennewell said that the commitments for which the Company was not yet prepared
to implement FAS 149 would not be treated as hedges and would be marked to fair
value through earnings.(835) Salfi concluded the exchange with a two-step plan
in which certain aspects of the documentation would be resolved by October 1,
with more complete documentation to be phased in thereafter.
The record also shows that KPMG was brought into the FAS 149
implementation effort at a relatively late date. According to the Timeline, the
first draft of a FAS 149 accounting policy was circulated internally on May 28,
2003, just thirty-three days before the standard's effective date, and KPMG did
not receive a copy for review until June 20, just eleven days before FAS 149
became effective.(836) New iterations of the draft policy were prepared, and the
Timeline shows a meeting on July 28, 2003, attended by KPMG and representatives
from Controller's and Portfolio, "to agree upon accounting policy for FAS
149."(837) Spencer would later reflect in hindsight on the
- ----------
(832) FAS 149 Adoption at Fannie Mae: OFHEO Review, dated Nov. 6, 2003, FMSE-IR
352360-87, at FMSE-IR 352365.
(833) Id. The reference to a four-month implementation period underscores the
extent to which the Company's effort to implement the standard was belated.
Although it is correct that the FASB issued the standard in April with an
effective date in July, the FASB had originally set the effective date as
April 1 when it announced its intentions in 2002. Furthermore, with the
FASB having completed its redeliberations on the exposure draft by
mid-December 2002, it is clear that the Company had more than four months
to react to the FASB's new positions on these matters. FASB ACTION ALERT
NO. 02-48,
http://www.fasb.org/action/aa122002.shtml (last visited Feb. 17, 2006).
(834) E-mail from P. Salfi to Janet L. Pennewell and Matthew Douthit, dated
Sept. 29, 2003, FMSE-E 1178554-56.
(835) Id.
(836) Timeline at 1, 2. According to the Timeline, the fact that KPMG had not
reviewed the policy previously was raised at a meeting the following day.
(837) Id.
223
need "to drive KPMG to full engagement and not allow them to derail you
mid-stream as happened with FAS 149."(838) However, the responsibility for any
delay in this regard must rest with the Company, which began the implementation
process late and brought KPMG into the effort only a few weeks before the
effective date.
Several factors further complicated the Company's implementation of
FAS 149. There is abundant evidence that, from late 2002 through 2003, Financial
Standards was understaffed and preoccupied by other matters. In her evaluation
of Boyles, Spencer acknowledged that, from an accounting perspective, 2003 was
the "Perfect Storm."(839) She pointed to the adoption of FAS 149, the issuance
of other accounting standards that had an impact on Fannie Mae, the Company's
SEC registration and its first Form 10-K filing, and Freddie Mac's disclosure
that it would restate its financial statements as a result of accounting
errors.(840) Spencer noted that Financial Standards had confronted these matters
"with a thinner staff than we both would have liked" and focused on the need to
build up the Financial Standards staff in the future.(841) Douthit (Maggio's
supervisor) remarked to his superior, Andrew McCormick, about the lack of
adequate resources in Financial Standards at about this time.
Maggio also believed that her Portfolio group, which was responsible
for providing the fair-value marks for the commitments, lacked adequate
staffing. As early as July 2, 2003, Maggio reported to her superiors in
Portfolio and to Spencer that the requirements of FAS 149 "will require
additional resources in the portfolio middle office group."(842) To justify her
request for two additional full-time employees, Maggio outlined the new tasks
that implementation of FAS 149 would require and emphasized that "each of these
components represents a process that is unique due to source data systems,
output format requirements, timing, or valuation technique."(843) Apparently,
Maggio's staffing requests were not met effectively. In an e-mail dated November
20, 2003, she
- ----------
(838) Boyles 2003 Performance Review.
(839) Id. Apparently this characterization originated with Boyles. Spencer
wrote: "Maybe your analogy of weathering the 'Perfect Storm' is apt as
well." Id.
(840) Id. A draft letter to OFHEO that the Company was preparing to describe its
implementation of FAS 149, and that appears to reflect Spencer's input also
noted that FAS 149 "hit at the all time peak of mortgage commitment
activity with interest rates at 45 year lows and a record commitment
pipeline of over $135 billion." Draft Letter to C. Dickerson, dated Mar.
25, 2004, Cataphora document i.h.185b92a6d2db24f5141927ab3d5f6d46, at 2.
(841) Boyles 2003 Performance Review at FMSE-SP 102951.
(842) Mem. from L. Maggio to Leanne G. Spencer, Andrew McCormick and M. Douthit,
dated July 28, 2003, FMSE-E 1116570-74.
(843) Id.
224
noted that one of the staff slots she requested had been filled by an existing
employee who had not been relieved of his or her previous duties; the other slot
was filled by hiring an employee from the Company's Office of Internal Audit
who, according to Maggio, was not available to work with her group until January
2004.(844)
Finally, the delays in implementation resulted in a delay in the
development of the Portfolio systems to mark the commitments to fair value and
the Financial Reporting systems to account for the hedged transactions. As late
as June 2004, the Company still was drafting requirements specifications for the
systems it would need to automate tracking and accounting for the commitment
activity captured by FAS 149.(845) The 2004 version of the Company's Portfolio
Transactions Procedures Guide states:
The existing [FAS 149] process is not fully automated with edit checks
to strengthen the review process. Many edit checks are automated, but
some are still in spreadsheets. Although the process is not efficient,
it is effective. . . .
There is still some risk within the project. First, Accounting Policy
and Legal are still deciding on when certain transactions need to be
marked. Second, the multiple marking methods in the review process are
not yet bullet proofed. Transfers of data and summary reports are
vulnerable due to the multiple spreadsheets used to hold marks.(846)
The Guide notes that system enhancements were planned for 2004.(847)
There can be little doubt that the lack of advance preparation and
adequate staffing affected the Company's ability to implement the accounting
standard effectively. As Spencer later acknowledged, "FAS 149 knocked us off our
horse which had begun to canter. We are only slowly building momentum."(848)
- ----------
(844) E-mail from L. Maggio to P. Salfi, dated Nov. 22, 2003, FMSE-E 172269-71.
(845) Requirements Specification, FAS 149: Fail Resolution Probability Report,
Version 1.0, dated June 28, 2004, FMSE-SP 95094-100.
(846) Portfolio Transactions Procedures Guide, Asset Execution Guidelines, dated
2004, FMSE 219765-74, at FMSE 219768.
(847) Id.
(848) Boyles 2003 Performance Review at FMSE-SP 102952.
225
V. FINDINGS REGARDING FANNIE MAE'S ACCOUNTING FOR FIRM COMMITMENTS
A. The Company's FAS 149 Policy
Financial Standards, as noted, circulated the first draft of a FAS 149
policy in May 2003.(849) After several iterations, the final version of the
accounting policy was issued in October 2003 (the "Policy").(850)
Under the Policy, most of the Company's commitments were presumed to
be derivatives and therefore eligible to be used in a hedged transaction. These
categories included commitments for the purchase of mortgage loans (including
loans acquired through ASAP arrangements), the purchase or sale of when-issued
or TBA securities, and the purchase or sale of specified MBS. The Policy
excluded other categories of transactions, such as commitments to purchase or
sell assets that the Company classified, or would classify, as trading assets
under FAS 115, and "best efforts" commitments (that is, commitments that are not
"firm").(851)
The Policy appears to reflect the Company's intention to designate
forward purchase or sale commitments as "all-in-one" cash flow hedges of changes
in the market price of the forecasted purchase or sale of the mortgage or
security underlying the commitment. As stated in the Policy, "[w]e will
designate forward portfolio purchase/sale commitments as the hedging derivatives
in cash flow hedges of the risk associated with the impact of changes in [the
prices of the] mortgage assets underlying the commitments/derivatives since
these mortgage assets will reside in the portfolio or come from the
portfolio."(852)
It also appears that the Company intended to use the matched-terms
method of hedge accounting for most of its commitments.(853) According to the
Policy, the critical terms of the commitments and the assets to be purchased or
sold would be the
- ----------
(849) Timeline at 1.
(850) Mem. from P. Salfi to Distribution, dated Oct. 22, 2003, FMSE-IR 482061-82
(hereinafter "Policy").
(851) Id. at FMSE-IR 482067. The Policy also established a rule regarding
commitments that did not close on the settlement date. According to this
rule, a commitment would not qualify for hedge accounting at the point in
time at which it became probable that the commitment "will not settle with
similar assets within 60 days of the original settlement date and,
therefore, the forecasted transaction is not probable of occurring." Id.
(852) Id. at FMSE-IR 482062 (emphasis added).
(853) Id. at FMSE-IR 482079.
226
same and "we will conclude that hedges are perfectly effective."(854) In most
instances, these would be cash-flow hedges in which the commitment hedged any
change in the price of the asset.
According to the Policy, purchase and sale commitments associated with
an MTBS trade were not to be linked in a hedge relationship because the changes
in the fair value of the two commitments would offset each other in the
Company's earnings. However, MTBS sale commitments associated with loans
acquired under ASAP trades would be linked as fair-value hedges of loans
acquired in ASAP trades; according to the Policy, the fair value of the loans
and the commitment "should offset because the life of the hedges is typically
very short."(855) That is, any change in the value of the pools would not
necessarily offset the change in the value of a sale commitment entered into on
an earlier date; however, the Company treated these differences as
inconsequential.(856)
The Policy also addressed circumstances in which a commitment would
not settle. According to the Policy, for example, hedge accounting would be
appropriate with respect to a transaction in which the counterparty pays a
pair-off fee instead of delivering the assets, if Fannie Mae were to use the
pair-off fee to defray the cost of purchasing similar securities in the open
market.(857) Similarly, under the Policy, hedge accounting would be appropriate,
and the Company would continue to apply hedge accounting in a fails to ourselves
situation if Fannie Mae were to consummate the purchase commitment by taking a
security from another seller into its portfolio.(858) The Policy supported these
positions by treating the assets as "fungible."(859)
- ----------
(854) Id.
(855) Id. at FMSE-IR 482080. The Policy stated that the maximum weighted average
time period between loan acquisition and the forward sale date for any
month to that point in 2003 was sixteen days.
(856) Id. ("So, we will conclude that the hedges are perfectly effective.").
(857) Id. at FMSE-IR 482069.
(858) Id. at FMSE-IR 482063, 68-69.
(859) Id. at FMSE-IR 482069. Another section of the Policy on the same subject
stated: "Our proposal is that TBA pools be treated as generic commodities
that are interchangeable amongst each other." Id. at FMSE-IR 482074. In
this respect, the Policy was internally inconsistent. The notion that the
assets are interchangeable or fungible is belied by the sorting and sifting
process itself, which is based on recognizing characteristics of an
instrument that would make the instrument more appealing than other,
similar instruments. As the Policy also noted, "we have a strategy to 'keep
the best, sell the rest.'" Id. Further, sorting and sifting was
inconsistent with an "all-in-one" approach to hedge accounting and made it
difficult to identify whether the transaction that occurred was the hedged
transaction
227
Based on the record compiled during our investigation, we conclude
that the approach to hedge accounting for commitments reflected in the October
2003 accounting policy and other documents is inconsistent with GAAP in several
respects, regardless of whether the Company's approach to hedge accounting was
based on the "all-in-one" cash flow hedge accounting guidance in Implementation
Issue G2. These inconsistencies center on the FAS 133 requirement that the
Company document the hedged transaction at inception, "with sufficient
specificity so that when a transaction occurs, it is clear whether that
transaction is or is not the hedged transaction."(860) In addition, the
Company's procedures for hedging firm commitments did not meet the FAS 133
requirement "[t]hat the occurrence of the forecasted transaction is
probable."(861) We explain below why, in our view, Fannie Mae's application of
hedge accounting to its firm commitments did not satisfy these requirements,
with attention to both the development of the requirements and the processes the
Company adopted.
B. Documentation of Hedged Transactions
The development of Fannie Mae's documentation for hedged transactions
involving forward-trade commitments suffered from the same fits and starts that
beset the effort overall. Management never developed a procedure that properly
documented the link between a commitment (derivative) and the purchase or sale
of the underlying asset (the hedged item).
Initially, management sought to adopt a practical approach to FAS
133's documentation requirement in which it would compile a list of purchase and
sale commitments at month's end. Those involved in the process apparently
expected to rely on this approach up until the night before FAS 149's effective
date. On June 30, 2003, however, Salfi sent to Maggio and others in Portfolio
and Financial Reporting an e-mail notifying them of a change in procedure:
I have not received all of KPMG's comments, but one major one has to
do with the frequency of hedge documentation. We must document that
the commitments are hedges by the end of the day that [they] are
entered. We originally thought we could do it monthly, but KPMG would
not accept that practical cut.(862)
- ----------
identified at the outset of the hedge, as purchases for the portfolio could
not be identified until that process was completed.
(860) FAS 133 P 28(a)(2).
(861) FAS 133 P 29(b).
(862) E-mail from P. Salfi to L. Maggio, dated June 30, 2003, Zantaz document
944907.
228
Salfi proposed corrections to the documentation "that we need to have . . .
beginning July 1" - that is, the following day.(863)
Other issues surrounding the documentation arose during the following
months. On September 29, 2003, for example, Salfi reported that the Company
would have to identify the individual commitments it intended to use as hedges:
"[G]oing forward, we are going to have to identify the deal numbers in our hedge
documentation for portfolio commitments that we document as cash flow hedges,
MTBS sale commitments that we document as fair value hedges, and MTBS buy
commitments that we will be documenting as cash flow hedges because of [fails to
ourselves]." According to Salfi, "this last documentation needs to start
occurring on Oct. 1 [two days after the e-mail] using the template I sent around
on Friday."(864) Maggio forwarded the e-mail to Douthit with the message,
"ANOTHER FAS 149 change!!!!!!!!!!"(865) Douthit forwarded Maggio's e-mail to
Pennewell, who prioritized the transactions based on their impact on Fannie
Mae's income; she identified documentation of fails to ourselves as "the big
problem."(866)
The Company's hedge documentation during this period specified that
the commitments "will now be used to lock-in the purchase or sale price on
forecasted mortgage asset acquisitions or sales and hedge against the impact of
changes in market interest rates on the future purchase or sale prices."(867)
The documentation went on to state that "[t]he critical terms of these
commitments match the forecasted purchases/sales, so we expect that the hedges
will be perfectly effective at inception and on an ongoing basis."(868)
Fannie Mae's approach was problematic, however, because the
documentation did not identify which trade, or group of trades, was the hedged
item, and
- ----------
(863) Id.
(864) E-mail from P. Salfi to J. Pennewell, copy to M. Douthit, dated Sep. 29,
2003, FMSE-E 1178554-56.
(865) Id. at FMSE-E 1178555.
(866) Id. at FMSE-E 1178554.
(867) Id. (unnumbered attachment); see also FAS 149 Adoption at Fannie Mae -
OFHEO Review, dated Nov. 6, 2003, FMSE-IR 352360, at FMSE-IR 352376
(hereinafter "Hedge Documentation Process").
(868) Hedge Documentation Process at FMSE-IR 352376. Another version of the
hedge documentation appears in the August 2003 e-mail from Salfi to Mary
Lewers. E-mail from P. Salfi to M. Lewers, dated Aug. 21, 2003, FMSE-E
117249-50.
229
which was not.(869) The MTBS trades, fails to ourselves, and sorting and sifting
illustrate the problem with Fannie Mae's approach to documentation. In an MTBS
trade, neither the purchase nor the sale commitment was treated as a hedge,
because Fannie Mae did not intend to take the securities into its portfolio;
moreover, any changes in the fair values of these commitments presumably would
offset each other, so hedge accounting was not necessary to address the effect
of the derivatives on the Company's earnings.(870) However, as a result of the
sorting and sifting process and its approach to satisfying third-party sale
commitments in advance of commitments to its portfolio, the Company could take
the security delivered pursuant to the MTBS purchase commitment into its
portfolio and substitute a security obtained in settlement of another commitment
that had been intended for the portfolio and thus had been documented as a
hedge.(871) The procedure, in effect, treated the unhedged transaction as the
hedged transaction, and vice-versa. Thus, those involved in the transaction did
not - indeed, could not - document at the outset of the hedge which commitment
transactions would result in the security delivered to the portfolio and, as
such, could not determine which commitments could qualify as hedges.
To address this issue, the Company would document the settled MTBS buy
commitment "as the replacement cash flow hedge of the forecasted acquisition of
assets into the portfolio."(872)
The Company's draft requirements specifications for the documentation
function in a proposed FAS 149 accounting system summarized this approach as
follows:
At a high level, our documentation plan is to produce a daily hedge
memo that indicates the total amount of new buy and sell commitments
for the day that qualify for cash flow hedges, and the outstanding
qualifying commitments to date. The text of this memo will explain
that the outstanding commitments-to-date number includes [fails to
ourselves] and third party pair offs. As a backup to this daily memo,
we will produce a file listing the IPOR deals
- ----------
(869) As noted above, the Policy appears to approach the hedges of commitments
as "all-in-one" hedges. The documentation can be read to be consistent with
that approach. Alternatively, it can be viewed as an effort to document
hedges involving more than one commitment. FAS 133 permits the latter,
subject in all cases to the requirement that, when a transaction occurs, it
is clear from the documentation whether the transaction is a hedged
transaction or not.
(870) Policy at FMSE-IR 482069.
(871) As a result of problems with the interaction between sorting and sifting
and ASAPs, the sorting and sifting process was suspended in November 2003.
E-mail from M. Douthit to A. McCormick, dated Nov. 6, 2003, FMSE-E 1179760.
(872) Id.
230
[that is, the commitments to acquire securities for the Company's
portfolio] that represent our portfolio position that qualifies for
cash flow hedge accounting. This file will also include the list of
corresponding external commitments (XPOR [commitments to purchase from
or sell to third parties], MTBS) and amounts that total this portfolio
position. . . . While these two sets of deals (internal and external)
will agree in total, we will not create a deal by deal
cross-reference. . . . After settlement, we can report on which
specific external commitment was used to fill any given [receipt into
the portfolio].(873)
In other words, the determination of which commitments resulted in the delivery
of a security to the portfolio, and thus qualified for hedge accounting, could
be accomplished only by a reconciliation process at month-end.(874)
As these documents and the fails to ourselves example illustrate, this
approach to FAS 149 hedged transactions did not satisfy the requirement in FAS
133 that the Company's documentation describe the transaction such that it would
be clear when the hedged transition occurred. We conclude, therefore, that the
Company's documentation did not satisfy the requirements of GAAP.
C. The Probability Assessment
As noted above, FAS 133 specifies that a forecasted transaction is
eligible for hedge accounting only if the transaction is "probable" of
occurring. For reasons similar to those stated above, we conclude Fannie Mae did
not meet this requirement.
The Policy identifies a number of instances in which a forward trade
would not occur. These include: The counterparty's (or Fannie Mae's) decision to
pay a pair-off fee in lieu of delivery; a cancel and correct; and the failure of
the Company's counterparty to perform on its commitment obligations
outright.(875) The Policy posits that these instances are relatively rare and
even in these circumstances "the hedged forecasted transaction (the purchase of
loans or securities) is still probable to occur because the underlying assets
are typically obtained within 60 days of the original settlement date."(876)
- ----------
(873) Requirements Specification: FAS 149, Cash Flow Hedge Documentation,
Version 1.3, dated Mar. 17, 2004, FMSE-SP 095598-611 (emphasis added).
(874) It is notable that, during implementation of FAS 133, the Company
developed systems (the DEBTS system and the FAS 133 system) to ensure that
it could document a link between a specified derivative and hedged
instrument.
(875) Policy at FMSE-IR 482066.
(876) Id.
231
The Policy addressed the probability assessment much as it had the
documentation requirement: it considered the transactions on an aggregate,
end-of-month basis. According to the Policy, this monthly analysis would
corroborate the initial assessment that the hedged transactions were probable on
the whole: "On a rolling 12 month basis, we will review loan pair-off activity,
securities cancel and corrects, and fails to assess the rate at which
commitments did not settle (and the forecasted transaction did not occur) within
60 days of the forecasted settlement date and our upfront conclusion that the
purchases are probable to occur."(877) That is, the Company would compare the
level of closed commitments to the total volume of commitments to determine the
overall level of transactions that did not occur. Although the policy itself
does not set a probability threshold, the Company set that threshold at
seventy-five percent - that is, a transaction was considered probable if, on an
aggregate, rolling, twelve-month basis, no more than twenty-five percent of the
forward trades linked to a forward commitment failed.(878) According to the
Company's documentation and the Policy, at the end of the month, the Company
would "verify . . . whether open purchase/sale commitments did meet the criteria
above to qualify for hedge accounting."(879)
- ----------
(877) Id.
(878) Requirements Specification, FAS 149: Fail Resolution Probability Report,
Version 1.0, dated June 28, 2004, FMSE-SP 95094-100, at FMSE-SP 95096.
(879) Hedge Documentation Process at FMSE-IR 352376. The Policy appears to have
selected the end of the month for assessing the probability that open
commitments were still expected to result in delivery of a loan or security
because that would be the point at which information on closed commitments
would be available:
To qualify for hedge accounting, we must also document the derivatives
used, the hedged items, the risk being hedged, how we will assess
hedge effectiveness, and measure hedge ineffectiveness. Each day, we
will establish purchase and sale commitments/derivatives as hedging
instruments in hedging relationships that protect against the effect
of changes in market interest rates on the cash flows related to the
prices of future acquisitions or sales. At month end, we will monitor
the timing and probability of forecasted acquisitions or sales based
on the status of the open commitments.
Policy at FMSE-IR 482065. The reference to month-end monitoring caused
confusion. In August 2003, Salfi sent Lewers an e-mail with the comment:
"Here is what we are using to document the commitments as hedges on a daily
basis." E-mail from P Salfi to M. Lewers, dated Aug. 23, 2003, FMSE-E
117249-50. Lewers noted the reference in the documentation to month-end
monitoring and posed several questions: "What does 'We will verify at
month-end whether open purchase/sale commitments did meet the criteria
above to qualify for hedge
232
It is not clear whether the Company had a system in place to
corroborate the probability assessment stated in the Policy. We were told during
interviews that a procedure was in place to track the probabilities manually
from the outset. A presentation regarding the FAS 149 implementation process -
which appears to be from no earlier than the fourth quarter of 2003 - however,
contained the following language:
PROBABILITY RISK
In order to qualify for hedge accounting, our forecasted transactions
must be probable to occur within 60 days of intended settlement.
Probability is defined as 75% actually occurring over a rolling 12
month period. A number of events count against our probability:
- Cash pairoffs
- Fails over 60 days
- Cancel/Corrects that change the commitment parameters or intended
settlement beyond 60 days.
We are not currently testing our probability %.(880)
The decision to exclude certain transactions entirely from the
probability assessment is also questionable. In a number of different scenarios,
such as fails to ourselves, the hedged transaction that the Company entered into
at the outset did not settle, although another transaction may have.
Nonetheless, Financial Standards concluded that these transactions would not be
included in the assessment of the probability that the hedged transaction that
the Company initially entered into would occur.
The requirements-specifications document for a proposed FAS 149
accounting system describes the approach to probability:
- ----------
accounting' mean? Specifically, who is 'we' and what is the evidence of
this verification process?" Salfi responded that he anticipated Financial
Reporting (that is, Lewers's group) would determine whether there were open
commitments at month's end that would not qualify for hedge accounting. Id.
(880) Undated FAS 149 Risk Assessment, FMSE-SP 95114-20, at FMSE-SP 95120
(emphasis added). The document refers to the fact that the Company was able
to defer $2.4 billion in other comprehensive income as a result of "third
quarter hedging relationships," suggesting that the document was prepared
during the fourth quarter of 2003 at the earliest. Id. at FMSE-SP 95118. We
were told that it is possible that the statement regarding probability
testing referred to automated testing.
233
In the long term, this [probability] report should evaluate each
derivative that was given cash flow treatment to determine its
disposition. These derivatives can either settle, be substituted with
another derivative (third party pair-off), fail, be net settled for
cash, or be substantially modified. If the derivative were
substituted, we should show the disposition of the replacement trade.
To do this correctly, we need to be able to specifically identify the
external commitment that is being given hedge treatment and to be able
to accurately trace through the replacement trade relationships. This
is difficult in the near term.(881)
A specification prepared at a later date stated: "We can substitute one external
trade for another as the cash flow hedge without impacting probability or
creating a DNQ event [that is, a hedged transaction that does not qualify for
hedge accounting], as long as we document the new trade when the substitution
occurs. This situation happens with third-party pair offs and [fails to
ourselves]."(882) In sum, the procedure excluded hedged transactions that had
not occurred from the probability assessment, so long as another hedged
transaction that settled was substituted for the original trade and that
substitution was documented.
Further, the decision to ignore pair-offs and fails in determining
whether it was probable the security underlying a commitment would be delivered
was inconsistent with the Company's apparent reliance on the "all-in-one" cash
flow guidance. As an "all-in-one" cash flow hedge required identifying a
specific transaction as the hedged item, once that transaction failed or was
paired off, hedge accounting was no longer appropriate because it was probable
that the hedged transaction would not occur. As such, gains or losses deferred
on that transaction should have been recognized in income. Gains and losses on
the derivatives were deferred as long as it was probable that the Company would
purchase a replacement security.
Our conclusions regarding the implementation of the FAS 149
probability assessment are similar to our conclusions regarding the
documentation requirement. There was no mechanism in place to meet the FAS 133
requirement that the Company apply hedged transactions only with respect to
transactions that were probable of occurring. For this reason, too, the use of
hedge accounting for commitments did not comply with GAAP.
- ----------
(881) Requirements Specification: FAS 149 Probability Report, Version 1.0, dated
Nov. 20, 2003, Zantaz document 785570, at 3-4.
(882) Requirements Specification: FAS 149, Cash Flow Hedge Documentation,
Version 1.3, dated Mar. 17, 2004, FMSE-SP 95598-611, at FMSE-SP 95601.
234
VI. FINDINGS REGARDING SENIOR MANAGEMENT, OFHEO, AND THE BOARD
The evidence overall reveals that senior managers in the Controller's
Office had little involvement in the FAS 149 implementation process. Spencer's
retrospective on the events of 2003 refers to Salfi's leadership of the effort
within Financial Standards, and Boyles stated that responsibility for the FAS
149 implementation effort fell primarily on Salfi. It appears that Salfi
endeavored to implement the standard in good faith, but the number and
complexity of the issues raised by the new standard, combined with the short
time period in which he had to work, led to significant errors.
There is no indication that Timothy Howard was involved in the FAS 149
implementation. On the contrary, an exchange between Howard and Boyles in June
2003 reflects Howard's lack of familiarity with the subject. Howard initiated
the exchange with an e-mail concerning the accounting problems that had been
noted in a recent Freddie Mac press release. The e-mail included a reference to
FAS 149: "The one item I'm not clear on, however, is the accounting for forward
commitments. You say that Freddie's forward commitments 'generally qualified as
derivatives under GAAP.' Did ours not? Why not? And what is FAS 149, what does
it change and when does it go into effect?"(883) Howard went on to say that he
"need[s] to get more clarification on this point. I don't in any way want to
underinform or mislead the Board."(884)
Boyles's reply to Howard offered only a brief overview of the issues
that FAS 149 raised for Fannie Mae. Boyles explained why the Company did not
treat forward commitments as derivatives prior to FAS 149, noted that FAS 149
requires that commitments be treated as derivatives, and explained that KPMG was
in the process of reviewing Fannie Mae's accounting, but "[s]o far they have not
indicated to me [Boyles] anything other than they agree with our accounting
treatment."(885) It does not appear that any other senior officers in the
Company were involved in the implementation of FAS 149.
An issue that arose later in 2003 drew senior management and the Board
into additional discussions regarding the FAS 149 implementation process. The
Company made an error in the preparation of its financial statements for the
third quarter of 2003, which was the first quarterly close in which FAS 149
affected the financial statements. The error resulted from the duplication of an
adjustment relating to the
- ----------
(883) E-mail from J. Boyles to T. Howard, dated June 27, 2003, FMSE-E 5639-41,
at FMSE-E 5640.
(884) Id.
(885) Id. at FMSE-E 5639-40.
235
valuation of the Company's outstanding commitments.(886) The calculations were
done mainly on spreadsheets (referred to as "end user systems"), as there was no
integrated FAS 149 system to make the necessary calculations. The error resulted
in a more than $1 billion understatement of total assets and stockholders'
equity on the Company's balance sheet.
Before the error came to light, on October 16, 2003, management had
issued a press release announcing its quarterly results.(887) Accordingly, on
October 29, 2003, management issued a new press release and filed a Form 8-K
with the SEC.(888) OFHEO issued a statement that same day noting the error and
suggesting that it "underscores the need for the special review OFHEO is about
to begin of accounting policies, practices, and internal controls at Fannie
Mae."(889)
The Company's Senior Vice President for Investor Relations responded
the next day with a second press statement: "These were honest mistakes made in
a spreadsheet used in the implementation of a new accounting standard. The
bottom line is that the correction has no impact on our income statement, but
resulted in increases to unrealized gains on securities, accumulated other
comprehensive income, and total shareholder equity (of $1.279 billion, $1.136
billion, and $1.136 billion, respectively)."(890)
Meanwhile, Franklin D. Raines alerted the Board to the error in a
memorandum dated October 29, 2003. He told the Board that, in connection with
the FAS 149 calculations, "the company calculated unrealized gains utilizing a
faulty
- ----------
(886) The adjustment was incorporated into a computation that Portfolio provided
to the Controller's Office; the Controller's Office later repeated the
adjustment.
(887) See Fannie Mae press release, dated Oct. 29, 2003, available at
http://www.fanniemae.com/newsreleases/2003/2807.jhtml?p=Media&s=News+Rele
ases (last visited Feb. 17, 2006).
(888) See Fannie Mae press release, dated Oct. 29, 2003, available at
http://www.fanniemae.com/newsreleases/2003/2822.jhtml (last visited Feb.
17, 2006).
(889) Statement of OFHEO Director Armando Falcon, Jr. Regarding Fannie Mae
Accounting Error, dated Oct. 29, 2003, available at
http://www.ofheo.gov/News.asp?FormMode=Releases&ID=113 (last visited Feb.
17, 2006).
(890) See Statement by Jayne Shontell, Fannie Mae Senior Vice President,
Investor Relations, dated Oct. 30, 2003, available at
http://www.fanniemae.com/ir/issues/financial/103003.jhtml (last visited
Feb. 17, 2006).
236
spreadsheet formula."(891) Management briefed the Board the following day at a
meeting convened by conference call. According to the minutes of the meeting,
Raines "reviewed the actions the company had taken since discovery of the error
.. . ., including reviews by senior management, interaction with the company's
regulators . . . and acting to ensure that the corporation fully understands
what occurred and implements the corporation's FAS 149 plan expeditiously."(892)
Spencer also addressed the Board. According to minutes of the Board
meeting she attended, Spencer "assured the Board that her team is focused on
expediting the automated implementation of these new accounting requirements and
that the necessary corporate resources had been devoted and would continue to be
devoted to implementing appropriate system changes to accommodate the
requirements of FAS 149."(893) Raines then "added that all appropriate changes
would be completed in stages, with final implementation by the end of first
quarter 2004."(894) It does not appear that Spencer alerted the Board to the
resource issues that had arisen during the implementation of FAS 149 - or the
other problems that the Controller's Office had faced in 2003 - either at the
October 30 Board meeting or thereafter.
On the contrary, according to the minutes of the February 2004 Audit
Committee meeting, Spencer referred to 2003 merely as "an active year in
adopting changes to accounting standards."(895) In response to a question from
one of the committee members concerning FAS 149 specifically, "Ms. Spencer
responded that the automation of the FAS 149 processes are [sic] currently
underway with an interim solution in place and a more permanent system being
developed."(896)
None of the Board members we interviewed recalled Spencer, or anyone
else, alerting them to problems stemming from a lack of resources or with
respect to the implementation of any accounting standard.
The Board and Audit Committee minutes suggest that senior management,
and particularly Spencer, were not entirely forthcoming to the Board regarding
the
- ----------
(891) Mem. from F. Raines to the Board of Directors, dated Oct. 29, 2003, Zantaz
document 3528788, at 2.
(892) Minutes of the Meeting of the Board of Directors of Fannie Mae, dated Oct.
30, 2003, FMSE 10449-51, at FMSE 10449.
(893) Id. at FMSE 10450.
(894) Id.
(895) Minutes of the Meeting of the Audit Committee of the Board of Directors of
Fannie Mae, dated Feb. 17, 2004, FMSE 504818-30, at FMSE 504821.
(896) Id.
237
implementation of FAS 149 or the problems the Company faced during 2003 - for
example, that the Controller's Office was understaffed.(897) In fact, the
document in which Spencer discussed the difficulties the Controller's Office had
faced in 2003(898) was dated just one week after the February 2004 Audit
Committee meeting. We have not seen evidence that Spencer told the Board about
2003 being the "Perfect Storm."
Spencer's failure to be fully forthcoming with the Board at the time
of the $1 billion computational error about the FAS 149 difficulties was
especially significant. OFHEO's press statement about the error made clear that
OFHEO intended to treat the error as an important matter. Her similar failure
before the Audit Committee in February 2004 was notable as well. On February 24,
2004, the week after the Audit Committee meeting, OFHEO reported to Fannie Mae
on the results of its FAS 149 review, including its conclusion that "[t]he lack
of a fully automated [FAS] 149 accounting process as well as the total number of
other end user computing systems at Fannie Mae raise concerns."(899)
Particularly in the circumstances surrounding these two meetings, we
believe that management should have taken extra care to inform the Board of
problems in the implementation of important accounting standards such as FAS
149. Had that information been conveyed, the Board could have assessed the
situation and taken such action as it deemed appropriate, both with respect to
the Company's internal affairs and with respect to the Company's relations with
OFHEO. We conclude that management's failure to keep the Board fully informed
deprived the Board of that opportunity.
PART D: CLASSIFICATION OF SECURITIES HELD IN PORTFOLIO
I. INTRODUCTION
In this Part, we consider Fannie Mae's classification of securities it
acquired as held-to-maturity ("HTM") or available-for-sale ("AFS"). In its
February 11, 2005 letter, OFHEO raised concerns with respect to Fannie Mae's
accounting for the securities it held in its portfolio. In particular, OFHEO
noted that the Company did not appear to be following the requirements of FASB
Statement No. 115, Accounting for Certain Investments in Debt and Equity
Securities ("FAS 115"),(900) with regard to the
- ----------
(897) See Boyles 2003 Performance Review at FMSE-SP 102951 (acknowledging that
the Controller's Office had a "thinner staff than we both would have
liked.").
(898) See supra note 838 and accompanying text.
(899) Letter from A. Falcon, Jr. to F. Raines, dated Feb. 24, 2004, FMSE-IR
352389-90, at FMSE-IR 352389.
(900) ACCOUNTING FOR CERTAIN INVESTMENTS IN DEBT AND EQUITY SECURITIES,
Statement of Fin. Accounting Standards No. 115 (Fin. Accounting Standards
Bd. 1993) (hereinafter "FAS 115").
238
timing of the classification of a security as either HTM or AFS. OFHEO stated
that the Company classified the securities in the portfolio "for accounting
purposes at the end of the month in which the trade settles."(901)
We conclude that Fannie Mae's accounting under FAS 115 violated an
unambiguous accounting rule regarding the classification of securities as HTM,
AFS, or trading. Moreover, the Company's procedure for determining a security's
classification involved the consideration of factors that would affect the
security's fair value. We saw no evidence, however, that the Company
intentionally used this mechanism to manipulate its net income. Moreover, at
least as of 2003, KPMG was aware of the Company's practices in this area and
raised no objection.
II. BACKGROUND
A. Applicable Accounting Principles
FAS 115 states: "At acquisition, an enterprise shall classify debt and
equity securities into one of three categories: held-to-maturity,
available-for-sale, or trading."(902) As to the HTM category, FAS 115 states:
Investments in debt securities shall be classified as held-to-maturity
and measured at amortized cost in the statement of financial position
only if the reporting enterprise has the positive intent and ability
to hold these securities to maturity.(903)
Unlike securities classified as AFS or trading, HTM securities are carried at
their amortized cost.(904) Classification of a security as HTM therefore
minimizes the volatility in equity and earnings associated with securities
classified as AFS and trading, respectively.
FAS 115 describes the circumstances in which a company may transfer
securities from one category to another. The movement of securities from the HTM
category to AFS or trading status is limited to six narrow circumstances (for
example, changes in the company's regulatory capital requirements, a significant
deterioration in the issuer's creditworthiness, or a change in the tax law that
alters the tax-exempt status
- ----------
(901) According to OFHEO, "[t]his process allows management to conduct several
intra-month economic benefits." February 11, 2005 OFHEO Letter at FMSE-IR
547319.
(902) FAS 115 P 6 (emphasis added).
(903) Id. P 7.
(904) See id.
239
of the interest on the debt security).(905) The sale of a security from the HTM
category for reasons other than those six narrow circumstances "taints" the HTM
portfolio. The penalty for tainting the HTM portfolio is to require the company
to reclassify all HTM securities as either AFS or trading securities and to
deprive the company of the right to classify new acquisitions as HTM for up to
two years.(906)
The principle behind FAS 115 is clear: because an HTM security will be
held for its entire term (absent unusual circumstances), the cost of that
security should be amortized over the security's term. Thus, in the FASB's view,
"a change in fair value, which would reflect a change in the market interest
rates or prepayment risk, is not relevant for a security that will be held to
maturity."(907) A security that a Company intends to sell, or that it may sell
prior to the security's maturity, however, should be marked to fair value to
reflect the amount that could be realized from a sale of that security.
The requirement that the determination of an intention to hold a
security as HTM be made "at acquisition" follows from this principle. As the
Board explained when it issued FAS 115:
The Board deliberately chose to make the [HTM] category restrictive
because it believes that the use of amortized cost must be justified
for each investment in a debt security. At acquisition, an enterprise
should determine if it has the positive intent and ability to hold a
security to maturity, which is distinct from the mere absence of an
intent to sell. The Board believes that, if management's intention to
hold a debt security to maturity is uncertain, it is not appropriate
to carry that investment to amortized cost; amortized cost is relevant
only if a security is actually held to maturity.(908)
Finally, we note that, as a practical matter, postponement of the classification
of a security as HTM would allow the acquiror to take into account any change in
the value of the security when it decides the category into which the security
will be placed, and thereby manage its financial statements to that extent.
- ----------
(905) See id. P 8.
(906) A GUIDE TO IMPLEMENTATION OF STATEMENT 115 ON ACCOUNTING FOR CERTAIN
INVESTMENTS FOR DEBT AND EQUITY SECURITIES: QUESTIONS AND ANSWERS
HELD-TO-MATURITY SECURITIES, Questions 12, 13 (Fin. Accounting Stds. Bd.
Nov. 1995); see also Armando Pimentel, Remarks to the Twenty-Fourth Annual
National Conference on Current SEC Developments (Dec. 11, 1996).
(907) FAS 115 P 62.
(908) Id. P 59.
240
B. Fannie Mae's Accounting Policy
Fannie Mae's accounting policy does not require that it classify the
securities that enter its portfolio "at acquisition." The October 2003 version
of Fannie Mae's accounting policy, which reflects prior policy as well, states
that the Company "classifies its investments in marketable debt and certain
equity securities as either [HTM, trading, or AFS] in the month of acquisition
and assess the appropriateness of the classification at each reporting
date."(909) The policy notes further that "[p]roper classification is important
because the accounting treatment depends on the classification."(910)
III. FINDINGS
A. Fannie Mae's Classification of Debt Securities
Given the nature of Fannie Mae's business and its portfolio management
strategies, most of the Company's securities were classified as HTM. A smaller
number were classified as AFS, based in part on the Company's preview of its
securitization activity (securities classified as AFS were used in the REMICs
that Fannie Mae created and sold). Fannie Mae also classified all "private
label" (non-Fannie Mae or Freddie Mac) securities as AFS.
In practice, Fannie Mae typically brings securities into its portfolio
during a month as HTM securities and at the end of the month determines the
final classification of those securities. Fannie Mae refers to this practice as
the Intra-Month Redesignation, or "IMRD," process.
The mechanics of the IMRD process are reflected in a number of
documents, including the Company's Portfolio Transactions Procedures Guide.(911)
Fannie Mae's trading systems allow traders to put one of four electronic "flags"
on each security that the Company acquires at the time the trader enters into a
purchase commitment. The four flags are HTM, HTM for dollar rolls (that is, the
securities will be used as collateral for dollar rolls), AFS, and trading. The
system's default classification - the classification when the trader does not
specify another classification - is HTM.
- ----------
(909) Financial Accounting Policy Guide: Nonmortgage Investments, dated Oct.
2003, FMSE-SP 79012-25, at FMSE-SP 79012; see also id. at FMSE-SP 78967
("Fannie Mae's policy is to determine the loan/MBS classification by the
end of the month in which the asset is purchased.").
(910) Id.
(911) Fannie Mae Portfolio Transactions Policy and Procedures Guide, dated May
11, 2004, FMSE 219734-81, at FMSE 219773-74.
241
Prior to the end of each month, an executive in Portfolio reviewed the
securities acquired during that month and determined whether they should be
maintained in the HTM category or moved into the AFS category. These decisions
were relayed at a brief "account designation" meeting at the end of each
month.(912) Following the meeting, a manager in Portfolio was responsible for
implementing the changes in the security classifications conveyed at the
meeting. The classification for each security would be changed in the relevant
Fannie Mae systems.(913)
According to interviewees, Fannie Mae's systems prohibit the removal
of a security from the HTM account following the close of the Company's books
for the month in which the security was acquired. At that time, only certain
personnel had the authorization to override the system controls and remove a
security from the HTM category. During the month of acquisition, however, the
security could be moved from the HTM category and, as a result of the IMRD
process, a substantial number of securities were moved from the HTM to AFS
category in the course of a typical month.(914)
We are aware of no accounting literature that would support Fannie
Mae's interpretation of the FAS 115 requirement that securities be classified
"at acquisition" as meaning "at the end of the month of acquisition," or through
a procedure like the IMRD process.(915) On the contrary, the FASB considered and
rejected a proposal that would have permitted a procedure similar to Fannie
Mae's. According to the FASB, "[s]ome respondents [to the FAS 115 Exposure
Draft] indicated that, although they have the intent to hold the vast majority
of their investments to maturity, they do not know at acquisition which specific
securities will or will not be sold. Having to classify securities upon
acquisition does not, in their opinion, provide the desired degree of
flexibility to manage their portfolio."(916) In response, the FASB rejected any
general approach that would
- ----------
(912) These meetings were attended by representatives of various trading groups
- such as the fixed-rate MBS and multifamily groups - who were supposed to
convey their groups' needs for certain categories of securities (such as
dollar rolls) for the following month.
(913) At our request, management provided us with a demonstration of the
relevant systems.
(914) It appears that up to sixteen percent of the securities acquired in a
given month might be redesignated from the HTM to AFS category. See E-mail
from Renie Grohl to Ann M. Kappler, et al., dated Dec. 19, 2002, FMSE-E
2233590.
(915) In our view, the classification of a security as HTM in the Company's
systems at acquisition was operative, and Fannie Mae improperly
redesignated HTM securities to its AFS account. According to several
interviewees, some of those involved in the IMRD process viewed the
original "flag" as inconsequential (and they viewed the reference in "IMRD"
to "Redesignation" as a misnomer).
(916) FAS 115 P 67.
242
permit flexibility in the classification of HTM securities in favor of
restricting the removal of securities in the HTM category to the six limited
circumstances discussed above.(917) For example, the FASB specifically rejected
an approach that would allow a company to specify a percentage of its portfolio
as not HTM at the end of each year.(918)
Interviewees had different explanations for the Company's application
of FAS 115 and its interpretation of the "at acquisition" requirement. Several
suggested that the Company's approach was a holdover from its practice prior to
the adoption of FAS 115. However, this explanation does not account for the
failure to address the issue when the Company adopted its FAS 115 implementation
policy in 1994, when it reviewed and revised its accounting procedures in 2003,
or when it reviewed its practices in connection with the sale in 2003 of
securities classified as HTM (discussed below). A 2003 presentation, for
example, states: "Classifications of loans and securities must be made by the
end of the month."(919)
Jonathan Boyles and other interviewees explained the Company's
approach by reference to the fact that the Company closed its books on a monthly
basis, in contrast to many banks and other financial institutions that close
their books on a daily basis.(920) By this view, the Company should not be
deemed to have designated its securities prior to the monthly close, as the
securities were not entered formally on the Company's books and records until
that time. Any gain or loss on the sale of the security during the month of
acquisition, and any unrealized gain or loss on the security, would be
recognized when the Company closed its books at the end of the month. There is
no documentary evidence, however, that Fannie Mae considered this rationale when
it adopted its FAS 115 accounting policy, or later when all accounting policies
were reviewed. Moreover, under this rationale, the FAS 115 "at acquisition"
requirement depends on how often a company closes its books. We have found no
language in FAS 115 to support that view, and the FASB rejected reclassification
of securities after acquisition except in limited circumstances.(921) Fannie
Mae's practice was inconsistent with this underlying principle.
- ----------
(917) Id. PP 68-70.
(918) Id. P 68.
(919) Undated Loan and Security Classifications, FMSE 93541-57, at FMSE 93550.
Interviews place the date of this presentation in early 2003. The final
page of the presentation, captioned "Summary," states that
"[c]lassifications must be determined at the time of purchase." Id. at FMSE
93557. When asked about this apparent inconsistency, Boyles indicated that
the point made on the final page of the presentation was intended to mean
"month of purchase."
(920) As we discuss below, this point is referenced in a KPMG workpaper.
(921) FAS 115 P 69. The FASB considered "whether the standard should permit
enterprises to sell without justification some specified amount of the
[HTM]
243
Finally, it does not appear that, prior to late 2003, the Company
considered the ramifications of the guidance in Emerging Issues Task Force Issue
No. 96-11, Accounting for Forward Contracts and Purchased Options to Acquire
Securities Covered by FASB Statement No. 115 ("EITF 96-11").(922) EITF 96-11,
issued in 1996, addressed circumstances in which a company entered into a
commitment to acquire a security that would be subject to FAS 115 (that is, the
security would be designated at acquisition as HTM, AFS, or trading).(923) Under
EITF 96-11, classification was required at the inception of the commitment, and
the subsequent accounting for those commitments would be consistent with the
accounting required by FAS 115 (i.e., commitments designated as AFS would be
marked to fair value with changes recognized in OCI, and commitments designated
as trading would be marked to fair value with changes recognized in
earnings).(924) With respect to commitments, therefore, classification as HTM,
AFS, or trading was required even before the Company actually acquired the
security.(925) Consideration of EITF 96-11, therefore, would have confirmed that
classification of a security at month's end was inappropriate. There is no
evidence that Fannie Mae considered the implications of EITF 96-11 in connection
with its interpretation or application of FAS 115.
The Company did consider the implications of EITF 96-11 in late 2003,
but only from the perspective of accounting for the fair value of the
commitments, and not with respect to the classification of the commitments or
the acquired securities. In an analysis of EITF 96-11 prompted by the Freddie
Mac restatement, Financial Standards noted:
EITF 96-11 requires that entities entering forward purchase contracts
or purchase options to acquire securities that will
- ----------
securities without calling into question the enterprise's intent to hold
other debt securities to maturity. The Board rejected that approach as
being inconsistent with the premise underlying the use of amortized cost -
that management intends to hold all such securities to maturity." The Board
concluded that "if the sale of a held-to-maturity security occurs without
justification, the materiality of that contradiction to the enterprise's
previously asserted intent must be evaluated." Id.
(922) ACCOUNTING FOR FORWARD CONTRACTS AND PURCHASED OPTIONS TO ACQUIRE
SECURITIES COVERED BY FASB STATEMENT NO. 115, Emerging Issues Task Force of
the Fin. Accounting Standards Bd., Issue No. 96-11 (May 1996) (hereinafter
"EITF 96-11").
(923) See id. para. 1.
(924) Id. paras. 3-4.
(925) Under EITF 96-11, with respect to commitments designated as HTM, "[i]f an
entity does not take delivery under the forward contract . . . the entity's
intent to hold other debt securities to maturity will be called into
question." Id. para. 3.
244
be accounted for under FAS 115 . . . be accounted for similarly to the
purchased securities. The forwards or options must be designated, at
inception, as [HTM, AFS, or trading] consistent with FAS 115.(926)
Financial Standards concluded that it had not complied with EITF 96-11, but only
by failing to book changes in the fair value of commitments to purchase mortgage
revenue bonds ("MRBs").(927) The effect of not applying the guidance in EITF
96-11 as to AFS securities was deemed inconsequential.(928) It appears that the
Company did not consider the impact of the guidance on its HTM portfolio.(929)
B. Practical Application of the Company's Policies
In the absence of a convincing rationale for the Company's
interpretation of the FAS 115 requirement that securities be classified "at
acquisition," we looked to the Company's application of its policy to determine
whether the practice suggested an inappropriate motivation to manage the
Company's financial statements. The evidence reveals that Fannie Mae's practices
were driven by considerations relating to the systems the Company had developed
and its interest in maintaining flexibility in the management of its portfolio.
We have found no evidence that the Company used its FAS 115 policy to manipulate
earnings directly, although its approach to FAS 115 could have materially
affected its financial statements.
The implications of FAS 115 for the Company were set forth in a
memorandum from James Parks to Timothy Howard and then Controller Michael Quinn,
dated April 15, 1993 (one month before FAS 115's issuance).(930) The memorandum
described the impact of the new rule on Fannie Mae's business. It noted that the
Company would have to establish "separate portfolios" for securities that it
might sell
- ----------
(926) Mem. from Jonathan Boyles to Distribution, dated Jan. 14, 2004, FMSE-SP
78679-85, at FMSE-SP 78684.
(927) Id. at FMSE-SP 78685; Audit Committee Update: Understanding Freddie Mac's
Accounting Restatement as It Affects Fannie Mae, dated Jan. 23, 2004,
FMSE-IR 379360-78, at FMSE-IR 379375.
(928) Audit Committee Update: Understanding Freddie Mac's Accounting Restatement
as It Affects Fannie Mae, dated Jan. 23, 2004, FMSE-IR 379360-78, at
FMSE-IR 379375.
(929) Under EITF 96-11, if an entity fails to classify as HTM a security for
which the commitment was designated HTM, then "the entity's intent to hold
other debt securities to maturity will be called into question." EITF 96-11
para. 3.
(930) Mem. from James Parks to Timothy Howard and Michael Quinn, dated Apr. 15,
1993, FMSE-IR 362117-19.
245
prior to their maturity date and that securities may not be transferred out of
the HTM category.(931) It further noted that "[b]uy/sell activity will have to
be done on a specific [security-by-security] identification basis, rather than
notionally as it is now, and run through a separate 'held-for-sale' portfolio.
This portfolio will have to be managed carefully to avoid earnings volatility
from the lower of cost or market accounting methodology."(932) The memorandum
further stated: "Our ability to manage earnings through sales out of portfolio
will be largely curtailed. It will still be possible to manage earnings to a
certain extent, however, by establishing a separate portfolio of MBS 'available
for sale.'"(933)
Parks explained during an interview that his statement about managing
earnings referred to Fannie Mae's practice of selling whole loans to re-balance
the average yields in its loan portfolio. Parks clarified that, although he
understood that FAS 115 applied to debt securities and not whole loans, he
thought there might be analogies between the way that Fannie Mae was accounting
for its loans and the new requirements of FAS 115. Parks also stated that he was
unaware of any situation in which Fannie Mae engaged in transactions other than
for a "valid business purpose" - i.e., solely to reach a particular accounting
result. Parks's memorandum did not address the issue of classification "at
acquisition."
In our interviews, the individuals in Portfolio Management who were
responsible for making the decision confirmed that they did have available to
them information regarding the securities's gain or loss position, although we
were told that these data were not reliable and were not used to make
redesignation decisions.
The executive responsible for making the decisions on whether a
security should be designated as AFS at month's end, Matthew Douthit,
acknowledged that he considered the securities' coupon and other features to
determine which securities would be held-to-maturity and which might be sold. He
stated, for example, that in the IMRD process he considered "economic
opportunities." In addition, Douthit noted that he also classified securities as
AFS in order to offset some of the volatility in Fannie Mae's equity resulting
from implementation of FAS 133.
Fannie Mae's emphasis on flexibility in its application of FAS 115
created the potential for errors in the Company's classification of securities.
An important event occurred in January 2003 when an employee in the Securities
Trading Operations ("STO") group of the Treasurer's Office overrode the
Company's controls over securities classified as HTM over a month-end in order
to sell a security out of the HTM portfolio
- ----------
(931) Id. at FMSE-IR 362118.
(932) Id. at FMSE-IR 362119.
(933) Id.
246
after the close of the month in which the security was acquired.(934) According
to the documentation compiled during the Company's own inquiry into the matter,
in December 2002 Fannie Mae entered into a brokered trade in which the Company
agreed to acquire certain securities and then sell them to a third party.
Because of an error at acquisition, the relevant securities were classified as
HTM instead of trading. The misclassification was not recognized until the
following month. A manager in STO engaged a systems analyst to override the
controls that would have prevented sale of those securities, and the securities
were transferred in two trades during January 2003.(935) The Company detected
the first trade and investigated the matter. It determined that the trade was
the result of the initial classification error and concluded that the sale would
not taint the portfolio.(936)
Interviewees suggested that KPMG, the Office of Auditing, and
Financial Standards all took this event seriously and understood the
implications that these mistakes had with respect to a potential taint of the
Company's portfolio. We understand that, in the wake of this event, Financial
Standards provided additional training on the requirements of FAS 115.(937) This
training contains the conflicting statements discussed above about the timing of
the characterization of the securities.(938) That proposition does not appear to
have been challenged at that time. On the contrary, e-mail correspondence
- ----------
(934) Mem. from Paul Jackson to Linda K. Knight and Leanne Spencer, dated Mar.
5, 2003, FMSE-IR 379252-54.
(935) Id. at FMSE-IR 379254.
(936) Id. According to the report, after the first trade from the HTM portfolio
was detected, the matter was referred to Boyles for his consideration. He
concluded that the trade was the result of an error and probably would not
result in a taint of the Company's portfolio. Hearing this, the STO manager
then made the second trade. According to the report, Boyles "was not aware
at the time of his discussion that these remaining pools had not settled
and would not have approved this subsequent transaction." Id.
(937) Nonetheless, there is evidence that a second event occurred later in 2003.
Apparently, this incident involved a systems error in which an entry to
redesignate securities to AFS was duplicated by the system. Once the issue
was identified, the securities were moved back to the HTM account. See
E-mail from Mary Lewers to Janet L. Pennewell, dated July 1, 2003, FMSE-E
1162461.
(938) Compare Undated Loan and Security Classifications, FMSE 93541-57, at FMSE
93550 ("Classifications of loans and securities must be made by the end of
the month.") with id. at FMSE 93557 ("Classifications must be determined at
the time of purchase.").
247
involving Portfolio Management in late 2003 conveys the understanding within
that group that a security has no classification until the month-end close.(939)
Thus, while there is no evidence that Fannie Mae used its securities
classification procedures to manage earnings directly, it did use the
flexibility provided by its policy to determine during the course of a month
which securities it would hold to maturity and which it would hold for potential
sale, with the corresponding impact on the Company's financial statements at a
later date.(940)
C. KPMG Review
Fannie Mae's policies regarding FAS 115 were available to its outside
auditor and a copy of the policy appears in KPMG's workpapers. Parks'
recollection was that there were a number of conversations with KPMG at the time
the FAS 115 policy was formulated, but he did not recall any details of those
conversations. Specifically, Parks did not recall any discussions regarding the
timing of the classification of the Company's securities. Boyles recalled
conversations with KPMG on this issue; according to Boyles, KPMG agreed with the
Company's policy on the timing of the securities' classification, but would have
preferred that Fannie Mae classify the AFS category as the default.
A KPMG workpaper dated August 2003 sets forth the Company's approach
to the classification of securities. The workpaper states: "This [FAS 115]
classification requirement is extended by end-of-month financial reporting
conventions; therefore, the final classification must be made within the month
the security is
- ----------
(939) See, e.g., E-mail from Matthew Douthit to Kenneth Scott, dated July 8,
2004, Zantaz Document 374684 ("We do not routinely move securities from HTM
to AFS as part of the month-end closing process. During the third week of
each month, we do review securities that have settled for portfolio during
the current month (as inventory, such assets are 'undesignated' until
month-end) and assign an inventory category effective on the first day of
the subsequent month (HTM, AFS, or HFT).")
(940) One document indicated that Fannie Mae might have used the IMRD process to
manage earnings, but we discount the document's reliability in this
respect. HTM Portfolio Redesignation, dated Dec. 30, 2004, Zantaz document
2296663. The document is titled "HTM Portfolio Redesignation" and is
captioned as a draft. The document relates to the Company's consideration
of a possible move of securities from the HTM portfolio to the AFS
portfolio in response to its September 27, 2004 agreement with OFHEO to
increase its capital surplus. Id. at 1. The document has a chart showing
the steps in the HTM Redesignation Process, and it labels each step either
"standard" or "enhanced" for purposes of this one-time reclassification.
Id. Two of the steps in the process are labelled "Select Securities &
Estimate Gain/Loss" and "Validate Gain Loss Estimates." This flow chart
indicates that these steps are "standard" procedures, rather than
"enhanced." Id. Interviewees denied that actual gain or loss data were used
as part of the IMRD process.
248
acquired." The workpaper discusses the IMRD process and notes, "[d]ecision
factors considered by Portfolio Management [in the IMRD process] include balance
sheet effects and economic opportunity."(941)
D. Executive Involvement and the Report to the Audit Committee
As mentioned above, in the wake of revelations concerning accounting
irregularities at Freddie Mac, the Company undertook an inquiry to determine
whether Fannie Mae's accounting raised similar concerns. In the course of that
analysis, Financial Standards concluded that the Company had not complied with
EITF 96-11, but only with respect to the acquisition of MRBs.(942) In a
memorandum sent from Boyles to Franklin D. Raines and others, Boyles concludes
on this issue:
Based upon our analysis it appears as though our purchases of MRBs
that ultimately were put into AFS classification should have been
accounted for under EITF 96-11. The largest quarterly purchase of MRBs
was approximately $301 million. Had all the purchase commitments been
open at a quarter end, all subsequent deliveries been classified as
available for sale and rates moved one point, the change in our
balance sheet value would have been $3 million.(943)
That information was incorporated into a presentation to the Audit Committee
dated January 23, 2004. The presentation states, "Fannie Mae did not apply EITF
96-11 but the result was inconsequential (balance sheet effect less than $3
million). No effect on earnings."(944)
We have not seen any other indication prior to 2004 regarding a
discussion with the Board or a Board committee on this topic.
IV. CONCLUSIONS
Fannie Mae's policies regarding the application of FAS 115 were
incorrect. Separate and apart from the question of whether (and when) the
Company's
- ----------
(941) Process Analysis Documentation - Acquisitions of MBS & Other
Mortgage-Related Securities, dated Aug. 2003.
(942) Mem. From J. Boyles to Distribution, dated Jan. 14, 2004, FMSE-SP
78679-85, at FMSE-SP 78684.
(943) Id. at FMSE-SP 78685.
(944) Audit Committee Update: Understanding Freddie Mac's Accounting as It
Affects Fannie Mae, dated Jan. 23, 2004, FMSE-IR 379360-78, at FMSE-IR
379375.
249
portfolio was tainted, its policy resulted in its accounting for securities as
AFS when they had been designated "at acquisition" as HTM.
The record we have compiled supports the conclusion that Fannie Mae
used the flexibility inherent in its approach to FAS 115 in a fashion that had
tangible benefits for the Company. The record does not, however, support the
conclusion that Fannie Mae used this approach to manage earnings directly.
Ultimately, the characterization of the securities as HTM or AFS had an effect
on Fannie Mae's financial statements when the securities in the AFS portfolio
were sold.
KPMG was aware of the Company's accounting policy and the IMRD
procedures, but did not object to either. It also acknowledged, and did not
object to, the use of the IMRD process to account for "balance sheet effects" or
to take advantage of an "economic opportunity."
PART E: RECOGNITION OF INTEREST EXPENSE AND INCOME
I. INTRODUCTION
In this Part, we address Fannie Mae's practice of "smoothing" the
monthly interest expense and income on certain investments and borrowings. Until
early in 2003, the Company's liquid investment portfolio ("LIP") and debt
accounting systems (known as ORION and STAR, respectively) determined interest
expense and income on all investments and debt instruments as if there were 30.4
days in each month (a "30/360" convention), even if the instruments' terms
required interest payments on either an "actual/365" or "actual/360" basis. As a
result of this practice, Fannie Mae avoided the fluctuations in interest income
and expense that would result from the fact that the twelve months of the year
(and the four calendar quarters) do not have the same number of days.(945)
The Company discontinued this practice in the second quarter of 2003
when it introduced a new version of the STAR system called iSTAR. At that point,
the Company began to recognize interest income and expense in accordance with
the actual terms of the instruments.
Fannie Mae's smoothing of interest income and expense came to our
attention during the investigation when we uncovered Cheryl DeFlorimonte's March
3, 2003 memorandum discussed below. This issue subsequently was included as a
topic for our review in OFHEO's February 11, 2005 letter to Stephen B. Ashley,
in which OFHEO asked "why the Enterprise believed it was permitted to recognize
monthly interest
- ----------
(945) Because the Company's LIP portfolio is relatively small, our inquiry
primarily focused on the recognition of interest expense on the Company's
debt portfolio.
250
expense on notes payable, in a monthly ratable manner that is different from the
contractually specified interest of the notes."(946)
As OFHEO's question suggests, Fannie Mae's accounting for interest
income and expense on certain arrangements prior to the second quarter of 2003
was problematic for several reasons. As a general proposition, GAAP requires the
accounting for interest income and expense to follow the terms of the relevant
instruments. Thus, Fannie Mae should have accounted for these investments and
borrowings by recognizing interest income and expense in accordance with the
legal terms of those arrangements, regardless of the fact that such treatment
would generate fluctuations in the recognition of interest income and expense
each month. By smoothing interest income and expense from month to month and
from quarter to quarter, Fannie Mae misstated its actual net interest income
during each period. The Company's accounting during the period prior to the
second quarter of 2003, therefore, violated GAAP.
II. BACKGROUND
The origins of Fannie Mae's practice of smoothing the recognition of
interest income and expense date to the 1970s. According to Richard Stawarz, who
joined Financial Reporting at that time, the proposition that Fannie Mae should
smooth its interest income expense was raised by the Company's then Chief
Economist, who wanted to eliminate calendar effects from the stated financial
results. Initially, the smoothing was accomplished manually. When the
calculation of interest expense was automated into the Company's STAR system, an
algorithm to automate the smoothing process was incorporated into the system.
The purpose of the smoothing function was known to those who joined
Financial Reporting later. A document prepared in 2001 in connection with
proposed revisions to the STAR system states that "[t]his process was
implemented to smooth out the bumps in interest expense (income) [sic] created
by having varying [sic] number of days in each month."(947) Janet L. Pennewell
stated that the practice began when the Company was publishing its results on a
monthly basis and wanted to avoid variations in reported interest expense that
stemmed only from the different number of days from month-to-month. Another
concern appeared to be that reported interest income and expense would fluctuate
from period to period, while Fannie Mae's mortgage-based revenues typically
followed a 30/360 convention (that is, interest paid to investors in
mortgage-backed securities is determined as if each month has 30 days). By
following a similar convention with respect to net interest expense, Fannie
Mae's interest income and expense would eliminate the fluctuations based on the
calendar, aligning the recognition of interest expense with the recognition of
interest income on a majority of the Company's mortgage portfolio.
- ----------
(946) February 11, 2005 OFHEO Letter at FMSE-IR 547326 (emphasis removed).
(947) iSTAR - Operations Requirements as of April 17, 2001, Zantaz document
1456873, at 27.
251
The 30/360 day convention was not required by Fannie Mae's accounting
policies, which do not refer to a process for monthly smoothing of interest
income or interest expense. Fannie Mae's accounting policy for interest income
states, "Fannie Mae recognizes interest income in the period that interest is
due and records an offsetting entry to accrued interest receivable or
cash."(948) Similarly, the applicable policy for interest expense confirms,
"Fannie Mae follows standard accrual accounting practices. Fannie Mae accrues
interest on a monthly basis, recording a debit to interest expense and a credit
to interest payable."(949) In this respect, neither the ORION nor the STAR
systems followed the accounting policy, as they did not accurately accrue and
recognize interest income in the period in which interest was due or follow
"standard accrual accounting policies."
In addition to the automatic smoothing accomplished by the Company's
systems, the Company also periodically accrued additional interest expense
through an on-top journal entry; the additional expense was then amortized over
the remainder of the year. For example, the Company recognized an additional
expense of $13.5 million in February 2001.(950) In February 2003, the Company
recognized an additional $15.4 million in interest expense "to increase debt
expense in February to 30.4 days from 28 days."(951) In May 2003, the Company
began to amortize that expense into income.(952) The Company posted an on-top
interest expense adjustment in March 2002, rather than February; Stawarz stated
that this calculation was especially complex, and therefore was delayed by a
month.(953)
According to Pennewell, the February adjustments were recorded because
the smoothing algorithms in the STAR system were viewed as unreliable. An on-top
adjustment would be made if the system's results appeared to be inconsistent
with
- ----------
(948) Interest Income and Accrued Interest Receivable, Financial Accounting
Policy Guide, dated Oct. 2003, FMSE-SP 78953-9118, at FMSE-SP 78980.
(949) Id. at FMSE-SP 79049. The 1994 version of the policy is similar.
(950) Homesite General Ledger for account 162200, Journal ID JE21125 (entry for
"Fractional Day Impact Adj.," effective date Feb. 28, 2001).
(951) Undated May 2003 Closing/Activity Notes, FMSE-SP 10854.
(952) Id. The Company delayed the amortization of the February interest expense
overstatement until May to coincide with the recognition of an adjustment
associated with the conversion of the STAR system to the iSTAR system. See
Undated March 2003 Closing Activity/Notes, FMSE-SP 10857.
(953) We have found no evidence that the Company recorded similar entries to
adjust the amount of interest income determined by the ORION system.
252
expectations or rough calculations of what the actual amounts should be.(954)
Stawarz confirmed that view. He said that those responsible for preparing Fannie
Mae's income statements understood that the STAR system results for February
were problematic, presumably because February was such a short month.(955)
Stawarz was responsible for evaluating the February results against an estimate
and determining the amount of the on-top adjustment for that month. According to
Stawarz, he calculated the February on-top adjustment on a handwritten work
sheet that he did not keep.
Fannie Mae's use of the 30.4-day convention for recognizing interest
income and expense resulted in unusual aberrations in the Company's annual
reported interest expense. One would expect that the approach the Company
adopted would affect intra-year accounting, but would not affect the Company's
end-of-year results. That is, the Company's monthly and quarterly results would
reflect a greater or lesser amount of interest expense than would be the case if
actual expense were recorded, but that any differences would be cancelled out in
year-end tabulations. An analysis of results for 2002 prepared by Mona Patel in
2003, however, shows that smoothing had the effect of reducing interest expense
(and increasing net income) by approximately $27.5 million in 2002.(956)
DeFlorimonte, who prepared the memorandum to which the analysis was attached and
who, during the relevant period, was responsible for the Company's debt
accounting, could not explain, and may not have been aware of the apparent
discrepancy.(957)
A review of the smoothing methodology showed that a discrepancy did,
in fact, exist. This discrepancy appears to be the result of how the ORION and
STAR systems calculated the monthly interest to be recognized. A diagram
prepared by personnel in the Debt Accounting Group showed that smoothing was
accomplished through the system by:
1. determining the total amount of interest to be earned (incurred)
over the life of the security (borrowing);
- ----------
(954) E-mail from Janet L. Pennewell to Mary Lewers, Cheryl DeFlorimonte, et
al., dated Nov. 4, 2002, FMSE-SP 10799.
(955) According to Richard Stawarz, even Timothy Howard knew that the reporting
systems were less reliable and yielded unusual results in February.
(956) Mem. from C. DeFlorimonte to Distribution, dated Mar. 3, 2003, FMSE
55102-12, at FMSE 55107.
(957) A separate document showing the effect of smoothing an interest income
from the LIP portfolio reveals the same effect. See Fannie Mae Accrual
Example Coupon Expense Smoothing Actual Day Accruals, dated Feb. 21, 2002,
Zantaz document 1154886.
253
2. determining the implied coupon on the security (borrowing) as if
its contractual terms required the monthly accrual of interest on the
basis of 30.4 days; and
3. calculating the amount of deferred interest to be recognized
monthly in order to adjust the interest income (expense) accrued on
the basis of the contractual terms of the security (borrowing) to the
smoothed amounts based on the implied coupon.(958)
Over the life of the investment or borrowing, the smoothing process would have
no impact on the cumulative income or expense recognized. Nor would smoothing
affect amount of interest income or expense recognized on a particular
investment or borrowing on a year-to-year basis. However, because the Company
effectively smoothed interest income and expense over the life of the instrument
and not over the calendar year, the process resulted in discrepancies in the
calculation of net interest income and expense at year-end. In sum, if the
anniversary date of the acquisition of an investment or issuance of a borrowing
were other than January 1, smoothing would result in the recognition of either
too much or not enough interest at the end of an annual reporting period. In
Stawarz's view, however, the impact on the Company's quarterly or annual results
would have been negligible, as a large portion of the Company's debt was
short-term debt with terms of less than a year.(959)
Documentation relating to revisions of the STAR system showed that the
Company considered abandonment of the 30/360 approach as early as 1999. A
document dated October 13, 1999 captioned "STAR+ Calculations Re-write Analysis"
proposed to "[r]emove smoothing from the accounting cost calculations, except
for step-up securities."(960)
A 2001 document described the rationale for the proposed change, and
emphasized that the smoothing process was more complicated than booking interest
in accordance with the terms of each instrument:
- ----------
(958) Controller's - Debt Accounting Group: Overview to Paul Weiss, LLP, dated
Dec. 19, 2005, FMSE-IR 703580-99, at FMSE-IR 703594.
(959) Further, if the Company processed an amortization end-date change at a
time when a balance in the deferred interest account existed, that balance
would subsequently only be reduced to zero over the remaining estimated
life of the borrowing (i.e., it would no longer be reduced to zero at the
instrument's anniversary date). Amortization end-date changes are discussed
in Chapter VI, Part M of this Report.
(960) Star+ Calculations Re-write Analysis, dated Oct. 13, 1999, Zantaz document
92466, at 1.
254
Currently, an implied coupon and deferred interest are calculated in
cases where the day count convention is not 30/360.... The implied
coupon was used in the subsequent level yield and amortization
programs. This practice caused numerous issues in amortization of
deferred fees, especially with short-term instruments. There were many
instances of over amortization in whole months and under amortization
(some times [sic] reverse amortization) in partial months.
Since this practice (smoothing) caused many subsequent issues, it has
been decided not to implement it in the new STAR operations except for
the case of step-up securities.(961)
The proposal made clear, however, that the elimination of the
smoothing function in STAR would not necessarily foreclose use of the 30.4-day
convention: "The requirement to smooth out expense/income bumps due to the
numbers of days in a month still exists, but will be done outside the system
(except for step-up (down) securities)."(962)
Final approval to discontinue the smoothing process was not granted
formally until 2003, right before the iSTAR system replaced STAR. In her March
3, 2003 memorandum to members of Controller's Office and in the Portfolio
Management group,(963) DeFlorimonte proposed to "[d]iscontinue the calculation
of and reporting on smoothing monthly expenses and average balances in our debt
statistics." (964) According to DeFlorimonte, the elimination of smoothing would
"simplify calculations and allow all reconciliation of debt expenses, balances
and costs to be more automated and transparent. It will also eliminate the
interest free distortions that result from smoothing."(965) DeFlorimonte
concluded by noting, "if smoothing is still desired, this will be accomplished
by a monthly, quarterly, or other frequency to be determined, on-top entry."
(966) Although the memorandum did not receive a formal response, the proposal to
- ----------
(961) iSTAR - Operations Requirements as of April 17, 2001, Zantaz document
1456873, at 27-28.
(962) Id. at 28.
(963) Mem. from C. DeFlorimonte to J. Pennewell, Jonathan Boyles, et al., dated
Mar. 3, 2003, FMSE 55102-03, at FMSE 55102. The memorandum does not appear
to have prompted a reaction from Boyles or Paul Salfi regarding the
consistency of smoothing with Fannie Mae's policy or with GAAP.
(964) Id.
(965) Id.
(966) Id.
255
eliminate smoothing from the iSTAR system was approved following authorization
from Timothy Howard.(967)
According to DeFlorimonte, the iSTAR system currently recognizes debt
expense as it accrues in accordance with the terms of the debt instruments.(968)
Documentation from 2004 shows that the Company considered manual on-top entries
to smooth the results of the iSTAR system, but did not post those entries. We
have seen no indication that the Company has smoothed its interest expense since
the introduction of the iSTAR system in 2003.
According to Stawarz, those responsible for the Company's financial
reporting, up to and including Howard, were aware that the Company was smoothing
interest income and expense. Howard, Leanne G. Spencer and others were aware at
least as of 2003 that the Company was discontinuing the practice. We have seen
no evidence that other members of senior management were aware of this issue
prior to that time. Notably, we see no indication that Financial Standards was
asked to set policy on this issue, or that this policy was ever raised with the
Board or any of its committees.
KPMG was aware of the smoothing process at least as of July 2003.
(969) At that time, KPMG reviewed the Company's general ledger account 1022,
which included a portion of the accrued interest expense that had not been
booked.(970) The workpaper describes the smoothing process in considerable
detail.(971) The KPMG partner on the audit team at that time confirmed during
our interview that he was aware of the process.
- ----------
(967) Leanne G. Spencer, in an e-mail dated May 22, 2003, to Pennewell, Stawarz,
and Lewers, notes, "I did inform Tim yesterday that we were officially
stopping 'smoothing'. He was fine with the decision. Told him we would
revisit - if conditions warranted in the future." E-mail from L. Spencer to
J. Pennewell, et al., dated May 22, 2003, Zantaz document 944953, at 1. In
Stawarz's view, the process was discontinued because interest rates were so
low and much of the Company's debt was "swapped out" in hedge
relationships. Accordingly, the process was not worth the effort.
(968) Mem. from C. DeFlorimonte to Distribution, dated Oct. 8, 2004, Zantaz
document 202983, at 1.
(969) Analysis of Accounts Receivable - No. 162200, dated July 2003.
(970) Id.
(971) Id. The document refers to an adjustment that had been necessary "to
appropriately maintain the books on a 30/360 day convention for certain
debt securities, including short-term notes." Id.
256
III. FINDINGS REGARDING THE RECOGNITION OF INTEREST EXPENSE AND INCOME
In sum, senior accountants in the Controller's Office - including
Spencer, Pennewell, and Stawarz - knew at some point that the Company was not
reporting interest expense and income accurately. Although the documentary
evidence is scant, Howard may have been aware as well. Moreover, the
Controller's Office apparently did not question the periodic on-top adjustments
or whether the supposed need for the adjustments meant that the smoothing
process was incorrect or unreliable generally. This process was not required by
Company policy, nor was Financial Standards asked for its views, at least until
the system was changed in 2003. Finally, it is notable as well that the practice
continued for four years between the time it was proposed to eliminate smoothing
to the cessation of the practice in 2003, and that both the removal of the
smoothing mechanism and the delay in the removal stemmed from practical
considerations rather than a concern for proper accounting or accurate
reporting.
PART F: ACCOUNTING FOR OTHER-THAN-TEMPORARY IMPAIRMENT
OF MANUFACTURED HOUSING BONDS AND
AIRCRAFT ASSET-BACKED SECURITIES
I. INTRODUCTION
In this section, we address Fannie Mae's accounting for
other-than-temporary impairment ("OTTI") of investments in manufactured housing
bonds ("MH bonds") and aircraft asset-backed securities ("Aircraft ABS").
Under GAAP, Fannie Mae is required to evaluate all of its
Held-to-Maturity ("HTM") and Available-for-Sale ("AFS") investments for OTTI.
Evidence showed that management failed to consistently monitor and adequately
document its review of all HTM and AFS investments for OTTI prior to 2003.
Although management did begin to consistently monitor its HTM and AFS
investments during 2003 through the formation of an Impairment Committee ("IC"),
the IC's review was not inclusive of all HTM and AFS investments. Insufficient
monitoring of investments both before and after the formation of the IC
represents a control weakness that could indicate underreporting of OTTI.
Furthermore, prior to 2004, management relied primarily on discounted
cash flow ("DCF") models in place of quoted market prices to measure impairment
on MH bonds and Aircraft ABS to determine the OTTI amounts it recognized, even
though bid/ask and dealer pricing was available. According to GAAP, however,
quoted market prices are the best evidence of fair value, and DCF models should
only be used to measure fair value in the absence of quoted market prices. While
we did not find that management chose to rely on DCF modeling in order to
achieve particular earnings goals, we note that the DCF model results included
assumptions that were subject to management discretion and data errors that
impacted both the timing and the amount of OTTI the Company recorded. We believe
that the Company should have procedures and
257
controls that ensure that the assessment of OTTI is not left to management's
discretion without appropriate guidelines.
In the second quarter of 2004, after discussions with OFHEO and the
SEC, Fannie Mae implemented a new approach to evaluating MH bonds and Aircraft
ABS for OTTI. The "4-Step Approach" requires the use of credit ratings and
market prices to determine the existence of OTTI, even when Fannie Mae does not
expect a loss of principal or interest. The 4-Step Approach also requires Fannie
Mae to recognize income subsequent to an impairment write-down if its estimate
of future cash flows warrants such recognition. The adoption of the 4-Step
Approach caused a significant increase in OTTI recognized, particularly for MH
bonds.
II. BACKGROUND
A. Applicable Accounting Standards
FASB Statement No. 115, Accounting for Certain Investments in Debt and
Equity Securities ("FAS 115"),(972) requires companies to evaluate HTM and AFS
securities for impairment and to write those securities down to fair value if
other than temporarily impaired:
If it is probable that the investor will be unable to collect all
amounts due according to the contractual terms of a debt security not
impaired at acquisition, an other-than-temporary impairment shall be
considered to have occurred. If the decline in fair value is judged to
be other than temporary, the cost basis of the individual security
shall be written down to fair value as a new cost basis and the amount
of the write-down shall be included in earnings (that is, accounted
for as a realized loss).(973)
SEC Staff Accounting Bulletin Topic 5-M, Other Than Temporary
Impairment of Certain Investments in Debt and Equity Securities ("SAB Topic
5-M"), was issued to clarify the Staff's views on accounting for noncurrent
marketable securities, specifically as they relate to determining whether
declines in fair value are other than temporary. In doing so, SAB Topic 5-M
provides guidance to public companies on the factors that companies should
consider in determining whether such securities are other than temporarily
impaired, such as "the length of the time and the extent to which the market
value has been less than cost," and "the financial condition and near-term
prospects of the issuer, including any specific events which may influence
- ----------
(972) ACCOUNTING FOR CERTAIN INVESTMENTS IN DEBT AND EQUITY SECURITIES,
Statement of Fin. Accounting Standards No. 115 (Fin. Accounting Standards
Bd. 1993) (hereinafter "FAS 115").
(973) See id. P 16.
258
the operations of the issuer" or, "the intent and ability of the holder to
retain its investment in the issuer for a period of time sufficient to allow for
any anticipated recovery in market value."(974)
Paragraphs Eight and Ten of FASB Emerging Issues Task Force ("EITF")
Issue No. 03-01, The Meaning of Other-Than-Temporary Impairment and Its
Application to Certain Investments ("EITF 03-01"), provide extensive guidance on
factors to consider in evaluating securities for impairment.(975)
Once OTTI has been identified, the investment must be written down to
fair value by a charge to earnings in the present period. FAS 115 defines fair
value as:
The amount at which an asset could be bought or sold in a current
transaction between willing parties, that is, other than in a forced
or liquidation sale. Quoted market prices in active markets are the
best evidence of fair value and should be used as the basis for the
measurement, if available. If a quoted market price is not available,
the estimate of fair value should be based on the best information
available in the circumstances.(976)
As reflected in the above definition, a company has some flexibility in
determining fair value. Nevertheless, it is clear that fair value based on
quoted market prices is preferred.(977)
After OTTI has been recorded, GAAP does not allow for the investment
to be "written-up" if the fair value of the investment recovers. However, GAAP
does
- ----------
(974) SEC Staff Accounting Bulletin, Topic 5-M, Other than Temporary Impairment
of Certain Investments in Debt and Equity Securities (2004), available at
http://www.sec.gov/interps/account/sabcodet5.htm#5m.
(975) THE MEANING OF OTHER-THAN-TEMPORARY IMPAIRMENT AND ITS APPLICATION TO
CERTAIN INVESTMENTS, Emerging Issues Task Force Issue 03-01 (2004). We note
that FASB Staff Position FAS 115-1 and FAS 124-1, THE MEANING OF
OTHER-THAN-TEMPORARY IMPAIRMENT AND ITS APPLICATION TO CERTAIN INVESTMENTS,
("FSP FAS 115-1 and FAS 124-1") (Nov. 3, 2005), nullified certain
impairment evaluation guidance in EITF 03-01 that was not already contained
in FAS 115 or SAB Topic 5-M, but carried forward guidance in EITF 03-01
regarding determination and disclosure.
(976) FAS 115 P 137 (as amended by ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND
HEDGING ACTIVITIES, Statement of Fin. Accounting Standards No. 133 (Fin.
Accounting Standards Bd. 1998)).
(977) FAS 115 PP 110-11.
259
provide for subsequent income recognition if the entity's expectation of
receiving cash flows has significantly increased. American Institute of
Certified Public Accountants ("AICPA") Statement of Position No. 03-3,
Accounting for Certain Loans or Debt Securities Acquired in a Transfer ("SOP
03-3"), states:
[If, upon subsequent evaluation,] [b]ased on current information and
events, it is probable that there is a significant increase in cash
flows previously expected to be collected or if actual cash flows are
significantly greater than cash flows previously expected, the
investor should recalculate the amount of accretable yield for the
loan as the excess of the revised cash flows expected to be collected
over the sum of (1) the initial investment less (2) cash collected
less (3) other-than-temporary impairments plus (4) amount of yield
accreted to date.(978)
B. Fannie Mae's Practice and Policy
1. OTTI Recorded
The majority of the OTTI that Fannie Mae recorded between 2001 and the
second quarter of 2004 related to MH bonds and Aircraft ABS. Our investigation
has focused on the accounting for those securities during that period because of
the significance of their contribution to the total amount of recognized
impairments. The following tables summarize the book and fair values of Fannie
Mae's HTM and AFS investments, unrealized losses on those investments, and the
OTTI recorded during that period (dollars in millions):
Table I - Mortgage and Non-Mortgage HTM and AFS Investments(979)
DECEMBER 31, 2001 DECEMBER 31, 2002 DECEMBER 31, 2003 JUNE 30, 2004
----------------- ----------------- ----------------- -----------------
FAS 115 BOOK FAIR BOOK FAIR BOOK FAIR BOOK FAIR
CLASSIFICATION VALUE VALUE VALUE VALUE VALUE VALUE VALUE VALUE
- -------------- ------- ------- ------- ------- ------- ------- ------- -------
HTM 539,254 546,075 440,431 458,624 481,974 492,916 458,257 460,028
AFS 68,357 68,783 203,947 210,500 239,900 243,466 241,255 242,329
- ----------
(978) ACCOUNTING FOR CERTAIN LOANS OR DEBT SECURITIES ACQUIRED IN A TRANSFER,
Statement of Position No. 03-3 P .07(b) (Am. Inst. of Certified Pub.
Accountants 2003).
(979) See Fannie Mae, 2003 Annual Report (Form 10-K), at 59-60, 64-65 (Mar. 15,
2004), available at
http://www.fanniemae.com/ir/pdf/sec/2004/f10k03152004.pdf (hereinafter
"2003 Form 10-K"); Fannie Mae, 2004 Quarterly Report (Form 10-Q), at 52-55
(Aug. 9, 2004), available at
http://www.fanniemae.com/ir/sec/index.jhtml?s=SEC+Filings (follow "All SEC
Filings" hyperlink; then follow "Quarterly Filings" hyperlink for PDF
format) (hereinafter "2004 2Q Form 10-Q").
260
Table II - Unrealized Losses on HTM and AFS Investments(980)
DECEMBER DECEMBER DECEMBER JUNE 30,
FAS 115 CLASSIFICATION 31, 2001 31, 2002 31, 2003 2004
- ---------------------- -------- -------- -------- --------
HTM (721) (133) (1,461) (4,829)
AFS (349) (482) (726) (1,441)
------ ---- ------ ------
TOTAL (1,070) (615) (2,187) (6,270)
====== ==== ====== ======
Table III - OTTI Recorded
YEAR ENDED YEAR ENDED YEAR ENDED SIX MONTHS ENDED
INVESTMENT TYPE 2001 2002 2003 JUNE 30, 2004
- --------------- ---------- ---------- ---------- ----------------
MH BONDS(981) -- (51) (155) (261)
AIRCRAFT ABS(982) -- -- (84) (36)
OTHER INVESTMENTS(983) (50) (59) (69) --
--- ---- ---- ----
TOTAL(984) (50) (110) (308) (297)
=== ==== ==== ====
- ----------
(980) See id.
(981) Homesite Journal Entry, Journal ID JE29222, dated Dec. 28, 2002; Homesite
Journal Entry, Journal ID JE29244, dated Jan. 28, 2003; Homesite Journal
Entry, Journal ID JE29314, dated Mar. 28, 2003; Homesite Journal Entry,
Journal ID JE49390, dated Sept. 28, 2003; Homesite Journal Entry, Journal
ID JE21633, dated Dec. 28, 2003; Homesite Journal Entry, Journal ID
JE49139, Mar. 28, 2004; Homesite Journal Entry, Journal ID JE49160, dated
Apr. 28, 2004; Homesite Journal Entry, Journal ID JE49320, dated June 28,
2004.
(982) Homesite Journal Entry, Journal ID JE29786, dated June 28, 2003; Homesite
Journal Entry, Journal ID JE29479, dated Feb. 28, 2004; Homesite Journal
Entry, Journal ID JE29316, dated June 28, 2004.
(983) Amounts were computed as the difference between total OTTI recorded and
MH/Aircraft ABS OTTI. It appears that most "Other Investments" (briefly
described below) are not investments subject to FAS 115, but still require
evaluation for impairment per the applicable GAAP. Our review focused on
OTTI recorded pursuant to FAS 115, specifically that for MH bonds and
Aircraft ABS.
(984) 2003 Form 10-K at 45-46; 2004 2Q Form 10-Q at 51-52.
261
2. Types of Investments
As shown in Table III above, the majority of the OTTI that Fannie Mae
recorded between 2001 and the second quarter of 2004 related to MH bonds and
Aircraft ABS.
(a) MH Bonds
Fannie Mae began investing in MH bonds in the mid-1990s in order to
satisfy HUD goals and to provide liquidity for loans extended to low and
moderate income borrowers.(985) The MH bonds in which Fannie Mae invests are
mortgage-related securities backed by manufactured housing loans issued by
entities other than Fannie Mae.(986) The Company's MH bond investments were
substantial - the portfolio's book value was $10 billion by the end of
2002.(987) Most of Fannie Mae's MH bonds were issued and serviced by Conseco
Finance Corporation ("Conseco").(988)
Fannie Mae began to closely monitor Conseco toward the end of 2001 as
a result of Conseco's financial troubles and potential for bankruptcy,(989) and
management noted in early 2002 that the Company could experience losses if the
baseline default rate increased.(990) Despite Conseco's bankruptcy on December
17, 2002,(991) management viewed its exposure to be immaterial primarily because
it held senior interests, and because "all but one" of the bonds were still
rated as investment grade.(992) Fannie Mae
- ----------
(985) E-mail from Adolfo Marzol to Charles V. Greener, dated Feb. 20, 2004,
Cataphora document i.1077559617000.m278273054, at 1.
(986) 2003 Form 10-K at 60.
(987) See id. Fannie Mae notes in its 10-K that approximately $0.6 billion of
the $10 billion were securities that were guaranteed by Fannie Mae.
(988) See Draft mem. from David Kightlinger, et al., to A. Marzol, et al., with
attached appendices, dated Sept. 2002, FMSE 106020-27, at FMSE 106021.
Other servicers included Oakwood Capital Management and Greenpoint Capital.
Id.
(989) See Mem. from A. Marzol to Daniel H. Mudd, et al., dated Dec. 18, 2001,
FMSE 107000-01, at FMSE 107000.
(990) Mem. from Jef Kinney to Timothy Howard, dated Mar. 27, 2002, FMSE
165026-31, at FMSE 165026-27.
(991) E-mail from Jeffrey Wise to Linda K. Knight, et al., dated Dec. 18, 2002,
Cataphora document i.1040210632000.748582297, at 1.
(992) Talking Points - Conseco Bankruptcy, dated Dec. 20, 2002, FMSE-E 2038484.
262
first recognized OTTI on MH bonds in the fourth quarter of 2002.(993) We have
found no evidence that Fannie Mae recognized OTTI on MH bonds in any period
prior to that date.
(b) Aircraft ABS
According to a March 14, 2003 draft memorandum from Paul Salfi in
Financial Standards, Fannie Mae began investing in Aircraft ABS in the late
1990s with the intent to hold the assets in its Liquid Investment Portfolio
("LIP") for two to five years.(994) The Aircraft ABS in which Fannie Mae invests
are trusts that have legal title to an underlying pool of aircraft. Repayments
to the ABS bondholders are primarily the cash flows from leasing the aircraft to
carriers or, secondarily, from the sale of the airplane itself.(995) By February
2003, Fannie Mae's book value of Aircraft ABS was approximately $440
million.(996)
The March 14, 2003 draft memorandum cited "[t]he events of September
11th coupled with the frail economy, high fuel prices, fear of terrorism and
war, and increased security costs" as reasons for the decline of the airline
industry in 2002.(997) According to Jonathan Boyles, the potential impairment of
the Aircraft ABS was a primary driver for organizing a formal IC in 2003. Fannie
Mae first recorded OTTI on its Aircraft ABS in June 2003.(998)
(c) Other Investments
As shown in Table III, above, although the majority of OTTI recognized
between 2001 and the second quarter of 2004 was for MH bonds and Aircraft ABS,
Fannie Mae recognized OTTI on other investments during this period as well.
These investments appear to have been composed largely of investments not
subject to FAS 115, such as investments in low income housing partnerships,
investments in alternative energy partnerships, equity investments in various
housing and community development
- ----------
(993) See Homesite Journal Entry for account 713125, Journal ID JE29222, dated
Dec. 28, 2002.
(994) Draft mem. from Paul Salfi, et al. to Ken Barnes, et al., dated Mar. 14,
2003, FMSE-IR 672690-99, at FMSE-IR 672690-91.
(995) Id. at FMSE-IR 672691.
(996) Id. at FMSE-IR 672690.
(997) Id. at FMSE-IR 672691.
(998) See Homesite Journal Entries for accounts 713127, Journal ID JE29786,
dated June 28, 2003.
263
institutions, equity investments in technology companies, and an investment in
an aircraft leverage lease.(999)
3. OTTI Accounting and Monitoring Methodologies
(a) Prior to the 4-Step Approach
Fannie Mae's 2001 Financial Accounting Policy Guide contained a brief
mention of OTTI, and contained no guidance on the factors that companies should
consider in determining whether such securities are impaired. It stated:
If the fair value of a HTM or AFS security is less than its carrying
amount and the decline is judged to be other than temporary:
- Fannie Mae reduces the carrying amount of the investment to its
fair value, which is reflected as the new "cost" basis
- The write-down is recorded in earnings as a realized loss
- The new costs basis is not adjusted for subsequent recoveries in
fair value.(1000)
In a memorandum dated September 27, 2002 to Leanne Spencer and Mortgage
Portfolio personnel, Ilan Sussan addressed OTTI on AFS securities and sought "to
describe indicators that should be considered in assessing whether securities
are other-than-temporarily impaired due to a decline in their market
values."(1001) The memorandum cited FAS 115, SAB Topic 5-M, and AICPA guidance
on OTTI assessment, and stated: "If any securities that meet any of these
criteria come to your attention, please inform Jonathan Boyles or myself
immediately. We will weigh all of these factors to determine if a security was
permanently impaired."(1002) Beyond these two documents, we did not find any
formal accounting policy for evaluating or recognizing OTTI.
Fannie Mae first formed an IC to evaluate investments for OTTI in
mid-2003.(1003) The IC Charter ("Charter"), as drafted by Boyles, called for
membership by the
- ----------
(999) See Fannie Mae's Impairment Policies and Practices, Assets & Liabilities
Policy Committee, dated Apr. 20, 2004, FMSE-IR 501826-34.
(1000) Financial Accounting Policy Guide, dated Dec. 2001, Zantaz document
1044810, at 43.
(1001) Mem. from Ilan Sussan to Leanne Spencer, dated Sept. 27, 2002.
(1002) Id.
(1003) See Mem. from Jonathan Boyles to L. Spencer, with attachments, dated May
28, 2003, FMSE 69379-83, at FMSE 69379.
264
Chief Credit Officer, the Controller, the Treasurer, the General Counsel, and a
Vice President from both Financial Standards and Corporate Tax.(1004) The
Charter appears to be consistent with GAAP requirements for OTTI determination
and describes review mechanisms that the IC and the business owners of the
investments should use to monitor investments. These mechanisms include a "Watch
List" of all investments with fair values at or below ninety-five percent of
carrying value and a "Potential Impairment Report" describing each at-risk
investment and the nature of the impairment risk.(1005) It appears that the IC
only monitored "non-agency" (i.e., excluding securities issued by Fannie Mae,
Freddie Mac, and other GSEs) and LIP investments, including Aircraft ABS but
excluding MH bonds.(1006)
While excluded from review by the IC, MH bonds were analyzed for loss
by Credit Policy beginning in 2002, after the effects of a potential Conseco
bankruptcy on the MH bond market became apparent.(1007) Credit Policy's analysis
used DCF modeling to determine the present value of potential losses on MH bonds
that were, in turn, used to determine OTTI.(1008) Even though we found no
formally documented criteria for evaluating MH bonds for OTTI specifically, we
did find some guidance in a January 8, 2004 e-mail. The e-mail described the
criteria as "low mark-to-market (less
- ----------
(1004) Undated Impairment Committee, Committee Charter, FMSE 130548-51, at FMSE
130548.
(1005) Id. at FMSE 130549.
(1006) Mem. from Joanne Collins to L. Spencer, dated Oct. 20, 2003, FMSE
69340-69346, at FMSE 69340. Collins writes: "Attached are the Watch Lists
for the Non Agency Securities and the LIP. The Non Agency MBS Watch List
includes mostly manufactured housing securities that are monitored for
impairment by another committee." Id. This language appears to have been
boiler plate for the IC recommendations prior to the implementation of the
4-Step Approach. See, e.g., Mem. from J. Collins to L. Spencer, dated Dec.
22, 2003, FMSE 69328-36 at FMSE 69328; Mem. from I. Sussan to L. Spencer,
dated Feb. 2, 2004, FMSE 164887-91, at FMSE 164887.
(1007) See Draft mem. from D. Kightlinger, et al., to A. Marzol, et al., with
attached appendices, dated Sept. 2002, FMSE 106020-27 (analyzing MH bond
exposure); see also Mem. from A. Marzol to D. Mudd, et al., dated Dec. 18,
2001, FMSE 107000-01 (same).
(1008) See, e.g., Fannie Mae Exposure to Conseco Manufactured Housing Bonds
spreadsheet, dated Mar. 27, 2003, FMSE 106388-89, at FMSE 106388. The total
present value of losses listed on the spreadsheet matches the cumulative
amount of MH bond OTTI recorded as of March 31, 2003. See Homesite Journal
Entries for account 713125, Journal ID JE29222, dated Dec. 28, 2002 ($51
million); Journal ID JE29244, dated Jan. 28, 2003 ($1.15 million); and
Journal ID JE29314, dated Mar. 28, 2003 ($66.25 million).
265
than 90 percent of par), projected losses occurring within a reasonable time
period (20 years), materiality of projected loss or materiality of change in
projection from previous quarter, and likelihood that loss will occur."(1009)
Fannie Mae's first comprehensive investment impairment policy,
including the protocols described in the Charter, appeared in the Company's
December 2003 Financial Accounting Policy Guide.(1010)
(b) The 4-Step Approach
In 2004, OFHEO reviewed Fannie Mae's OTTI accounting for MH bonds in
the course of the Special Examination.(1011) According to Boyles, OFHEO believed
that the provisions of EITF 99-20, Recognition of Interest Income and Impairment
on Purchased and Retained Beneficial Interests in Securitized Financial Assets,
rather than FAS 115, applied to these investments. Fannie Mae disagreed, and
brought its disagreement to the SEC. Although the SEC staff did not object to
the Company's accounting policy, it suggested that Fannie Mae work with OFHEO to
draft a policy upon which both could agree.
As a result, Fannie Mae revised its OTTI evaluation of MH bonds and
Aircraft ABS effective the second quarter of 2004. Fannie Mae memorialized its
new approach, known as the "4-Step Approach," in a June 22, 2004 letter to
OFHEO,(1012) and communicated the 4-Step Approach to the SEC in a letter dated
August 3, 2004.(1013)
- ----------
(1009) E-mail from D. Kightlinger to Kieran Gifford, et al., dated Jan. 8, 2004,
Zantaz document 1004217.
(1010) See Financial Accounting Policy Guide, Asset Impairment Review, dated
Dec. 2003, FMSE-IR 511818-21.
(1011) See Talking Points to Board, dated Apr. 20, 2004, FMSE-IR 227241-42, at
FMSE-IR 227242.
(1012) Letter from J. Boyles to Christopher H. Dickerson, with attachments,
dated June 22, 2004, FMSE-SP 42125-34, at FMSE-SP 42125-26.
(1013) Letter from J. Boyles to Donald T. Nicolaisen, with attachments, dated
Aug. 3, 2004, FMSE-IR 362436-41 at FMSE-IR 362437. In addition to
communicating the new 4-Step Approach, the letter refers to an April 28,
2004 letter, and states:
[Y]ou [SEC] told us [Fannie Mae] that you believed our accounting
policies regarding other-than-temporary impairment were consistent
with generally accepted accounting principles. You also stated that
you believed that the approach by our regulators had value and that we
should work with them and our external auditors to settle
266
Boyles stated that the policy represented a compromise between OFHEO's demands
and what the Company viewed as appropriate accounting under GAAP. The 4-Step
Approach, as documented in the above memorandum, is divided into "Day One" and
"Day Two" accounting.(1014)
(1) Day One Accounting
Day One accounting addresses the threshold question of whether an
investment is OTTI. The steps are as follows:
Step 1: Does Fannie Mae's estimate of cash flows show loss of
principal or interest?
If yes--write-down to fair value
If no--move to step 2
Step 2: Has the bond been downgraded to BB or lower?
If yes--write-down to fair value
If no--move to step 3
Step 3: Has the bond been downgraded to BBB and trading below 90 of
adjusted book?
If yes--write-down to fair value
If no--move to step 4
Step 4: Is the bond is [sic] A-rated or better and trading below 80
of adjusted book value?
If yes--write down to fair value
If no--mark-to-market through OCI(1015)
- ----------
the accounting issues and come back to you with our final agreement.
Id. at FMSE-IR 362436; See also letter from J. Boyles to D. Nicolaisen,
dated Apr. 28, 2004, FMSE-IR 483271-82. This document can be found in the
accompanying Appendix at Tab D.6.
Boyles explained that his summary of the SEC's position, above, was limited
to the question of whether to apply FAS 115 instead of EITF 99-20. He did
not believe that the SEC had given broad approval of Fannie Mae's OTTI
accounting practices.
(1014) Letter from J. Boyles to C. Dickerson, with attachments, dated June 22,
2004, FMSE-SP 42125-34, at FMSE-SP 42125-26.
(1015) Id. (footnotes omitted).
267
Step One encompasses Fannie Mae's prior policy for determining whether
an investment was impaired on an other-than-temporary basis. The additional
three steps respond to OFHEO's demand that the Company use changes in credit
ratings and market prices as primary indicators of OTTI, thereby minimizing
management judgment. Fannie Mae stated in its June 22, 2004 letter to OFHEO that
it would "rely primarily on quoted market prices to determine the fair value of
these securities" and calculate OTTI if determined to exist.(1016)
(2) Day Two Accounting
Day Two accounting provides for income recognition subsequent to the
determination and recognition of impairment.(1017) As support for its Day Two
accounting, Fannie Mae looked to paragraph 7(b) of SOP 03-3,(1018) which allows
subsequent income accretion by adjusting the yield of a security if "it is
probable that there is a significant increase in cash flows previously expected
to be collected or if actual cash flows are significantly greater than cash
flows previously expected."(1019) Under Day Two accounting, Fannie Mae accretes
certain OTTI recognized - less a non-accretable portion called a "holdback" -
into income over the remaining life of the security.(1020) The holdback is an
estimate of the amount of non-accretable OTTI and is determined using cumulative
default rates from the results of a historical study performed by Moody's on
corporate bonds.(1021)
Later in 2004, Fannie Mae published its "Other-Than-Temporary
Impairments of Non-Agency Securities: Policy and Operational Procedures" manual,
which effectively codified and operationalized the 4-Step Approach.(1022) The
manual applies the 4-Step Approach not only to MH bond and Aircraft ABS (the
only categories
- ----------
(1016) Id. at FMSE-SP 42126.
(1017) Id.
(1018) Id. at FMSE-SP 42127.
(1019) ACCOUNTING FOR CERTAIN LOANS OR DEBT SECURITIES ACQUIRED IN A TRANSFER,
Statement of Position No. 03-3 P .07(b) (Am. Inst. of Certified Pub.
Accountants 2003).
(1020) See Letter from J. Boyles to C. Dickerson, with attachments, dated June
22, 2004, FMSE-SP 42125-34, at FMSE-SP 42129.
(1021) See id. at FMSE-SP 42126-27.
(1022) See Other-Than-Temporary Impairments of Non-Agency Securities: Policy and
Operational Procedures, dated Feb. 10, 2005, Zantaz document 1927868.
268
of investments that were subject to OFHEO's inquiry), but also to all non-agency
securities and certain LIP securities.(1023)
III. FINDINGS
A. Accounting Policy and Monitoring
In our view, Fannie Mae's policies and practices for monitoring OTTI
prior to the adoption of the 4-Step Approach were inadequate in several
respects. First, because FAS 115 was effective as of 1994, management should
have begun formal evaluation of all of its HTM and AFS securities for OTTI as of
that time. As noted above, the Company did not have a comprehensive process in
place to monitor its investments subject to FAS 115 for OTTI until formation of
the IC in mid-2003.(1024) In response to the question of why Fannie Mae did not
have an IC prior to 2003, Boyles stated only that, prior to the formation of the
IC, Portfolio did not generally encounter OTTI issues because it held only
highly rated securities.
Without an IC, Fannie Mae's OTTI monitoring was reactive rather than
proactive; securities were only evaluated for OTTI when brought to the attention
of the Controller's Office. As the Conseco bankruptcy and airline industry
decline demonstrated, even highly rated investments can fall sharply in value
and experience OTTI. Because we have found no consistent practices for
monitoring OTTI prior to 2003, we cannot say whether the Company appropriately
recognized OTTI on these or any other investments prior to that date.
Second, even after establishing a formal process, it does not appear
that the IC monitored all HTM and AFS investments that had unrealized losses,
and thus potential OTTI. As an example, the December 2003 IC meeting Watch Lists
contained only "non-agency" LIP and investments with fair value that was
ninety-five percent or lower than book value.(1025) We have found no
documentation showing that management verified that all other investments with
unrealized losses were not other-than-temporarily impaired in some other way.
Although the IC technically included MH bonds on its Watch Lists, it
did not monitor them for OTTI.(1026) Furthermore, while it is true that MH bonds
were
- ----------
(1023) See id.
(1024) See supra text accompanying notes 1003-1006.
(1025) See, e.g., Mem. from I. Sussan to L. Spencer, with attachments, dated
Feb. 2, 2004, FMSE 164887-91, at FMSE 164888-91. We note that certain other
investments not on the Watch Lists subject to FAS 115 appear to have been
included in the IC's review as well.
(1026) See supra note 1006 & accompanying text.
269
evaluated for losses by Credit Policy beginning in 2002, we found very little
documentation of management's MH bond OTTI evaluation (other than the DCF model
results). Prior to the adoption of the 4-Step Approach, OTTI recorded for MH
bonds appears to have been primarily for those bonds with fair values of ninety
percent or less of book value, and whose DCF model showed a loss of principal
and/or interest. We saw no evidence that other criteria required by SAB Topic
5-M were considered, such as the length of time that the fair value of a
security was below book value.
Third, we note that the IC was not, in practice, attended by senior
management as contemplated by the Charter. Boyles stated that he drafted the
Charter at Spencer's request, but that the document he created was "overkill"
and that Spencer intended the IC to serve a more advisory role. Over time,
Boyles was the most senior employee to attend IC meetings and, eventually, even
he only attended sporadically.
B. Management Modification of the MH Bond DCF Modeling
In addition to the lack of any comprehensive policies or procedures to
assess OTTI for all HTM and AFS securities, we also found several instances in
which management's exercise of discretion over the DCF model directly affected
the amount of OTTI recorded. Although we would expect a model to be refined over
time as new information becomes available, and have found no evidence that
management used its discretion with respect to the model to manage earnings to
specific targets, management's ability to influence the model results
represented another control weakness that could indicate underreporting of OTTI.
Fannie Mae's MH bond DCF model was created and maintained by Credit
Policy beginning in 2002, with Howard in an oversight role.(1027) Fannie Mae
relied on model-generated data for impairment purposes to varying degrees
between the time of its first OTTI charge for MH bonds through the adoption of
the 4-Step Approach.
One instance of management's involvement related to the servicing fee
assumption for four Conseco bonds on which OTTI was recognized in December 2002.
In that case, it appears from a spreadsheet used in a meeting with Howard,
Spencer, and KPMG in December 2002, that the bonds were modeled for loss
according to five different servicing fee assumptions.(1028) Ultimately, Fannie
Mae recorded $51 million of OTTI on MH bonds in December 2002,(1029) which was
the loss corresponding to the 100
- ----------
(1027) See Manufactured Housing Securities Status Report, Presented to: Assets
and Liabilities Policy Committee, Fannie Mae Board of Directors, dated Nov.
19, 2002, FMSE-IR 655695-708 at FMSE-IR 655703 (indicating Howard as the
lead for "Manufactured Housing Project Initiatives," including "Exposure
Assessment . . . [m]odel individual securities' cash flows").
(1028) Selected MH Securities Held in Mortgage Portfolio spreadsheet, dated Dec.
19, 2002, FMSE 130466.
(1029) Homesite Journal Entry for 713125, Journal ID JE29222, dated Dec. 28,
2002.
270
basis point servicing fee assumption.(1030) Had the higher servicing fee of 120
basis points been used, OTTI recorded would have been $66.6 million.(1031) While
selection by management of the 100 basis points did reflect an expected increase
in the servicing fee due to the potential Conseco bankruptcy, we have found no
valid rationale for not using the higher servicing fee of 120 basis points given
other evidence available at the time. It is evident from a March 2002 memorandum
to Howard that management was aware at the time that market rates for servicing
were as high as 130 basis points.(1032) In fact, management based its "deep
dive" analysis in September 2002 on a servicing fee assumption of 120 basis
points.(1033) In addition, management appears to have been aware that the
bankruptcy court in the Conseco matter had approved an interim order on December
20, 2002 raising the servicing fee to 125 basis points for a period of thirty
days.(1034) Later versions of the DCF model reflected the servicing fee
increase.(1035)
In March 2003, management exercised discretion over another key
assumption in the DCF model: the default rate. Robert Kazdin, Director - Credit
Policy, who was responsible for modeling the loss on collateral for the MH bond
DCF, stated that in early 2003 he updated his portion of the model to reflect
improved data on loan pool activities. Kazdin stated that, in March 2003,
management, including Brian Graham, Adolfo Marzol and Howard, met and made minor
adjustments to his default rate assumptions to reflect higher expected defaults
in the near-term and lower expected defaults in the long-term (i.e., yielding
lower losses overall). This updated model was referred to as "Scenario Three"
and was used by the Company to model the cash flows on MH bonds from March 2003
until late 2005. Although Kazdin was not certain, he stated that the rationale
for adjusting the rate to be lower in later years was to be more reflective of
"core business" experience.(1036) While management's assumption differed from
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(1030) Selected MH Securities Held in Mortgage Portfolio spreadsheet, dated Dec.
19, 2002, FMSE 130466.
(1031) See id.
(1032) Mem. from J. Kinney to T. Howard, dated Mar. 27, 2002, FMSE 165026-31, at
FMSE 165029.
(1033) Draft mem. from D. Kightlinger, et al., to A. Marzol, et al., dated Sept.
2002, FMSE 106020-27, at FMSE 106021-22.
(1034) Manufactured Housing Securities Status Report, Presented to: Assets and
Liabilities Policy Committee of the Fannie Mae Board of Directors, dated
Jan. 21, 2003, FMSE 106994-99, at FMSE 106998.
(1035) Mem. from D. Kightlinger, et al., to Brian Graham and K. Gifford, dated
Apr. 10, 2003, FMSE 74974-75, at FMSE 74974. The fee was set at 125 basis
points for the first year, and 115 basis points thereafter. Id.
(1036) We understand that Kazdin used "core business" to refer to those
securities backed by conventional mortgages.
271
Kazdin's original model, Kazdin stated that the default rates were the hardest
assumption to model, that he was comfortable that management's change to the
assumption was reasonable, and that if he thought otherwise he would have
objected. In addition, Kazdin noted that, until recently, actual collateral
losses tracked below projected losses (under Scenario Three), prompting changes
to the model in late 2005.
On another occasion in September 2003, Howard and Spencer gave
guidance to Graham and others in Credit Policy to alter the DCF model results
used to record MH bond OTTI. After Credit Policy completed its third quarter
2003 OTTI estimate based on the DCF, Howard directed Graham to exclude certain
items from the estimate that he felt reflected "normal volatility."(1037) In
addition, Spencer directed Graham to exclude certain bonds with losses from the
estimate.(1038) The impact of these changes in the third quarter of 2003 was
documented by Graham in an October 6, 2003 memorandum to Howard, in which Graham
noted the exclusion of "a number of effects that reflect normal volatility" that
would have "increase[d] total forecast potential losses by approximately $8
million."(1039)
Aside from management discretion to alter the DCF models, documents
showed that data used in the models sometimes contained errors that, had they
been identified earlier, may have resulted in recording OTTI earlier. A
particular instance was documented in an August 2003 memorandum and involved the
weighted average coupon rate and Oakwood MH bond servicing fee data.(1040)
Although the errors in the data
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(1037) E-mail from B. Graham to D. Kightlinger, et al., dated Sept. 23, 2003,
FMSE-E 624263-64, at FMSE-E 624263.
(1038) See E-mail from L. Spencer to B. Graham, dated Sept. 30, 2003, FMSE-E
1685148-49, at FMSE-E 1685149.
(1039) Mem. from B. Graham to T. Howard, with attachment, dated Oct. 6, 2003,
FMSE 74631-33, at FMSE 74631. The exclusions Graham listed were consistent
with the Howard and Spencer changes noted above: (1) a decrease in losses
due to a change in the discount rate used in the model, (2) an increase in
losses resulting from the deterioration of the weighted average coupon
("WAC") rate, and (3) certain bonds with de minimis losses per corporate
accounting policy guidance.
(1040) Mem. from A. Marzol and B. Graham to T. Howard, dated Aug. 22, 2003, FMSE
106844-45, at FMSE 106845. The WAC error was a result of a previous
decision to install an edit in INTEX (a third-party cash flow modeling
software) that holds the loan level note rates for fixed rate loans in
Conseco MH transactions constant over time, assuming that any swings in the
data were errors. However, as Conseco began to modify and/or extend the
loans, legitimate changes in the WAC were ignored due to the previous edit.
Marzol indicated this change "results in an increase in our projected loss
for Conseco bonds of $28 million." Id. at FMSE 106844. The servicing fee
error was a result of a renegotiation of the fee (by Oakwood due to its
bankruptcy) to 100 basis points and senior in the waterfall, and Marzol
notes "[t]he
272
appeared to have been corrected, OTTI was potentially underreported in previous
periods.
C. Fair Value Determinations
1. MH Bonds
Fannie Mae's use of DCF models to estimate impairment loss for its MH
bonds for 2002 and most of 2003 was based on the belief that the illiquidity of
the MH bond market (due to the Conseco bankruptcy and general MH bond market
downturn) caused market data to be unavailable and/or unreliable. This rationale
has been consistently cited in interviews and revealed in documents.(1041) KPMG
also appears to have been aware of the use of DCF models and did not object to
it.(1042) Nevertheless, we conclude that the use of the DCF models was
inappropriate.
While Fannie Mae is correct that DCF models may be used in the absence
of better data on fair value, we have found that market data did, in fact, exist
for MH bonds during the period. First, when Fannie Mae transferred all of its MH
bonds from HTM to AFS in September 2002 in conjunction with its adoption of
OFHEO's Risk Based Capital requirements, the Company received prices from
dealers for some of the
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resulting increase in our loss projection is approximately $12 million."
Id. at FMSE 106845.
(1041) See, e.g., E-mail from Rob Schaefer to A. Marzol, et al., dated Feb. 17,
2004, FMSE-E 2155495-97, at FMSE-E 2155496 (stating that "[i]n 2002, when
news of Conseco's collapse was breaking, the market was too illiquid to be
relied upon for a good market price, and so our marks at that time were
based upon internal estimates using general market pricing information");
see also 2003 Form 10-K at 46 (stating that "[w]hen market quotations are
not readily available because of the nature of the security or illiquid
market conditions - as occurred during the downturn in the manufactured
housing sector - we estimate the fair value based primarily on the present
value of future cash flows, adjusted for the quality of the rating of the
securities, prepayment assumptions, and other factors, such as credit
enhancements . . . ").
(1042) See KPMG Conseco Bonds workpaper, dated Jan. 2003. In the KPMG year-end
2002 audit workpaper regarding impairments, Fannie Mae's external auditing
firm notes, "Kerry Gifford and Steven Shen led the efforts to model the
expected cash flows for purposes of determining management's estimate of a
current price. Although these securities are traded, a Bloomberg price may
not represent an appropriate valuation given the limited volume of trades
and a [sic] given the priority of a given investors [sic] variable
interest. Fannie Mae performed a NPV calculation for purposes of
determining fair value." Id.
273
most illiquid MH bonds in order to mark these securities to fair value.(1043)
Second, our review of Bloomberg's pricing service showed that bid/ask pricing
was available for most of the MH bonds on which Fannie Mae recognized impairment
during the period it used its DCF models to determine OTTI. We note that the
OTTI recorded was higher than it would have been if the prices from Bloomberg
were used, but GAAP is clear that using quoted market prices to measure value is
preferred.(1044)
2. Aircraft ABS
Fannie Mae also used a DCF model to estimate fair value for its
Aircraft ABS.(1045) The IC cited the same rationale for using DCF models for
Aircraft ABS that was used to estimate OTTI for MH bonds - an illiquid market.
But quoted market prices had been obtained at the time, and should have been
considered when measuring fair value. Further, management's explanations for the
decision to use the model were inconsistent.
In a July 7, 2003 memorandum, David Benson, Vice President and
Assistant Treasurer - Portfolio, explained the DCF analysis that ultimately
supported an impairment charge of $83.5 million (recorded in the second quarter
of 2003) on Aircraft ABS. The memorandum indicated that Fannie Mae used the DCF
model to determine fair value despite the fact that "[q]uoted indicative (not
for trading) prices" showed even lower fair values.(1046) Benson appears to have
justified the use of DCF based on a "dearth of transactional activity to
validate quoted levels."(1047) Benson further stated that he felt confident in
the DCF model because he was familiar with the details, and that the fair value
price generated by the DCF model represented the prices at which a willing buyer
and a willing seller would enter into a transaction currently. But Benson
defined indicative prices in the same way, stating that he had no reason to
believe the indicative prices received were unreliable or obtained from
unreliable sources. Benson added that, ultimately, the decision to use fair
value per the DCF model was not his decision.
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(1043) See E-mail from S. Shen to Janet L. Pennewell, et al., dated Sept. 24,
2002, Zantaz document 1940768, at 1. In the e-mail, Shen notes that "[t]he
bonds to focus on are the 1999 and 2000 vintages. We had the majority of
those deals specifically mark [sic] by the dealers because they have the
leasst [sic] amount of liquidity." Id.
(1044) Boyles stated that although he was not involved in generating the market
values, he assumed that Fannie Mae did not believe the Bloomberg prices
were accurate because there were no trades in the market for these bonds.
(1045) Mem. from David Benson to Peter Niculescu, L. Knight, et al., dated July
7, 2003, FMSE-IR 321383-85, at FMSE-IR 321384.
(1046) Id. at FMSE-IR 321383.
(1047) Id.
274
The IC ultimately recommended use of DCF-generated fair values; the
July 9, 2003 IC minutes reflect the $83.5 million write-down (listed as $84
million in the minutes), and note: "If we had used market quotes, we would have
another $45M in write-downs. However, we believe market quotes represent a fire
sale because the market for aircraft securities is currently not very
liquid."(1048)
In hindsight, management's own analysis in the first quarter of 2004
showed that the claim of "fire sale" prices did not prove to be valid for at
least one of the Company's Aircraft ABS. The July 7, 2003 Benson memorandum
shows that the PALS A1 security had a DCF-based fair value of $70.19 and a
quoted indicative price of $60.00.(1049) In 2004, the PALS A1 security was
written down to a fair value of $48.50, a price that was $11.50 lower than the
indicative price of $60.00 that was dismissed in 2003 as representing a "fire
sale."(1050)
In summary, both MH bond and Aircraft ABS quoted market prices were
available during the time that management was using the DCF model results to
determine the amount of OTTI to record. Management was required under GAAP to
consider these prices in determining fair value when recording OTTI,
particularly for those securities with market prices that were lower than fair
values derived from the DCF models.
We note that the SEC provided guidance in 1986(1051) that companies
may not rely on their subjective calculations of fair value versus valuations of
external pricing
- ----------
(1048) Draft Minutes of the Meeting of the Impairment Committee, dated July 9,
2003, FMSE 69363-65, at FMSE 69363.
(1049) Mem. from D. Benson to P Niculescu, L. Knight, et al., dated July 7,
2003, FMSE-IR 321383-85, at FMSE-IR 321384.
(1050) Mem. from D. Benson to P Niculescu, L. Knight, et al., dated Mar. 5,
2004, FMSE-E 1386760-62, at FMSE-E 1386760.
(1051) See Accounting for Loan Losses by Registrants Engaged in Lending
Activities, Exchange Act Release No. 34-23,854, 17 C.F.R. Part 211 *1,
*13-14 (Dec. 1, 1986), stating:
The Commission will presume that active markets reflect objective
measures for current fair values, determined by the beliefs of
reasonably informed persons regarding the present and future economic
utility of the items being traded and the risks associated therewith.
Thus, without independent and objective support for derived valuations
that can be demonstrated to more appropriately reflect fair value in
particular sets of circumstances, derived valuations exceeding current
values in active markets should not be used in cases where fair value
accounting is required by GAAP.
275
sources and reiterated that view in 2004 in an enforcement proceeding.(1052)
Accordingly, we recommend that the Company promptly adopt procedures that ensure
objective evaluation of fair value in accordance with GAAP.
D. Timing of Recognition
In our view, management waited too long to evaluate OTTI on its
Aircraft ABS, and thus may have underreported OTTI on those investments prior to
the evaluation by the IC. The weak state of the industry, poor market
conditions, and the numerous public companies that recorded impairment charges
on their aircraft-related assets in 2002 were well documented by Fannie Mae's
own due diligence in early 2003.(1053) Indeed, Fannie Mae was aware that several
other companies had recorded impairment related to aircraft investments as early
as in 2002.(1054) Boyles (the IC chair) suggested that the delay in monitoring
resulted from a simple lack of awareness by the Company. Specifically, Boyles
said that he had no knowledge that Fannie Mae owned
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(1052) See In the Matter of Morgan Stanley, 2004 SEC LEXIS 2573 (Nov. 4, 2004).
The SEC issued a cease and desist order against Morgan Stanley in regards
to Morgan Stanley's valuation of certain aircraft in its leasing portfolio
and certain bonds in its high-yield bond portfolio. Regarding Morgan
Stanley's high-yield bond portfolio, the SEC stated that:
The majority of the overvaluations occurred with bonds in the
telecommunications industry. For those bonds, Morgan Stanley believed
that market conditions rendered third-party price quotations
unreliable. In such market conditions, GAAP required Morgan Stanley to
use its best efforts to determine the fair value of the bonds, which
is the price at which a willing buyer and a willing seller would enter
into a current exchange. Instead of following GAAP to determine the
fair value for those bonds, Morgan Stanley valued those bonds by
"taking a longer view of the market" and essentially put its
subjective opinion about the value of the bonds ahead of prices quoted
by external pricing sources. In effect, Morgan Stanley valued its
positions at the price at which it thought a willing buyer and seller
should enter into an exchange, rather than at the price at which a
willing buyer and a willing seller would enter into a current
exchange.
Id. at *12-13.
(1053) See Draft mem. from P Salfi, et al. to K. Barnes, et al., dated Mar. 14,
2003, FMSE-IR 672690-99.
(1054) Id. at FMSE-IR 672692.
276
Aircraft ABS prior to 2003 and that, if the IC had been in place prior to 2003,
the Company might have recognized impairment on Aircraft ABS earlier.
In addition, it appears that management's reliance on DCF models in
place of "indicative prices" led to further delays in recognizing impairment on
Aircraft ABS. As noted above, management was aware in the second quarter of 2003
that, if it had based its fair value on market quotes, it would have recognized
an additional $45 million in OTTI on Aircraft ABS, but dismissed these market
quotes as a "fire sale."(1055) Nevertheless, management did not record any
further OTTI on its Aircraft ABS during 2003. In the first quarter of 2004,
management recognized additional OTTI of approximately $21.7 million on one of
its Aircraft ABS, PALS 2001-1A A1. We note that $10.2 million of the $21.7
million(1056) would have been recognized in 2003 had its indicative price of $60
not been dismissed as a "fire sale" price.
PART G: ACCOUNTING FOR INVESTMENTS IN INTEREST-ONLY
MORTGAGE-BACKED SECURITIES
I. INTRODUCTION
This section addresses Fannie Mae's accounting for investments in
interest-only mortgage-backed securities ("IO MBS"). Beginning in 1995,
management combined its IO MBS investments with other securities (specifically,
MBS and REMIC securities) for accounting purposes, and treated the IO MBS as an
increase in the premium or a reduction in the discount on the other security.
Management initially obtained approval from KPMG for this accounting treatment
for the IO MBS investments. We believe, however, that this approach violates
GAAP. EITF 90-2, which addressed an analogous situation and should have been
applied by management to the accounting for its IO MBS investments, required
that an exchange transaction take place before the accounting for the individual
interest-only and principle-only securities can change.
Furthermore, management's motive for engaging in combined accounting
was to avoid recognizing impairment charges on the IO MBS, which would have
resulted in volatility in the income statement. While management initially
consulted with and obtained approval from KPMG, by 1998, management knowingly
withheld from KPMG its impairment analysis on the IO MBS, apparently fearing
that the new KPMG audit team might change the decision of the old audit team and
require management to change its accounting, which could have resulted in the
Company being required to recognize impairment losses.
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(1055) See supra text accompanying note 1048.
(1056) See Homesite Journal Entry for account 713127, Journal ID JE29479, dated
Feb. 28, 2004.
277
Finally, management failed to inform the Board of the issues relating
to its accounting for the IO MBS investments until OFHEO raised questions about
these practices in April 2004. This is particularly troubling because the
Freddie Mac restatement raised nearly identical issues, and management, in its
presentation to the Board about the Freddie Mac restatement in January 2004, not
only failed to disclose the existence of its own problematic synthetic IO MBS
combinations, but led the Board to believe that Fannie Mae did not have similar
issues to those raised at Freddie Mac.
II. BACKGROUND
A. Applicable Accounting Standards
An investment in IO MBS entitles an investor to a portion of the
interest payments on the MBS. Changes in the fair value of an investment in IO
MBS are directly related to changes in interest rates: When interest rates
increase, the fair value of IO MBS increase; when interest rates decline, the
fair value of IO MBS decline. This results from the fact that, as a general
matter, when interest rates increase, the speed at which borrowers prepay or
refinance their mortgages declines. Conversely, when interest rates decline, the
speed at which borrowers prepay or refinance their mortgages increases.
Increased prepayments reduce the total amount of interest received over the life
of MBS; therefore, the cash flow to the holder of an investment in IO MBS also
will decline. For that reason, the Emerging Issues Task Force (the "EITF")
concluded, in EITF 93-18, that IO MBS are high risk investments.(1057) A
decrease in interest rates that is accompanied by an increase in prepayments
could cause an investor to lose some or all of his investment.
B. Fannie Mae's Accounting for Investments in IO MBS
Fannie Mae began acquiring IO MBS as investments in 1994. The
Company's IO MBS portfolio increased from $125 million in July 1994 to $524
million
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(1057) RECOGNITION OF IMPAIRMENT FOR AN INVESTMENT IN A COLLATERALIZED MORTGAGE
OBLIGATION INSTRUMENT OR IN A MORTGAGE-BACKED INTEREST-ONLY CERTIFICATE,
Emerging Issues Task Force of the Fin. Accounting Standards Bd., Issue No.
93-18 (Mar. 1994) (superceded by RECOGNITION OF INTEREST INCOME AND
IMPAIRMENT ON PURCHASED AND RETAINED BENEFICIAL INTERESTS IN SECURITIZED
FINANCIAL ASSETS, Emerging Issues Task Force of the Fin. Accounting
Standards Bd., Issue No. 99-20 (July 2000)) (hereinafter "EITF 93-18").
EITF 93-18 requires an investor in IO MBS to measure impairment for the
difference between the carrying amount of the investment and the current
fair value of that investment. Id. EITF 93-18 indicates that impairment
should be recognized when the present value (determined using a risk-free
rate) of the investor's best estimate of the future cash flows to be
received on the investment is less than the carrying amount of the
investment. Id. The investor's best estimate of the future cash flows
should incorporate the investor's most current estimate of future
prepayments. Id.
278
as of April 30, 1995.(1058) Fannie Mae acquired its IO MBS investments when
interest rates were high;(1059) as a result, Fannie Mae was exposed to the risk
that it would have to recognize impairment of those investments if interest
rates declined and borrowers refinanced their mortgages (which did occur
beginning in 1995). It appears that management determined the effective yield on
the IO MBS at the time of purchase as required by EITF 89-4, but did not
recalculate the yield subsequently as EITF 89-4 also required.(1060)
1. Motivation for the Decision to Combine IO MBS with Other
Securities for Accounting Purposes
In late 1995, management, with KPMG's concurrence, combined its IO MBS
with REMIC securities to create "Synthetic REMICs." The combination of the two
securities was done only for accounting purposes; in other words, the Company
did not enter into any transactions that would have been expected to change the
characteristics of either the IO or the REMIC security, "which would have been
one permissible reason for combining the securities."(1061) Instead, Fannie
Mae's decision appears to have been
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(1058) See Mem. from Sam Rajappa to Timothy Howard, Thomas A. Lawler, Joseph
Amato, Deborah Cohen, James Parks, Leanne G. Spencer, Richard DePetris, and
Jonathan Boyles, dated June 22, 1995, FMSE-IR 213735-36, at FMSE-IR 213735
(hereinafter "Rajappa Memo").
(1059) See Undated IO/REMIC Package Briefing for Tim Howard, FMSE-SP 86636-40,
at FMSE-SP 86636 (hereinafter "IO/REMIC Briefing"). This and other examples
of documents relevant to the discussion in Chapter VI, Part G can be found
in the accompanying Appendix at Tab D.7.
(1060) See Mem. from J. Boyles to Distribution, dated Oct. 26, 1995, FMSE-IR
213989-4050, at FMSE-IR 213990. In this memorandum, Boyles wrote: "IO
securities yields are currently being calculated and recorded according to
EITF 89-4 at the time of purchase, however, subsequent recalculation of the
effective yield with current prepayment assumptions have [sic] only been
performed on a portion of the portfolio and is extremely time consuming."
Id.
(1061) See, e.g., EXCHANGE OF INTEREST-ONLY AND PRINCIPAL-ONLY SECURITIES FOR A
MORTGAGE-BACKED SECURITY, Emerging Issues Task Force of the Fin. Accounting
Standards Bd. Issue No. 90-2 (Mar. 1990) (nullified by ACCOUNTING FOR
TRANSFERS AND SERVICING OF FINANCIAL ASSETS AND EXTINGUISHMENTS OF
LIABILITIES, Statement of Fin. Accounting Standards No. 125 (Fin.
Accounting Standards Bd. Jun. 1996)) (addressing accounting by an investor
who exchanges IO and PO MBS with issuing trust for MBS); see also
TRANSACTIONS INVOLVING SPECIAL-PURPOSE ENTITIES, Fin. Accounting Standards
Bd. Staff Position Topic D-14 (Fin. Accounting Standards Bd. 1989) (setting
forth conditions that must be met in order to allow transferor to avoid
consolidating trust; consolidation of trust would require transferor to
account for transferred financial assets in same manner as it did before
transfer) (nullified by CONSOLIDATION OF VARIABLE INTEREST ENTITIES - AN
279
partially motivated by a desire to avoid recognizing impairments on its IO MBS,
a requirement that would have resulted from increased mortgage
prepayments.(1062) Contemporaneous documentation indicates that Fannie Mae
considered approaching KPMG as early as September 5, 1995, because of concerns
over potential impairment charges.(1063) A document entitled "IO/REMIC Package
Briefing for Tim Howard" ("IO/REMIC Briefing"), stated the following:
Financial Standards performed impairment testing on the IO portfolio
in the fall of 1995 and determined that many of the IO's were either
impaired or close to being impaired.
To mitigate the potential earnings risk, Fannie Mae linked the IO's
with specific REMICs that were purchased at the
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INTERPRETATION OF ARB NO. 51, Fin. Accounting Standards Bd. FIN 46(R) (Fin.
Accounting Standards Bd. 2003).
(1062) See Rajappa Memo at FMSE-IR 213735. Rajappa noted:
As a first pass to estimate the impairment trigger point,
Portfolio Management used the groupings of IO securities utilized
in their periodic mark-to-market calculations. The expected cash
flows of these groupings from the April 30 IO portfolio,
discounted at a risk-free interest rate (using a June 14 Treasury
yield curve) across multiple interest rate scenarios within ALMS,
was $544 million. Although there is a $20 million cushion above
the impairment trigger, I believe we need to monitor closely this
portfolio in light of the effect that changes in interest rates
can have on IO values. In addition, I understand that Portfolio
Management plans to value the IO portfolio on an individual
security basis beginning this month.
Id.
(1063) See Mem. from R. DePetris to T. Lawler, et al., dated Sept. 5, 1995,
FMSE-IR 213731-32, at FMSE-IR 213731. This memorandum summarized a
discussion regarding "IO impairment and yield recalculation." Id. DePetris
stated that "Portfolio management will redo the July 31 risk-free rate
impairment schedule using projected CPRs that are more consistent with our
internal prepayment model." Id. At some point after that update, the group
planned to "meet with the appropriate representatives from Peat Marwick
[KPMG] to discuss our position that measuring impairment for our IO
securities without evaluating changes in value of the assets bought in
combination with those IOs does not make sense." Id.
280
same time and were looked at together in the decision to purchase the
securities.(1064)
Management analyzed its IO MBS investments on an individual security
basis later in 1995, using a methodology that appears to have been consistent
with the guidance in EITF 93-18.(1065) The analysis suggested that a write-down
of $29.2 million was required due to impairment.(1066) Based on our review of
the Company's 1995 financial statements, however, it does not appear that
management recognized the write-down.
In addition to the IO/REMIC combinations created in 1995, management
also accounted for seven pairs of IO and principal only ("PO") securities
acquired between 1999 and 2002 on a combined basis, using the conclusions
reached in 1999 as support for that accounting treatment.(1067) The Company's
accounting for combinations of IO MBS and PO MBS was subject to the provisions
of FASB Statement No. 125, which requires a transfer of a financial asset as a
precondition to changing the accounting for that asset. But, as with the prior
combinations, Fannie Mae did not transfer its IO MBS and PO MBS and therefore
should not have accounted for the separate securities as if there had been a
transfer.(1068)
2. Discussions with KPMG
As noted above, management discussed its plan to combine IO MBS with
other securities with KPMG in November 1995. KPMG concurred with Fannie Mae's
combined IO accounting. Management's rationale for this plan was most clearly
set forth in a November 27, 1995, draft memorandum from Richard DePetris, then
Director--Financial Standards:
The purpose of this memo is to document the discussion at last week's
meeting relating to Fannie Mae's purchase of
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(1064) IO/REMIC Briefing at FMSE-SP 86636 (emphasis added).
(1065) EITF 93-18 paras. 4-5.
(1066) See Interest Income Impact, dated Nov. 9, 1995, FMSE-IR 213694-98, at
FMSE-IR 213694. The document analyzed the effect on net interest income of
writing down the impaired IO MBS and adjusting the yield as required by
EITF 89-4 on the remaining securities. Id.
(1067) See Draft letter from J. Boyles to John James, dated Oct. 28, 2004,
Zantaz document 796794, at 1.
(1068) See ACCOUNTING FOR TRANSFERS AND SERVICING OF FINANCIAL ASSETS AND
EXTINGUISHMENTS OF LIABILITIES, Statement of Fin. Accounting Standards No.
125 (Fin. Accounting Standards Bd. 1996) (hereinafter "FAS 125").
281
interest-only securities in combination with other mortgage-backed
securities that, together, have the characteristics of MBS collateral.
1. We explained we do not buy IOs in isolation but as held-to-maturity
assets with other securities (e.g., POs, standard MBS, and PAC or
sequential REMIC bonds) as a package . . . .
2. We agreed that the only accounting guidance related to
recombinations of securities was EITF 90-2 that deals with exchanges
of POs and IOs from the same trust and requires recording the
recombined security at fair value. No existing accounting literature
specifically addresses combining securities from different trusts.
3. Peat Marwick [KPMG] agreed that, in substance, buying separate IO
and PO securities, even if from different trusts, was similar to
buying a REMIC tranche or security issued through a trust that is
backed by the same IO and PO securities, particularly since Fannie Mae
has the ability to form a trust with the individual securities as
collateral.
4. Because we have purchased and monitor market performance of the
securities bought as a package in terms of the combined cash flows,
Peat Marwick [KPMG] agreed with us that substance could prevail over
form in evaluating and accounting for these securities, whether or not
the securities were put in a trust at purchase or subsequently.
5. Because Fannie Mae will recover its investment in the "effective"
security produced by combining the cash flows of the IOs and other
MBS, it would not fall within the definition of a high-risk security
in EITF 89-4 nor the provisions in the Exposure Draft on transfers and
securitization of financial assets [FAS 125] dealing with financial
assets subject to prepayment. Therefore, the "effective" security may
be included in the held-to-maturity classification and the principal
balance is not subject to writedown due to prepayments.(1069)
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(1069) Draft mem. from R. DePetris to T. Lawler, S. Rajappa, D. Cohen, J. Parks,
L. Spencer, Thanasis Simos and KPMG, dated Nov. 27, 1995, FMSE-IR
213933-34, at FMSE-IR 213933. We disagree with KPMG's advice to Fannie Mae.
Acquiring an IO MBS and a PO MBS from different trusts is not the same as
purchasing a REMIC security because of the possibility that the mortgages
underlying the IO
282
KPMG was copied on this memorandum, and we have confirmed that a copy of this
document is in KPMG's files. What is not clear from this memorandum is whether
management discussed with KPMG its motive behind the combined accounting, that
is, management's desire to avoid impairment write-downs. We understand that Ken
Russell of KPMG may have been consulted on this matter in his role as a member
of KPMG's Department of Professional Practice. Russell agreed that the
accounting for the proposed combinations was a matter of substance over form.
3. The Internal Policy for the Acquisition of IO MBS
In March 1996, management drafted a policy to implement its accounting
for IO MBS. In a draft memorandum from that month, Sam Rajappa, then Controller,
discussed the Company's acquisition of synthetic MBS:
Fannie Mae's policy is not to purchase interest-only securities (IOs)
as individual investments but purchase them with the intention of
achieving a desired yield or other investment characteristic through
the combination with other securities to form a "synthetic MBS."
In Fall 1995, we obtained KPMG Peat Marwick's concurrence that a trust
structure, similar to those for MBS, would not be necessary for these
synthetic MBS to receive MBS accounting.
In December 1995, all securities purchased in combination with IOs
were identified and formed into 56 synthetic MBS. During January 1996,
these synthetic MBS were transferred to separate pool types in PITS,
and are not accounted for as MBS as opposed to each component in the
synthetic MBS receiving separate accounting treatment.(1070)
The memorandum also set forth the following policy for purchasing synthetic MBS:
Synthetic MBS generally can only be formed using securities that were
purchased on the same day as the IO security, however, exceptions can
be made if there is documentation explaining the reasons for the
securities
- ----------
MBS and PO MBS will not prepay at the same rate. Furthermore, although
Fannie Mae had the ability to form a trust, it would have been required to
sell an interest in the trust to one or more third parties to avoid
consolidating the trust and unwinding the desired accounting.
(1070) Draft mem. from S. Rajappa to T. Lawler, L. Spencer, et al., dated Mar.
25, 1996, FMSE-IR 213556-58, at FMSE-IR 213557.
283
being purchased on different days and prior approval by the SVP -
Portfolio Management. Purchasing IO securities with the intention of
matching them with flow business is prohibited. (Note: Settlement
dates can vary by up to one month.) . . .
Synthetic MBS that have a significant premium run the risk of being
treated as a high-risk investment and marked-to-market through equity,
or potentially through earnings if impaired. Because of this risk, the
formation of premium Synthetic MBS must be approved by the Senior Vice
President - Portfolio Management.(1071)
Fannie Mae issued the policy as a final document on April 10, 1996.(1072)
In a March 26, 1996 e-mail exchange between Boyles and Parks, then
Controller--Multifamily (formerly Vice President--Financial Standards), Parks
suggested revising the draft policy to "provide a guideline as to what is
considered 'significant MBS [premium].'"(1073) In response, Boyles suggested
leaving the definition intentionally vague for fear of running afoul of FAS 125:
We left the wording about what constitutes 'significant premium'
purposely vague because if we were to specify 25 percent or 15 percent
as significant premium, someone (peat) may come along and force
several of our packages into an AFS category. If you remember, we had
several packages with premiums over 50 percent. By leaving it vague
and requiring SVP sign-off on any premium securities on new packages,
we hope to eliminate the problem going forward.(1074)
Boyles did not have any specific recollection of this e-mail exchange, stating
only that Fannie Mae had defined "significant premium" to mean a premium in
excess of twenty
- ----------
(1071) Id. at FMSE-IR 213557-58.
(1072) See Mem. from S. Rajappa to Distribution, dated Apr. 10, 1996, FMSE-IR
213554-55.
(1073) E-mail from J. Boyles to J. Parks, dated Apr. 3, 1996, FMSE-IR 213559-60,
at FMSE-IR 213560. Under paragraph 14 of FAS 125, an investment that could
be prepaid so the holder would not recover substantially all of the
carrying amount should be classified as an available-for-sale ("AFS") or
trading security and recorded at fair value. FAS 125 P 14.
(1074) Id. at FMSE-IR 213559 (emphasis added).
284
percent.(1075) Boyles's e-mail showed his recognition that the combined
accounting was an aggressive interpretation that might be challenged by KPMG,
and also demonstrated his willingness to obscure the facts from KPMG.
4. Subsequent Accounting for Synthetic MBS
Fannie Mae accounted for its synthetic MBS in the same manner as it
accounted for REMICs. That is, because of system limitations, management used
the sum-of-the-years's digits ("SYD") method to amortize premium or discount on
its REMIC and synthetic MBS securities, rather than level yield accounting
required under FAS 91.(1076) As recounted in the IO/REMIC Briefing:
These "packages" [the synthetic MBS] were then given 15 year SYD
tables for the amortization of the premium based on our analysis of
the projected cash flows at the end of 1995. The 15-SYD table was used
because we believed it was a close proxy for level yield accounting.
We were unable to use level yield accounting because of systems
constraints.(1077)
By 1998, the use of the fifteen-year SYD table had resulted in a
significant under-amortization of "premium" associated with the synthetic MBS.
According to the IO/REMIC Briefing for Howard:
We reevaluated the packages in the fall of 1996 and determined we had
under-amortized premium into earnings by approximately $28 million.
This was because rates had dropped since the time of the original
analysis. The working group decided that no action should be taken but
that we would continue to monitor the problem and conduct a detailed
analysis annually.
Over the past several months, we again took a look at how these
packages are performing and found that we had under-amortized premium
into earnings by over $50 million. In addition, our analysis revealed
that several of the REMICs linked to IO's are expected to mature in
the near future leaving only an IO security in the package. We also
found that several packages now had such significant
- ----------
(1075) Boyles also stated that he left the decision on how to define significant
premium to Lawler because he felt it was a business decision.
(1076) See supra Chapter IV.
(1077) IO/REMIC Briefing at FMSE-SP 86636.
285
premiums associated with them that they should be classified as
available for sale.(1078)
In fact documents show that by December 1998, the under-amortization had
increased to approximately $180 million.(1079)
As noted above, KPMG generally was aware of the Company's catch-up
position (and in fact concluded that Fannie Mae's failure to record all of the
catch-up in 1998 was in error, posting the unrecorded catch-up to its summary of
unadjusted errors).(1080) Further, KPMG was consulted in 1995 about combining IO
and other securities; however, evidence showed that the information about
management's accounting for IO MBS as of 1998, and the impaired status of the
combinations, were kept from KPMG. As stated in the IO/REMIC Briefing:
KPMG has apparently forgotten about these [synthetic MBS]
transactions, and we have not brought these issues to their attention.
They have experienced significant turnover since we originally adopted
the "package" accounting and, as a result, there is currently only one
member of the audit team that remaining [sic] from the fall of 1995.
The accounting team they currently have on the audit is more
technically proficient, and if they stumble across these packages, may
not be as easily convinced of the current accounting treatment. We
have made every effort to keep our analysis confidential.(1081)
Boyles did not recall preparing the IO/REMIC Briefing document, but acknowledged
that the electronic user identification associated with the document was his,
and that he had no reason to dispute the assertion that he was the author.
Although Boyles was emphatic that he did not withhold information from KPMG,
both the fact that the document was found on Boyles's hard drive and his
inability to explain who else could have prepared this document made it
difficult to credit Boyles in this regard.
- ----------
(1078) Id. (emphasis added).
(1079) See, e.g., Fannie Mae Catch-up Summary, dated Jan. 8, 1999, FNMSEC 2677.
Management's error in its accounting for IO MBS contributed materially to
the amount of the catch-up computed at the end of 1998, a portion of which
was recognized by the Company in its 1998
(1080) Fannie Mae, 1998 Annual Report, at 63 (1999), available at
http://www.fanniemae.com/global/pdf/ir/annualreport/1998/fullreport.pdf.
(1081) IO/REMIC Briefing at FMSE-SP 86636-37 (emphasis added).
286
Moreover, an e-mail dated January 28, 2002, from Spencer to Howard
regarding "KPMG and Freddie," on which Boyles was copied, provided further
evidence of management's awareness that information about the manner in which
Fannie Mae accounted for IO MBS had been kept from KPMG.(1082) Spencer wrote:
"There is at least one thing that we know of where we have a favorable
accounting treatment and that is on the IO's we have on our books. Freddie is
doing IO accounting and we are not. KPMG has not figured that out - but Jonathan
reminded me of this."(1083) Accordingly, we conclude that Boyles did, in fact,
withhold information from KPMG with respect to the impairment of IO/REMIC
combinations and that Howard and Spencer were aware of this fact.
III. FINDINGS
A. Management's Disclosures About Accounting for IO MBS to the Board of
Directors or its Committees
We have found no evidence that management communicated its manner of,
or motive for, IO MBS accounting to the Board or any of its committees prior to
January 2004. Moreover, when management did provide information about its IO MBS
accounting methodology to the Audit Committee in a January 2004 presentation, it
failed to disclose the Company's accounting methods fully.
The January 2004 presentation to the Audit Committee was in response
to the Audit Committee's direction to management to determine whether any of the
issues identified in Freddie Mac's restatement were applicable to Fannie Mae.
(1084) Financial Standards prepared a matrix that identified the accounting
issues discussed in the Freddie Mac restatement, the effect on Freddie Mac of
the restatement (both in cumulative earnings impact as well as the restated
accounting), whether Fannie Mae had similar issues, and whether the Freddie Mac
restatement raised concerns for Fannie Mae's own accounting practices. (1085) In
this matrix, management made the following statements about Freddie Mac's
accounting for IO securities:
Freddie Mac invests in IO securities and during the restatement
process they determined that they had not been properly applying
impairment accounting for these securities. This error arose because
they did not have a
- ----------
(1082) See E-mail from L. Spencer to T. Howard, dated Jan. 28, 2002, FMSE
487130.
(1083) Id. (emphasis added).
(1084) See Audit Committee Update: Understanding Freddie Mac's Accounting
Restatement as It Affects Fannie Mae, dated Jan. 23, 2004, FMSE-IR
378611-23.
(1085) See Review of Accounting Issues Related to Freddie Mac's Earnings
Restatement, dated Jan. 14, 2004, Zantaz document 289451.
287
complete population of IO securities due to the following four issues.
. . . Freddie Mac combined IO securities with other securities in a
trust and accounted for the combined as a security under FAS 115 even
though they owned all or substantially all of the new
securitization.(1086)
In the matrix, Financial Standards then made the following incomplete
representation to the Audit Committee about its own IO MBS accounting:
We have also combined an IO security with discount MBS (WAMU)
transaction and put them into a security. We sold off 10 percent of
the security so that we would not have to consolidate the IO back onto
our books. It appears that because Freddie Mac owned all or
substantially all of the resulting security they had to consolidate
this structure, which was exactly what we were trying to avoid. It
appears their accounting agrees with how we thought these deals would
work . . . .
On occasion we have simultaneously purchased an IO security along with
the matching PO security and accounted for them as a combined security
similar to [Freddie Mac's] transaction regarding linked swaps
described above. It appears [Freddie Mac] [has] reached the same
conclusion [that the individual IO and PO securities purchased
simultaneously should be accounted for as a combined security] as we
have.(1087)
Financial Standards' presentation suggested to the Board that Fannie Mae's IO
MBS accounting should be of no concern to the Board.
The statement in the first paragraph was incomplete because it omitted
information about the Company's synthetic MBS dating back to 1995, which would
have notified the Board that the Company's accounting was even less defensible
than the accounting Freddie Mac was restating. Moreover, the discussion in the
second paragraph may have given the Board unwarranted comfort. According to
Boyles, Freddie Mac's securitization program is substantially different in
structure than Fannie Mae's. Those differences were cited by management as
support for differences in how the companies accounted for buy-up fees, but were
ignored in this circumstance.
- ----------
(1086) Id. at 11.
(1087) Id. at 11-13.
288
April 2004, after OFHEO and Deloitte & Touche raised questions about
the accounting for synthetic MBS, management finally informed the Audit
Committee that its accounting for IO MBS was a potential issue. The
second-to-last slide in a presentation to the Audit Committee in April
indicated, "OFHEO has questioned our practice of bundling for accounting
purposes interest-only (IO) with principal-only (PO) securities or other
securities."(1088) The minutes did not provide any further information on the
details that may have been presented to the Audit Committee.(1089)
B. Discussions with the SEC Regarding Accounting for IO MBS
After OFHEO raised the Company's synthetic MBS accounting as an issue
in the Special Examination, management chose to address this issue directly with
the SEC. As part of its preclearance letter to the SEC regarding Fannie Mae's
policy for measuring and recognizing other-than-temporary impairments of
investment securities, management asked the SEC:
May a company that purchases an IO security and a PO security account
for them on a combined basis - if: (1) the IO and PO have the same
notional amount; (2) the IO and PO are issued by the same
counterparty; (3) the purchaser retains a unilateral right to
reconstitute the IO and PO and obtain the underlying MBS collateral;
(4) the two were purchased in contemplation of each other; and (5) the
economics of owning the IO and PO are identical to owning the
collateral that underlies them both?(1090)
The fact pattern in this letter, however, presented a "best" case
scenario and omitted any information about the actual combinations that were
formed by Fannie Mae in 1995. When asked why Fannie Mae chose to use the above
fact pattern in its letter to the SEC rather than describing the synthetic MBS
arrangements in place since 1995, Boyles explained that the Company wanted to
address what it considered to be the "best" case, on the theory that if it could
not persuade the SEC that combined accounting was appropriate in the "best"
case, it would not be able to convince the SEC of the accounting for the
synthetic MBS.
- ----------
(1088) Audit Committee Briefing: Impairment Policies and Practices and Update on
Special Exam, dated Apr. 19, 2004, Zantaz document 808283, at 14.
(1089) See Minutes of the Meeting of the Audit Committee of the Board of
Directors of Fannie Mae, dated Apr. 19, 2004, FMSE 504838-46.
(1090) Letter from J. Boyles to Donald T. Nicolaisen, dated Apr. 28, 2004,
FMSE-IR 483271-82, at FMSE-IR 483279.
289
Boyles also stated that he likely mentioned the existence of the
synthetic MBS in a conference call with the SEC. His recollection is supported
by an e-mail dated November 3, 2004, from Boyles to the SEC, stating:
I already described what this schedule shows . . . . Keep in mind the
Post 1996 IO's are being recombined into MBS and the Pre-1996 IO's are
being sold and we've taken the necessary writedowns to their market
value (about $7 million) in the third quarter to reflect our intention
to sell in the fourth quarter.(1091)
Attached to the e-mail was a spreadsheet showing the notional amounts of the
pre-1996 and post-1996 IOs, along with average price information and estimates
of the book value of the IOs as of December 31, 2001, 2002, and 2003, and
September 30, 2004.(1092)
The SEC ultimately concluded that Fannie Mae should account for the IO
and PO securities described in its preclearance letter on a separate basis until
it exchanged those separate securities for a mortgage-backed security.(1093) The
SEC apparently did not object to Fannie Mae's proposal to apply the proper
accounting to its IO MBS prospectively, that is, the SEC did not require the
Company to restate prior periods to correct the error.(1094) The SEC also did
not object to Fannie Mae's proposal to determine the carrying amounts for the
separate IO and PO components by performing a relative fair value calculation
and allocating the carrying amount of the combined instrument based on those
relative fair values.(1095) Boyles had advised the SEC that Fannie Mae had to
allocate the carrying amount of the combined instrument to the individual
components because the Company did not have records that reflected those
individual components.(1096)
IV. CONCLUSIONS
Based on our review of the facts, we conclude that:
- ----------
(1091) E-mail from J. Boyles to J. James, dated Nov. 3, 2004, Zantaz document
796557.
(1092) See Undated Pre/Post 1996 Notional IOs spreadsheet, Zantaz document
796560, at 1-2.
(1093) See Letter from J. Boyles to J. James, dated Sept. 15, 2004, Zantaz
document 691098, at 1.
(1094) Id.
(1095) Id.
(1096) Id.
290
Management "aggressively interpreted" GAAP when it began accounting
for IO MBS on a combined basis with other securities. In our view, the
accounting violated GAAP. Management's motive behind the IO MBS accounting on a
combined basis was to avoid complying with EITF 93-18, which would have required
recognition of impairment losses.
Notwithstanding the views of management at the time, the accounting
literature governing when it would be appropriate to combine two legally
separate financial instruments was clear. Although EITF 90-2 addressed a fact
pattern involving IO and PO securities issued from the same trust, the consensus
was clear that an exchange transaction was required to take place before the
accounting for the individual IO and PO securities could change. The
authoritative literature recognizes that, in some cases, a specific transaction
may not be covered by an established accounting principle.(1097) In that case,
companies should account for the transaction by reference to an established
accounting principle that applies to an analogous transaction. In the current
circumstance, EITF 90-2 addressed an analogous situation and should have been
applied by Fannie Mae to the accounting for its synthetic MBS. Furthermore, FAS
125 provided explicit guidance on what conditions must be met to derecognize a
financial asset. This guidance applied to Fannie Mae's accounting for IO and PO
securities that it "combined" and treated as an MBS.(1098) Among other
conditions, FAS 125 requires a transfer of the financial assets for a company to
be able to derecognize those assets.(1099) As with its combination of IO and
REMIC securities, Fannie Mae did not transfer the IO and PO securities and thus
did not meet the conditions in FAS 125.
Although management initially obtained KPMG's approval for its
synthetic MBS accounting, it appears that by 1998, management, including Boyles,
had concealed information from KPMG for fear that KPMG might require a change in
the accounting for IO MBS, including recognition of impairment losses. Both
Howard and Spencer were aware of this fact.
Management failed to inform the Board of its methodology for synthetic
MBS until OFHEO raised questions in April 2004.
PART H: SECURITIZATION OF WHOLLY-OWNED MBS
In this section of our Report, we discuss pools of mortgages in which
Fannie Mae came to acquire a 100 percent interest.
- ----------
(1097) See THE MEANING OF PRESENT FAIRLY IN CONFORMITY WITH GENERALLY ACCEPTED
ACCOUNTING PRINCIPLES, FOR NONGOVERNMENTAL ENTITIES, Amendment to Statement
on Auditing Standards No. 69 P .09, (Am. Inst. of Certified Pub.
Accountants 2005).
(1098) See FAS 125 PP 9, 10(a), 11(a)-(b), 12.
(1099) Id.
291
I. INTRODUCTION
In its February 11, 2005 letter to Stephen B. Ashley, OFHEO raised
concerns regarding Fannie Mae's treatment of MBS in which the Company came to
own 100 percent of the certificates in a trust.(1100) In that circumstance,
Fannie Mae continued to report its investment in the MBS as a security. The
issue OFHEO raised was whether Fannie Mae was required to consolidate the trust,
thereby recognizing the mortgage loans underlying the security.(1101) We discuss
below OFHEO's concerns regarding Fannie Mae's approach to the consolidation
issue, the relevant accounting literature, and the facts we uncovered in the
course of our review.
Our conclusion is that the Company's accounting in this area, although
designed to avoid the need to consolidate the loans onto its balance sheet, was
the result of an inadvertent misapplication of the accounting literature. The
Company's accounting based on the misapplication was reversed after Financial
Standards learned of its mistake and corrected the Company's accounting policy.
Securities Accounting then assessed the impact of the error on the Company's
financial statements and determined that impact to be immaterial. We understand
that Fannie Mae is reviewing the latter conclusion as part of its restatement
effort.
II. BACKGROUND
A. Accounting Literature on Consolidation
In the normal course of its business, Fannie Mae issues guarantees to
holders of securities backed by pools of mortgage loans. In a majority of its
securitization transactions (referred to as "lender swap transactions"), lenders
transfer pools of mortgage loans meeting certain criteria to trusts that Fannie
Mae establishes and for which it serves as trustee. The lenders usually receive
a certificate (the MBS) evidencing the right to receive the cash flows from the
underlying loans, less a guaranty fee retained by Fannie Mae. If the cash flows
from the underlying mortgages are not sufficient to meet scheduled principal and
interest payments due to the certificate holder, the Company makes up any
deficiency under the terms of its guaranty. Under accounting literature that
became effective in 2003, the Company records the fair value of the guaranty
liability on its balance sheet as a liability on issuance of the certificate; it
subsequently recognizes an additional liability for probable losses it will be
required to absorb under its guaranty.
- ----------
(1100) See February 11, 2005 OFHEO Letter, FMSE-IR 547318-30.
(1101) Id. at FMSE-IR 547329.
292
An interpretation issued by the FASB in January 2003 provides guidance
on when consolidation of entities meeting certain conditions is required.(1102)
FIN 46 provides a scope exclusion for entities that meet the FAS 140 definition
of a Qualifying Special Purpose Entity ("QSPE").(1103) The results of this
determination can be significant, as the accounting for loans and securities is
not identical in all circumstances.
FIN 46 governs the consolidation of the Fannie Mae trusts. Under FIN
46's scope exclusion, Fannie Mae is not required to consolidate the trust and
its underlying loans if the trust is a QSPE.(1104) The requirements for QSPE
status are addressed in FAS 140 and include a two-part test.(1105) First, the
trust "cannot be unilaterally dissolved by the transferor, its affiliates, or
its agents."(1106) Second, the trust must satisfy one of two conditions: (a) at
least ten percent of the fair value of the trust certificates must be held by
third parties, or (b) the transfer of the loans must be a "guaranteed mortgage
securitization" ("GMS").(1107) FAS 140 defines a GMS as "a securitization of
mortgage loans that . . . includes a substantive guaranty of a third
party."(1108)
Fannie Mae treats the securitization of pools of loans under the
lender swap program as GMSs. To the extent that no party has the unilateral
ability to dissolve the trust underlying the MBS, then the trusts are QSPEs
(assuming other conditions are met).
B. OFHEO's Concerns
In the February 11 OFHEO Letter, OFHEO noted that, in certain
circumstances, Fannie Mae acquired ownership of 100 percent of the certificates
in a
- ----------
(1102) See CONSOLIDATION OF VARIABLE INTEREST ENTITIES: AN INTERPRETATION OF ARB
NO. 51, FASB Interpretation No. 46 (Fin. Accounting Standards Bd. Jan.
2003) (hereinafter "FIN 46").
(1103) See id. P 4.
(1104) See id.
(1105) See ACCOUNTING FOR TRANSFERS AND SERVICING OF FINANCIAL ASSETS AND
EXTINGUISHMENTS OF LIABILITIES (A REPLACEMENT OF FAS STATEMENT NO. 125),
Statement of Fin. Accounting Standards No. 140 (Fin. Accounting Standards
Bd. 2000) (hereinafter "FAS 140").
(1106) See id. P 36.
(1107) See id.
(1108) See id. P 364.
293
mortgage-backed security.(1109) Moreover, according to OFHEO, Fannie Mae's
accounting policy stated that ownership of 100 percent of a mortgage-backed
security gives Fannie Mae the unilateral right to dissolve the underlying
pool.(1110) OFHEO cited two approaches that the Company had taken to address
"potential consolidation problems" associated with wholly-owned MBS.(1111)
According to OFHEO: "These solutions were to transfer wholly owned pools of
securities from AFS ["available-for-sale"] to HTM ["held-to-maturity"] or to
sell 1% of the wholly owned pool to a third party."(1112) OFHEO observed that
Fannie Mae "also developed a process of forming 'mega pools', the collateral of
which is comprised of multiple wholly owned pools, so that the sale of 1% of the
'mega pool' could solve the consolidation issue."(1113)
OFHEO raised concerns regarding the Company's determination that it
could avoid consolidation of the trust either through the sale of a one percent
interest in a mega pool or by reclassifying securities from AFS to HTM.(1114)
According to OFHEO, "it appears that the Enterprise has created accounting
policies related to its MBS pool activities whose primary purpose is to avoid
consolidation."(1115)
C. The Company's Approach to Consolidation
Fannie Mae considered the effect of FIN 46 and the consolidation issue
during the first half of 2003. An undated document entitled "Portfolio AFS Whole
Pool Movement Analysis, Draft v.2" identified the two strategies noted in the
February 11 OFHEO Letter as strategies that could be used as part of a quarterly
FIN 46 "clean-up" process.(1116) The document outlined several strategies and
stated that "[s]elling as little as 1% of a pool, including newly formed mega
pools, is enough to satisfy the requirement of
- ----------
(1109) February 11 OFHEO Letter at FMSE-IR 547329.
(1110) Id.
(1111) Id.
(1112) Id.
(1113) Id.
(1114) Id.
(1115) Id.
(1116) See Portfolio AFS Whole Pool Movement Analysis, Draft v.2, dated May 27,
2003, FMSE 81258-59.
294
not having control of the security."(1117) The document also discussed
"[m]ovements from AFS to HTM" as another mechanism "to ensure compliance."(1118)
A document dated the following month captioned "Whole Pools Update"
provides further background on the Company's deliberations.(1119) It stated that
a number of different options for addressing the consolidation issue had been
considered and "[s]enior management settled on a combination" of three
strategies: (1) move pieces of whole pools that had slow prepayment rates from
AFS to HTM; (2) "sell 1% of the average prepaying whole pools with balances in
AFS in the form of megas"; and (3) sell AFS securities that prepay
quickly.(1120) The document further indicated that, by that time, the Company
had created and sold interests in four megas; that it had sold "100% of the fast
prepaying AFS to the street"; and that the Company planned to redesignate MBS
with an aggregate balance of $7.2 billion from AFS to HTM.(1121) The FIN 46
"clean-up" process in future months "may include" additional redesignations of
securities from AFS to HTM, sales of AFS securities, and/or the formation of
megas.(1122)
Fannie Mae finalized its accounting policy with respect to FIN 46
consolidation and the clean-up strategies during the second half of 2003. A
draft policy memorandum prepared by Paul Salfi and Angela Hairston of Financial
Standards opened with two propositions: That a "wholly-owned MBS trust fall[s]
within the scope of FIN 46," and "[a]s owner of 100 percent of the beneficial
interest in an MBS pool and guarantor of the trust, Fannie Mae has the
unilateral ability to dissolve the MBS pool."(1123) The authors concluded that,
in those circumstances, FIN 46 would require consolidation of the trusts.(1124)
The draft policy addressed two of the options the Company had chosen
for addressing the consolidation issue. These options "involve either a)
transferring the securities from AFS to HTM or b) selling a portion of the pool
to give up control so that
- ----------
(1117) Id. at FMSE 81258.
(1118) Id.
(1119) See Whole Pools Update, dated Jun. 19, 2003, FMSE 60777-80.
(1120) Id. at 60777.
(1121) Id. at 60778.
(1122) Id. at 60779.
(1123) Draft mem. from Paul Salfi and Angela Hairston to Andrew McCormick, dated
July 2, 2003, FMSE-E 380523-27, at FMSE-E 380523.
(1124) Id.
295
we are not required to consolidate."(1125) Jonathan Boyles stated during an
interview that selling a portion of the pool meant selling at least one percent.
In his view, the sale of any interest in the megas would preclude the Company's
unilateral ability to alter the trusts, but he believed that a one percent
minimum threshold was advisable.
As to the redesignation of AFS to HTM, a later draft of the same
memorandum stated that the redesignation would make consolidation
unnecessary.(1126) It reasoned that because the accounting for HTM securities
and held-for-investment ("HFI") loans are similar,(1127) the amounts recorded
would be the same regardless of whether Fannie Mae consolidated and recorded the
value of the underlying HFI loans or recorded the value of the HTM
securities.(1128) In addition, the Company "would continue to reflect a guaranty
liability for MBS on our balance sheet."(1129) In these circumstances, the
memorandum concluded, "consolidation of the loans underlying wholly-owned HTM
MBS pools would not affect Fannie Mae's financial position" and therefore "it
would not be meaningful to the reader of our financial statements if we
reclassed the [HTM] MBS to whole loans."(1130)
With regard to the creation of mega pools, this draft memorandum
incorporated the conclusion from the previous draft that, upon sale of a portion
of the mega pools, Fannie Mae would not have the unilateral ability to dissolve
a trust.(1131) The final version of the policy, signed by Hairston and addressed
to Leanne G. Spencer, was dated October 6, 2003.(1132) In substance, it was the
same as the July 30 draft memorandum.
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(1125) Id. at FMSE-E 380524. The draft did not address the third option of
selling outright pools that prepaid quickly, as outlined in the June 19
Whole Pools Update memorandum.
(1126) See Draft mem. from A. Hairston to Leanne G. Spencer, dated Jul. 30,
2003, FMSE-IR 710015-18, at FMSE-IR 710016.
(1127) HTM securities and HFI loans are carried at amortized historical cost.
HFS loans, by contrast, are recorded at the lower of historical cost or
market, with adjustments recorded in income.
(1128) See Draft mem. from A. Hairston to L. Spencer, dated Jul. 30, 2003,
FMSE-IR 710015-18, at FMSE-IR 710016.
(1129) Id.
(1130) Id.
(1131) Id. at FMSE-IR 710017.
(1132) See Mem. from A. Hairston to L. Spencer, dated Oct. 6, 2003, FMSE
81253-57.
296
In early 2004, another accountant in Financial Standards, Jennifer
Liner, was assigned to work on the accounting for a transaction that also raised
issues under FIN 46 and the QSPE scope exception. Liner stated that, in the
course of her work on that transaction, she had reviewed Fannie Mae's accounting
policies on the subject. She also stated that she discussed certain issues with
the FASB staff.(1133) In particular, Liner asked whether the securitization of
MBS would be considered a GMS as defined by FAS 140.(1134) The FASB staff
responded in the negative.(1135) Liner subsequently described the conversation
in a new accounting policy; referring to FAS 140's definition of a GMS as "a
securitization of mortgage loans," the FASB staff opined that a GMS "only
applies to loans securitized into securities, not resecuritizations of
securities," as in the case of a mega.(1136) It appears that Liner presented
this reasoning to the FASB staff and the staff did not disagree.
Liner reported her discussion to others in the Controller's
Office(1137) and began to prepare the new policy regarding wholly-owned MBS. The
new policy, dated November 2, 2004, addressed both the mega pools issue and the
effect of redesignation of MBS from AFS to HTM on the requirement that the
Company consolidate the trusts.(1138)
As to the megas, Liner wrote that the Company had "viewed these as
guaranteed mortgage securitizations since the underlying securities going into
the [mega] are (or were believed to be) guaranteed mortgage securitizations, and
the Trust is just a pass-through entity."(1139) She noted the FASB staff's
concurrence with her conclusion
- ----------
(1133) E-mail from Jennifer Liner to Vickie Lusniak, dated Aug. 12, 2004, Zantaz
document 1048922.
(1134) Id.
(1135) Id.
(1136) Mem. from J. Liner to Distribution, dated Nov. 2, 2004, FMSE-IR
357892-902, at FMSE-IR 357893 n.4 (hereinafter "Liner Mem.").
(1137) See E-mail from J. Liner to Jonathan Boyles, et al., dated Aug. 13, 2004,
Zantaz document 1048922, at 1 ("[W]e confirmed with FASB that a guaranteed
mortgage securitization only includes securitization of loans to
securities, not securities to securities").
(1138) See Liner Mem. In connection with the discussion of megas, Liner also
considered similar issues raised in other types of pools, such as PPS pools
and portfolio REMICs. PPS pools are like megas, but rather than receiving
and securitizing a pool created by another party, Fannie Mae creates the
pool itself from loans that it acquires for its portfolio. A Portfolio
REMIC is a similar structure, but the resulting trusts have different
tranches; security holders acquire an interest in a particular tranche of
the trust. Id. at FMSE-IR 357892-93.
(1139) Id. at FMSE-IR 357894.
297
that "[m]egas are resecuritizations of securities (rather than loans), therefore
they do not meet the definition of guaranteed mortgage securitization in FAS
140."(1140) In order to be a QSPE and avoid consolidation, therefore, "we must
sell at least 10 percent of the fair value of the beneficial interest in the
Trust to third parties and 10 percent of the fair value of the beneficial
interests in the Trust must be held by third parties throughout the life of the
Trust."(1141) Liner concluded that the megas would be subject to consolidation
under FIN 46.(1142)
As to the redesignation of securities from AFS to HTM, Liner's
analysis acknowledged that the accounting for the HTM securities and HFI loans
is the same, at least with respect to each being recorded at its amortized
cost.(1143) She also acknowledged the fact that Fannie Mae reports its guaranty
of the MBS as a liability, which would be inconsistent with consolidation of the
loans on the Company's balance sheet (that is, Fannie Mae could not record a
liability to itself).(1144) She concluded that FIN 46 required consolidation of
the pools and that, following consolidation, the guaranty should be reported as
an allowance for loss associated with the consolidated loans.(1145)
Securities Accounting prepared an analysis of the impact of the error
in the original policy.(1146) The analysis concluded that the transfer of an
interest in the mega pools, which had been recorded as a sale, should have been
recorded as a secured borrowing, since the assets in the mega pools had been (or
should have been) consolidated onto the Company's balance sheet.(1147) According
to Boyles, the Company concluded that it was not required to consolidate the
individual loans into its balance sheet because the MBS were guaranteed mortgage
securitizations and Fannie Mae's transfer of an interest in the megas precluded
unilateral dissolution of the trusts. The
- ----------
(1140) Id.
(1141) Id. at FMSE-IR 357894.
(1142) Id. at FMSE-IR 357895. Liner's reasoning with respect to PPS pools
differed slightly from her reasoning with respect to megas, but the
conclusion was the same. Id. at FMSE-IR 357894-95.
(1143) Id. at FMSE-IR 357896.
(1144) Id. at FMSE-IR 357897.
(1145) Id.
(1146) See Mem. from Chris LeBel to Ilene Topper, dated Nov. 11, 2004, FMSE-IR
357873-76.
(1147) Id. at FMSE-IR 357873-74.
298
analysis concluded that the cumulative impact of the accounting error on the
Company's earnings was $17.9 million.(1148)
According to Salfi, KPMG was aware of the Company's deliberations
regarding the application of FIN 46 during 2003.
III. CONCLUSIONS
Based on the evidence available to us, we agree with OFHEO that Fannie
Mae's focus during the first half of 2003 was on the development of strategies
for avoiding consolidation of its trusts onto its balance sheets. Consolidation
would have had some impact on the Company's balance sheet and income statement.
Boyles also noted that the "clean-up" and, if necessary, consolidation of the
individual mortgage-backed security trusts among the thousands that Fannie Mae
had established would be an enormous undertaking. In his view, therefore, the
Company's concerns were also administrative, and the creation of mega pools and
similar strategies were a means of avoiding that burden.
However, the evidence overall leads us to the conclusion that this
accounting error in the 2003 policy was an inadvertent misapplication of the
accounting literature. As to mega pools, the documentation reveals that Fannie
Mae's accounting team was focused almost exclusively on one issue: that Fannie
Mae's ownership of 100 percent of a trust would give it the unilateral ability
to dissolve the trust, and therefore might preclude treatment of the trust as a
QSPE. It does not appear that the authors of the policy gave much thought to the
separate issue of whether the mega pools (or similar structures) would meet the
second part of the QSPE requirement - particularly, whether the megas would be
considered GMSs. As noted above, they simply operated on the assumption that
they would, because the MBS included in the mega pools were considered GMSs.
The conclusion that the redesignation of securities from AFS to HTM
had the same impact on the Company's balance sheets as consolidation of the
underlying loans was incorrect because loans and securities are presented
separately on the Company's balance sheet. It appears that the authors of the
original policy focused on the similar manner in which HFI loans and HTM
securities are carried. In addition, their approach was consistent with its
treatment of the guaranty as a liability. They do not appear to have considered
the approach Liner devised of reclassifying the guaranty liability as a loan
loss reserve.
Most importantly, Liner addressed the QSPE issue with the FASB staff
in 2004 and, following that conversation, Financial Standards reversed its
previous policy
- ----------
(1148) Id. at FMSE-IR 357874.
299
promptly.(1149) It appears that Liner prepared her new policy memorandum with no
objection from others at the Company and without substantial concern for the
impact it ultimately would have on the Company's financial statements.
PART I: ACCOUNTING FOR INCOME TAX RESERVES AND CERTAIN TAX-ADVANTAGED
TRANSACTIONS
I. INTRODUCTION
In this Part, we discuss issues related to Fannie Mae's accounting for
income tax reserves. Our review centered on the reserves related to tax credits
the Company received from synfuel partnerships and on the tax benefits
associated with certain tax-advantaged transactions known at Fannie Mae as Short
Term Interest Securities ("STIS"). We focused on how Fannie Mae reported tax
contingencies and benefits on its financial statements.
II. BACKGROUND
A. Applicable Authoritative Literature and Principles
Financial Accounting Standards Board ("FASB") Statement No. 5,
Accounting for Contingencies ("FAS 5"), is the governing standard for
recognition of a liability for tax-related contingencies.(1150) Under FAS 5, a
liability for a tax contingency would not be recognized until it is probable
that "a liability had been incurred at the date of the financial statements,"
and the amount of potential loss is reasonably estimated.(1151)
Because certain of Fannie Mae's tax-advantaged transactions created
temporary differences (i.e., differences between the book and tax basis of
assets and liabilities), the Company was also required to follow the
requirements set forth in FASB Statement No. 109, Accounting for Income Taxes
("FAS 109").(1152) FAS 109 sets forth the objectives of accounting for income
taxes, which are to recognize: (1) the amount of taxes payable or refundable for
the current year; and (2) deferred tax liabilities and assets
- ----------
(1149) We do not address the separate question of whether the Company was
required to consolidate the trusts in the period in which it acquired a 100
percent interest in the trust (that is, whether any FIN 46 "clean-up" could
be prospective only).
(1150) ACCOUNTING FOR CONTINGENCIES, Statement of Fin. Accounting Standards No.
5, (Fin. Accounting Standards Bd. 1975).
(1151) See id. P 8. A company may not make an accrual for general or
unspecified business risks, often referred to as "reserves for general
contingencies." See id. P 14.
(1152) ACCOUNTING FOR INCOME TAXES, Statement of Fin. Accounting Standards No.
109, (Fin. Accounting Standards Bd. 1992).
300
for the future tax consequences of events that have been recognized in an
enterprise's financial statements or tax return.
FAS 109 does not define the requisite confidence level that an
enterprise must have to recognize financial statement benefits that result from
a certain tax position. While practice has been mixed, a company was generally
required by its outside auditor to conclude that it was more likely than not
that the company's position would be sustained if challenged in order to
recognize a tax benefit from a tax-advantaged transaction for financial
reporting purposes.
B. Fannie Mae's Accounting for Income Tax Reserves and Tax-Advantaged
Transactions
1. Tax Reserves
(a) Fannie Mae's Process for Determining Amounts in the Tax
Reserve
Interviewees have explained that Fannie Mae's income tax reserve was
reviewed at quarterly meetings. Personnel from Corporate Tax(1153) and the Legal
Department participated in these meetings ("quarterly tax reserve meetings") and
reviewed the tax reserve by discussing the Company's potential or unresolved tax
disputes with the Internal Revenue Service ("IRS"). The group considered the
likelihood that the IRS would prevail in a dispute over each issue and would
reach a consensus as to the percentage likelihood of such loss. Those
percentages were used in turn to compute the amount of a tax reserve for each
item. Minutes were not kept of the quarterly tax reserve meetings.
Although no written policy existed to guide the decisions made at the
quarterly tax reserve meetings, we understand that the participants at these
meetings came to a consensus by considering existing precedent and the degree of
uncertainty surrounding each issue. Corporate Tax Director Lavina Chawla
explained that Legal Department personnel played a pivotal role in the
assessment and would consider factors such as tax law guidance, any perceived
ambiguity in the law, IRS inquiry trends, previous IRS positions, and the
conduct of other companies on similar issues. Carolyn Swift, currently Special
Tax Counsel--Corporate Tax,(1154) explained that Fannie Mae tax attorneys
typically were already familiar with the issues prior to the quarterly tax
reserve meetings, since they likely had discussed them when the Company first
considered entering into the transactions. In addition, Fannie Mae occasionally
asked outside counsel for advice with respect to potential or unresolved tax
disputes.
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(1153) Although there is no formal tax department at Fannie Mae, we refer
collectively to the Company's tax accountants as "Corporate Tax."
(1154) Carolyn Swift was the head of the tax attorney unit from 1989 to 2002.
301
Since recording the tax reserve was ultimately a matter of financial
accounting, after the quarterly tax reserve meetings, the head tax accountant at
the time (either a Director or Vice President in Corporate Tax) would meet with
the Company's Controller to review the decisions made with respect to the tax
reserve at the quarterly tax reserve meetings. We understand that these meetings
took place on a quarterly basis while Leanne G. Spencer served as Controller
from 1999 through 2005, but during Sam Rajappa's tenure as Controller, prior to
1999, these meetings occurred only when tax reserve amounts were significant.
Financial Reporting was responsible for recording the tax reserves after the
meeting with the Controller.
As noted, we interviewed a number of individuals who participated in
the quarterly tax reserve meetings and reviewed documents relating to Fannie
Mae's tax reserve. The process the Company used to establish the reserves was
reasonable. Given the lack of documentation supporting the rationale for tax
reserve determinations, and the fact that the establishment of reserve amounts
depended on the exercise of collective judgment at the time the reserve level
was set, we have not reached any conclusions as to whether the amounts agreed to
at the quarterly tax reserve meetings were reasonable and whether they
represented known tax liabilities.(1155)
(b) Decisions Regarding the Amount Recorded in the Tax
Reserve
Documents suggest that management may have recorded amounts to the
tax reserve for inappropriate earnings management purposes. A 1996 memorandum
written by Spencer, then Vice President--Financial Reporting, to Timothy Howard
suggests that Spencer may have contemplated making adjustments to the tax
forecasts, and possibly the tax provision or tax reserve, that were based on
decisions unrelated to known tax liabilities.(1156) In particular, with regard
to the Company's forecast for the third quarter of 1996 quarter, Spencer wrote:
We've done the following: . . . reversed the tax entry we booked in
September for qtr [sic] management of $2.3 million and assumed that
reversal would occur in Dec 96 . . . [a]nd, I have now held nothing
back such as the
- ----------
(1155) The lack of specific documentation relating to tax reserve amounts does
not necessarily indicate that the reserves were inappropriate, but it
precludes us from conducting a specific analysis of the issue.
Furthermore, we were not able to interview certain individuals who
played important roles in Corporate Tax during the period on which our
review focused. William E. Einstein (a former Vice President) declined
our request for an interview, and we could not locate Christina Immelman
(a former Director). Finally, Leanne Spencer stopped cooperating with
our investigation and was thus unavailable.
(1156) See Undated mem. from "Leanne" to "Tim," FMSE-IR 359599-601, at FMSE-IR
359599.
302
previous earnings management items that I've been plugging to the
tax line over the last several forecasts, with the reversing of the
tax entry."(1157)
Unfortunately, we were unable to question Spencer about this document because it
was produced after Spencer announced her intention to decline all future
requests for interviews.(1158) Regardless, this memorandum suggests that Spencer
may have been over-reserving for tax liabilities that she later reversed to
income.
A second document raises additional concerns about the recording of
the tax reserve amounts. A 1997 document entitled "December Earnings Actions"
found in Shaun Ross's files(1159) listed three "Proposed Actions," including
"Accrue Interest for Tax Items in Dispute (Misc)" in the amount of $12
million.(1160) When shown the document, Ross said that he neither recognized it
nor understood the material represented. Rajappa, who was Controller in 1997,
said that the document did not provide enough context for him to understand
whether the "proposed actions" were "optional."(1161) Based on our understanding
of the process used to determine the tax reserve, if management thought that
there were tax items in dispute, accruing interest for such items would not be
optional.(1162)
A third document is a memorandum from Fannie Mae tax attorney Hal
Gann to Howard, entitled "Usefulness of a `Cushion' for Deferred Taxes." Gann
wrote that Fannie Mae could better evaluate and manage its tax law exposure by
"not booking into current earnings all of the savings projected for various
tax-advantaged transactions,"
- ----------
(1157) Id.
(1158) See discussion supra Chapter II.
(1159) Shaun Ross was a Financial Analyst in the Controller's Office before
Fannie Mae promoted him to Project Manager in 1997.
(1160) Undated December Earnings Actions, Zantaz document 1512032. While the
document itself is undated, we believe its reference to an achievable
EPS amount of $2.8325 indicates its creation year as 1997. The reported
EPS for year-end 1997 was $2.83. Fannie Mae Information Statement, dated
Mar. 31, 1998, at 19, available at
http://www.fanniemae.com/markets/debt/pdf/infostmtmar1998.pdf.
(1161) Rajappa speculated that the creator of the document may have intended to
illustrate the amount included in the forecast, but labeled it as a
proposed action because further work was necessary before the forecasted
figure could be finalized.
(1162) Rajappa generally agreed with this conclusion, stating that accruing
interest is not optional for Fannie Mae when it believes it is "going to
lose" an item in dispute.
303
and instead using part of the tax reserve as a "cushion."(1163) Gann noted how
Fannie Mae could manage the "cushion" to result in smoother Company earnings:
[A] book "cushion" can help you maintain consistent growth in
earnings. If we find an idea that can trim $35 million off of our
1999 tax expense by capturing a permanent loss of up to $100
million, should we execute all $100 million and risk depressing 2000
earnings by comparison if we do not find as many good ideas in that
year? Should we limit ourselves to $60 million of losses -$21
million of tax savings - just to avoid setting the bar too high for
2000? A "cushion" may offer a compromise that allows us to capture
all $100 million of loss on the tax return, but book only $21
million of the savings into 1999 earnings. The additional $14
million of reserved tax savings can be managed, like a reserve for
credit losses, to walk that fine line between saving enough for a
rainy day and depressing earnings by being overly pessimistic.(1164)
While no interviewees recalled Spencer ever disagreeing with the tax
reserve amounts reached by consensus at the quarterly tax reserve meetings, the
three documents discussed above call into question whether Spencer or other
recorded amounts relating to the tax reserve inappropriately.
2. Fannie Mae's Recognition of Synfuel Tax Credits
(a) Overview of Synfuel Tax Credits
Beginning in 1998, Fannie Mae acquired limited partnership interests
in three Internal Revenue Code Section 29 synthetic fuel facilities.(1165) The
investments Fannie Mae made in these partnerships essentially allowed the
Company to earn tax credits based on the fuel production of these alternative
energy facilities.(1166) Before
- ----------
(1163) Mem. from Hal Gann to Timothy Howard, dated Sept. 28, 1998, Zantaz
document 2254187, at 1. Leanne G. Spencer, Einstein, and Swift are
listed as carbon copy recipients of this memorandum. Id. at 2.
(1164) Id. at 2.
(1165) Mem. from Jonathan Boyles and Sheslie Royster to Executive Officers,
dated July 9, 2003, Zantaz document 807185, at 1. Internal Revenue Code
Section 29 was renumbered and amended in 2005 as Section 45K. It
provides a production tax credit for "liquid, gaseous, or solid
synthetic fuels produced from coal." I.R.C. Section 45K (c)(1)(C)
(2005).
(1166) Mem. from J. Boyles and S. Royster to Executive Officers, dated July 9,
2003, Zantaz document 807185, at 1.
304
investing, Fannie Mae required that each partnership obtain a Private Letter
Ruling ("PLR") from the IRS affirming that the proposed synthetic fuel
production process used by the partnerships resulted in the creation of a
synthetic fuel that would make investors in the partnerships eligible for the
tax credit.(1167)
Fannie Mae initially purchased interests in three synfuel
partnerships, an investment that totaled $53 million.(1168) In addition, Fannie
Mae made periodic "tax credit fundings" based on the partnerships' synfuel
production levels.(1169) Fannie Mae booked tax credits generated by the
investments and claimed tax deductions for the partnership-generated operating
losses.(1170)
Based on management's sense that the IRS had increased its scrutiny
of synfuel investments, it determined that it would not recognize all of the
synfuel tax credits earned on its financial statements, and instead reserved a
portion of the credits.(1171) The uncertainties increased when the IRS began
auditing numerous synfuel syndicators in 2002, including two of the Fannie Mae
partnerships.(1172) For purposes of allocating a reserve amount for the synfuel
tax credits in 2002, individuals who participated in the quarterly tax reserve
meetings apparently reached a consensus that a reserve of twenty-five percent of
the total tax benefit would be appropriate.(1173) Although interviewees could
not recall why twenty-five percent was chosen as the appropriate level for the
tax
- ----------
(1167) Id.
(1168) Id.
(1169) Id.
(1170) Id.
(1171) See, e.g., Mem. from W. Einstein to T. Howard, dated Sept. 1, 2000,
FMSE-IR 375930-37, at FMSE-IR 375934 (expressing concern that the IRS
might view some synfuel partnership practices as "spray on" tax credits
and treat them as abusive corporate tax shelters). Other evidence
suggests that management added to the tax reserve for synfuel tax
credits based on increased IRS scrutiny.
(1172) KPMG Tax Credits Documentation, dated Dec. 31, 2003; Undated 2002 Tax
Strategies PowerPoint Presentation, Zantaz document 482600, at 2.
(1173) See Synfuel Reserves, dated Feb. 2004 (listing a twenty-five percent
"required reserve" for tax credits received from 1999 through 2002); see
also Synfuel Reserve Analysis, dated Oct. 14, 2002, FMSE-IR 347242-57
(hereinafter "Synfuel Reserve Analysis Folder"), at FMSE-IR 347249
(listing the reserve percentage as twenty-five percent for year-end
2002); Undated 2002 Tax Strategies PowerPoint Presentation, Zantaz
document 482600, at 2 (recommending the creation of a twenty-five
percent reserve for the synfuel tax credits).
305
reserve, a PowerPoint slide entitled "2002 Tax Strategies" states that this
amount "would make our risk assessment similar to our largest partner in this
[sic] deals...."(1174)
(b) Amounts Actually Reserved for the Synfuel Tax Credit
Documents indicate that Fannie Mae in fact maintained a reserve that
exceeded twenty-five percent of the Company's total synfuel tax credits. A
spreadsheet dated October 14, 2002 analyzed the 2002 synfuel tax credit reserve
amounts and listed the "reserve %" line-item as twenty-five percent.(1175) It
projected Fannie Mae's actual benefit received through year-end to be just under
$70 million, and accordingly calculated the "Reserve Requirement" to be just
over $17 million. However, a subsequent line-item listed the "current reserve"
for the unrecognized synfuel tax credits as approximately $45 million, which
would be more than $27 million over the twenty-five percent reserve. The
spreadsheet further indicates that this "excess" amount was to be released at
year-end.(1176) If management changed its synfuel reserve estimate for the end
of 2002 and thought that $28 million of the reserve was "excess," it should have
recognized that change by releasing $28 million of the reserve at that
time.(1177)
However, it does not appear that Fannie Mae released this excess
amount at year-end 2002. A Fannie Mae document found in KPMG's workpapers states
that Fannie Mae's cumulative synfuel tax credits as of year-end 2002 was $70.4
million and indicated that the then current reserve level was $46.2 million,
which was $28.6 million in excess of the twenty-five percent "required reserve"
amount.(1178) A September 15, 2003 tax reserve schedule also notes $28 million
of excess reserve associated with the
- ----------
(1174) Undated 2002 Tax Strategies PowerPoint Presentation, Zantaz document
482600, at 2.
(1175) Synfuel Reserve Analysis Folder at FMSE-IR 347249.
(1176) Id. (listing the $27,695,719 as a line-item labeled "Release").
(1177) ACCOUNTING CHANGES, Accounting Principles Board Opinion No. 20 (As
Amended), P. P. 10, 13, 31, 36 (Fin. Accounting Standards Bd. 1971).
Accounting Principles Board Opinion No. 20, Accounting Changes (APB 20")
requires management to update estimates and correct errors in previously
issued financial statements, including those related to tax reserves.
(1178) Synfuel Reserves, dated Feb. 2004.
306
synfuel tax credits.(1179) A handwritten note on this document indicates that
the $28 million was "on top of" the twenty-five percent reserve.(1180)
No one we interviewed offered any reason why the Company would have
reserved an amount above the twenty-five percent level. Nevertheless, we note
that, in 2003, KPMG concluded that the tax credits included in Fannie Mae's tax
provision, including the synfuel tax credits, were materially correct.(1181)
(c) Reversal of Amounts Reserved for Synfuel Tax Credits
In July 2003, the IRS further called into question the validity of
the synfuel tax credits when it issued Announcement 2003-46, which stated the
IRS had reason "to question the scientific validity of test procedures and
results that have been presented as evidence that fuel underwent a significant
chemical change," and indicated the possibility that the IRS might revoke PLRs
that allowed enterprises to recognize tax credits related to investments in
synfuel producers that relied on improper procedures and results.(1182) However,
in November 2003, the IRS issued Announcement 2003-70, which concluded that the
procedures and results relating to the chemical changes in synfuel production
were valid if applied "in a consistent and unbiased manner," and thus
investments in partnerships that produced synfuel accordingly would be eligible
for tax credits.(1183)
In addition, the audits of Fannie Mae's synfuel partnerships ended
with positive results in 2003, leading Fannie Mae to determine that it no longer
needed to
- ----------
(1179) Fannie Mae IRS Interest and Tax Reserve Accrual Analysis as of December
31, 2003, dated Sept. 15, 2003, Zantaz document 2146859. This tax
reserve schedule indicates that the unbooked synfuel credits were
included as "Over-Provided Taxes" in the "Reserve Available." Id.
(1180) Id.
(1181) KPMG Tax Credits Documentation, dated Dec. 31, 2003. The workpapers
indicate that KPMG "agreed the actual (or estimated) credits reported by
the operator to the amounts recorded on the Synfuel credit worksheet."
Id. KPMG also reconciled "the tax credits reported on the subledgers to
the amounts reported in the [general ledger] and tax provision." Id.
(1182) IRS Announcement 2003-46, Section 29 - Test Procedures and Significant
Chemical Change, dated July 28, 2003, available at
http://www.irs.gov/irb/2003-30_IRB/ar13.html (last visited Feb. 17,
2006).
(1183) IRS Announcement 2003-70, Section 29 - Test Procedures and Significant
Chemical Change, dated Nov. 17, 2003, available at
http://www.irs.gov/irb/2003-46_IRB/ar12.html (last visited Feb. 17,
2006).
307
reserve amounts in its tax reserve related to synfuel tax credits.(1184) As a
result, Fannie Mae released its reserves for these credits.
According to internal Fannie Mae records, the Company released
$28,570,379 of its synfuel tax reserve during the third quarter of 2003.(1185)
Records show that $30,481,304 was released near the end of the fourth
quarter.(1186) Witnesses were unable to explain why the amounts were released
over two quarters, and we have seen no documents that offer a reason. Since
there is no documentation regarding the rationale for releasing the synfuel
reserve over two quarters, we are unable to conclude whether releasing the
amounts in two stages during 2003 was appropriate.
3. Issues Related to the STIS Transactions
(a) Overview of the STIS Transactions
The STIS transactions had two steps. Fannie Mae would first transfer
a pool of mortgage loans into a REMIC trust, and then it would sell interests in
the trust that were entitled to the first six to eight coupon interest
payments.(1187) Fannie Mae retained all other cash flows related to the
mortgages, and it accounted for the proceeds received as a borrowing, i.e., the
Company recognized no income for book purposes.(1188) The STIS transactions
provided a tax benefit in that they allowed Fannie Mae to recognize a loss for
tax purposes in the year of sale.(1189) The Company would recognize taxable
income in subsequent periods as the discount created from the loss on the sale
was accreted for tax purposes.(1190)
- ----------
(1184) See E-mail from Lavina Chawla to C. Swift, dated June 1, 2004, Cataphora
document i.1086214772000.m789455637, at 3.
(1185) See Homesite General Ledger for account 811116, Journal ID JE25313
(setting forth the recognition of the reserve into income); see also
Homesite General Ledger for account 811117, Journal ID JE25313 (same).
(1186) See Homesite General Ledger for account 811115, Journal ID JE25608
(setting forth the recognition of the reserve into income); see also
Homesite General Ledger for account 811117, Journal ID JE25608 (same).
(1187) Mem. from C. Swift to Ann M. Kappler, dated Nov. 20, 2003, Zantaz
document 558508.
(1188) Mem. from Richard Stawarz to S. Rajappa, dated June 16, 1998, FMSE-IR
301919-22, at FMSE-IR 301919.
(1189) E-mail from James M. Harrington to J. Boyles, dated Feb. 12, 2002,
FMSE-IR 597083.
(1190) Id.
308
In this manner, the STIS transactions allowed Fannie Mae to monetize
a portion of its loan portfolio and obtain a tax benefit. Fannie Mae received
cash up-front, while deferring recognition of the taxable income on the
accretion of the discount over the life of the underlying loans. To accomplish
this goal, Fannie Mae stripped only a de minimis(1191) amount of interest from
each loan, such that the underlying loan could be treated as "unstripped" for
tax purposes, and the Company could include all remaining interest payments in
income, as if the transaction had not taken place.(1192) KPMG(1193) created a
complex model that Fannie Mae used to identify and quantify which loans to strip
payments from in order to achieve these goals.(1194)
Fannie Mae entered into two STIS transactions, one in 1998 ("STIS
1") and one in 2000 ("STIS 2"). Fannie Mae originally contemplated entering into
STIS transactions on a quarterly basis, but ultimately did not due to market
conditions.
(b) Legal Opinion
Documents show, and Swift confirmed, that Fannie Mae obtained a
draft "should" opinion letter from an outside law firm prior to entering STIS
1,(1195) but never received a final, signed version of the letter.(1196) Swift
explained that Fannie Mae often chose not to incur the expense of obtaining a
final legal opinion when deciding whether to enter tax-related
transactions.(1197) Similarly, Fannie Mae opted not to obtain a should opinion
letter for STIS 2 after outside counsel confirmed that its views with regard to
the transaction were the same as for STIS 1.(1198)
- ----------
(1191) The de minimis guidelines are set forth in I.R.C. Section 1273(a)(3)
(2000).
(1192) Mem. from C. Swift to A. Kappler, dated Nov. 20, 2003, Zantaz document
558508.
(1193) The KPMG group that proposed the STIS transactions was separate from the
KPMG audit group.
(1194) See Letter from Steven M. Rosenthal to S. Rajappa, dated Feb. 17, 1998,
FMSE-IR 368899-901.
(1195) See supra text accompanying note 1210.
(1196) E-mail from Michael Rufkahr to C. Swift and Alexis Moore, dated Oct. 29,
2003, Zantaz document 2116486-88, at 1.
(1197) In fact, Swift added that Fannie Mae sometimes chose only to receive
oral legal opinions as a further less expensive alternative to draft
written opinions.
(1198) Id.
309
(c) Business and Economic Justifications for the STIS
Transactions
With respect to tax-advantaged transactions, it is generally
understood within the accounting profession that companies must have a
legitimate business purpose unrelated to tax benefits to justify recognizing a
benefit on tax-advantaged transactions.(1199) Fannie Mae's management was aware
that any tax-advantaged transaction that the Company entered into also needed to
have business and economic justifications unrelated to the tax benefits.(1200)
Documents show that management determined that the STIS transactions had the
following non-tax benefits:
(1) Accelerated receipt of cash from sale of interest coupons;
(2) Protection from the risk of extreme increases in the rate of
prepayment speeds on the underlying mortgages;
(3) Access to new investors that traditionally had not been
willing to invest in Fannie Mae short-term debt; and
(4) A positive financial statement impact.(1201)
Several documents we reviewed during the investigation led us to
focus on the existence and relative weight of the business purposes that
management articulated as support for the STIS transactions. For example, a
document containing handwritten notes that we understand were written by William
E. Einstein, then Vice President--Corporate Tax, read:
How critical is it that we have a business purpose? - w/no
prepayment risk, we don't reach any new investors.(1202)
- ----------
(1199) See Tina Steward Quinn & Tonya K. Flesher, A Weapon From the Past,
JOURNAL OF ACCOUNTANCY, July 2002, available at
http://www.aicpa.org/PUBS/JOFA/jul2002/quinn.htm (last visited Feb. 17,
2006).
(1200) We note that Fannie Mae was not required to have an independent business
justification to invest in synfuel partnerships.
(1201) Mem. from W. Einstein and S. Rajappa to T. Howard, with attachments,
dated Mar. 19, 1998, FMSE-IR 183262-69, at FMSE-IR 183263-64; Mem. from
W. Einstein to T. Howard, with attachments, dated Feb. 25, 2000, FMSE-IR
301924-28, at FMSE-IR 301925-26; Accord Short Term Interest Security
Additional Discussion Meeting, dated Jan. 7, 2000, FMSE-IR 376037.
(1202) Fax cover sheet, from S. Rosenthal to W. Einstein, dated Oct. 29, 1997,
FMSE-IR 182795. As noted above, Einstein has left Fannie Mae's employ
and was not available to be interviewed.
310
Another document was a note from Rajappa to Howard, attached to a March 1998
memorandum entitled an STIS "Executive Summary."(1203) Rajappa wrote, in part:
This is the `business justification' memo on STIS and as such
influenced quite heavily by the lawyers (OGC [Office of General
Counsel] & [outside counsel]).(1204)
Later on the same page, Rajappa continued:
The last two schedules depict that these deals are profitable (just
barely!) even without considering the economic benefits of
postponement of payment of taxes.(1205)
Documents indicated that the expected pre-tax profit for STIS 1 was nearly
$800,000, inclusive of all up-front costs.(1206) The expected pre-tax profit for
STIS 2 was nearly $700,000, assuming no costs from STIS 1 were allocated to the
second transaction.(1207)
When asked about his first comment, Rajappa explained that his
intent was to convey to Howard that both Fannie Mae's internal and outside
counsel had reviewed and commented on this memorandum and that Einstein and
Rajappa had not created this document alone. Rajappa stated that it was not his
intent to convey to Howard that the lawyers had influenced the business
justifications.
Rajappa explained that his intent with regard to the second
handwritten note to Howard was to convey that the deal made economic sense even
without the tax benefits, even if the results could be characterized as "not
that profitable." Swift and Jonathan Boyles, both of whom had knowledge of the
STIS transactions at the time STIS 1 was entered in 1998, stated that they
believed that the business and economic justifications were genuine and
contemplated by management prior to entering the STIS transactions.
- ----------
(1203) Handwritten notes from "Sam" to "Tim," dated Mar. 20, FMSE-IR 183262-69,
at FMSE-IR 183268.
(1204) Id.
(1205) Id.
(1206) Mem. from W. Einstein to File, with attachments, dated Nov. 2, 1999,
FMSE-IR 376038-41, at FMSE-IR 376039.
(1207) Mem. from W. Einstein to H. Gann, et al., with attachments, dated Nov.
3, 1999, FMSE-IR 375944-57, at FMSE-IR 375953 (an attachment estimating
the profit based on a transaction with zero over-collateralization).
311
(d) Results of the STIS Transactions
As it turned out, due to market conditions, the actual financial
statement benefits of the STIS transactions were not as great as the Company had
projected. Interest rates began to fall in 1998, causing prepayment rates on
loans to increase, which both shortened the period during which Fannie Mae could
defer recognizing the discount on the loans and caused the Company to incur
prepayment risk. Without these benefits, it became uneconomical for Fannie Mae
to engage in STIS transactions and, because of the poor market conditions, the
Company decided not to enter these transactions quarterly as originally
contemplated. Furthermore, management had planned to allocate the approximately
$2.5 million in upfront costs among the quarterly STIS transactions the Company
anticipated.(1208) Instead, Fannie Mae recognized all of the upfront costs as a
cost of STIS 1.(1209)
We understand that management decided to enter into STIS 2 in 2000
because it believed that interest rates would soon rise.
III. FINDINGS
We conclude that the process management used to determine its tax
reserves appears reasonable; however, we were unable to form any conclusions as
to whether specific tax reserves were appropriate. We also note that documents
indicate that Leanne Spencer and Financial Reporting may have recorded amounts
to tax reserves that were not connected to known tax liabilities, but instead
were booked for inappropriate earnings management purposes.
We conclude that management determined the amount of the reserve
related to the Company's synfuel tax credits, but kept an unexplained additional
or "excess" amount in the reserve at year-end 2002 that it released to earnings
in 2003. In addition, management did not release the reserve related to synfuel
tax credits all at once, but instead released a portion of the reserve in the
third quarter of 2003 and the rest in the fourth quarter of 2003. Interviewees
were unable to explain why the amounts were released over two quarters, and we
have seen no documents that offer a reason.
With regard to the STIS transactions management opted to obtain only
a draft "should" opinion(1210) from outside counsel even though management
expected the
- ----------
(1208) Mem. from W. Einstein and S. Rajappa to T. Howard, with attachments,
dated Mar. 19, 1998, FMSE-IR 183262-69, at FMSE-IR 183267 (STIS
Transaction Cost Allocation).
(1209) Mem. from W. Einstein to File, with attachments, dated Nov. 2, 1999,
FMSE-IR 376038-41, at FMSE-IR 376038.
(1210) A "should" opinion generally refers to a legal opinion that states a
company's anticipated position "should prevail" upon challenge by a
taxing authority.
312
IRS to examine the transactions. Interviewees stated that they believed that
that the STIS transactions had genuine economic benefits distinct from the tax
benefits. Even though certain documents from the Company's files appear to
question whether the transactions had an adequate business justification, we
agree with that assessment.
PART J: ACCOUNTING FOR INSURANCE PRODUCTS
I. INTRODUCTION
In this section, we report on management's use and consideration of
certain insurance arrangements primarily for the impact such arrangements may
have had on the Company's earnings. Fannie Mae purchases mortgage insurance in
order to mitigate its exposure to credit losses on loans, to comply with the
Charter Act (i.e., the Company is required to have credit enhancement for loans
with a loan to value ("LTV") ratio equal to or greater than eighty percent), and
also as a broader risk mitigation strategy.(1211) Mortgage insurance may be
purchased on an individual loan basis, or to cover losses incurred on a pool of
loans. Fannie Mae refers to mortgage insurance that it acquires (as opposed to
being provided by the lender or borrower) as a "back-end credit enhancement"
("BCE") because the policy covers loans already acquired by the Company. Fannie
Mae typically purchased BCE policies to cover losses incurred on a pool of
loans.
Beginning in 2001, management began considering finite risk
insurance(1212) products and other insurance transactions for earnings-related
goals in addition to the goal of mitigating the Company's exposure to losses.
Specifically, the insurance products were considered by management either to
shift income between periods (in particular from 2001 and 2002, into 2003 and
2004), or to offset the impact of other actions that would result in an increase
in earnings that had not been forecasted. In particular:
- In early 2001, management discussed but did not execute with
MMC Capital ("MMC") an insurance product, the premium for
which would offset a significant increase in income
attributable to a possible reduction of the allowance for loan
losses (the "Allowance")(1213) (the "MMC Proposal").
- ----------
(1211) E-mail to Adolfo Marzol, Timothy Howard, et al., dated July 13, 2002,
FMSE-E 2163479-93.
(1212) For purposes of this analysis, a policy is considered a "finite risk"
insurance arrangement if it does not provide for a true transfer of
risk. FASB Staff Update, Insurance Risk Transfer, January 2006.
(1213) Fannie Mae, 2002 Annual Report (Form 10-K), at 51 (Mar. 31, 2003),
available at
http://www.fanniemae.com/ir/pdf/annualreport/2002/2002annualreport.pdf
(hereinafter "2002 Form 10-K").
313
- In January 2002, management executed a policy with Radian,
which was expected to result in recognition of premium expense
in 2002, with claim reimbursements in 2003 and 2004. The
stated purpose of the policy was to cover Fannie Mae's
exposure for a portion of a deductible on an existing
insurance policy covering the Expanded Approval Timely Payment
Rewards (or "EA/TPR") loans (the "Radian Transaction"). Fannie
Mae announced in November 2005 that it will restate its
accounting for the Radian Transaction on the grounds that it
"did not transfer sufficient underlying risk of economic loss
to the insurer" for the policy to qualify for the insurance
accounting treatment it was given.(1214)
- In 2002, management restructured a corporate life insurance
("COLI") policy to accelerate the payment of policy
acquisition costs in the current period rather than continuing
to pay such costs on an annual basis for the period 2002
through 2007 (the "COLI Restructuring").
- Management also considered executing finite risk/BCE
arrangements to accomplish more strategic purposes. That is,
in the latter half of 2003 and the beginning of 2004,
management contemplated a finite risk insurance transaction
with ACE in order to expand the number of insurers in the
mortgage insurance market but ultimately did not do so because
the policy did not qualify as insurance for accounting
purposes.
We conclude that management's accounting for the Radian Transaction
was not in accordance with GAAP, and that management was, in fact, motivated by
the objective to shift income out of 2002 into future years in executing the
policy.
II. BACKGROUND
A. Role of Credit Policy, Generally
At all relevant times, Credit Policy's primary function at Fannie
Mae was, and is, to manage credit risk within the Company.(1215) As part of its
role, Credit Policy
- ----------
(1214) Fannie Mae, Notification of Late Filing (Form 12b-25), at 8 (Nov. 10,
2005), available at
http://www/fanniemae.com/media/pdf/newsreleases/f1625111005.pdf.
(1215) 2003 Fannie Mae Self Assessment Questionnaire, A. Marzol, Executive Vice
President--Credit Policy, dated Oct. 2003, FMSE-E 600866-921, at 600866;
Corporate Objective Progress Report, dated Oct. 30, 2001, Zantaz
document 3912425; Undated 2002 Fannie Mae Self Assessment Questionnaire,
A. Marzol, Executive Vice President--Credit Policy, Zantaz document
2734087; 2004 Fannie Mae Self Assessment Questionnaire, A. Marzol,
Executive Vice President--Credit Policy, Zantaz document 2318357, at 1.
314
was responsible for, among other things, obtaining credit enhancements on loans,
including those with an LTV equal to or greater than eighty percent.
Certain members of Credit Policy were very conscious of how the
group's work affected the Company's earnings. Brian Graham, a former Senior Vice
President, stated that all credit enhancements had the effect of smoothing the
impact of losses on the financial statements when the losses were incurred, and
that Credit Policy's function was to mitigate the volatility of losses or, more
colloquially, to smooth losses.(1216) Graham stated that, while in hindsight it
may have been better not to use the term "earnings smoothing" to describe what
they were doing, he believed that using insurance policies to mitigate the
Company's exposure to risk of loss was, and remains, the proper function of
Credit Policy.
In addition, evidence showed that management from 2001 through 2004
viewed BCEs as a source of revenue generation in addition to protecting Fannie
Mae against credit losses. Indeed, Adolfo Marzol, head of Credit Policy, stated
that he viewed revenue growth as part of his responsibilities.(1217) Likewise,
contemporaneous correspondence between Graham and members of the Controller's
Office reflect a willingness to manage the timing of claim reimbursements in
order to manage the timing of income recognition. For example, in a 2001 e-mail,
Graham informed Leanne G. Spencer that he had instructed his team to "defer
receipt" of payments owed to Fannie Mae on Secondary Market Coverage deals in
order to avoid "exaccerbat[ing] [sic] your 4Q [earnings] situation."(1218)
Spencer approved Graham's instruction.(1219) As we discuss
- -------------------
(1216) Credit Policy on occasions also referred to this function as "smoothing
earnings." E.g., E-mail from Robert Schaefer to Brian Graham, Carlos
Perez, et al., dated May 14, 2001, FMSE-IN 1475-78, at FMSE-IN 1475 (this
and other examples of documents relevant to the discussion in Chapter VI,
Part J can be found in the accompanying Appendix, at Tab D.10); see also
E-mail from Janet L. Pennewell to Christine Cahn and R. Schaefer, dated
Mar. 7, 2001, FMSE-IN 1460; Credit Portfolio Strategies Weekly Status
Update, dated June 1, 2001, FMSE-IN 32209-11, at FMSE-IN 32210.
(1217) E-mail from A. Marzol to Lawrence M. Small, Franklin D. Raines, Jamie S.
Gorelick and Sharon L. Taylor, dated July 10, 1999, FMSE-IR 20690-92, at
FMSE-IR 20690, 20692; E-mail from R. Schaefer to B. Graham and C. Perez,
et al., dated Nov. 28, 2001, Zantaz document 2206443, at 11 ("Their goals
mirrored ours, in that they were also concerned about showing increasing
revenue.").
(1218) E-mail from Leanne G. Spencer to B. Graham, dated Dec. 12, 2001, FMSE-E
2052293. Graham further wrote that he was "[s]till working on some deals
that would have a bigger and positive impact on your 4Q and 2002
challenge." Id. He also stated that Secondary Market Coverage was one
area in which Credit Policy was a revenue generator for Fannie Mae by
seeking more cost effective insurance for pools of loans.
(1219) Id.
315
in greater detail below, Credit Policy also considered insurance policies as a
means to shift income from 2001 and 2002, into 2003 and 2004.(1220)
B. Fannie Mae's Consideration of Finite Risk Insurance Policies
1. MMC Proposal
According to various members of Credit Policy interviewed, there was
pressure in early 2001 to reduce the Company's loan loss reserves. Graham stated
that the Controller's Office asked him in early 2001 to find an insurance
product that would replace the protection provided by the loan loss reserve
should Fannie Mae be compelled to draw down its reserve.(1221) Graham then met
with representatives of MMC in early 2001 to discuss potential policies for this
purpose.(1222) According to Robert Schaefer, Director--Credit Policy, who
attended this meeting with Graham, Graham explained to MMC representatives that
Fannie Mae was considering reducing its loan loss reserve and was looking for a
credit enhancement transaction that would have a one-time charge to the P&L that
would offset the positive income effect from the reduction in the loan loss
reserve. The other requirements, according to Schaefer, were that the policy
have a high chance of "paying off" in future years, and would be treated as
insurance for accounting purposes. Documents prepared by MMC representatives to
summarize the meeting corroborated Schaefer's recollection, and stated: "We
discussed two issues raised by Fannie Mae (1) FM's interest in a structured
insurance policy (i.e., finite risk) to replace some portion of the $800mm+ loan
loss reserve . . . . FM's objectives would be to spread
- -------------------
(1220) E.g., E-mail from A. Marzol to B. Graham, Daniel H. Mudd, Louis Hoyes,
Timothy Howard and L. Spencer, et al., dated Oct. 17, 2001, FMSE-IN 2732;
E-mail from R. Schaefer to C. Perez and Darren Thompson, dated May 3,
2002, FMSE-IN 1457. Indeed, there appears to have been an "overall
corporate effort to move income out of 2002 and into later years." QBR
Summaries, dated May 2002, FMSE-IR 565521-27, at FMSE-IR 565521, 56524.
(1221) Undated Start Date as an SVP, Zantaz document 2904394; E-mail from B.
Graham to C. Perez and R. Schaefer, dated June 25, 2001, FMSE-IN 1512.
(1222) In negotiating the MMC Transaction, Fannie Mae Credit Portfolio
personnel, including. Schaefer, Graham, Perez, and others had
conversations with representatives of two companies under the Marsh &
McLennan Companies' umbrella (collectively, "MMC"). They met with James
Carey and Nicholas Zerbib of MMC Capital, which was, at that time, the
private equity business of MMC. They also met with Joseph Peiser and Paul
Sclafani, of MMC Enterprise Risk, the risk management consulting business
of MMC. E-mail from J. Carey to B. Graham, R. Schaefer, N. Zerbib, J.
Peiser, and P. Sclafani, dated Apr. 19, 2001, FMSE-IN 1463-65.
316
volatility of the loss reserve over time, whether that volatility resulted from
accounting pressure to reduce or increase the reserve or from actual
experience."(1223)
MMC then proposed what it characterized as a finite risk insurance
product.(1224) It appears that Financial Standards and Credit Policy recognized
early on that such a policy might not qualify for insurance accounting.(1225)
Nonetheless, from June through July 2001, Credit Policy assembled a working
group of individuals in Financial Standards, Corporate Tax and the Legal
Department to vet the MMC proposal.(1226) The working group was initially
referred to as the "Loss Smoothing Team," and the project was known as the "Loss
Insurance Initiative."(1227)
- ----------------
(1223) E-mail from R. Schaefer to B. Graham, et al., dated May 14, 2001, FMSE-IN
1475-78, at FMSE-IN 1477 ("We discussed two issues raised by Fannie Mae:
(1) FM's interest in a structured insurance policy (i.e., finite risk) to
replace some portion of the $800mm+ loan loss reserve . . . . FM's
objectives would be to spread volatility of the loss reserve over time,
whether that volatility resulted from accounting pressure to reduce or
increase the reserve or from actual experience."); accord Handwritten
Notes from R. Schaefer, dated May 19, 2001, Zantaz document 2207005;
E-mail from B. Graham to R. Schaefer and C. Perez, dated June 12, 2001,
FMSE-IN 1497-500, at FMSE-IN 1497 ("Our goal should not be to keep the
loss reserve high. Instead our goals should be: - Accelerate future year
expenses into 2001 and 2002 - Potentially enable us to draw down our
reserve in 2003 and beyond . . . .").
(1224) E.g., E-mail from J. Carey to B. Graham, R. Schaefer, et al., dated Apr.
19, 2001, FMSE-IN 1463-65, at FMSE-IN 1465; E-mail from R. Schaefer to B.
Graham, C. Perez, et al., dated May 14, 2001, FMSE-IN 1475-78, at FMSE-IN
1475.
(1225) E-mail from Gregory Johnson to R. Schaefer, Jonathan Boyles, Chip Jordan,
et al., dated June 5, 2001, FMSE-SP 80210; E-mail from G. Johnson to R.
Schaefer, et al., dated June 6, 2001, FMSE-IN 1496.
(1226) Members of the working group included Financial Standards employees Paul
Salfi and J. Boyles; Fannie Mae lawyers Michael Daze and Daniel Smith;
Tom Gick, an outside attorney with Sutherland Asbill & Brennan LLP;
Credit Policy personnel R. Schaefer, C. Perez, Michael Goldberg, and B.
Graham; and Controller's Office personnel J. Morgan Whitacre and C.
Jordan; David Menn, Director--Corporate Risk and Insurance Management;
and G. Johnson, Senior Financial Analyst--Credit Portfolio. E-mail from
R. Schaefer to P. Salfi, C. Perez, et al., dated July 12, 2001, FMSE-SP
80205-09.
(1227) See, e.g., Credit Portfolio Strategies Weekly Update, dated June 29,
2001, FMSE-IN 33120-122, at FMSE-IN 33121. Schaefer later told the team
to "refer to this project as the Loss Insurance Initiative." E-mail from
R. Schaefer to P. Salfi, J. Boyles, C. Perez, M. Goldberg, G. Johnson,
J.M. Whitacre, M. Daze, B. Graham, C. Jordan, D.
317
Sometime during the second half of 2001, Fannie Mae terminated its
consideration of the MMC proposal. According to both Graham and Schaefer, the
inability for the transaction to qualify as insurance for accounting purposes
was the reason for its termination. According to Schaefer, Financial Standards
ultimately opined that the proposal would not receive insurance accounting
because the timing of cash flows were set by the contract.(1228) Additionally,
Graham stated that the economics of the MMC Proposal were unfavorable due to
MMC's failure to understand the mortgage market.
2. Radian Transaction
According to Adolfo Marzol, former interim Chief Risk Officer,
Franklin D. Raines announced to the Senior Leadership Team at a quarterly
business review ("QBR") meeting in approximately May 2001 that Fannie Mae's
outlook reflected a revenue strength that required "a mindset shift." Marzol
said he understood Raines to be asking the attendees to look for opportunities
to make investments for the future instead of looking to maximize profits in the
current year. Marzol also recalled Raines specifying that the investments should
neither be "fliers" nor create a multi-year drain on profitability. We also note
that a May 2001 document suggests that Controller's Office likewise shifted its
focus to increasing EPS in 2003 and later years.(1229)
Marzol identified the following actions that, to his knowledge,
flowed from Raines's guidance: the Radian Transaction, a restructuring of a COLI
policy(1230), debt buybacks,(1231) and the sale of Title I loans.(1232)
- -------------------
Smith, D. Menn, David Kightlinger, Scott Lesmes, Jennifer M. Osborn, and
Marylou Batson, dated July 12, 2001, FMSE-SP 80205-09.
(1228) KPMG workpapers reflect that it opined that the transaction would not
qualify for insurance accounting. Undated mem. to Fannie Mae File. We
have not heard that the tax or other attorneys consulted by Credit Policy
expressed any objection to the deal.
(1229) E-mail from R. Schaefer to B. Graham, et al., dated May 25, 2001, FMSE-IN
1479-81, at FMSE-IN 1480 ("Morgan W also mentioned that [with] less
concern surrounding $6.46, there was less inertia behind an immediate
reduction to the loss reserves. If anything, there is more concern about
an earnings drop-off after 2003.") Graham and Schaefer clarified that by
"less inertia," Schaefer meant less impetus.
(1230) See infra Subsection II.B.4.
(1231) See infra Chapter VI, Part L.
(1232) See discussion infra Chapter VI, Part L. According to Marzol, Title I
loans were partially-insured government loans. Fannie Mae's pool of such
loans was performing very poorly and the Company took the opportunity to
sell the loans.
318
In the summer of 2001, following Raines's guidance, Marzol told his
team in Credit Policy that the Company was looking to make investments in the
current year for the future and asked Graham to make a list of things that
Credit Policy had foregone due to prior budget constraints. The list prepared by
Graham in response included, among other things, reducing the size of the
deductible on a back-end mortgage insurance policy he had obtained earlier in
the year for Fannie Mae's EA/TPR loans.(1233) That item, however, was not
immediately authorized.
Documents showed that Raines reiterated his guidance to Credit
Policy in the fall of 2001. In an e-mail to his reports in November 2001, Marzol
wrote: "Dan, Lou and I met last night with FDR [Raines]. He personally
reiterated guidance he had given through Dan last week - that he views keeping
the credit loss line under control as a top priority. He is more than prepared
to trade revenues for losses . . . ."(1234) While Graham did not recall the
e-mail in particular, he did recall hearing in the fall of 2001 that management
was very concerned with potential volatility in credit losses; Graham said that
his team again looked at ways to address the deductible exposure on the EA/TPR
product. A structure was bid out to several insurers, but the transaction was
ultimately executed with Radian; according to Graham, the Radian bid was
attractive, possibly because it was mispriced.(1235)
Evidence showed that management chose to insure the EA/TPR loans in
part because the potential default characteristics of those loans would result
in Fannie Mae receiving a substantial amount of expected claim reimbursements in
2003 and 2004, accomplishing the objective of shifting income to those years.
For instance, in a November 20, 2001 e-mail, Graham wrote to Schaefer: "The goal
is to have lots of loans that will fail quickly (albeit 18 months out) and in
large enough numbers to generate the desired P&L result."(1236) Additionally, in
a December 12, 2001 e-mail, Marzol wrote to Mudd that the "goal is to take
portions of the portfolio that we are absolutely sure will have losses in
2003-2004 and transfer that exposure for highly cost effective premium levels,
with as much premium recognized in 2002 as possible. Target portfolios include
- ---------------
(1233) When Credit Policy received bids on insurance for the EA/TPR product,
Marzol decided that Fannie Mae would be better off because of pricing to
purchase insurance with a deductible. Accordingly, in the first
transaction insuring the EA/TPR product, Fannie Mae agreed to absorb
losses on the portfolio of loans up to one percent of the original
principal balance of the loans (i.e., a one percent deductible).
(1234) E-mail from C. Perez to R. Schaefer, et al., dated Oct. 17, 2001, FMSE-IN
2732.
(1235) E-mail from B. Graham to R. Schaefer, dated Nov. 26, 2001, FMSE-IN 1348.
(1236) E-mail from B. Graham to R. Schaefer, dated Nov. 20, 2001, FMSE-IN 3245.
319
the 1% of initial loss not credit enhanced for EA/TPR loans as well as similar
ABN-AMRO product we acquired."(1237)
The Radian Transaction went through several reviews by various
business heads at Fannie Mae before it was approved. First, Credit Policy
reviewed the transaction's structure with Financial Standards.(1238) According
to interviewees, Financial Standards personnel told Credit Policy employees that
its advice on whether the transaction would qualify for accounting as insurance
depended on the answers to three questions.(1239) Schaefer recalled that
Financial Standards may have done this because they were not very knowledgeable
about the insurance area and the business aspect of insurance; with Graham's
guidance, Schaefer provided Financial Standards with answers to the three
questions.(1240) According to Schaefer, Financial Standards concluded that the
transaction qualified as insurance for accounting purposes after reviewing the
answers.
Financial Standards's conclusion that the arrangement qualified as
insurance for accounting purposes was, in part, based on the conclusion that it
was reasonably possible that the insurer could incur a significant loss.(1241)
Schaefer, who
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(1237) E-mail from A. Marzol to D. Mudd, B. Graham, L. Hoyes, and T. Howard,
dated Dec. 12, 2001, Zantaz document 4002092; see also E-mail from B.
Graham to L. Spencer, J. Pennewell, A. Marzol, et al., dated Dec. 18,
2001, Zantaz Document 2146743 (identifying the Radian Transaction as a
"`Business Management' Strategy" that would have an "Earnings Impact:
Insurance premium amortized over time for book and tax; claims payments
offset losses which will tend to occur in the 2003-2005 timeframe").
(1238) We have not seen evidence that KPMG specifically vetted the Radian
Transaction.
(1239) The three questions were: was there "`more than a remote' probability of
variability in the amount of the non-present valued cash flows; [was
there] `more than a remote' probability of variability in the timing of
the cash flows; [and was the] probability greater than ten percent that
[PV(MI Premiums) - PV(MI Claim Reimbursement) - PV(G&A expenses)] >
10%*PV(MI Claim Reimbursements)." EA/TPR Loss Insurance Proposal, dated
Dec. 18, 2001, FMSE-IN 29761-62.
(1240) Id.; E-mail from P. Salfi to J. Boyles, dated Dec. 19, 2001, Cataphora
document i.1008778059000.551783345. Additionally, Schaefer stated that at
some point in late 2001 he learned that Radian would be accounting for
the transaction as a deposit. He said he later told Salfi, and that Salfi
had no reaction to the news. Schaefer did not recall whether he told
Salfi before or after he had provided Financial Standards with the
answers to the three questions, but, he said Financial Standards did not
change its conclusion that the Radian Transaction qualified for insurance
accounting based on the information.
(1241) EA/TPR Loss Insurance Proposal, dated Dec. 18, 2001, FMSE-IN 29761-62;
E-mail from P. Salfi to J. Boyles, dated Dec. 19, 2001, Cataphora
document i.1008778059000.551783345.
320
provided the underlying information to Financial Standards on which they relied
to opine on the Radian Transaction, stated that he understood the accounting
criterion to mean there should be a ten percent chance that the insurer could
suffer a loss of ten percent or more of the premium. In determining the
insurer's possible losses, the Company included not only claim reimbursements,
but also the insurer's costs of administering the policy. Our review of the
analysis showed that it was only by including an estimate of the insurer's
administrative costs that management concluded that it was reasonably possible
the insurer would incur a significant loss under the policy. In our view, the
inclusion of the administrative costs was not in accordance with GAAP.
FASB Statement No. 113, Accounting and Reporting for Reinsurance of
Short-Duration and Long-Duration Contracts (hereinafter "FAS 113"), provides
guidance on when an arrangement transfers sufficient risk to qualify as
insurance for accounting purposes. In particular, FAS 113 states:
The ceding enterprise's [insured's] evaluation of whether it is
reasonably possible for a reinsurer [insurer] to realize a
significant loss from the transaction shall be based on the present
value of all cash flows between the ceding [insured] and assuming
[insurer] enterprises under reasonably possible outcome. . . .(1242)
The guidance in Paragraph 10 is clear that only payments between the
insurer and the insured should be considered. To make this point even clearer,
however, the FASB staff issued interpretive guidance in 1993 that is directly
relevant to the Radian Transaction. Question 16 of "Accounting for Reinsurance:
Questions and Answers about Statement 113," and its response state:
Q -- In determining the amount of the reinsurer's loss under
reasonably possible outcomes, may cash flows directly related to the
contract other than those between the ceding and assuming companies,
such as taxes and operating expenses of the reinsurer, be considered
in the calculation?
A -- No. Paragraph 10 states that the evaluation is based on the
present value of all cash flows between the ceding and assuming
enterprises under reasonably possible outcomes and therefore
precludes considering other expenses of the reinsurer in the
calculation.(1243)
- -------------------
(1242) ACCOUNTING AND REPORTING FOR REINSURANCE OF SHORT-DURATION AND LONG-
DURATION CONTRACTS, Statement of Fin. Accounting Standards No. 113, P. 10
(Fin. Accounting Standards Bd. 1992) (emphasis added).
(1243) ACCOUNTING FOR REINSURANCE: QUESTIONS AND ANSWERS ABOUT STATEMENT 113, at
Question 16 (Fin. Accounting Standards Bd. 1993).
321
While Fannie Mae is not a reinsurer, it was unreasonable for Financial Standards
to conclude that the risk transfer test was satisfied with respect to the Radian
policy by including administrative costs that the literature plainly dictated
were inappropriate for a reinsurer to include. Whether the arrangement is called
insurance or reinsurance, the objectives of the insured or ceding parties are
the same - to transfer the risk of loss. As such, the same test for making that
determination would apply.
The Radian Transaction was also reviewed and approved by Timothy
Howard in consultation with Spencer and Janet L. Pennewell. Before approving the
transaction, Howard asked Spencer and Pennewell for assurance that accounting
had vetted and recommended the transaction. After the meeting, Spencer and
Pennewell sent Howard the following e-mail:
We both would lean slightly in favor of [executing the Radian
Transaction]. On the plus side, it helps some with our challenge and
gives us a little additional credit protection in a bad environment.
On the negative side, we don't think the economics are very
compelling and think the payback has a chance of being longer than
shown in their base case.(1244)
Howard forwarded the e-mail to Graham and Schaefer, stating that he was "fine
[with] going ahead with this," but characterizing his approval as
"lukewarm."(1245)
The Radian Transaction also was presented by Marzol to Daniel H.
Mudd and discussed with other Executive Vice Presidents, including Louis Hoyes,
Executive Vice President--Single Family Business. While Mudd had no recollection
of having reviewed the policy, documents showed that senior executives were
copied on an exchange between Hoyes and Marzol about the merits of the
policy.(1246) The documents showed that Hoyes objected to the policy because of
his belief that the terms of the insurance motivated the Company to foreclose on
mortgagees who were poor and/or had blemished credit, a motivation that Hoyes
deemed to be contrary to Fannie Mae's
- -------------------
(1244) E-mail from T. Howard to B. Graham, R. Schaefer, L. Spencer, J.
Pennewell, dated Dec. 21, 2001, FMSE-IN 1397.
(1245) Id.
(1246) According to Schaefer, Marzol and he made a presentation to Mudd that was
similar to the presentation they previously made to Howard. See also Loss
Insurance Proposal, FMSE 529289-93 ("Presented to Dan Mudd 1/08/02");
Calendar File, Zantaz document 2132291 ("Mudd, Dan 1/8/02 8:30 10:00
`Adolfo will drop by to talk to you.'"). It is not clear whether Mudd's
approval was being sought or whether he was simply being briefed;
moreover, it appears based on the calendar entry that Mudd's meeting with
Marzol and Schaefer occurred before the Hoyes-Marzol e-mail exchange
began debating the policy.
322
mission. The offending term, according to Hoyes, was that the policy paid
benefits only on foreclosure.(1247) In the e-mail Hoyes sent to Marzol, which
copied Mudd, Robert J. Levin and Howard, Hoyes wrote: "Should we be exposing
Fannie Mae to this type of political risk to `move' $40 million of income? I
believe not."(1248) When asked to explain the "$40 million of income" comment,
Hoyes said he was simply responding to Marzol's message to him, which had made
that point. Indeed, Marzol's e-mail to Hoyes explained:
The transaction is intended to deliver on a request of FDR and a
corporate need to make sure the loss line is well managed and that
we do so while revenues are strong. . . . Bottomline [sic] - there
is a significant reduction of losses that occurs in 2003-2005 if
foreclosure rates are near the average. Otherwise, the reduction in
losses occurs from 2003 to 2007. The net income after tax impact is
a reduction in NIAT for 2002 and 2003, then turning into positive
P/L in either scenario.(1249)
Notwithstanding Hoyes's objection, Marzol had already received approval from
Howard, and he gave his team approval to move forward with the transaction
sometime on January 8, 2002.(1250) The transaction was executed at the end of
January 2002.
3. ACE Proposal
Another finite risk insurance policy that management considered, but
ultimately did not execute, was a proposal offered by ACE. ACE representatives
visited Fannie Mae in March or April 2003 to discuss opportunities for doing
business with the Company. Fannie Mae had a strategic interest in doing an
insurance deal with ACE: there were only seven potential counterparties in the
mortgage insurance market, of which Fannie Mae had policies with four, and
management wanted to increase the number of potential counterparties.(1251)
According to Schaefer, Graham determined that
- --------------
(1247) Hoyes said the EA/TPR product was targeted to borrowers at the upper-end
of "sub-prime" in order to expand the bounds of "prime." As such, he said
his job was to motivate this staff to work with borrowers in default on
their mortgages in order to keep them in their homes and he did not want
this policy to create a disincentive.
(1248) E-mail from L. Hoyes to A. Marzol, D. Mudd, Robert J. Levin, Thomas E.
Donilon and T. Howard, dated Jan. 8, 2002, Zantaz document 4159375.
(1249) Id.
(1250) E-mail from A. Marzol to R. Schaefer, B. Graham, et al., dated Jan. 9,
2002, FMSE-IN 10997-1001, at FMSE-IN 10997.
(1251) Schaefer stated that the ACE Proposal was meant to create a new insurance
policy on loans with a loan to value ratio of greater than eighty percent
that were delivered through the Dedicated Channel. At the time, these
loans were insured by PMI under
323
the best opportunity for business was with ACE, a new market entrant who had not
participated in the primary risk layers of insurance, and for ACE to cover prime
business such as loans delivered to Fannie Mae through the Dedicated
Channel.(1252)
Fannie Mae and ACE considered several structures over an extended
period of time. The first structure that Credit Policy brought to Financial
Standards' attention was one that Financial Standards opined would not receive
insurance accounting. KPMG, through Financial Standards, also indicated that the
accounting would need to be bifurcated so that the payment for coverage over the
threshold would be treated as insurance, but the premium for the base coverage
would be treated as a deposit.(1253) Schaefer said, aside from the accounting
treatment question, the accountants were uncomfortable with the "optics" of the
proposal's direct connection between the premium to be paid and claims
reimbursements.
Credit Policy then considered an alternate structure that would give
Fannie Mae the right to cancel the policy, which would create the "risk" of loss
to ACE needed for accounting purposes.(1254) Financial Standards opined that the
entire premium under the revised structure qualified for insurance accounting
treatment.(1255) Additionally, lawyers vetted the revised ACE Proposal for
compliance with the Charter Act and potentially other issues.
Ultimately, the ACE proposal was not consummated, but the facts
surrounding the ultimate rejection of the ACE Proposal bear mention. At the
outset, Thomas E. Donilon had expressed concerns based on public policy
considerations
- -------------------
the pmiSELECT program. He also stated that Fannie Mae wanted an
alternative to PMI. Schaefer clarified that the Dedicated Channel loans
insured under pmiSELECT were not related to the Home Solutions loans that
PMI refused to continue insuring under pmiSELECT.
(1252) At the time, these loans were covered under the pmiSELECT program.
(1253) E-mail from P. Salfi to Michelle Vaniels, dated Oct. 16, 2003, FMSE-E
1171242-43; Draft mem. from P. Salfi to R. Schaefer, et al., dated Dec.
11, 2003, FM SRC 354186-88.
(1254) KPMG asked Fannie Mae whether the cancellation provision was more than a
conceptual possibility. Fannie Mae took the position that, although
Fannie Mae would continue to have a Charter requirement to maintain a
credit enhancement on the loans, conceptually, there could be an economic
reason to cancel the transaction with ACE. For instance, Schaefer said,
if home prices continued to rise and Fannie Mae performed a
mark-to-market analysis that showed a large percentage of the loans
having LTVs below eighty percent, it would cancel the policy.
(1255) E-mail from P. Salfi to R. Schaefer and Jason N. Barrett, dated Dec. 16,
2003, FMSE-E 177626-29.
324
concerning Fannie Mae's introduction of ACE as a new entrant in the mortgage
insurance field. His concerns did not kill the proposal.(1256) Credit Policy
continued to push for approval of the ACE Proposal even after Financial
Standards and KPMG expressed misgivings.(1257) Boyles expressed his concerns
about the proposal to Marzol in mid to late December 2003. And on December 30,
2003, Dan Smith sent Marzol and others a memorandum stating, in relevant part,
that KPMG:
- advises that the structure satisfies accounting rules
necessary to treat our payments to Ace [sic] as insurance
premiums, but
- counsels us to consider carefully the risks of entering a
transaction in which the accounting treatment, based on
technical rules, may appear inconsistent with the underlying
economics of the business transaction.(1258)
Nonetheless, in a January 2, 2004 e-mail from Marzol to Howard, Marzol wrote:
"We are moving towards executing, but we still have some time where we can have
further dialogue."(1259) Marzol's continued push for the proposal
notwithstanding Boyles's and KPMG's concerns reflected a tone that was
representative of Fannie Mae's overall culture, that is, a senior business
executive did not take accountants's objections to a
- --------------
(1256) We were told that Donilon's concerns were addressed. However, no one
could tell us what steps were taken to resolve them.
(1257) Financial Standards and KPMG provided an opinion that the policy would
receive insurance accounting so long as ACE would agree to include a
cancellation option in the policy. Without the cancellation option,
Fannie Mae would account for the premium and annual adjusted premium in
the bifurcated manner described above, which presented great operational
challenges. See also Undated Events leading up to the Present, FMSE
54905-11, at FMSE 54905. Nonetheless, regardless of the cancellation
option and an understanding that the accounting was supportable under
GAAP, there was concern that the accounting may not be consistent with
the economics. E-mail from D. Smith to A. Marzol, B. Graham, J. Boyles,
P. Salfi, Ann M. Kappler, T. Donilon, et al., dated Dec. 30, 2003,
Cataphora document i.1072828593000.1988983619. It is not clear, but it is
possible that this concern had to do with whether Fannie Mae's right to
cancel the policy was a substantive right given its need for insurance
coverage for loans with LTV ratios in excess of eighty percent.
(1258) E-mail from D. Smith to A. Marzol, B. Graham, J. Boyles, P. Salfi, A.
Kappler, T. Donilon, et al., dated Dec. 30, 2003, Cataphora document
i.1072828593000.1988983619.
(1259) E-mail from A. Marzol to T. Howard, B. Graham, J. Boyles, and L. Spencer,
dated Jan. 2, 2004, Cataphora document i.1073065333000.1693380808.
325
proposed transaction as definitive, and looked to Howard to be the ultimate
decisionmaker.
According to Schaefer, the ACE Proposal was rejected sometime in
2004 after ACE withdrew its agreement to the cancellation option, and the prior
proposed bifurcation accounting was deemed operationally too difficult to
implement. According to contemporaneous documents, ACE withdrew its agreement in
July 2004.(1260)
4. Corporate Owned Life Insurance
During 2001 and 2002, Credit Policy also analyzed whether it could
restructure existing COLI policies to accelerate the payment of deferred
acquisition costs due from the Company, which the Company had been paying
through a reduction in the return on the policy.(1261) According to Marzol, the
restructuring was another item that came out of Raines's guidance to invest for
the future by incurring expenses in the present period. The Company decided to
restructure COLI in this manner because management felt that it had the
wherewithal to pay the costs at once in 2001 and 2002.(1262)
Fannie Mae restructured one COLI policy it had with MetLife in
response to Raines's guidance.(1263) As Graham wrote in a December 18, 2001
e-mail, the earnings
- ----------------
(1260) E-mail from R. Schaefer to D. Thompson, et al., dated July 20, 2004,
Cataphora document i.1090331892000.32456200, at 5 ("ACE decided that our
unrestricted right to cancel the policy was unworkable for them.").
(1261) E-mail from B. Graham to L. Spencer, J. Pennewell, A. Marzol, Joseph J.
Sakole, dated Dec. 18, 2001, Zantaz Document 2146743 ("Accelerating
Amortization of Capitalized Expenses in COLI deals"); Credit Portfolio
Strategies Weekly Status Report, dated Mar. 15, 2002, FMSE-IN 33008-10;
Corporate Owned Life Insurance, dated Apr. 9, 2002, Zantaz Document
1944984.
(1262) Marzol said that he meant Fannie Mae had earnings sufficient to absorb
the charge. Graham believed that Fannie Mae wished it had not structured
the deals as it had when Fannie Mae entered the deals because it ended up
financing the broker commission at the policy earnings rate, which
exceeded Fannie Mae's borrowing cost. Fannie Mae took the opportunity in
2001 to restructure the MetLife policy in a way that Fannie Mae would
have preferred it had done originally; the restructuring closed in 2002.
According to Schaefer, Graham's objective was similar to his objective
for the Radian Transaction: to pay as much expense as Fannie Mae could in
2001 and 2002 in order to avoid paying those expenses in outer years.
(1263) E-mail from B. Graham to T. Howard, A. Marzol, L. Spencer, Jef Kinney and
Jeffrey Cravath, dated Dec. 21, 2001, FMSE-E 994863 ("We're trying to cut
similar deals with the other insurers we have COLI out under the
assumption that you still want this type of flexibility around the first
and second quarter of 2002. Let us know if/when you want to take the
hit.")
326
impact would reduce "miscellaneous income in the period it is taken; future
earnings would be enhanced since yields would no longer be depressed by
amortization expense."(1264) The restructuring of the policy resulted in Fannie
Mae recording $11 million in miscellaneous expense during the second quarter of
2002, which represented an acceleration of the deferred acquisition costs and
state premium taxes that Fannie Mae was originally scheduled to pay, through
reductions in the return on the policy, through December 31, 2007.(1265) The
Company paid for the acceleration of the costs through a reduction in the cash
surrender value in its policies with MetLife.(1266)
Fannie Mae considered restructuring other policies in 2002, pursuant
to Pennewell's guidance that "there [was] additional opportunity to accelerate
expenses into" 2002 and that the Company was "looking at initiatives that will
add income in 2004 and 2005."(1267) Notes on a presentation about the economics
of accelerating the deferred expenses indicate that the Company then planned to
"[n]ext look[] @ AIG Life 1998" and "New York Life."(1268) However, we have not
seen any evidence that Credit Policy restructured additional COLI policies in
2002.
The consideration given to restructuring other COLI arrangements was
part of the broader efforts described throughout this section to identify
transactions that would have a similar result as the restructuring of the COLI
policy (i.e., that would result in the recognition of expense in 2002 but would
generate a return to the Company in subsequent years). That effort appears to
have been directed by Howard with assistance
- -------------------
(1264) E-mail from B. Graham to L. Spencer, J. Pennewell, A. Marzol, J. Sakole,
dated Dec. 18, 2001, Zantaz document 2146743.
(1265) Corporate Owned Life Insurance, dated Apr. 9, 2002, Zantaz document
1944984, at 2, 12; see also Letter Agreement, dated Dec. 23, 1997,
FMSE-IR 720841-61; Letter from Metropolitan Life Insurance Company to
Darren Thompson, dated Apr. 1, 2002, FMSE-IR 720840.
(1266) Corporate Owned Life Insurance, dated Apr. 9, 2002, Zantaz document
1944984, at 2.
(1267) E-mail from R. Schaefer to C. Perez and D. Thompson, dated May 3, 2002,
FMSE-IN 1457; see also Credit Portfolio Strategies Weekly Status Report,
dated May 10, 2002, FMSE-IN 32736-40, at FMSE-IN 32737; E-mail from T.
Howard to B. Graham and L. Spencer, dated Dec. 31, 2001, FMSE 644037
("We're trying to cut similar deals with the other insurers we have COLI
out under the assumption that you still want this type of flexibility
around the first and second quarter of 2002. Let us know if/when you want
to take the hit. Unless we hear different guidance, we will continue to
work toward the same goal of taking hits in Q1 and Q2 next year.")
(1268) Corporate Owned Life Insurance, dated Apr. 9, 2002, Zantaz document
1944984, at 1.
327
from Spencer. In an e-mail dated December 31, 2001, to Graham and Spencer,
Howard responded to Graham's earlier e-mail that described in general the
economics of the COLI restructurings and stated Graham's "[g]oal of note was to
find out whether an approach like this - if we can make it all work - is
consistent with what you are looking for in Q1 and/or Q2."(1269) In his
response, Howard stated:
Leanne is the right person to take the lead on this. We're trying to
build up an inventory of these sorts of transactions. Ideally, we
can get a notion of the economics and payback of each without the
party that came up with the idea having to do too much work. That
won't be the case all of the time, unfortunately. As we get into the
quarter, we should have a better sense of which ones we want to
do.(1270)
Howard's response that "we should have a better sense" of what
transactions management wanted to do as "we get into the quarter" seems to echo
Marzol's point about the Company deciding to restructure the MetLife COLI policy
because it had the "wherewithal to pay the costs" (i.e., sufficient earnings to
absorb the charge). In other words, management would decide between transactions
that presumably were economically viable based on where they were during the
quarter in relation to earnings forecasts, and only those transactions that
would not impair the Company's ability to meet analysts' expectations would be
executed.
III. FINDINGS REGARDING INSURANCE PRODUCTS
We conclude that, during the period from 2001 through 2004, Credit
Policy considered transactions primarily for earnings-related goals rather than
merely to mitigate the Company's exposure to credit losses or to satisfy the
requirements of the Charter Act. While we acknowledge that the proper role of
Credit Policy is to mitigate losses through the use of mortgage insurance
products, and that a well-designed insurance policy will have the effect of
smoothing the impact of losses when they occur, the evidence we found reflected
management's goals were really to "smooth" income and to use insurance policies
as a way to show stable earnings growth.(1271) In particular, we
- -------------------
(1269) E-mail from T. Howard to B. Graham and L. Spencer, dated Dec. 31, 2001,
FMSE 644037.
(1270) Id.
(1271) E.g., E-mail from B. Graham to R. Schaefer and C. Perez, dated June 12,
2001, FMSE-IN 1497-500; E-mail from R. Schaefer to B. Graham, et al.,
dated May 14, 2001, FMSE-IN 1475-78, at FMSE-IN 1477; E-Mail from J.
Peiser to R. Schaefer, dated May 28, 2001, FMSE-IN 1482-85, at FMSE-IN
1485 (stating that a benefit of the MMC "Property Catastrophe program,"
was to "achieve earnings smoothing for first catastrophe - risk transfer
for second catastrophe."); Credit Portfolio Strategies Weekly Status
Update June 1, 2001, FMSE-IN 32209-11, at FMSE-IN 32210
328
found that the Radian Transaction was one part of an inappropriate overall
corporate effort to shift income out of 2001 and 2002, into 2003 and 2004.
Fannie Mae has announced that it will be restating its accounting
for the Radian Transaction based on its determination that there was
insufficient risk transfer to Radian for the transaction to qualify for the
insurance accounting treatment that it was given.(1272) We concur that the
accounting for the Radian Transaction was not in accordance with GAAP. Apart
from the error in accounting for the policy, however, we also question its
economics. Viewing Fannie Mae's upfront premium payment on the "insurance"
policy as the equivalent of the purchase of any other investment, we question
whether management reasonably expected the return on that investment to be equal
to, or greater, than the return on any other investment of comparable risk.
Management did consider this question when analyzing the terms of the Radian
Transaction in November 2001.(1273) Based on estimates of the timing of claim
reimbursements and an upfront premium payment of forty-six basis points, Credit
Policy determined that the "investment" would result in a yield of 3.25
percent.(1274) At that time, after the Federal Reserve had lowered interest
rates, the yield on a three-year Treasury Bill was 3.5 percent.(1275) It appears
that the only way to justify the "investment" in the Radian policy as being a
better economic investment was if it had a lower risk than the Treasury
Bill.(1276) However, even that comparison is not completely valid given that
there is no uncertainty as to the timing of cash flows on a Treasury Bill; when
the timing of cash flows is uncertain, a prudent investor would demand a higher
yield to compensate for the uncertainty. Thus, in our view, the Company accepted
a lower yield on its "investment" in the Radian policy solely to achieve the
income-shifting objective.
Further, while Fannie Mae did not enter into either the MMC Proposal
or the ACE Transaction, we also conclude that the two policies were considered
by management for an improper purpose. With respect to the MMC Proposal, Credit
Policy was acting on a request by the Controller's Office to enter into an
insurance transaction that would offset the impact of reducing the loan loss
reserve, and not really to address
- ----------
(Under the heading, "Loss Smoothing," the document reads: "Had a
follow-up call (with Mike, Greg, and Dan Smith) with Joe Peiser @MMC to
discuss his proposal for Earnings Smoothing.").
(1272) Fannie Mae, Notification of Late Filing (Form 12b-25) at 8 (Nov. 10,
2005).
(1273) E-mail from B. Graham to R. Schaefer, M. Goldberg, C. Perez, et al.,
dated Nov. 26, 2001, FMSE-IN 1348.
(1274) Id.
(1275) Id.
(1276) Id.
329
any loss mitigation concerns.(1277) This reflects, at a minimum, that the
Controller's Office was aware that the Allowance was excessive in 2001, but as
discussed in detail in Chapter VI, Part A, the Allowance was not reduced until
2004. Further, evidence suggested that management was concerned about the
potential spike in income as a result of the reduction in Allowance, and what
such an event may mean for the Company's ability to meet Raines's challenge of
doubling EPS in five years, or to the Company's goals of showing steady earnings
growth.(1278) Accordingly, we find that the primary motivation behind
consideration of the MMC Proposal was inappropriate.
Further, while Fannie Mae did not enter into either the MMC Proposal
or the ACE Transaction, we also conclude that the two policies were considered
by management for an improper purpose. With respect to the MMC Proposal, Credit
Policy was acting on a request by the Controller's Office to enter into an
insurance transaction that would offset the impact of reducing the loan loss
reserve, and not really to address any loss mitigation concerns.(1277) This
reflects, at a minimum, that the Controller's Office was aware that the
Allowance was excessive in 2001, but as discussed in detail in Chapter VI, Part
A, the Allowance was not reduced until 2004. Further, evidence suggested that
management was concerned about the potential spike in income as a result of the
reduction in Allowance, and what such an event may mean for the Company's
ability to meet Raines's challenge of doubling EPS in five years, or to the
Company's goals of showing steady earnings growth.(1278) Accordingly, we find
that the primary motivation behind consideration of the MMC Proposal was
inappropriate.
As for the ACE Proposal, the evidence reflecting management's
discussions about this proposal showed that Credit Policy advocated a
transaction notwithstanding the misgivings expressed by KPMG, Financial
Standards, and the Law and Policy Group.(1279) Moreover, Credit Policy's
decision to embed a right to cancel in the proposal to satisfy the insurance
accounting test illustrated management's outcome-oriented approach, rather than
a merit-based approach, toward structuring the transaction. Without the right to
cancel, the proposal would not have qualified for insurance accounting
treatment. However, it is not clear whether the right to cancel was more than a
theoretical possibility.(1280)
Finally, with respect to management's restructuring the MetLife COLI
policy in 2002, again, evidence showed that management's sole motivation for
doing so was to manage earnings and incur expenses in 2002 to depress income. In
particular, Fannie Mae only accelerated expenses to be incurred through 2007
(instead of all costs due under the policy). We do not find fault with
management's accounting in 2002 to
- ----------
(1277) E-mail from R. Schaefer to B. Graham, et al., dated May 14, 2001, FMSE-IN
1475- 78, at FMSE-IN 1477 ("We discussed two issues raised by Fannie Mae:
(1) FM's interest in a structured insurance policy (i.e. finite risk) to
replace some portion of the $800mm+ loan loss reserve . . . . FM's
objectives would be to spread volatility of the loss reserve over time,
whether that volatility resulted from accounting pressure to reduce or
increase the reserve or from actual experience.").
(1278) E-mail from R. Schaefer to B. Graham, et al., dated May 25, 2001, FMSE-IN
1479- 81, at FMSE-IN 1480 ("Morgan W also mentioned that with less
concern surrounding $6.46, there was less inertia behind an immediate
reduction to the loss reserves. If anything, there is more concern about
an earnings dropoff [sic] after 2003."). It was possible that the Company
was worried that it would not attain $6.46 in 2003 and was looking to
increase earnings by reducing the Allowance, but also by purchasing
insurance to replace the lost Allowance coverage. Graham said Fannie Mae
did not go forward with the MMC Proposal because the proposal was not
workable. See also discussion supra Chapter VI, Part A.
(1279) See E-mail from A. Marzol to T. Howard, B. Graham, J. Boyles, and L.
Spencer, dated December 31, 2003, Cataphora document
i.1073065333000.1693380808.
(1280) Undated ACE Primary MI Structure, FMSE-IN 7846-47.
330
recognize the acceleration of COLI policy expenses it would incur through 2007,
which appears to be consistent with GAAP. We note only that Fannie Mae chose to
accelerate its costs when the Company had excess earnings, even though it would
have been economical for the Company to have done so previously.
PART K: ACCOUNTING FOR OUT-OF-PORTFOLIO SECURITIZATION
("PORTFOLIO POOLING SYSTEM")
This section of our report concerns an error in the interface
between two systems that resulted in loans destined for securitization being
erroneously designated as held for investment.
I. INTRODUCTION
In its February 11, 2005 letter to Stephen B. Ashley, OFHEO reported
that an error in Fannie Mae's Portfolio Pooling System ("PPS") had led to the
misclassification of loans that the Company held in its portfolio. The matter
referred to Fannie Mae's Out of Portfolio Securitization ("OOPS") program, which
the Company uses to securitize loans it acquires. According to OFHEO:
During a system upgrade in 2004 for the Portfolio Pooling System
(PPS), the Enterprise found a system error whereby all loans
acquired during the month intended for pooling were marked as HFI
[held for investment] at the end of the month regardless of whether
the loans were initially marke[d] as HFS [held for sale] or HFI. In
subsequent months, upon securitization and sale of the mortgage
securities, the underlying loans were taken off the books and gains
or losses were booked. This re-designation process occurred from the
time that the OOPs [sic] program was created in 1983 until 2004,
when, AFTER 21 YEARS, management detected and corrected the system
error.(1281)
OFHEO stated its understanding that the Company "did not perform any analysis to
evaluate the magnitude of the error or the impact on the financial statements."
Finally, OFHEO concluded, "For Fannie Mae to operate a system for two decades
that inaccurately classified securities for financial reporting is simply
unacceptable, and is indicative of a breakdown in oversight and compliance."
(1282)
We identified two issues for review in connection with the PPS
error. First, what was the nature of the error, and second, why did it go
undetected for over twenty years?
- ----------
(1281) February 11, 2005 OFHEO Letter at FMSE-IR 547322.
(1282) Id.
331
II. BACKGROUND
Based on the information available to us, we have no reason to
believe that the error was other than a coding mistake in the link between two
of the systems involved in the OOPS and loan accounting processes. The Company
likely did not notice the error in the interface because the Controller's Office
received a report on HFS loans from PPS that was used to record lower of cost or
market value ("LOCOM") adjustments before the error had any effect on the
systems of record. Moreover, in light of the Company's accounting policies at
the time (which permitted the Company to decide the classification of loans at
the end of the month), combined with its strategy of holding substantially all
mortgage loans as investments, it is understandable how the error could have
been missed.(1283)
When the Company uncovered the error, it considered the financial
impact of the matter and, in view of its accounting policy at the time,
concluded that it was inconsequential. We understand that, in the course of its
restatement work, the Company is reviewing that assessment based on a
re-evaluation of the relevant accounting standards.
A. PPS and the Coding Error
The coding error that OFHEO described in its letter occurred in the
interface between two systems: PPS and LASER, the Company's system of record for
the mortgage loans it holds in its portfolio. In order to understand the error
and its impact, a review of the process that ends with Fannie Mae securitizing
loans from its portfolio is necessary.(1284)
- ----------
(1283) Although, FAS 65 is not as clear as FAS 115 regarding when loans should
be designated as HFI or HFS. Compare ACCOUNTING FOR CERTAIN MORTGAGE
BANKING ACTIVITIES, Statement of Fin. Accounting Standards No. 65, P. 32
(Fin. Accounting Standards Bd. 1982) (hereinafter "FAS 65") with
ACCOUNTING FOR CERTAIN INVESTMENTS IN DEBT AND EQUITY SECURITIES,
Statement of Fin. Accounting Standards No. 115 (Fin. Accounting Standards
Bd. 1993) (hereinafter "FAS 115"). FAS 65 is read to require that a
company determine the loan's classification at the time of the
transaction. Fannie Mae designated loans as HFI or HFS at the end of the
month of acquisition. We understand that Fannie Mae is reconsidering that
policy as part of its restatement. Our explanation of how the error could
have been missed considers the context in which the Company determined
the classification of its loans; that explanation should not be construed
as agreement with that accounting policy.
(1284) At our request, personnel from Portfolio Management delivered a
presentation describing the systems involved in the OOPS process and the
nature of the error. We received similar information from personnel
currently in Financial Standards.
332
Fannie Mae acquires mortgage loans through its "cash" program. The
Company then determines whether it will keep the loans in its portfolio or
whether it will securitize the loans (that is, transfer a pool of loans to a
trust in exchange for a mortgage-backed security). PPS is used only to process
the loans that the Company acquires in the cash program; it is not involved in
the Company's far larger "swap" program, in which Fannie Mae exchanges loans for
Company-issued MBS and directs those loans into a trust.(1285)
Fannie Mae executes commitments to purchase loans each month through
its eCommitting facility. When the transaction settles, the loans are processed
through the Company's IBM Cash system. The IBM Cash system validates the loans
received against the commitment, "funds" the loans, and records the transfer of
ownership to Fannie Mae. The loans are then processed for transfer to PPS.
The IBM Cash system and PPS sort loans into those that are eligible
for pooling and those that are not. For example, Fannie Mae does not have the
ability to pool adjustable-rate mortgages ("ARMs"); therefore, ARM loans are
sorted into the "ineligible for pooling" category. Other loans also might have
features that make them ineligible for pooling. Ineligible loans are passed
through to LASER and do not appear in PPS. LASER's default setting for loans is
HFI, so ineligible loans are given that designation.
Loans that are eligible for pooling enter PPS. At that stage, and
throughout the month in which the loans are acquired, a group in Portfolio
Transactions reviews the loans and, by the end of the month, divides the loans
into three categories: (1) loans that will be pooled and securitized at the end
of the month; (2) loans that might be pooled and securitized at a future date
but not at the end of that month; (3) and loans that the Company will keep in
its portfolio indefinitely.
At the end of month, PPS "tags" the loans. Those destined for
pooling that month or later are designated as HFS; those that the Company will
hold in its portfolio are designated as HFI. PPS transmits that information to
LASER through an interface. Loans that are slated to be pooled that month are
delivered into a trust.
We understand that the system error arose from the difference in the
timing of when loans are set-up in LASER and when PPS transmits its information
to LASER. Loans are set-up in LASER at the beginning of the month following the
month in which they are acquired. Accordingly, when PPS transmits
classifications to LASER at the end of the month of acquisition, LASER does not
show a record for that loan and the designation is not effective. At the
beginning of the next month, when the loans are set up in LASER, that lack of
designation results in a default designation of HFI. We also understand that
loans designated for a future pool would appear in PPS each month
- ----------
(1285) In an analysis of the PPS error that Jonathan Boyles prepared in March
2004, he reported that securitizations of the Company's own portfolio
totaled approximately $7 billion, or 0.6% of the Company's total
securitization activity. Mem. from J. Boyles to File, dated Mar. 31,
2004, Zantaz document 1944857, at 5.
333
subsequent to acquisition until those loans were either pooled or Portfolio
Transactions determined they were not to be pooled. At the end of each of those
succeeding months, those loans would reflect an HFS tag in LASER as a result of
the designation in PPS until they were either included in a pool for
securitization or the loan designation was changed from HFS to HFI (i.e., the
loan would not be pooled).
As OFHEO noted in its letter, the OOPS process was developed in the
early 1980s. We have seen no documentation or other evidence to indicate that
the system error was anything more than an oversight regarding the interface
between PPS and LASER and the timing of the data exchange between the systems.
As OFHEO noted, the principal question in these circumstances is one of controls
- - that is, why the Company did not recognize the error during that twenty-year
period.
B. Accounting for HFS Loans
The designation of loans as HFI or HFS was significant to Fannie Mae
from an accounting perspective. Loans designated as HFI are carried on Fannie
Mae's balance sheet at amortized historical cost. HFS loans are recorded at the
acquisition cost, but are subsequently recognized at LOCOM, with adjustments
reflected in income.(1286)
We therefore considered the perspective of the Controller's Office
with respect to the financial reporting of the loans that the Company held for
sale. Three aspects of the error were significant.
First, the Controller's Office did not make LOCOM adjustments based
on the HFS inventory in LASER. Rather, the Controller's Office received a report
each month of the inventory in PPS. According to Richard Stawarz, the
Controller's Office based its LOCOM adjustments on the PPS reports. A document
captioned "FAS 65 LOCOM Accounting Policy and Operational Procedures," although
apparently updated recently to reflect more current practice, referred to the
Controller's Office's receipt of reports from Portfolio, and from PPS
specifically, regarding the inventory of HFS loans.(1287) Because the error did
not affect the loans in PPS, the error would not have been apparent to the
Controller's Office.
Second, the Company's general ledger accounts during the period 2000
through 2005 show entries for LOCOM adjustments on HFS loans, but not
consistently. The entries in 2000 were less than $200,000. We found no
adjustments during 2001 through March 2004. Periodic LOCOM entries appeared in
the general ledger after that
- ----------
(1286) FAS 65 P. 4.
(1287) FAS 65 LOCOM Accounting Policy and Operational Procedures, dated June 10,
2004, FMSE-IR 632788-91. The document has no indication of when it was
first produced. The person identified as the "Process Performer" was
Emily Passeri, who joined the Company in December 2003, but it is
possible that the document predates her.
334
date. We have not identified the reason(s) for the three-year gap in LOCOM
adjustments. However, the earlier LOCOM adjustments are consistent with the
statement that the Controller's Office received reports of HFS loan inventory,
and explains why an error in the designation process would have been invisible
to it.
Finally, in light of the Company's accounting practices in this area
(i.e., classifying loans at the end of the month), the recorded LOCOM
adjustments at least through 2004 were relatively small. This relates to the
Company's accounting policy concerning HFS loans. Because the Company did not
designate loans until the end of the month, it treated loans acquired and pooled
during a month as securities, not as loans. Any decline in the fair value of
most of the loans that passed through the PPS system during the month of
acquisition, therefore, were small, and discrepancies were difficult to
recognize.
A change in that accounting treatment in 2004 appears to have
originated in a memorandum prepared by Jeffrey Juliane, who noted that,
"[d]uring the holding period of OOPS loans, prior to securitization, these
assets need to be valued at LOCOM."(1288) He said "any loan that is purchased
in the month and pooled in the same month, no matter how long the holding period
of these loans are [sic] these assets are not valued at the lower of cost or
market prior to delivery to STATs for transformation into a security. This is
incorrect." (1289) Juliane reported that at the end of the previous period, the
Company "had outstanding on our books $1.4 billion dollars [sic] of OOPs
inventory in our security portfolio."(1290) LOCOM adjustments began again in
March 2004.(1291)
III. FINDINGS REGARDING THE PORTFOLIO POOLING SYSTEM
The group within Fannie Mae to which the HFS designation was
relevant was the Controller's Office. The PPS-LASER interface error did not
affect their work, as they received reports from the PPS system before the error
had any effect on the designation of the loans. Moreover, the Company's approach
to accounting for HFS loans prior to 2004 meant that the volume of loans subject
to LOCOM accounting was small, making detection of any error in the population
more difficult. With these points in mind, we can understand how the error in
the interface between PPS and LASER could have been missed for as long as it
was.
- ----------
(1288) Mem. from Jeffrey Juliane to Janet L. Pennewell and Mathew Douthit, dated
Jan. 28, 2004, FMSE-IR 521365-69, at FMSE-IR 521365.
(1289) Id.
(1290) Id.
(1291) This information is reflected in the Company's general ledger, which is
available on Homesite.
335
PART L: THE DEBT REPURCHASE ("BUYBACK") PROGRAM
I. INTRODUCTION
This section addresses Fannie Mae's execution of debt repurchase
transactions ("buybacks") in the period from 2000 through 2004, including
management's motivation for the buybacks, the impact of the buybacks on the
Company's reported earnings, and the disclosures internally and to the public
concerning the buybacks. Buyback transactions were not raised as an area of
concern by OFHEO in its 2004 Report or in its February 11, 2005 letter to
Stephen B. Ashley. We focused on buybacks as transactions after discovering
e-mails between senior management that appeared to focus on EPS impact of
conducting buyback transactions.
Based on our review, we conclude that buyback transactions were
accounted for and reported in accordance with GAAP. Management also fully
disclosed the debt buybacks and the resulting losses in Fannie Mae's published
financial statements. We further conclude that there were legitimate business
reasons for executing debt buybacks from 2000 to 2004, including management of
interest rate risk and other portfolio management-related goals. We have found
however, that management's execution of buybacks suffered from the following
deficiencies.
First, while there was a legitimate business purpose for conducting
debt buybacks, management also had the purpose of using buybacks to affect the
Company's EPS. Evidence showed that management conducted buybacks to depress
income in 2001 through 2003, so that the Company could show stable earnings
growth in subsequent years. Moreover, in determining the size of the buybacks on
any particular occasion, management appears to have focused primarily on the
impact on current period EPS, rather than on any economic analysis. Management's
EPS-related purpose for the buybacks was never disclosed to the Board at any
time, including at a meeting of the Assets and Liabilities Policy Committee of
the Board in January 2004, where management presented, for the first time, an
after-the-fact view of the buybacks conducted in prior years. Notwithstanding
management's failure to disclose its EPS-related strategy for buybacks, however,
the financial press ultimately did understand and focused on this strategy in
mid-2004. We believe it was incumbent on management to fully disclose to the
Board its EPS-related purpose in executing buybacks, before executing the
transactions, especially in view of the fact that management's compensation was
tied not only to EPS, but also to its ability to grow EPS by certain percentages
on an annual basis.
Second, in our view, management executed buybacks in the relevant
time period with little or no contemporaneous analysis of the transactions'
economic benefits to the Company, and followed no clear policy or procedure
before executing such transactions. While we have not found evidence that the
buyback transactions were clearly uneconomic, the absence of any procedure or
contemporaneous documentation supporting buyback decisions represented, in our
view, a control weakness. For example, management who were interviewed about the
buybacks conducted from 2001 through 2003 offered two contradictory statements
about whether contemporaneous economic
336
analysis existed. On the one hand, Controller's Office staff, such as Janet L.
Pennewell, contended that there was a contemporaneous "economic analysis"(1292)
supporting Portfolio's recommendations on buybacks; indeed, a document
reflecting Franklin D. Raines's request for supporting economic analysis for
buybacks seemed to corroborate Pennewell's recollection. On the other hand,
Peter Niculescu, Executive Vice President--Portfolio, dismissed the idea of
conducting economic analysis before recommending buybacks during the relevant
time period as ridiculous, and contended that such analysis would have been so
"simple" that it would not have been worth the paper on which it is written.
This inconsistency in senior management's recollections about the need or
existence of supporting documentation for transactions that caused the Company
losses in excess of $2 billion in one year, suggested to us that the Company's
policies and procedures relating to such transactions were inadequate.
Accordingly, we recommend that the Company develop and implement clear
procedures that identify the documentation and approval authorities required for
conducting buyback transactions.
II. BACKGROUND
Fannie Mae is one of the world's largest issuers of debt securities.
Fannie Mae has stated in public disclosures that its primary purpose for selling
debt instruments is to obtain funds to finance its mortgage purchases and other
business activities.(1293) Fannie Mae operates in the secondary mortgage market
by purchasing mortgage loans from a variety of lenders, including mortgage
companies, savings institutions, credit unions, and commercial banks. Fannie Mae
packages these loans into MBS, for which it guarantees payment of principal and
interest, or purchases these loans for cash and retains the mortgages in its
portfolio.(1294)
From time to time, Fannie Mae extinguishes debt by repurchasing
previously issued noncallable debt at market rates, or by exercising its option
for callable
- ----------
(1292) We have not found any contemporaneously prepared analysis that would have
permitted management to review and approve the "economics" of buyback
transactions prior to their execution. An "economic" analysis would
reflect the assumptions made with respect to the terms and duration of
the replacement debt and the debt cost savings compared to the
incremental cost of the buyback, as well as the effect of the buyback
transactions on Fannie Mae's asset/liability mix. See infra Subsection
III.B.
(1293) See Fannie Mae, Understanding Fannie Mae Debt, available at
http://www.fanniemae.com/markets/debt/understanding_fm_debt/
ufmd_role.jhtml? p=Debt+Securities&s=Understanding+Fannie+Mae+Debt (last
visited Feb. 17, 2006).
(1294) Fannie Mae, 2003 Annual Report (Form 10-K), at 2 (Mar. 15, 2004),
available at http://www.fanniemae.com/ir/pdf/sec/2004/f10k03152004.pdf
(hereinafter "2003 Form 10-K").
337
debt securities.(1295) According to Fannie Mae's disclosures, debt
extinguishment serves to reduce future debt costs and enable the Company to
strategically manage interest rate risk in response to market conditions.(1296)
The total amount of debt extinguished appears on the Company's
income statement as a gain or loss on the repurchase of debt.(1297) From 2001 to
2003, Fannie Mae recognized cumulative pre-tax losses on debt extinguishments of
approximately $3.5 billion.(1298) This figure includes the call and repurchase
of debt securities and notional principal of interest rate swaps.(1299) The
total debt extinguishment amounts for fiscal years 2001 through 2003 are
summarized below:(1300)
Table 1:
FISCAL YEAR
(DOLLARS IN DEBT TOTAL DEBT PRE-TAX GAIN
MILLIONS) DEBT CALLED REPURCHASED EXTINGUISHMENT (LOSS)
- ------------ ----------- ----------- -------------- ------------
FY 2001 $ 173,000 $ 9,000 $ 182,000 ($ 524)
FY 2002 174,000 8,000 182,000 (710)
FY 2003 246,000 20,000 266,000 (2,261)
----------- ----------- -------------- ------------
Total $ 593,000 $ 37,000 $ 630,000 ($ 3,495)
=========== =========== ============== ============
The substantial increase in debt extinguishment activity during 2003
was driven by several factors. Per Fannie Mae's 2003 Form 10-K:
The historically low interest rate environment that persisted
through the first half of 2003 made it economical for us to call or
redeem high cost debt. In anticipation of increasing liquidations in
our mortgage portfolio as a result of heavy refinancing activity, we
replaced the higher cost debt with shorter-term, lower-cost debt.
This dynamic resulted in a
- ----------
(1295) Fannie Mae publishes a list of outstanding callable and noncallable debt
on the Company's website. See Fannie Mae, Debt Activity, available at
http://www.fanniemae.com/markets/debt/debt_activity/outstanding.jhtml?
p=Debt+S ecurities&s=Debt+Activity&t (last visited Feb. 17, 2006).
(1296) 2003 Form 10-K at 38.
(1297) Id. at 122.
(1298) Id. at 38.
(1299) Id.
(1300) Id.; Fannie Mae, 2002 Annual Report (Form 10-K), at 32 (Mar. 31, 2003),
available at http://www.fanniemae.com/ir/pdf/sec/2003/f10k03312003.pdf
(hereinafter "2002 Form 10-K").
338
temporarily elevated spread between the yield on our mortgage assets
and our funding cost. We chose to reinvest a portion of the income
generated from these temporary circumstances in debt repurchases to
reduce our future debt costs.(1301)
Additionally, Fannie Mae's 2003 Form 10-K states that:
A loss realized on a debt repurchase in the current year results in
correspondingly lower debt costs in the future. The debt cost
savings will be realized over the period remaining until the
scheduled maturity of the debt repurchased. We select individual
securities to repurchase based on which securities we believe are
trading at attractive prices in the market as well as
asset/liability risk management purposes. We expect a significant
reduction in the level of debt repurchases in 2004.(1302)
The Company refers to the early extinguishment of noncallable debt
securities as its "Benchmark Securities Buyback Program," which will be referred
to below as the "Benchmark Buyback Program."( 1303) The majority of debt
extinguishment losses from 2001 through 2003, shown in Table 1, supra, resulted
from the Benchmark Buyback Program. As can be seen in Table 2, infra, below, the
total loss incurred by Fannie Mae from this program over this period was
approximately $3 billion. Additionally, the Benchmark Buyback Program
represented approximately 89% of the Company's debt repurchases during the years
2000 to 2004,(1304) and 86% of the losses
- ----------
(1301) 2003 Form 10-K at 38-39.
(1302) Id. at 39.
(1303) See Fannie Mae, Benchmark Securities - Buyback Program, available at
http://www.fanniemae uybacks_overview (last visited Feb. 17, 2006).
(1304) During the same period, there were seventy buyback transactions
categorized by Fannie Mae as "outside" the Benchmark program. Of this
total, all forty-four transactions in 2004 appear to be outside the
Benchmark program. See Undated Buyback Total Debt spreadsheet, Zantaz
document 1573400, attached to e-mail from Ashley Dyson to David Benson,
et al., dated Mar. 16, 2005, Zantaz document 1573396.
339
incurred on buybacks in that period.(1305) Table 2 is a summary of data obtained
from Fannie Mae.(1306)
Table 2
FISCAL YEAR
(DOLLARS IN MILLIONS) FY 2000 FY 2001 FY 2002 FY 2003 FY 2004 TOTAL
- ----------------------------- ------- -------- --------- ----------- ------- ----------
Benchmark Securities
Buybacks w/Book Gain $ 52.58 $ - $ 8.12 $ 2.10 $ - $ 62.79
Buybacks w/ Book Loss - (357.59) (610.05) (2,104.21) - (3,071.85)
------- -------- --------- ----------- ------- ----------
Benchmark Book Gain (Loss) 52.58 (357.59) (601.93) (2,102.11) - (3,009.06)
------- -------- --------- ----------- ------- ----------
Outside Benchmark Securities - (53.85) - (55.32) 32.14 (77.03)
------- -------- --------- ----------- ------- ----------
Total Book Gain (Loss) $ 52.58 ($411.44) ($ 601.93) ($2,157.43) $ 32.14 ($3,086.08)
======= ======== ========= =========== ======= ==========
This section only addresses Fannie Mae's extinguishment of Benchmark debt.(1307)
Moreover, given the size of the losses and increases in buyback activity, the
primary focus of our investigation was fiscal years 2001 through 2003.
III. FINDINGS REGARDING FANNIE MAE'S BUYBACK PROGRAM
Our investigation addressed the following primary issues with
respect to Fannie Mae's debt buyback program: (A) the use of debt repurchases to
meet current EPS targets and depress future EPS growth targets through a reduced
EPS base; (B) the possibility that uneconomic debt repurchases were entered into
for this purpose; and (C) the adequacy of disclosures relating to the buybacks.
- ----------
(1305) See Huron's Analysis of Fannie Mae's March 15, 2005 Debt Repurchase,
Benchmark Buyback Program spreadsheet: Debt Buyback Results Percentage of
Total Transactions, FY 2000-2004 worksheet. The analysis was derived from
Undated Buyback Total Debt spreadsheet, Zantaz document 1573400, attached
to e-mail from A. Dyson to D. Benson, et al., dated Mar. 16, 2005, Zantaz
document 1573396.
(1306) See Undated Buyback Total Debt spreadsheet, Zantaz document 1573400,
attached to e-mail from A. Dyson to D. Benson, et al., dated Mar. 16,
2005, Zantaz document 1573396 (documenting buyback transactions in fiscal
year 2000 through the first quarter of 2005). The book gain (loss)
differences of ($112.6) million, ($108.1) million, and ($103.6) million
in 2001, 2002, and 2003, respectively, between Table 1 and Table 2,
represent the variance from the reported gain (loss) on debt
extinguishment per Fannie Mae's 2003 Form 10-K and the total book gain
(loss) of Benchmark buybacks recorded on the Company's transaction
spreadsheets. See id. (under the "Book Gain ($mm) Pre-tax" column).
(1307) Our review of Fannie Mae's accounting treatment for extinguishment of
callable debt will be addressed separately. See discussion infra Chapter
VI, Part M.
340
A. Earnings-Related Strategy
In its published financial statements, the Company offered two
primary reasons for entering into debt buyback transactions: (1) management of
the Company's interest rate risk, and (2) the reduction of future debt
costs.(1308) In order to achieve its goals related to interest rate risk,
management uses debt buybacks to manage the duration gap, as a "portfolio
management tool" to control the Company's debt trading mix, and as a means to
achieve asset/liability balancing. We have no reason to question the propriety
of these stated goals, and further conclude that the Company's financial
reporting for these transactions was in compliance with GAAP. However, we found
several documents suggesting that management set parameters for the debt
buybacks based on current quarter earnings forecasts, and that buyback
transactions were executed strategically within those parameters to achieve
specific, to-the-penny, EPS figures. These EPS figures, in turn, were in line
with analyst expectations and predetermined AIP targets.
For example, in a September 24, 2003 e-mail to Spencer and
Niculescu, Howard described a conversation that he had had with Franklin D.
Raines in which the two contemplated using debt repurchases to control EPS
growth for the third quarter of 2003, and specifically to achieve a double-digit
increase over the previous year. It appears that the goal of hitting a
predetermined EPS target, including a one cent "cushion," was the primary driver
in the decision about how much debt to repurchase in this quarter. Howard
stated:
I was able to get to Frank this evening on the buyback loss for the
third quarter. (I also showed him the sheet that had $8.87 EPS in
2004, but told him that it was the result of front-ended income that
we did not intend to let flow through.)
His thought for the third quarter - which I think is a good one--
was to come in at an EPS number that would be a double-digit
increase from the third quarter of 2002. A third quarter EPS of
$1.79 would do that - it would be 10.5% above the $1.62 we reported
in the third quarter of 2003.
If that's what we want to do, doing $400 million buyback tomorrow
would cause us to fall short of our objective. Using Leanne's
numbers, a $400 million buyback would put us at $1.78. And of
course, that's without any cushion.
- ----------
(1308) Fannie Mae, 2001 Annual Report, at 26, available at
http://www.fanniemae.com/ir/annualreport/index.jhtml?s=Annual+Reports+%26
+Proxy+Statements (last visited Feb. 17, 2006); 2002 Form 10-K at 32;
2003 Form 10-K at 38.
341
So - we need a lower cap. Without doing any analysis, I'd be
inclined to say $350. A $375 million cap would give us a penny of
cushion ($1.80 versus our $1.79 target). Leanne, how much of a
cushion would you like, if we're shooting for double-digit growth
from Q3 2003? Your view of the right cushion should determine the
maximum loss number we give to Dave.(1309)
Another example, a September 5, 2001 e-mail from Howard to Spencer
and Pennewell, demonstrated a similar approach to budgeting buyback losses in
terms of EPS targets, in this instance for future periods. According to Howard,
Linda K. Knight and others believed:
[Fannie Mae] could generate losses in the $40 to $50 million range.
The current projection has us doing $80 million in losses on
buybacks, so - assuming the rest of the projection remains unchanged
and we do indeed wish to come in at $1.31 on third quarter EPS -
this would leave us with $30 to $40 million to do later on this
month in long zeros or 30 years.(1310)
Pennewell did not dispute that buyback transactions had been used to
meet EPS forecasts. She described a process, similar to the approach
demonstrated in the above e-mails, whereby Howard and Raines determined a
"budget" for buyback losses based on the Controller's Office earnings forecast,
and applied that budget to the transactions recommended by the Treasurer.
Pennewell stated her belief that the buyback budget corresponded to the
difference between actual earnings and earnings targets. Knight described a
similar practice and stated that the Treasurer generally identified buyback
opportunities based on favorable pricing and then engaged in conversations with
Spencer and/or Howard, who gave approval for certain of those transactions based
on specific gain/loss parameters.
Niculescu stated that he was not involved in the earnings-strategy
component of buyback sizing decisions. Rather, according to Niculescu, he had
given Howard in 2003 a "standing" recommendation to execute as many debt
repurchase transactions as possible due to the compelling economic environment.
Neither Knight nor Niculescu could identify an instance in which the Company
missed an EPS target as a
- ----------
(1309) E-mail from Timothy Howard to Peter Niculescu and Leanne G. Spencer,
dated Sept. 24, 2003, Zantaz document 554934, at 2. This and other
examples of documents relevant to the discussion in Chapter VI, Part L
can be found in the accompanying Appendix, at Tab D.12.
(1310) E-mail from J. Pennewell to Shaun Ross et al., dated Sept. 5, 2001,
Zantaz document 1562367, at 1 (forwarding earlier e-mail from T. Howard
to L. Spencer, J. Pennewell, et al.).
342
result of executing a buyback transaction. We have similarly not found any
evidence of such an instance.
Additional documents support the notion that the principal driver
behind Fannie Mae's buyback budget related to present-period earnings
management. For example, in a December 10, 2003 e-mail to Knight regarding a
debt buyback transaction, David Benson, Vice President -- Credit Policy, cited
Pennewell as communicating a "need" for $250 to $325 million.(1311) Similarly,
in a May 30, 2003 e-mail to Pennewell and Spencer, Benson similarly stated that
"[the buyback transaction's] objective would be to meet any quarter end
requirements for income and liability management purposes."(1312) And, in an
October 16, 2003 e-mail to Spencer and others about not "overshooting" EPS,
Howard stated that "[t]he FAS 149 transition adjustment gave us an additional
$285 million (pre-tax) in income. To hit the EPS number we'd planned for, we
needed to buy back that much more debt."(1313)
Other evidence showed that another objective of management's buyback
strategy was to diminish earnings in the present period in order to more easily
achieve future EPS growth goals. In particular, management strategically used
debt buyback transactions as one of several means to achieve the challenge laid
down by Raines in 1999 to double EPS in five years. An unidentified speech
prepared for a senior management retreat in 1999 made this point clear:
So having to double earnings when your base year has very high
income is a challenge. Tim [Howard], who has always been more clever
than I, on the other hand, used the excess float income to buy back
debt at a loss thereby depressing his income in the base year.(1314)
In addition to this document, members of management interviewed during this
investigation have consistently cited debt buybacks as a method used by Fannie
Mae in 2001 and 2002 to "shift" income into future years.(1315) For example,
Adolfo Marzol stated that Fannie Mae repurchased debt pursuant to guidance from
Raines in May 2001
- ----------
(1311) E-mail from D. Benson to Linda K. Knight, dated Dec. 10, 2003, Zantaz
document 1577517.
(1312) E-mail from D. Benson to L. Spencer and J. Pennewell, dated May 30, 2003,
FMSE-IR 566482-84, at FMSE-IR 566482.
(1313) E-mail from T. Howard to L. Spencer et al., dated Oct. 16, 2003, FMSE-E
31897-98, at FMSE-E 31897.
(1314) Cape Cod Strategic Meeting, dated June 28, 1999, FMSE-IR 577572-86, at
FMSE-IR 577572.
(1315) QBR Summaries, dated May 2002, FMSE-IR 565521-27 at FMSE-IR 565524.
343
that the Company seek opportunities to invest in the future instead of
maximizing profit in the current year.(1316) Niculescu also stated that
management, and Howard in particular, sought buybacks as a means to pursue a
"stable pattern of earnings," which he confirmed meant sequential earnings
growth.(1317)
This EPS-related strategy for buybacks was, in our view, a possible
motivation for management because management's bonus plan was tied to final
reported EPS without regard for non-operating or non-recurring items. Had the
Company not executed buybacks in these years, the Company would have achieved
EPS numbers that were even higher than the actual results. Such results,
however, would have set a higher bar for showing growth for years 2003 and 2004.
By engaging in transactions that depressed the EPS for 2001 and 2002, management
lowered the base year for purposes of measuring subsequent years' EPS growth,
which was a metric used for setting bonuses.(1318)
B. Documentation for Buyback Decisions
We have found no contemporaneous documentation of any analysis of
the economic benefits of entering into buyback transactions, either by the
Controller's Office, Mortgage Portfolio, or senior management, including the
CFO. Based on our review of documents and based on witness interviews, we
conclude that management did not perform any contemporaneous economic analysis
of the benefit of debt buyback transactions. While certain individuals, such as
Pennewell, stated the belief that such analyses had been performed by Mortgage
Portfolio, none could recall with any specificity or identify any documentation.
Knight and Niculescu, furthermore, denied that such analysis was prepared in
their areas.
Niculescu stated that the calculation of economic benefit to Fannie
Mae of buyback transactions was so simple and obvious that it likely would not
have been written down. He also stated that in 2003, he had made a standing
recommendation to Howard to buy back as much debt as possible. Nevertheless, at
least one document we reviewed suggests that at least Raines believed that an
economic analysis was relevant to his decision as to whether to authorize a
large debt repurchase. Responding to brief descriptions by Howard and Niculescu
of the rationale for entering into $1.7 billion of debt repurchase and losses of
$290 million, Raines stated: "I am fine with this. The document you showed me
didn't seem to have the economics of the buybacks included
- ----------
(1316) While not referring to specific guidance from Raines, Robert Schaefer
similarly recalled that buybacks were one way that the company sought to
increase income in future years.
(1317) Louis Hoyes, Executive Vice President - Single Family, also noted that
buybacks were one means by which Fannie Mae could achieve stable earnings
growth.
(1318) See generally infra Chapter VIII, Subsection III.B.2.
344
on it. Did I misread it?"(1319) This e-mail reflected at least Raines's
impression that such an analysis was being performed. While the economic
advantage of some buyback transactions may have been so obvious or intuitive to
Niculescu or Howard given market conditions at the time, the total absence of
any documentation requirement or process for conducting these significant
financial transactions, demonstrated an ad hoc approach to conducting buybacks
that, in our view, was a control weakness.
Similarly, while Fannie Mae publicly stated that interest rate risk
management was a primary purpose for conducting debt buybacks,(1320) we also did
not find any analysis or documentation of this effort. Knight affirmatively
stated that Fannie Mae did not, as a matter of course, analyze a link between
replaced debt and the new, cheaper debt issued by the Company. Niculescu
minimized asset/liability balancing as a driver for buyback transactions and
stated that buybacks would only help Fannie Mae's asset/liability management
strategy to a very small extent. Niculescu further stated that an analysis
regarding the effect of buyback transactions on Fannie Mae's asset/liability
balancing would be complex, and would be difficult to execute contemporaneously
for each transaction.(1321)
Finally, we found no policy or operational document governing Fannie
Mae's debt buyback program.(1322) Pennewell, Knight, and Niculescu all stated
that Howard retained and exercised his authority both to set the budget for
buyback losses, and ultimately to sign-off on only certain of those transactions
identified by the Treasurer. Howard's authority over buyback transactions
appears to be confirmed by the documents described above. The lack of written
guidance on debt buybacks, and Howard's apparently broad discretionary authority
without Board of Directors authorization, further cemented our views that there
were little or no controls governing buyback decisions.
C. Economics of Fannie Mae Debt Buybacks
To determine whether the buyback transactions executed by management
during the relevant period were, in fact, economically beneficial to the
Company, we analyzed over 600 debt securities repurchased between 2000 and 2004
as part of the
- ----------
(1319) E-mail from F. Raines to T. Howard, dated Dec. 17, 2003, Zantaz document
872583, at 1.
(1320) 2003 Form 10-K at 38.
(1321) Id.
(1322) See Buyback Process Meeting, dated Jan. 20, 2004, FMSE-IR 685233
(suggesting a lack of formal guidelines for buyback transactions).
345
Benchmark Buyback Program.(1323) Our testing did not identify any transactions
that were clearly uneconomic.
Our assessment was high-level and based on data provided by the
Company.(1324) A full assessment of the economics of buyback transactions would
center on the savings associated with replacing high-cost debt with lower-cost
debt compared to the incremental cost of the buyback. The assessment would also
include the related repricing and interest rate risk of future movement of
interest rates at the time of the buyback transactions as well as the use of
capital to fund the significant losses incurred.
As part of our analysis, we compared the loss on the retired debt to
the present value of the interest savings from repaying the high coupon debt and
replacing it with lower market rate debt of the same maturity. Use of matched
maturity replacement debt assumes that the maturity of the replacement debt is
equal to the remaining period of the extinguished debt. This assumption makes
the transaction "neutral" from an interest rate risk/asset and liability
perspective before consideration of prepayments on mortgage investments.
Under this testing, we concluded that 76.7% of the Benchmark
transactions had insufficient savings on a matched maturity basis. The present
value of the total benchmark buybacks with insufficient savings on a matched
maturity basis for the period 2001 through 2004 was approximately $627 million
and the calculated net future cost for Benchmark buybacks form 2001 through 2004
totaled approximately $404.4 million.(1325) These findings are summarized in
Table 3, below.
- ----------
(1323) We did not include transactions identified by the Company as "Not
Benchmark" or "Outside Benchmark" in this analysis.
(1324) We relied primarily on several versions of Fannie Mae's "Buyback Total
Debt" spreadsheets that detail historic buyback transactions. The updated
versions contain current and historical data. The most recent spreadsheet
was attached to a March 16, 2005 e-mail from Dyson to Niculescu, Benson,
Knight, Ross, and others regarding "MTN buyback." The attachment "Buyback
Total Debt" contains buyback transaction data from 2000 through the first
quarter of 2005, including the "Notional Repurchased ($mm)" amount, the
Company "Book Gain ($mm) Pre-tax," and corresponding "Trade Date"
information for each buyback. See supra notes 1304 and 1306.
(1325) Per Fannie Mae's documentation, thirteen, thirteen, and forty-four
buyback transactions in 2001, 2003, and 2004, respectively were
categorized as "outside Benchmark securities." See Undated Buyback Total
Debt spreadsheet, Zantaz document 1573400, attached to e-mail from Ashley
Dyson to David Benson et al., dated Mar. 16, 2005, Zantaz document
1573396.
346
Table 3
FANNIE MAE FY 2001-2004 BUYBACKS
--------------------------------------------
Number of % of
Debt Buyback Transactions Transactions Amount ($mm) Transactions
------------------------- ------------ ------------ ------------
Buybacks w/ Net Future Savings 122 $ 222.59 23.3%
Buybacks w/ Net Future Cost 401 ($ 627.03) 76.7%
--- --------- -----
Total Benchmark Buybacks 523 ($ 404.44) 100.0%
--- --------- =====
Outside Benchmark Securities 70 ($ 18.91)
--- ---------
TOTAL 2001 - 2004 BUYBACKS 593 ($ 423.35
=== =========
However, to the extent the Company was replacing and shortening the
debt maturity in response to an acceleration of prepayments on the mortgage
assets held for investment, this matched maturity assumption does not reflect
the true potential savings because it does not reflect the lower cost of shorter
term debt and therefore is not conclusive.
Indeed, while the lack of a full economic analysis by the Company
prevents us from fully modeling all factors, our independent analysis of
reasonable "break even" rates (i.e., the rates at which the Company could have
borrowed in order to recover losses incurred as a result of the buyback
transactions) and corresponding maturities during the relevant period suggests
that the Company could have recouped the losses incurred in connection with the
buybacks.
D. Disclosures
We next examined whether management fully disclosed all components
of its debt buyback strategy to the public and to the Board of Directors.
1. Public Disclosure
Fannie Mae accurately disclosed the most important facets of its
Benchmark Buyback Program to the investing public. These disclosures included
some statements about the role of earnings in buyback decisions. For example,
Fannie Mae stated in its Form 10-Q for the quarter ending March 31, 2004:
"Because debt repurchases, unlike debt calls, may require the payment of a
premium and therefore result in higher extinguishment costs, we generally
repurchase high interest rate debt at times (and in amounts) when we believe
Fannie Mae has sufficient income available to absorb or offset those higher
costs."(1326)
- ----------
(1326) Fannie Mae, 2004 Quarterly Report (Form 10-Q), at 11 (Aug. 9, 2004),
available at http://www.sec.gov/Archives/edgar/data/310522/
000095013304003115/w99629e10vq.htm. An earlier draft of similar language
in the second quarter 10-Q also contained the following qualifier:
"provided the impact of such purchases is consistent with our earnings
goals." See Revised Debt Extinguishment Language,
347
By early 2004, market analysts had made the connection between
Fannie Mae's Benchmark Buyback Program and the Company's earnings goals. For
example the Dow Jones Newswire published an article on April 15, 2004 regarding
Fannie Mae's first quarter financial results, entitled "Fannie Mae 1Q EPS Seen
On Target, As Debt Buyback Slowed."(1327) The article stated:
Fannie Mae (FNM) is expected to post a modest gain in first-quarter
profits, largely because the mortgage giant scaled back a deliberate
strategy of debt repurchases that weighed down the bottom line in
previous periods.
. . . "We believe a reduction in debt buyback expenses provided a
cushion to earnings," Lehman Brothers analyst Bruce Harting said.
Fannie's debt-repurchase strategy was a voluntary practice it used
in recent years to "cookie jar" or push out abundant earnings to
future quarters. In effect, Fannie Mae paid premiums to buy back
high-cost debt, moderating earnings growth and lowering future
funding costs. In breaking the habit, Fannie Mae may be signaling
that the days of heady earnings growth have waned.
"The losses on debt repurchase last year were largely discretionary,
designed to transfer income from years of enormous strength, such as
the 2003 refi boom, to leaner times, such as years of falling refis,
rising ARMS and slowing asset growth," Sanford Bernstein analyst
Jonathan E. Gray recently said in a research note.(1328)
In an internal e-mail forwarding the above article to Niculescu, Howard did not
dispute Jonathan Gray's characterization of the buybacks:
FYI - I'll bet that most analysts and investors will view the
absence of debt buybacks in the first quarter the same way Jonathan
Gray did. If so, we may not even get the question, and if we do get
it, some version of his
- ----------
dated May 10, 2004, Zantaz document 790842, at 2. The qualifier, however,
was removed before the disclosure was finalized.
(1327) E-mail from T. Howard to P. Niculescu, dated Apr. 15, 2004, Zantaz
document 877604, at 1 (forwarding the Dow Jones Newswire article of same
date).
(1328) Id. at 1 (emphasis added).
348
interpretation as our answer is what most of our audience will
expect to hear.(1329)
While Fannie Mae's public disclosures did not state expressly that
formal economic analyses supported buyback decisions, management made several
statements in disclosure documents and on investor calls that suggested the
existence of a contemporaneous analysis of economic benefit, which, as noted
above, did not exist. For example, the Company stated in its 2003 Form 10-K that
"[t]he historically low interest rate environment that persisted through the
first half of 2003 made it economical for us to call or redeem high cost
debt."(1330) Howard and Niculescu also engaged in the following discussion
during a July 15, 2003 call with investors:
PETER NICULESCU, EVP MORTGAGE PORTFOLIO BUSINESS, FANNIE MAE: Let me
add just a couple of brief points. The first is that the actual
liquidations we're expected to see in the mortgage portfolio in July
and August will almost certainly be higher than the numbers we
recorded in May and June . . . it takes a couple of months for that
to flow through into mortgage liquidations. And you will see higher
prepayments, higher liquidations out of the mortgage portfolio in
July and August than we had seen previously.
The second point is that our opportunities to buy back debt have
been relatively advantages to us in the last couple months, really
ever since the presses partly as a result of the Freddie Mac
restatement. And it may very well be the case as we look forward in
the next couple of months that we will continue to see advantageous,
economically advantageous opportunities for us to buy back debt as a
result of some of these, the current market trading levels.
[DAVID HOCHSTIM]: Okay. And then could you just talk again a bit
about debt repurchases and the NPV of - I guess prospective
purchases and how much more positive it can be if you get these
market opportunities that Freddie creates for you and over what
period of time could these, I guess, benefits accrue?
PETER NICULESCU: . . . It's worth noting that if we - if we buy,
let's say, three-year debt and as a result, incur a -- a loss at the
time of purchase, what we have done is
- ----------
(1329) Id.
(1330) 2003 Form 10-K at 38.
349
reduced lower our costs of funds for the next three year, by the
future value of that - of that debt by - of cost. So it is an
immediate lowering of our - of our cost of funds for that time
period. Obviously we're lowering the cost of funds by less on an
annual basis but for a longer time period.
TIM HOWARD: Peter, it's true that the payback we get is typically
more than the present value of the expenditure, that we will
typically be able to achieve debt reissue or having trade better for
subsequent issues.
PETER NICOLESCU [sic]: Absolutely. This is part of what's been
helpful to us as a result of some of the market volatility that
we've seen recently that we've been able to buy back debt at levels
that are generally more available to us than issuing the debt so
there's a net benefit in the immediate future that we can execute
that. Along the term there's probably a fit to the overall market in
our ability to issue and that becomes clear to our investors and our
debt that if the debt reaches a level where it's attractive for us
to buy it back, we will do so, and that -- that, in turn has a
beneficial effect, I believe, on we can issue debt and where the
debt program as a whole goes in the future.(1331)
Niculescu confirmed that there were no contemporaneous analyses
performed to determine "economically advantageous opportunities" or to ensure
that "payback" was more than "present value of the expenditure." In fact, in
Niculescu's view, such analyses would be so elementary as to not require written
documentation. Notwithstanding his views, the above discussion could be read to
suggest that management had conducted economic analysis before making buyback
decisions, which would not be accurate.
2. Board Disclosure
We have found no evidence showing that management disclosed to the
Board its earnings-related strategy for buybacks. In fact, we found no
statements to the Board or any of its committees prior to 2004 - when the vast
majority of the buyback transactions already had been executed - and the
statements in 2004 to the Board did not disclose the earnings-related strategy
for buybacks.
Niculescu gave a presentation on "Debt Repurchase" to the Assets and
Liabilities Policy Committee of the Board of Directors of Fannie Mae on January
22,
- ----------
(1331) Draft updated disclosure outline attachment to e-mail from J. Lopez to G.
Baer et al., dated Sept. 30, 2004, Zantaz document 2920368, at 9-10.
350
2004.(1332) The presentation made brief reference to an earnings component in
buyback decisions, stating: "If market conditions provide a compelling
opportunity to buy back debt, we will consider the repurchase and factor the
earnings and cost impacts into the decision."(1333) Statements elsewhere in the
presentation, however, as well as the line quoted above, suggest that decisions
on buybacks were based on economics, cost/benefit analysis, and interest rate
risk assessments. For example, Niculescu cited the following as factors for
"[d]etermining [w]hich [s]ecurities to [r]epurchase":
a. Duration management
- If the match of assets with liabilities requires less
long-term debt, we can reduce long-term debt by buying
it back
b. Reducing the average future cost of debt
- The attractiveness of buying back debt in any particular
maturity is relative to where we expect to be able to
fund at the same maturity in the future. This involves
making judgments on the relative attractiveness of
different repurchase candidates.(1334)
Taken as a whole, in our view, the presentation suggested to the Board that
buyback decisions were based primarily on an analysis of multiple factors
relating to the economic benefit to the Company, and did not disclose the fact
that earnings management was a principal driver behind management's buyback
decisions.
In summary, we have not found any evidence that management ever
disclosed to the Board its strategic use of buybacks to structure EPS growth or
to achieve forecasted EPS. Such information, in our view, was critical
information for the Board's ability to assess the quality of the Company's
performance; moreover, because bonuses were calculated based on the final
reported EPS without regard for non-operating or non-recurring items, we believe
that management's strategic use of buybacks to achieve earnings goals should
have been made transparent to the Compensation Committee for its consideration
in awarding bonuses.
- ----------------------
(1332) See Debt Repurchase presentation, Assets and Liabilities Committee,
Fannie Mae Board of Directors, dated Jan. 22, 2004, Zantaz document
1371682.
(1333) Id. at 4.
(1334) Id. at 8.
351
IV. RECOMMENDATIONS
Based on these findings, we believe that the Company would benefit
from three primary recommendations. First, we recommend that management
contemporaneously document the basis for recommending or executing buyback
transactions. We do not challenge earnings targets as a factor to consider
before executing buyback transactions. However, we question the strategic use of
buyback transactions to achieve specific EPS goals, as outlined above, and we
find that the disclosure to the Board about management's strategy for the
buybacks were inadequate. We believe that accurate documentation of the decision
to conduct buyback transactions is necessary to ensure that management's purpose
is transparent to all, including the Board. We recommend that Fannie Mae
implement procedures and policies for such documentation going forward.
Second, in similar vein, the Company should improve its internal
controls regarding buyback transactions by creating and documenting a clear
execution, approval, and monitoring process. As noted in the April 2005 Office
of Audit's "Debt Funding Audit," the Company's controls were inadequate and:
"Accounting policy guidelines need to be expanded to better address . . .
benchmark repurchase agreements[.]"(1335) In addition, the report noted that the
monitoring controls of the Treasurer's Back Office ("TBO") require improvement
including more formal review and approval by management.(1336) Management's
corrective actions addressing these concerns stated that effective immediately,
"TBO will ensure that all Benchmark repurchases are verified by a TBO analyst
and reviewed by TBO management, including formal sign-off on the Trade Log
Binder."(1337) Finally, the corrective actions stated: "In addition, all
benchmark repurchases require approval from the Executive vice [sic] President
[Niculescu] prior to execution. Treasury Compliance will monitor all
transactions, to ensure that proper authorization is received. Monitoring
efforts began March 28, 2005."(1338)
We recommend that management implement these corrective actions
immediately, to the extent it has not already done so. Additionally, we
recommend that the Executive Vice President -- Mortgage Portfolio perform a
comprehensive review of the economics of buyback transactions as part of the
approval process. The Company also should maintain its documentation of any
analysis consistent with its document retention policies.
- ------------
(1335) Debt Funding Audit, Audit Report, Office of Auditing, dated Apr. 29,
2005, FMSE-IR 685070-87, at FMSE-IR 685071.
(1336) Id. at FMSE-IR 685079.
(1337) Id. at FMSE-IR 685081.
(1338) Id.
352
Finally, we recommend that management provide regular and
comprehensive briefings to the Board of Directors regarding the purpose, nature,
and results of buyback transactions before they are executed, rather than
after-the-fact.
PART M: ACCOUNTING FOR THE AMORTIZATION OF CALLABLE DEBT EXPENSES
In this Part, we discuss Fannie Mae's accounting for the costs it
incurred when it issued callable debt.(1339) We consider the Company's policy,
as well as its application of that policy through "amortization end-date
changes."
I. INTRODUCTION
As described in other sections of this Report, Fannie Mae issued
both callable and noncallable debt to finance its activities. When Fannie Mae
issued debt, it incurred various expenses such as commissions, legal fees, and
similar costs. In addition, any difference between the face amount of the debt
and the proceeds from issuance gave rise to a premium or discount on the debt
issuance.
Fannie Mae's accounting for these debt issue costs was inconsistent
with GAAP in several respects. These accounting treatments were not driven by
systems limitations, or by an effort to simplify the application of complex
accounting rules to a large portfolio. On the contrary, the Company's accounting
in this area required cumbersome and time-consuming operations that would have
been unnecessary had it properly followed the accounting literature. Moreover,
the Company did not apply its approach to the accounting for callable debt
expense in a consistent fashion. On at least one occasion, for the quarter ended
September 2002, it made a late on-top entry that can be explained only as an
effort to offset another entry and thereby bring net interest income in line
with the Company's expectations.
The Company's approval of the amortization of callable debt expense
appears to reflect Financial Standards' long-standing misinterpretation of the
applicable accounting rules, rather than a deliberate disregard of them. The
evidence concerning the periodic adjustments, and particularly the adjustment in
the third quarter of 2002, however, leads to the conclusion that the Company
used these adjustments to meet earnings expectations. At the very least, Leanne
G. Spencer and Janet L. Pennewell played key roles in recording that adjustment.
The evidence also shows that KPMG was aware of the Company's
accounting policy regarding callable debt expense, and also was aware of the
September 2002 on-top adjustment. It does not appear, however, that KPMG knew
all of the circumstances surrounding that adjustment.
- --------------
(1339) This issue was not raised by OFHEO in its 2004 Report or in its February
11, 2005 letter to Stephen B. Ashley.
353
II. BACKGROUND
A. Applicable Accounting Principles
The relevant accounting literature, Accounting Principles Board
Opinion No. 21, Interest on Receivables and Payables, ("APB 21"), requires that
premium or discount associated with debt be amortized over the life of that
debt:
With respect to a note that by the provisions of this section
requires the imputation of interest, the difference between the
present value and the face amount shall be treated as discount or
premium and amortized as interest expense or income over the life
of the note in such a way as to result in a constant rate of
interest when applied to the amount outstanding at the beginning of
any given period. This is the interest method. Other methods of
amortization may be used if the results obtained are not materially
different from those that would result from the interest
method.(1340)
When the debt is not callable, the life over which the premium or
discount and issue costs should be amortized is equal to the time period between
issuance and maturity. APB 21 does not distinguish between noncallable and
callable debt in this regard. That is, unless and until the call option is
exercised, the period over which debt issue costs should be amortized is the
period between issuance and contractual maturity. If the debt is called prior to
maturity, any unamortized costs would be recognized in the period in which the
debt is repaid.
- --------------
(1340) INTEREST ON RECEIVABLES AND PAYABLES, Accounting Principles Board Opinion
No. 21, P. 15 (Accounting Principles Bd. 1971) ("APB 21"). OMNIBUS
OPINION - 1967 AMORTIZATION OF DEBT DISCOUNT AND EXPENSE OR PREMIUM, APB
Opinion No. 12 (Accounting Principles Bd. 1967) ("APB 12"), also
addresses the interest method, stating:
The objective of the interest method is to arrive at a periodic
interest cost (including amortization) which will represent a level
effective rate on the sum of the face amount of the debt and (plus
or minus) the unamortized premium or discount and expense at the
beginning of each period.
APB 12 makes clear that the period over which premium (or discount) and
expense (i.e., debt issue costs) are recognized is the same.
354
B. Fannie Mae's Application of the Literature
Fannie Mae's practice for amortizing issue costs on callable debt
was to determine the likely date on which it would call the debt and amortize
the expense over the period from issuance to that date. Fannie Mae's 1994
accounting policy guidelines regarding debt issue costs stated:
The estimated life is used to determine the effective cost of funds
for callable debt. The estimated life is reviewed as needed based on
interest rate movements and the interest accrual (for "step-up"
debt) the amortization period for discount, issue cost and deferred
hedging results is adjusted accordingly on a prospective
basis.(1341)
In other words, the amortization period for callable debt (1) was to be based on
the estimated, rather than the actual, life of the debt, and (2) the estimate
could be revised on an undefined "as needed" basis.
The 1994 policy cites as support the consensus on EITF 86-15, and
quotes the following passage from that consensus:
The borrower's periodic interest cost should be determined using the
interest method based on the outstanding term of the debt. In
estimating the term of the debt, the borrower would consider plans,
ability and intent to service the debt. Debt issue costs should be
amortized over the same period used in the interest cost
determination.(1342)
The Company reworded its policy regarding the amortization of
callable debt costs in the 2003 version of its accounting policy guidelines,
although the substance - including the reference to review of the amortization
period "as needed" - remained the same:
Fannie Mae uses estimated life to determine the effective cost of
funds for callable debt. Fannie Mae reviews the estimated life based
on interest rate movements on a regular basis. Fannie Mae adjusts
the amortization rate for premium/discount and hedge results on a
prospective basis. Additionally, Fannie Mae amortizes debt issuance
costs over the estimated life of the callable debt using the
interest
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(1341) Financial Accounting Policy Manual, dated Oct. 20, 1994, FMSE-SP
79123-239 at FMSE-SP 79193 (emphasis added).
(1342) INCREASING-RATE DEBT, Emerging Issues Task Force of the Fin. Accounting
Standards Bd., Issue No. 86-15 (May 1986) ("EITF 86-15").
355
method. The amortization period associated with these debt issuance
costs is reviewed as needed based upon interest rate movements and
debt extinguishments.(1343)
The 2003 policy references APB 21 as the source for this guidance.
In applying its accounting policy, Fannie Mae would compute
"amortization end-date changes." That is, if a change in interest rates resulted
in a new expected call date for the Company's debt, when the Company made an
amortization charge, the Company would amortize the relevant expense over the
debt's new estimated life. As reflected in the Company's policy, the practice
was to determine the estimated life of the Company's callable debt at the outset
and to re-evaluate that estimate at varying intervals.
In our view, the Company's policy violated GAAP. APB 21 requires
that all debt issue costs be amortized "over the life of the note," consistent
with the period over which premium or discount is recognized.
Fannie Mae's 1994 policy guidelines, and individuals in the
Controller's Office during our interviews, referred to EITF 86-15 as the basis
for the Company's policy in this area. That guidance, however, does not address
callable debt. EITF 86-15 addresses a fact pattern in which a company issues
debt that matures in three months, but that could be extended at the issuer's
option in three month increments at a higher interest rate, with a maximum
possible term of five years. The literal application of APB 21 to that fact
pattern would have resulted in the amortization of debt issue costs over the
first three months, even though it was likely that the issuer would exercise its
option to extend the maturity date. The EITF concluded that the issuer should
project the term for which the debt would be outstanding and use that estimated
period to determine the effective interest rate. We do not believe it was
appropriate for Fannie Mae to analogize to the guidance on extendible debt in
determining its accounting for callable debt.
Moreover, although the 1994 policy refers to EITF 86-15, the 2003
version of the policy omits that reference in deference to APB 21. However, that
change had no impact on the Company's accounting. It does not appear on the
record available to us that the Company considered changing its policy during
its review of the accounting policy in 2003.(1344)
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(1343) Financial Accounting Policy Guide, dated Oct. 2003, FMSE-SP 78953-9118 at
FMSE-SP 79049.
(1344) The treatment of issue costs on callable debt was considered even prior
to the date of the revision to the policy. See Mem. from Jonathan Boyles
to James Kocornik-Mina, dated May 28, 2002, FMSE-SP 40331. The memorandum
states: "If, however, the expected life changes (as commonly happens with
callable debt in changing rate environments) a new yield must be computed
from the date the expected life changed to the new end of life."
356
Finally, even assuming that it was appropriate to analogize to the
consensus reflected in EITF 86-15, that guidance would not permit the Company to
change the amortization rate once the initial expected life had been chosen.
This feature of Fannie Mae's policy does not have a basis in the accounting
literature.
Separate from the misinterpretation of the accounting literature is
the reference in the Company's accounting policy (since at least 1994) to
changes in the amortization end-dates "as needed." The evidence (discussed
below) shows that the Company's application of its policy resulted in
inconsistent revisions to the amortization end-dates. The Company performed the
end-date changes only when it was logistically convenient or otherwise deemed
necessary by senior management in the Controller's Office. The Company has not
offered a rationale in any accounting standard for this feature of its policy.
In sum, the record shows that Fannie Mae's policy regarding the amortization
of the debt issue costs associated with callable debt was based on an incorrect
interpretation of the accounting rules. The Company's policy, moreover, appears
to have invited inconsistent application of the amortization end-date change
process. Particularly in view of the latter, we reviewed the history of the
Company's application of that process.
C. Amortization End-Date Changes
By all accounts, as reflected in both interviews and documents,
Fannie Mae did not apply its policy regarding the calculation of amortization
end-date changes for callable debt with regularity. The officials responsible
for the application of the policy - including Janet L. Pennewell and individuals
in Financial Reporting responsible for debt accounting - acknowledged that the
end-date changes were conducted only episodically.(1345)
When an amortization end-date change was undertaken, the process
was initiated by a request from the Controller's Office to Portfolio Management
for an update on the expected call dates of the Company's debt. Portfolio
Management would then determine the expected call dates and prepare an estimate
of the income or expense associated with the end-date changes. The Debt
Accounting group in the Controller's Office would incorporate the new end-dates
into the Company's STAR (and, later, its iSTAR) debt accounting system in a test
environment and determine the actual income or expense associated with the
end-date changes. The results of the test runs in the Controller's Office were
then compared with the estimates received from Portfolio Management, and any
discrepancies were evaluated. Senior personnel in the Controller's
- -----------
(1345) We did not discuss this issue with Leanne G. Spencer prior to her refusal
to participate in further interviews.
357
Office would then decide whether or not to adjust the amortization of issue
costs by moving the test into production.(1346)
There are indications that the Company was very sensitive even to
seemingly minor differences between Portfolio Management's projections and the
results of the tests conducted in Financial Reporting. In 2001, Cheryl
DeFlorimonte reported a $1.2 million difference between the Portfolio Management
estimate and the results of the Financial Reporting calculations. She told her
supervisors, "We have spent all day trying to ascertain the reason for the
unusually large variance of $1.2 million, to no avail."(1347) She then explained
the disruption this had on other activities: "We have been unable to use the
STAR production database for the last four work days. Consequently, a back log
of new deals, rate resets, and calls have accumulated. We need to make a
decision ASAP as to whether we should rely on the results from the test done in
STAR Acceptance and proceed with the update to Production, or whether we should
again postpone the update due to the $1.2 million variance between STAR and
Portfolio Management projections."(1348) Pennewell sent an e-mail to
DeFlorimonte and others later that afternoon stating: "just [sic] so you know, I
approved this despite the difference from projection. The alternative was
deferring and trying again next month, which did not seem desirable since I view
the only downside as the risk that we record a little too much expense this
year."(1349)
The Portfolio Management personnel responsible for calculating the
end-date changes did not ordinarily produce a report on this subject, or
calculate the income effect of the end-date changes. Rather, that group was able
to extract the relevant estimates from its broader effort to manage the
Company's portfolios and provide earnings estimates. Supporting the financial
reporting function, therefore, required an extra undertaking on the part of
Portfolio Strategy.
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(1346) Documents reflect the role of Financial Reporting on the decision of
whether to book an adjustment and in what amount. An e-mail dated January
26, 2000 from Gary Robinson to Ted Belay, for example, concerns the
procedure for implementing an amortization end-date change in February.
After describing the process (including an initial run in STAR's test
mode, and then in its production mode), it states, "Gary will present the
results to Financial Reporting's management on the morning of Thursday,
Feb. 17th. The results of this anaylyst [sic] may require that we
eliminate certain months for amortization end date changes in the source
file." E-mail from G. Robinson to T. Belay, dated Jan. 26, 2000, Zantaz
document 738103.
(1347) E-mail from Cheryl DeFlorimonte to Richard Stawarz and Janet L.
Pennewell, et al., dated Mar. 19, 2001, FMSE-IR 684282.
(1348) Id.
(1349) E-mail from J. Pennewell to C. DeFlorimonte, et al., dated Mar. 19, 2001,
FMSE-IR 684281.
358
The Controller's Office, too, had no system for processing an
end-date change efficiently, or for calculating the effect on the Company's
debt-cost amortization into a normal close of the Company's books at the end of
a reporting period. An amortization end-date change, we have been told, required
up to four days' effort during which the STAR debt accounting system would be
unavailable to process other activity. Accordingly, the step could not be
implemented either at the close of the quarter or when other work was deemed
more important. For example, in August 2004 (after the Company had converted to
iSTAR), the Controller's Office decided not to process an end-date change or to
book the resulting change in the amortization of callable debt expense;
Financial Reporting "pass[ed] on Aug[ust] implementation due to resource
constraints and materiality." The implementation of the end-date change was
scheduled for the following November.(1350)
Other documents convey a similar message. In November 2003, for
example, Financial Reporting notified Portfolio Management of an anticipated
end-date change calculation. The notification states: "After several discussions
with members from the Financial Reporting group, we have decided to proceed with
the amortization end date changes using the November file. During the month of
December, we will be tasked with providing numerous estimates, including the
impact from debt buyback/derivative termination activity. We prefer not to
complicate matters with amortization end date estimates the last month of the
quarter/year."(1351)
In 2003, Financial Reporting began a process to implement the
end-date changes in a more systematic fashion. According to instructions issued
by Pennewell, the most significant change in the Company's procedures that
resulted from this effort was that Portfolio Management would provide Financial
Reporting with a new estimate of end-date changes and the income impact of those
changes on a regular basis. At that point, Financial Reporting would "determine
whether the impact is material...." Then, "if material," the end-date changes
would be implemented in a test mode, evaluated against the Portfolio Management
estimates, "and any differences researched. Once we're comfortable with [the]
results," the changes would be recorded in the debt accounting system.(1352)
- ----------------
(1350) E-mail from Rick Swick to William Quinn, dated Aug. 30, 2004, FMSE-E
1785523. Another e-mail in the same chain, dated August 23, 2004, from
DeFlorimonte to Pennewell and Mary Lewers explained that the end-date
change was impossible due to deployment of iSTAR Release 2.1. The e-mail
stated that the end-date change would be implemented in November: "Our
policy is to perform end date changes during the first or second month of
the quarter. However, based on current resources, processing end date
changes and simultaneously producing quarterly reporting during the month
of October is not recommended." Id.
(1351) E-mail from C. DeFlorimonte to R. Swick, dated Nov. 6, 2003, FMSE-E
1821333.
(1352) E-mail from J. Pennewell to R. Swick and W. Quinn, dated Aug. 11, 2003,
FMSE-E 265996-97.
359
A memorandum incorporating these instructions was prepared in
October 2004.(1353) It called on Portfolio Management to provide an end-date
change analysis for Financial Reporting on a quarterly basis. The updates would
be scheduled during the first month of the quarter but, "[i]n the event a
conflict with another significant business activity renders an update
impracticable during the month of the scheduled update," then (1) if the update
had been scheduled for the first month of the quarter, it would be rescheduled
for the second month, and (2) if the update was scheduled for the second month,
the situation would be presented to senior management for their review;
"[d]epending on the materiality of the estimated impact on income/expense that
would result from end date changes during that month of the scheduled update,
senior management will make a decision whether to defer processing the
amortization end date changes . . . or process the update in spite of the
conflicting business activity."(1354) Apparently, in light of the issuance of
the OFHEO Report in September 2004, there was little, if any, further
consideration of these issues.
D. The September 2002 End-Date Adjustment
The Company recorded $35.3 million of additional amortization
expense through an on-top entry for the third quarter of 2002. Contemporaneous
documentation associates this entry with a separate $43 million entry to
recognize additional interest income as a result of a premium/discount
amortization adjustment. Had the Company not recognized the $35.3 million
adjustment, its net interest income would have increased by 3.7 percent over net
interest income for the second quarter of 2002. The amortization end-date change
reduced the change in net interest income from the second quarter to 2.3
percent.(1355)
According to one member of Financial Reporting, who recorded the
events leading up to that adjustment:
Based on discussions with KPMG, Tim and Frank, today Janet requested
that we book an on-top estimated amortization expense entry for the
September reporting period. Because of the decreasing rate
environment, a large income entry for purchase discount amortization
has been generated for the September reporting period. These
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(1353) According to DeFlorimonte, Financial Standards delayed preparation of a
formal procedure to implement Pennewell's instructions pending the
conversion of the STAR system to the iSTAR system.
(1354) Draft mem. from C. DeFlorimonte to Distribution, dated Oct. 4, 2004,
Zantaz document 202983.
(1355) Comments attributed to Controller's Office management in a survey
conducted in late 2002 by Marsh Risk Finance indicate that a change in
net interest income of more than three percent "would be viewed as
significant."
360
decreasing rates have also necessitated that we perform an
amortization end date update on our callable debt portfolio. This
end date change procedure will increase expense, (pulling up the end
dates) and has been scheduled to be implemented for the October
reporting period. However, in order to match our mortgages with our
liabilities, the 35.3 million estimated expense impact from the
amortization end date changes will be recorded as an on top entry on
September. This on-top entry will be reversed during the October
reporting period and the actual amortization end date chances [sic]
will be processed. Management staff attending this discussion
included [Pennewell, Richard Stawarz, Mary Lewers, Gary Robinson,
Jennifer Wall and DeFlorimonte].(1356)
Journal entries dated October 10, 2002, with an effective date of September 28,
2002, reflect the $35.3 million entry.(1357)
The suggestion in the e-mail is that the decision to book this
adjustment was prompted by a desire to offset most of a discount amortization
adjustment. That suggestion, although not based on the first-hand knowledge of
the e-mail's author, appears credible for several reasons. First, as the e-mail
notes, the amortization end-date change was not scheduled until the following
quarter. Therefore, Financial Reporting did not have the opportunity to process
its own adjustment in the STAR system, but rather took the unusual step of
basing the end-date change entry on a Portfolio Management estimate. Then, in
the fourth quarter, the Company reversed the $35.3 million entry and processed
the actual end-date change. The decision to book the end-date change ahead of
schedule and based on an estimate gives credence to the e-mail's implication
that the Company used the entry to offset another unusual entry that period.
Second, other evidence shows that the Company was concerned about
the volatility associated with these adjustments, even on a monthly basis. In
the fourth quarter of 2002, the Company calculated that the amortization
end-date change resulted in additional interest expense of $31.5 million, $24.1
million, and $19.3 million for October, November, and December 2002,
respectively.(1358) The Company booked the
- -----------------
(1356) E-mail from C. DeFlorimonte to C. DeFlorimonte, dated Oct. 10, 2002,
FMSE-IR 437919. The e-mail was prepared by DeFlorimonte and sent to
herself. She stated that she prepared the e-mail because of the unusual
nature of the entries she was asked to book. We have seen no
corroboration of DeFlorimonte's suggestion that Frank Raines was involved
in the decision to book this entry.
(1357) Journal Entry, dated Oct 10, 2002, FMSE-IR 437922.
(1358) E-mail from C. DeFlorimonte to J. Pennewell and W. Quinn, dated Nov. 4,
2002, FMSE-SP 10804.
361
$31.5 million in October, at the same time that it reversed the $35.3 million
entry reversing the entry from the second quarter.(1359) These October entries
therefore largely offset each other.
The Company also recorded an additional adjustment of $14.5 million
in October, reflecting one-third of the $43.4 million expense associated with
the November and December estimates. The $14.5 million entry was reversed by a
$7.5 million entry in November and a $7 million entry in December.(1360) This
approach was recorded in Stawarz's handwritten note as follows: "Recorded a
$14.5 million OOC [out-of-cycle] expense in Oct to smooth remaining expense from
the debt end date over Nov and Dec. Reverse $7.5 mil of above in Nov. and
remaining $7.0 mil in Dec."(1361) An entry on the Company's December 2002
Closing Notes, which Stawarz also prepared, states: "Reversed $7.0 million end
amortization smoothing entry (to spread costs evenly over the quarter) and
credited to clean debt expense."(1362) Although Stawarz acknowledged that he
prepared the handwritten notes, he professed to have no recollection of the
$35.5 million adjustment in the third quarter of 2002, or the other entries in
the fourth quarter.
Third, it appears that the Company did not fully disclose the
circumstances of this adjustment in this matter to its outside auditors. A KPMG
audit workpaper dated October 25, 2002, captioned "On-top entry related to the
amortization of debt issuance costs" discusses the $35.3 million entry. After
discussing the Company's general approach to the amortization of callable debt
issue costs, the memorandum states: "Generally, the change in amortization
period is run through the STAR system and is reflected in the general ledger at
period end. However, in the third quarter, the on-top entry was booked due to
timing of when the rate path information was available and the completion of the
analysis."(1363) DeFlorimonte confirmed that this was not an accurate
- --------------
(1359) Undated October 2002 Closing Notes, FMSE-SP 10807.
(1360) Journal entries reflecting these adjustments are attached to an e-mail
from Pennewell to DeFlorimonte dated November 4, 2002. E-mail from J.
Pennewell to C. DeFlorimonte and W. Quinn, et al., dated Nov. 4, 2002,
Zantaz document 1974463. In addition, DeFlorimonte prepared a handwritten
chart showing the various entries based on instructions she received.
Undated handwritten notes, FMSE-IR 437928.
(1361) Id.
(1362) December 2002 Closing Notes, dated Dec. 2002, FMSE-SP 10860. Handwriting
on another copy of the Pennewell e-mail cited supra note 1360 states:
"43.4 /3 = 14.5. On top entry to be booked over the next three months per
Dick/Gary." E-mail from C. DeFlorimonte to J. Pennewell and W. Quinn, et
al., dated Nov. 4, 2002, Zantaz document 1449228.
(1363) Mem. from Jennifer Eng to Third Quarter Workpapers - Quarterly Review
Binder, dated Oct. 25, 2002.
362
statement of what had occurred. It should be noted, however, that KPMG's
workpaper attributes this information to Portfolio personnel; it does not appear
that KPMG discussed the matter with anyone in the Controller's Office.(1364)
Fourth, there are other indications that the Company used its
amortization of issue costs to offset the impact of entries in other areas. At
about the same time as the $35.3 million adjustment was under consideration, an
issue arose with respect to a separate adjustment of nearly $19 million
associated with the amortization of the expense associated with exercised
swaptions. An e-mail from Pennewell states: "Leanne says book the whole $19
million in September. We'll likely offset with a pda [premium/discount
amortization] on-top. Both should be OOC."(1365)
The impact of the amortization end-date changes on the Company's
financial statements is reflected in e-mails exchanged at about this time. In
her November 4, 2002 e-mail to Pennewell, DeFlorimonte noted that the increase
in expense as a result of the September/October end-date change was $74.9
million.(1366) This is consistent with the Company's journal entries regarding
the on-top adjustments (that is, the $31.5 million booked in October (after
reversal of the September entry) and the $43.4 million increase in November and
December). DeFlorimonte projected an increase in expense of $72.9 million in
2003 and a decrease in expense of $11.9 million in 2004. Pennewell responded
that "we may still want to spend some time trying to figure out what is making
the 2003 and 2004 numbers so different."(1367)
Finally, it appears that the manner in which the end-date change was
executed in the third quarter of 2002 was inconsistent with how end-date changes
were processed in other periods. For example, in May 2002, the Company did not
process
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(1364) In an interview, Mark Serock, the KPMG audit partner at the time, stated
that he had discussed the $43 million premium/discount amortization
adjustment with Pennewell, Spencer and Timothy Howard. After Serock
concluded his discussion with them, Howard and Spencer approached KPMG to
tell them of the amortization end-date adjustment.
(1365) E-mail from J. Pennewell to M. Lewers, C. DeFlorimonte, R. Stawarz, and
Shaun Ross, dated Nov. 4, 2002, FMSE-SP 10799. No one we spoke to
recalled the e-mail or the $19 million entry. Pennewell speculated that
DeFlorimonte might have been concerned about the need to book an
unexpected $19 million expense, and that the e-mail was Pennewell's
effort to resolve the situation. However, when asked whether she was
concerned about a $19 million adjustment at that time, DeFlorimonte said
she was not.
(1366) E-mail from C. DeFlorimonte to J. Pennewell and W. Quinn, dated Nov. 4,
2002, FMSE-SP 10804.
(1367) E-mail from J. Pennewell to C. DeFlorimonte, dated Nov. 4, 2002, FMSE-SP
10801.
363
end-date changes for any debt that it anticipated calling in June, July, or
August.(1368) However, in September 2002, a significant portion of the $35.3
million adjustment resulted from accelerating amortization of issue costs on
debt called in October, November, and December into the third quarter
result.(1369)
III. FINDINGS
The Company's accounting policy regarding debt issue costs was
inconsistent with GAAP insofar as it (1) treated callable debt and noncallable
debt differently at the outset, and (2) sanctioned end-date amortization charges
"as needed." Although one can question both the reference to inapplicable
accounting literature in the pre-2003 policy, and the failure to change the
policy when the appropriate literature was cited in the 2003 version of the
policy, we have seen nothing to suggest that these deviations from GAAP were
other than inadvertent misinterpretations of the literature.
The Company's application of its policies and procedures regarding
the amortization of callable debt issue costs was inconsistent and, on at least
one occasion in the third quarter of 2002, deployed in a fashion that was a
deviation from the Company's past practice for the purpose of offsetting another
entry and avoiding volatility in a key financial measure. Moreover, although it
appears that Fannie Mae's outside auditor was aware of the Company's accounting
policy as reflected in its policy guidelines, and at least as of 2002 was aware
of the adjustment in September 2002, the evidence suggests that KPMG may not
have been fully informed as to the nature of, or reasons for, this
adjustment.(1370)
- -------------------
(1368) E-mail from C. DeFlorimonte to R. Stawarz, dated May 30, 2002, Zantaz
document 1974487.
(1369) The record contains a chart reflecting the amortization end-date changes
and cost of the debt included in the calculation. FMSE-IR 437950-76. An
incomplete copy of the chart was also included in KPMG's workpapers.
(1370) In April 2005, the Company's Office of Auditing ("Internal Audit") issued
an audit report on debt funding. See Office of Auditing, Debt Funding
Audit, dated Apr. 29, 2005, Zantaz document 1450686. Its findings are
relevant to the issues under consideration. In summary, Internal Audit
concluded: "Policies and modelling functions for changing amortization
end dates on callable debt lack Financial Standards' guidance and
approval. Also, controls need improvement to ensure consistent
implementation, effective data validation checks, and adequate
documentation." Internal Audit also noted that "[a]ccounting policy
guidance needs to be expanded to better address step rate debt, benchmark
repurchase agreements and debt issuance costs."
364
PART N: MINORITY LENDING INITIATIVE
In this Part, we report on accounting issues that arose in the
course of Fannie Mae's Minority Lending Initiative ("MLI").
I. INTRODUCTION
Fannie Mae implemented the MLI program in 2002 to increase the
Company's financial support for mortgages to African-American homeowners. The
initiative was seen as an important component of the Company's overall mission
and, by some, as a means of securing loans that would meet the guidelines set by
HUD.
Concerns regarding the initiative itself were raised to us by a
Company employee in response to an e- mail broadcast to all employees by Ann M.
Korologos, Chair of the SRC of the Board of Directors.(1371) The employee was
concerned that the Company appeared to be paying an excessive price for loans
that were underperforming and that the MLI program might have been devised to
meet corporate targets. As noted above, we have concluded that the plan was
envisaged by some as a means of achieving corporate targets - specifically, the
Company's internal mission goals as well as HUD goals - but we saw nothing in
the record of the program to indicate that it had an improper purpose.
In the course of our review of the record, however, we identified
one issue concerning the accounting for payments in 2003 that the Company made
to Resource Bancshares Mortgage Group, Inc. ("RBMG"), the mortgage lender that
sold Fannie Mae a majority of the loans acquired under the MLI program. The
Company capitalized these payments as part of the cost of the acquired loans.
Given the nature of the payments, however, we believe the Company should have
expensed them in 2003. The aggregate amount of the payments we have been able to
identify was approximately $35.5 million.
II. BACKGROUND
A. The MLI Program
The MLI program began early in 2002 when the Company set a goal to
acquire approximately 10,000 purchase- money mortgages of African-American
homeowners.(1372) The program involved a new product that would be launched
through a lending partner involved in the African-American community.(1373)
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(1371) See infra Chapter XI, Part A.
(1372) Minority Lending Initiative Review Report, dated Oct. 10, 2003, FMSE-KD
15557-633, at FMSE-KD 15560 (hereafter "MLI Report"); MLI 1 Update,
dated Sept. 2, 2003, FMSE-IR 670769-80, at FMSE-IR 670771 (hereinafter
"MLI 1 Update").
(1373) MLI 1 Update at FMSE-IR 670770.
365
Fannie Mae identified RBMG as one of its lending partners in the MLI
program.(1374) The first phase of the initiative involved an agreement between
Fannie Mae and RBMG to sell loans that satisfied the MLI criteria to Fannie Mae.
In 2002, RBMG began to offer mortgages to its customers under the terms of the
program. RBMG in turn sold these loans to Fannie Mae. Under the terms of the
agreement, Fannie Mae paid a premium for the loans - essentially paying a market
price for prime loans, but receiving loans with credit characteristics more
closely associated with subprime loans.(1375)
The MLI program was troubled from the outset in many respects. The
most significant issue stemmed from the fact that the loans originated under the
MLI program had loan to value ("LTV") ratios of ninety-seven percent or
greater.(1376) Fannie Mae understood that it was required under its Charter to
have some form of credit protection for the amount of the loans in excess of
eighty percent LTV.(1377) Accordingly, Credit Policy arranged for a mortgage
insurer to cover the loans under an existing policy.(1378) However, because the
loans to be insured had lower credit scores than the loans the policy was
originally written to cover, and because the Company only planned to hold the
loans for a short time before selling them, Credit Policy provided verbal
assurances that the insurer could cancel the coverage after a one-year
period.(1379) As Fannie Mae continued to acquire loans from RBMG, however, it
was unable to find a buyer for the MLI loans at a price that would not generate
a substantial loss. In February 2003, the Company made the decision to classify
loans it had acquired to that point, as well as new loans it would acquire under
the program, as held for investment.(1380)
- ------------
(1374) MLI Report at FMSE-KD 15661. Fannie Mae also had arrangements to
acquire MLI loans originated by two other lenders. MLI 1 Update at
FMSE-IR 670773. Neither of those lenders appears to have been a party
to the arrangement discussed herein.
(1375) See E- mail from Renee Schultz to Andrew McCormick, dated Aug. 28,
2003, FMSE-E 1116534-35, at FMSE 1116535 ("We are offering a market
rate for sub-prime credit quality, and paying up 110 bps in price for
it!!").
(1376) See MLI 1 Update at FMSE-IR 670774.
(1377) MLI Report at FMSE-KD 15564. Fannie Mae's initial plan was to
accumulate loans originated under the program and sell them. Id. at
FMSE-KD 15558. Accordingly, the loans should have been classified as
held for sale on the acquisition date.
(1378) Id. at FMSE-KD 15565.
(1379) Id. at FMSE-KD 15564-65.
(1380) Id. at FMSE-KD 15563.
366
The mortgage insurer canceled Fannie Mae's coverage under the policy
after the one-year period.(1381) Accordingly, loans in the MLI pipeline that the
Company had committed to purchase, as well as the loans that the Company was
holding pending possible sale, would not have been in compliance with the
Charter.
After receiving notice that the mortgage insurer was exercising its
right to cancel coverage of the MLI loans, the Company considered several
options to address the Charter compliance issue relating to loans that Fannie
Mae had committed to acquire.(1382) These strategies revolved primarily around
selling some or all of the loans at a loss, or acquiring mortgage insurance at
high premiums.(1383)
As to loans "in the pipeline" that the Company was obligated to
acquire, the Company structured another arrangement. Under this arrangement,
another company, Self Help, agreed to purchase the loans that Fannie Mae was
committed to purchase from RBMG.(1384) Self Help would then sell the loans to
Fannie Mae with a six- month recourse period (that is, Self Help would
repurchase any loans that defaulted within six months of the sale). According to
Fannie Mae, this credit enhancement to the loans resolved the Charter compliance
problem.(1385)
In recognition of the fact that the loans were originated at
favorable interest rates given the borrowers' credit ratings, however, Self Help
acquired the loans from RBMG at a discount to the price Fannie Mae was committed
to pay. In order to make RBMG whole, Fannie Mae made a series of payments to
RBMG equal to the difference between the price at which Self Help acquired the
loans and the Company's commitment price.
The MLI program and, in particular, the payments to RBMG reflecting
the subsidy that Fannie Mae paid on the loans, resulted in a substantial
economic loss for the Company.(1386) In September 2003, the decision was made to
cancel the program.(1387)
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(1381) See id. at FMSE-KD 15568.
(1382) MLI 1 Update at FMSE-IR 670773.
(1383) Id.
(1384) E- mail from Rebecca Mattoni to Janet L. Pennewell, dated June 21,
2004, FMSE 543587-90.
(1385) Id. at FMSE 543587. The original proposal was for RBMG to execute a
six- month repurchase agreement, but the Company concluded that such an
agreement was not feasible. MLI 1 Update at FMSE-IR 670773. A
transaction with Self Help was considered subsequently. Undated MLI
Loan Pipeline: Deal Alternatives, FMSE-E 170959-60, at FMSE-E 170959.
(1386) MLI 1 Update at FMSE-IR 670773-74.
367
Based on the information available to us, we do not question the
rationale or motives behind the MLI program. We understand that the management
issues raised by the MLI experience were examined within the Company in late
2003 and certain recommendations - including the need for more coordination and
cooperation - were proposed.(1388)
B. Accounting for the Payments to RBMG
In late 2003, Financial Standards was asked to consider how the
Company should record the payments to RBMG. At one point, Financial Standards
concluded that the payments should be recognized as an expense. Financial
Standards then reversed that decision and determined that the payments could be
capitalized as part of the cost of the loans acquired from Self Help.
E- mail exchanges on the subject suggest that this change of views
occurred following discussions with KPMG, but the exchange does not permit a
definitive conclusion as to the nature of KPMG's advice.(1389) Jonathan Boyles
recalled that KPMG approved the capitalization of the payments.
According to internal documents, the Company made payments to RBMG
in October, November, and December 2003 totaling $35,536,254,42.(1390) We have
been unable to determine the rationale for the ultimate decision that the
payments should be
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(1387) MLI Report at FMSE-KD 15564.
(1388) See id. at FMSE-KD 15570-71.
(1389) Consultation with KPMG on this issue is reflected in two e- mails. In
an e-mail exchange between Jonathan Boyles and Paul Salfi, Boyles
reported that "kpmg [sic] has said that if we buy these and put them
into hfi [held for investment] then they would go on at cost. Only a
pair off would be an immediate hit. They checked with their national
office." E- mail from J. Boyles to P. Salfi, dated Sept. 24, 2003,
FMSE-E 171246. This e-mail appears to reflect a view that the payments
to RBMG should have been expensed, resulting in an "immediate hit."
In a second e- mail, also dated September 24, 2003, from Leanne G.
Spencer to Louis Hoyes and Timothy Howard, states: "Jonathan took KPMG
through the transaction w/ Self- help [sic]. They opined, after seeing
the transaction, that capitalizing the loss from the pairoff was
appropriate." E- mail from L. Spencer to L. Hoyes and T. Howard, dated
Sept. 24, 2003, FMSE-E 1155661. Boyles, who had been copied on the
earlier e- mail, responded that "[t]his treatment is consistent with
other pair off transactions we do when we pair off and buy like
assets." Id.
(1390) E- mail from R. Schultz to Jeffrey Juliane, dated Nov. 21, 2003, Zantaz
document 1011100.
368
capitalized. Had Fannie Mae recognized the $35.5 million of additional expense,
it would have reduced earnings for 2003 by $.02 per share.
III. FINDINGS REGARDING THE MLI PROGRAM
In our view, the Company's decision to capitalize the payments to
RBMG was not consistent with GAAP. FAS 91 provides that only those fees paid to
the party from whom loans are acquired (or amounts received from that party) may
be capitalized as part of the purchase price.(1391) In this case, the relevant
payments did not go to Self Help.
We are unable to determine the basis for the decision to capitalize
the expense because we are unable to reach a conclusion as to the content of
KPMG's advice. The only documentary sources of that advice - the two e- mails -
are ambiguous. Boyles' recollection is that KPMG approved the decision to
capitalize the expense and his e- mail indicates that, in his view, the payments
to RBMG were similar to a pairoff fee, which the Company historically had
treated as a cost of the acquired loan.
PART O: ACCOUNTING FOR REALIGNMENTS AND THE SECURITY MASTER PROJECT
I. INTRODUCTION
This section addresses the Company's accounting for differences
generated in the process of identifying and correcting errors and mismatches
between its amortization database and loan and securities databases. The process
of adjusting the amortization database to match the loan and securities
databases was known as a "realignment."
We focused on management's accounting for the impact of realignments
initially because of the concerns OFHEO raised in the OFHEO Report. OFHEO
reported, in substance, that management's accounting for realignment impacts
from 2002 through 2004 was not consistent with GAAP and was designed to manage
earnings. Specifically, OFHEO took issue with management's practice of including
realignment differences in its estimation of catch- up, alleging that "the
catch-up results were changed by including adjustments that were incorrect or
inconsistently applied."(1392)
We concur with OFHEO's assertion that management did not account for
realignment impacts properly under GAAP. In certain circumstances, realignments
represented corrections of errors, and as such, management should have analyzed
and accounted for their impact in accordance with Accounting Principle Board
Opinion No.
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(1391) FAS 91 P. 15.
(1392) OFHEO Report at 58.
369
20, Accounting Changes ("APB 20"),(1393) effective for fiscal years beginning
after July 31, 1971. Management failed to do so. Additionally, management
introduced data into iPDI, the amortization system of record, through
realignments that it knew, or should have known, was incorrect.
Moreover, management's accounting for realignment impacts identified
between 2000 and 2004 was not consistent. For the most part, management deferred
the recognition of these differences by recording them to balance sheet accounts
and amortizing them into income over multiple years. On other occasions, in
addition to deferring the recognition of these differences and amortizing them
into income over time, management included the cumulative deferred realignment
amounts and estimates of future realignments in its calculation of catch-up; and
still on other occasions, management recognized the realignment impacts into
income in the period they were identified.
Employees with responsibility for the realignments whom we
interviewed could provide neither a credible reason why management failed to
apply APB 20 to realignment impacts nor any coherent rationale for the
inconsistent accounting treatment of such impacts. At a minimum, this
demonstrates that the Company did not have adequate accounting policies or
procedures to ensure compliance with GAAP in this area. Furthermore, the
decision to capitalize and defer realignment impacts over time smoothed out the
errors' impact on income in any one period. With respect to the inclusion of
realignments and estimates of realignments in the catch- up calculation in 2003,
we conclude that management was motivated, in part, to avoid recording or to
reduce the amount of the catch-up adjustment required under the Company's
amortization policy.
II. BACKGROUND
Fannie Mae's current system of record for premium and discount
amortization is iPDI, which was historically known as PDS and PDI (collectively,
"iPDI"). iPDI calculates and records premium and discount amortization to the
general ledger by applying amortization factors to original premium and discount
amounts. The original premium and discount amounts that iPDI relies upon are
received monthly, for new acquisitions, from the STAMPS (for MBS(1394)) and
Delivery (for whole loans) systems. The original premium and discount data from
STAMPS and Delivery is also provided to the STATS (for MBS) and LASER (for whole
loans) databases which track the Company's portfolios of MBS and whole loans at
a security or loan level.
After the original premium and discount data is provided to iPDI,
STATS, and LASER, changes to the classification of the loan or security, or
amount of original
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(1393) ACCOUNTING CHANGES, Opinion No. 20 (Accounting Principles Bd. 1971).
(1394) MBS data includes Real Estate Mortgage Investment Conduits ("REMICs")
data.
370
premium and discount, may be made to the data in STATS and LASER.(1395) Changes
to the data in STATS and LASER included adjustments to correct securities
misclassifications, make post-purchase price adjustments and track liquidations.
Because there is no automatic feed from STATS and LASER to iPDI, Fannie Mae
periodically conducted manual "realignments" so that the original premium and
discount balances in iPDI matched those in STATS ("STATS realignment") and LASER
("LASER realignment").(1396)
These realignments caused changes to the original premium and
discount balances in iPDI, which resulted in corresponding changes to the
accumulated amortization balances in iPDI and ultimately to the balance sheet.
Rather than recognize the offsetting amount to earnings, management most often
deferred the recognition of these amounts. We review in this section
management's various methods for dealing with the impact of these realignment
adjustments, none of which was consistent with GAAP.
III. FINDINGS REGARDING THE ACCOUNTING TREATMENT OF REALIGNMENT IMPACTS
A. Management's Deferral of Realignment Impacts
Management's accounting for realignment impacts was, for the most
part, inappropriate under GAAP because it allowed the Company to defer over
multiple years the recognition of income or expense resulting from errors in
amortization. As such, APB 20 governs the treatment of realignment impacts.
Because the data necessary to properly classify loans and securities was
available at the time of acquisition, we consider realignment differences to
arise out of a "misuse of facts." Accordingly, based on the guidance in APB 20,
we conclude that the impact of realignments is a correction of an error.
APB 20 requires management to determine the impact of such an error
on prior periods, as well as the impact of correcting the cumulative error on
the current period. If any of these impacts are determined to be material, then
the Company must report the error as a prior period adjustment and disclose the
error in the current period financial statements.(1397) If all of these impacts
are determined to be immaterial, then the
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(1395) Changes to classification are significant because the classification of
loans and securities is a key factor in the determination of how
quickly the associated premium and discount should be amortized.
(1396) We do note that, in one instance, the manner in which Fannie Mae
treated collateral used in dollar roll transactions created errors in
STATS. We also note that in this case management ultimately
"transferred" these errors to iPDI by updating the balances in iPDI
with those in STATS rather than identifying the reasons for the
differences between STATS and iPDI.
(1397) APB 20 P.P. 36-38.
371
Company can simply record the cumulative error in the current period without any
disclosure. SEC Staff Accounting Bulletin No. 99 - Materiality ("SAB 99"),
issued and effective on August 12, 1999, is the pronouncement that addresses
materiality and should be used in determining the accounting treatment in these
situations.
Some members of the Controller's Office - Janet L. Pennewell, Mary
Lewers, and Richard Stawarz - stated that the rationale for management's
accounting for realignments was that the data in iPDI was better controlled and
hence more reliable than the data in STATS and LASER; however, we do not find
this explanation to be persuasive. If the data in iPDI was in fact better
controlled and more reliable than the data in STATS and LASER, the Company
should not have updated the information in iPDI, which was used in determining
the amortization.(1398)
1. Deferral of STATS Realignment Impacts
In 2000, and roughly once a year thereafter, the Company performed a
realignment analysis, which compared iPDI to STATS and recorded the realignment
impact to the balance sheet.(1399) In 2000, the realignment impact was
approximately $81.9 million of additional expense. Rather than analyze this
impact under APB 20, management deferred the realignment impact in two balance
sheet accounts. Approximately $77.1 million of the $81.9 million adjustment was
recorded to an account that typically contained amortization on-top amounts that
had not yet been applied to certain accumulated amortization accounts (i.e.,
1201-07).(1400) Documents and interviews suggest that Jeffrey Juliane may have
considered this account to be similar to a reserve and that recording an amount
to this account was viewed as the equivalent of recording it to the income
statement.(1401) This account typically contained amortization on top
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(1398) Indeed, Stawarz conceded that not processing a realignment would have
been an appropriate option. Stawarz also stated that Fannie Mae
intended, ultimately, to move the amounts recorded to the deferred pool
account into income once the data issues in STATS had been resolved. We
have seen no evidence that amounts recorded to the 1201-01 account were
ever reversed and recorded to the appropriate accounts.
(1399) See, e.g., Fannie Mae STATS Realignment Project Analysis - Summary,
Period Ended October 31, 2000, dated Nov. 30, 2000, FMSE-SP 5009-12;
Journal Entry, dated Nov. 30, 2000, FMSE-SP 11624; Fannie Mae STATS to
PDI Realignment, Period Ended May 31, 2003, dated May 15, 2003, FMSE
193818-20; Journal Entries, dated May 20, 2003, FNMSEC 4375, 4379, and
4382.
(1400) Fannie Mae STATS Realignment Project Analysis - Summary, Period Ended
October 31, 2000, dated Nov. 30, 2000, FMSE-SP 5009-12; Journal Entry,
dated Nov. 30, 2000, FMSE-SP 11624.
(1401) E- mail from Joyce Philip to Jeffrey Juliane, dated July 1, 2003,
FMSE-E 2104712. Patricia Wells stated that amounts recorded to the
1201-07 account already would
372
amounts recorded but not yet applied to certain accumulated amortization
accounts.(1402) Inexplicably, the remaining $4.8 million was recorded to another
balance sheet account.(1403)
In August 2001, management identified the differences between STATS
and iPDI, but did not record any adjustments attributable to the differences
identified in the analysis.(1404) Pennewell stated that she postponed processing
the realignment to avoid causing iPDI to reclassify original premium and
discount into different acquisition years. According to Pennewell, such a
reclassification was not appropriate because acquisition years generally should
not change.(1405) Although the data anomalies were never explained or resolved,
a year later, management went forward with the realignment in order that the
Company's systems not continue to be misaligned.(1406) Pennewell's concerns in
2001 appear to have been reasonable. However, given her explanation,
management's decision to record the results of the realignment analysis in 2002
created errors in iPDI that ultimately resulted in errors in amortization.
From 2002 to 2003, management's practice was to record the
realignment impact to the balance sheet (account 1201-01), and amortize these
amounts into income over time.(1407)
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have been charged to the income statement through on-top entries. This
explanation, coupled with the mechanics of the realignment entry, in
this instance, was consistent with viewing the account as a reserve. In
other words, since the balance in the account was established by on-top
entries that impacted the income statement, any entries clearing
amounts from this account could have been considered already charged to
the income statement.
(1402) In effect, the Company's treatment of the realignment difference as a
reduction of the balance results in using the "reserve" for a purpose
other than the one for which it was established.
(1403) This account, 1230-90, the "PDI Conversion Clearing" account, contained
deferred amortization amounts related to a previous system conversion.
(1404) Fannie Mae STATS iPDI Realignment Summary Analysis, Period Ended August
31, 2001, dated Sept. 13, 2002, FMSE 193762-73.
(1405) Mem. from Janet L. Pennewell to File, dated Nov. 15, 2004, Zantaz
Document 1000371, at 2.
(1406) Mem. from J. Pennewell to File, dated Nov. 15, 2004, Zantaz Document
1000371, at 2.
(1407) Account 1201-01, also referred to as the deferred pool bucket by Fannie
Mae, is an asset account subject to amortization. Amounts recorded to
this account are treated as new acquisitions and amortized over a proxy
life consistent with a fixed-rate
373
Stawarz stated that the decisions on how to treat realignment
impacts were made in multiple meetings at which he, Roger Barnes, Lewers,
Pennewell, and Leanne G. Spencer together concluded that the deferral of
realignment impacts was appropriate.(1408) Beyond this, employees' recollections
were vague as to who had the ultimate responsibility for the decision to defer
realignment impacts. We find that the absence of a clear chain of authority or
approval for accounting decisions that could have as much as an $81 million
impact (i.e., in 2000) on the Company's financial statements was a failure in
the Company's internal controls.
As discussed above, we conclude that STATS realignments, which were
undertaken in large part to correct misclassified securities in iPDI, should
have been accounted for as a correction of an error under APB 20.(1409)
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conventional mortgage. Mortgage Portfolio Deferred Price Adjustments
Policy and Operational Procedures, Realignment Policy, dated Apr. 30,
2004, FMSE 193585-86; Mortgage Portfolio Deferred Price Adjustments
Policy and Operational Procedures P. 4.2.4, dated Aug. 31, 2004, FNMSEC
4169 (these documents, as examples of documents relevant to the
discussion in Chapter VI, Part O, can be found in the accompanying
Appendix, at Tab D.15.); see also Tr. of June 8, 2004 OFHEO Dep. of J.
Juliane at 137:24-138:14 (hereinafter "June Juliane OFHEO Testimony").
(1408) Richard Stawarz was the only individual to acknowledge to us his role
in deciding the accounting treatment for the realignment impact.
Pennewell claimed that she did not decide how the realignment
differences would be recorded; rather, she said Roger Barnes was
responsible for determining the appropriate treatment of them. But
Barnes claimed that the decisions came down from upper management
through his direct supervisor, Mary Lewers. Lewers, for her part,
disclaimed any role in instructing or conveying instructions to Barnes
and pointed to Pennewell and Stawarz, even though Barnes did not report
directly to either of them. Nonetheless, Lewers did say that she agreed
with the decision to defer the recognition of realignments.
(1409) This also appears to have been KPMG's conclusion following its review
of certain realignments. After that review, KPMG noted that the
"misclassifications appeared to be an error . . . pursuant to APB 20."
KPMG Significant Issues and Decisions KPMG workpaper, dated Dec. 1,
2003; see also FAS 91 - Amortization Catch-up Adjustment for Net
Interest Income KPMG workpaper, dated July 30, 2003; see also
discussion infra at note 1452.
374
2. Deferral of LASER Realignments Prior to 1998(1410)
Management also processed LASER realignments since the early 1990s.
The impact of these LASER realignments in the early 1990s were in the magnitude
of tens of millions of dollars and, as with STATS realignments performed in 2002
to 2003, were capitalized and amortized over a proxy life.(1411) Management
offered rationale similar to that offered for STATS realignment impacts for its
treatment of LASER realignment impacts, that is, they had more confidence in the
data in iPDI than they did in the data in LASER due to data integrity issues in
LASER.(1412) This rationale is no more persuasive for LASER realignments than it
was for STATS realignments. We conclude that the LASER realignment impacts also
should have been considered corrections of errors under APB 20, and therefore
management's treatment of LASER realignment impacts in the early 1990s was not
in accordance with GAAP.
B. Some Realignment Impacts Were Recorded into Income in the Period in
Which They Were Identified
Beginning in 1998, management recorded LASER realignment impacts
(which involved relatively minor amounts) to the income statement in the period
in which the differences were identified.(1413) We have not heard any
explanation for treating these
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(1410) Our investigation has not uncovered contemporaneous documentation
regarding these pre-1998 LASER realignments. Our knowledge of the
treatment of these realignment impacts is based solely on statements
made by Fannie Mae employees in the context of describing LASER
realignments performed in the "early 1990s." We are not certain that
the treatment of LASER realignment impacts in the "early 1990s" is
consistent with the treatment of all pre-1998 LASER realignment
impacts; however, we note that the treatment described to us differed
from the treatment that we observed starting in 1998 and for which we
had contemporaneous documentation.
(1411) Mem. from J. Juliane to File, dated Oct. 22, 2003, FNMSEC 2892-93.
(1412) See Pennewell OFHEO Testimony at 426:24-429:23.
(1413) Journal Entry, dated Dec. 3, 2002, FNMSEC 4411 (recording difference to
income statement); Journal Entry, dated Mar. 28, 2003, FNMSEC 4399
(same); Journal Entry, dated Dec. 31, 2003, FNMSEC 4348 (same); Journal
Entry, dated Mar. 25, 2004, FNMSEC 4272 (same). Both Financial
Standards and the Office of Auditing questioned management's
methodology and assumptions used to calculate the impact, and have
criticized Controller's Office's failure to test its assumptions about
the cause of the mismatches between LASER and iPDI. See Undated FAS 91
- Realignment Handwritten Notes, FMSE-IR 289633 (notes from the files
of Gregory Ramsey); Mem. from Joyce Philip to L. Spencer, dated Sept.
3, 2004, FMSE-IR 377946-48, at FMSE-IR 377947. We saw no evidence that
Controller's Office addressed these questions.
375
impacts differently from the pre-1998 impacts, and have assumed that the
difference may be due to the relatively small size of the LASER realignments
beginning in 1998. The inconsistent treatment of these impacts suggested that
management had unfettered discretion in accounting for realignment impacts, and
there was no clear policy or practice at the Company on how to account for
realignment impacts.
C. Inclusion of Realignment Impacts in the Analysis of Catch-Up
Beginning in 2003, management included the cumulative, unrecognized
portion of realignment impacts that had been deferred in prior periods
("cumulative realignment deferral") and estimates of the impact that a security
reclassification effort, known as Security Master, would have in its FAS 91
amortization calculation.(1414) Management disclosed this information to KPMG,
and KPMG did not object.(1415)
1. Security Master Project
Beginning in 2002, management undertook what became known as the
Security Master Project. The Security Master Project was intended to set rules
for the assignment of FAS 91 types to securities, which would reclassify
securities in STATS that had been assigned the wrong FAS 91 types, and automate
the process of assigning FAS 91 types to securities in STATS by implementing a
new rules-based application.(1416) Management anticipated recognizing a
realignment impact as a result of implementing Security Master, and included an
estimate for the Security Master impact in the FAS 91 amortization calculations
in the first quarter of 2003.(1417)
In its amortization calculation for the second quarter of 2003,
management revised its estimate of the impact of implementing Security Master,
and also included the
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(1414) See Q1-2003 Forecast Update, Amortization Runs Sensitivity, December
Book, FMSE-IR 55889; FAS 91 - Amortization Catch-up Adjustment for Net
Interest Income, dated July, 2003; Mem. from J. Juliane to File, dated
July 29, 2003, FMSE-SP 91-93; Mem. from J. Juliane to File, dated Oct.
22, 2003, FNMSEC 2892-93; Mem. from J. Juliane and Rene LeRouzes to
File, dated Apr. 27, 2004, FMSE-SP 260-62.
(1415) See FAS 91 - Amortization Catch- up Adjustment for Net Interest Income,
dated July 30, 2003; Significant Issues and Decisions KPMG workpaper,
dated Dec. 1, 2003.
(1416) Mem. from J. Juliane to File, dated July 29, 2003, FMSE-SP 91-93, at
FMSE-SP 92.
(1417) FAS 91 - Amortization Catch-up Adjustment for Net Interest Income,
dated July 30, 2003.
376
cumulative realignment deferral for STATS realignments.(1418) Finally, in its
amortization calculation for the third quarter of 2003, Pennewell made the
decision to include all outstanding cumulative realignment deferrals.(1419)
According to Pennewell, KPMG concurred with her decision to include realignments
in the catch-up analysis.
By including the estimated impacts of Security Master and the
cumulative realignment deferral in the catch-up analysis, management was able to
reduce the size of, or avoid altogether, the on-top adjustment it would have
been required to record under the Company's Amortization Policy(1420) ("Policy")
during the first three quarters of 2003. Our review of the facts shows that:
- In the first quarter of 2003, the estimated catch-up before
the inclusion of the estimated Security Master Project impact
was roughly $177.2 million in income. The Policy threshold in
this quarter was $99.6 million, and therefore a $77.6 million
adjustment to increase interest income would have been
required under the Policy to bring the catch- up to the
precision threshold.(1421) By including the $118.5 million
estimated expense for the Security Master Project, the
catch-up number was reduced from $177.2 million to $58.7
million, which fell within the Policy threshold, and thus no
adjustment was recorded.(1422) If management had not included
the estimated impact of Security Master in the calculation of
catch-up, the Policy would have required management to record
the $77.6 million of catch- up income, which would have
increased Core EPS from the reported amount of $1.84 to $1.89
for the quarter.(1423) Analysts' consensus
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(1418) This included the unamortized amounts related to the November 2002 and
May 2003 STATS realignments. Mem. from J. Juliane to File, dated July
29, 2003, FMSE-SP 91-93.
(1419) The LASER realignment deferrals relate to realignments performed prior
to 1998. Mem. from J. Juliane to File, dated Oct. 22, 2003, FNMSEC
2892-93.
(1420) We conclude, in Chapter IV of this Report, that the Amortization Policy
was not in accordance with GAAP.
(1421) Q1 2003 Forecast Update, Amortization Runs Sensitivity, December Book,
dated Apr. 30, 2003, FMSE-IR 55889.
(1422) Id.; Q1-2003 Forecast Update, Amortization C-Up Sensitivity, December
Book, FMSE-SP 564A.
(1423) Assuming a thirty-five percent statutory tax rate, the after-tax income
impact of recognizing an additional $77.6 million of interest income
would have been $50.4 million. When divided by the Company's 990.2
million diluted average shares outstanding for the first quarter of
2003, the after-tax impact on EPS would have
377
expectation for the quarter were $1.73.(1424) While the
Company's results exceeded analysts' expectations, by reducing
the amount of the catch- up that would have had to be
recognized as additional interest income, the Company was able
to avoid a spike in net interest income and net income that
may have made it difficult to meet EPS growth targets in
future periods.
- In the second quarter of 2003, the estimated catch-up before
the inclusion of a Security Master estimate and any cumulative
realignment deferral was $220.5 million of income. The Policy
threshold in this quarter was $105.2 million, that would have
required management to recognize an additional $115.3 million
of interest income to bring the catch-up to the
threshold.(1425) However, management reduced the catch- up
adjustment to $126.4 million by including a revised Security
Master estimate and cumulative STATS realignment deferral
totaling $94.1 million of deferred expense. Accordingly, an
adjustment to recognize additional interest income of only
$21.2 million was recorded.(1426) If management had not
included these realignment adjustments into the calculation of
catch-up, it would have had to record an additional $94.1
million of interest income, which would have increased Core
EPS from the reported $1.86 to $1.92 for the quarter.(1427)
Analysts' consensus expectation for the quarter was
$1.87.(1428)
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been an increase of $0.05. Fannie Mae Selected Financial Information as
of Dec. 31, 2003, available at
http://www.fanniemae.com/ir/pdf/earnings/2003/iap123103.pdf. This
analysis assumes management would have deferred the realignment impact
as it had previously done.
(1424) Fannie Mae First Quarter Net Income Rises 60.5%, BLOOMBERG NEWS, Apr.
14, 2003.
(1425) Q2-2003 Forecast Update, Amortization C-Up Sensitivity, dated Aug. 8,
2003, FMSE-IR 35544.
(1426) Mem. from J. Juliane to File, dated July 29, 2003, FMSE-SP 91-93, at
FMSE-SP 91.
(1427) Assuming a thirty-five percent statutory tax rate, the after-tax income
impact of the $94.1 million would have been $61.2 million. When divided
by the Company's 982.3 million diluted average shares outstanding for
the second quarter of 2003, the after-tax impact on EPS would have been
an increase of $0.06. Fannie Mae Selected Financial Information as of
Dec. 31, 2003, available at
http://www.fanniemae.com/ir/pdf/earnings/2003/iap123103.pdf. This
analysis
378
- In the third quarter of 2003, the calculated catch-up was
$298.1 million of additional interest income. Since the Policy
threshold in this quarter was $111 million, an adjustment to
recognize an additional $187.1 million of interest income
would have been required. However, by including adjustments
which totaled a net of $79.6 million of expense,(1429) the
calculated catch-up amount was reduced to $218.5 million of
income. The new catch-up amount required only the recognition
of an additional $107.5 million of interest income.(1430) Had
management not included these realignment adjustments, it
would have been required to record an additional $79.6 million
of interest income under the Policy, which would have
increased Core EPS from the reported $1.83 to $1.88 for the
quarter.(1431) Analysts' consensus
- -------------
assumes management would have deferred the realignment impact as it had
previously done.
(1428) Fannie 2nd-Qtr Net Income Seen Rising 28%: Outlook, BLOOMBERG NEWS,
Jul. 15, 2003.
(1429) In addition to including, as adjustments, the cumulative realignment
deferral amounts for both STATS and LASER realignments and the "actual
impact" of the Security Master Project, management reduced the catch-up
amount by an additional $30.4 million to reverse the effects of
amortization of discount on four principal-only ("PO") securities sold
during the quarter. A document that discusses the additional adjustment
stated that "during the third quarter Fannie Mae sold [four] PO's that
had a current period catch- up of $30.4 million of income. Since our
modeling was done using a June 30 book, we had to adjust the [catch-up]
results for any material subsequent events." Mem. from J. Juliane to
File, dated Oct. 22, 2003, FNMSEC 2892-93, at FNMSEC 2892. We have seen
no evidence that the Company ever adjusted its catch-up to reflect the
effect of sold securities prior to this quarter.
(1430) Mem. from J. Juliane to File, dated Oct. 22, 2003, FNMSEC 2892-93, at
FNMSEC 2892.
(1431) Assuming a thirty-five percent statutory tax rate, the after-tax income
impact of the $79.6 million would have been $51.7 million. When divided
by the Company's 975.9 million diluted average shares outstanding for
the third quarter of 2003, the after-tax impact on EPS would have been
an increase of $0.05. Fannie Mae Selected Financial Information as of
Dec. 31, 2003, available at
http://www.fanniemae.com/ir/pdf/earnings/2003/iap123103.pdf. This
analysis assumes management would have deferred the realignment impact
as it had previously done.
379
expectation for the quarter were $1.75.(1432) As noted
previously, by treating realignments as the Company did,
management avoided a spike in net interest income and net
income for the quarter that may have made it difficult to meet
future EPS growth targets.
(a) Management Rationale for Incorporating Adjustments into
Catch-Up Calculations
According to Pennewell, it was KPMG that instructed management to
include the estimated impact of implementing Security Master into the catch-up
analysis as soon as it could reasonably be estimated. However, a document
obtained from KPMG's workpapers for the first quarter of 2003 showed that it was
management who proposed to KPMG the idea of including the Security Master
estimate into the catch- up framework. The document stated that the Company's
calculated catch-up for the first quarter of 2003 fell outside the Policy
threshold, and KPMG indicated that management should have recorded the
additional income of $77.6 million to comply with its Policy.(1433) According to
the workpaper, management declined to do so because it was "in the process of
implementing a new application named - Security Master."(1434) According to this
document, management chose not to record the $77.6 million amount because it
anticipated incurring $118.5 million of expense when Security Master was
implemented, which would bring catch- up within the Policy range.(1435)
As for including cumulative realignment deferrals in the catch- up
analysis, according to Pennewell, the idea was first raised in a conversation
that she had with Ann Eilers of the Office of Auditing ("Internal Audit") at the
beginning of July 2003.(1436) Pennewell believed that it was appropriate to
include cumulative realignment deferrals in
- -------------
(1432) Fannie Mae 3rd-Qtr Profit Seen Rising 8%: Outlook, BLOOMBERG NEWS, Oct.
16, 2003.
(1433) FAS 91 - Quarterly Review KPMG workpaper, dated Apr. 2003.
(1434) Id.
(1435) Id. Documents also showed that, from the beginning, the Controller's
Office staff sought to spread out over time the financial impact of the
Security Master project. In a May 2002 e- mail, Pennewell asked Juliane
for available options for recording the effects of the Security Master
Project. Specifically, Pennewell asked Juliane when Fannie Mae could
start recording an estimate, how Fannie Mae could "get kpmg
comfortable," and whether Fannie Mae could "justify booking it over the
next 12 months (instead of just through the end of the year?) or
instead, could we just bleed it off over time?" E- mail from J.
Pennewell to J. Juliane, dated May 16, 2002, FMSE-IR 176623.
(1436) E- mail from Ann Eilers to J. Pennewell, dated July 1, 2003, FMSE-E
53219-20; Undated Chart of Realignments and Treatment Used, FMSE-IR
353179.
380
catch-up because realignments identify "inception-to-date" (i.e., cumulative)
adjustments to amortization and should be included in the overall analysis of
catch-up, which she also considered to be an "inception-to-date" adjustment. We
do not believe that an "inception-to-date" adjustment view of realignment
impacts justifies the inclusion of these amounts into catch-up. This rationale
is inconsistent with management's stated purpose for the "precision" threshold
in the Policy. By its terms, the Policy was established to account for
fluctuations in catch-up due to the "imprecision associated with forecasting
prepayments," and not to deal with security classification errors.(1437) Since
cumulative realignment deferrals do not relate to the imprecision in modeling
prepayments, they should not have been included in the catch-up framework. In
addition, Pennewell's justification for including realignment impacts in the
calculation of catch-up is further evidence that management viewed the
"precision" threshold, set forth in the Amortization policy, more as a
"materiality" threshold for all "inception to date" differences.
Juliane also rationalized the treatment of including cumulative
realignment deferrals in the catch-up analysis, saying: "When you sit down and
you take a hard look at what these things actually represent, these are
acquisitions that have no underlying collateral associated with them, which in
effect is a paid-off security or paid-off loan. So fully incorporating these
into the [catch-up] framework makes complete sense to me."(1438) Juliane, like
Pennewell, could not offer a credible reason why a realignment impact that is
unrelated to the imprecision in forecasting prepayments should be considered in
relation to amounts provided for the "precision" threshold.
We conclude that the inclusion of both the estimated impact of
Security Master and the cumulative deferred realignment amounts was motivated by
management's desire to reduce the calculated catch-up to an amount closer to the
Policy threshold and thereby avoid the earnings volatility that would have
resulted from recording large catch-up adjustments to interest income.(1439)
(b) Calculation of the Security Master Estimate
As for how management estimated the impact of Security Master in
2003, Juliane apparently conducted an analysis of the impact that Security
Master Project would have on the calculated catch-up. That analysis generated
three estimates, all of which would have reduced interest income.(1440)
According to Juliane, management
- ---------
(1437) Letter from Jonathan Boyles to Stephen M. Cutler, dated Nov. 3, 2004,
FNMSEC 151-59, at FNMSEC 154; see discussion supra Chapter VI.
(1438) Tr. of Aug. 31, 2004 OFHEO Dep. of J. Juliane at 121:9-15 (hereinafter
"August Juliane OFHEO Testimony").
(1439) See discussion supra Chapter IV, Subsection IV.B.
(1440) Undated MBS Reclass Summary Update, FMSE-SP 155-57. LeRouzes, Juliane's
direct report who was responsible for running PDAMS and later, AIMS,
claimed
381
elected not to use the larger estimate because it contained mistakes, but never
explained what the mistakes were. Rene LeRouzes, who prepared the estimates at
Juliane's instruction, stated that he did not know of any mistakes in the
estimates. LeRouzes also stated that it was Juliane who chose the final estimate
that was used in the first quarter of 2003, but that he did not know the basis
for this selection.(1441) While we agree with OFHEO's conclusion that by
including the $118.5 million estimate of the Security Master impact in the
catch-up analysis the Company was able to avoid recording any catch-up
adjustment, we found no evidence to support OFHEO's assertion that management
selected the $118.5 million estimate instead of the $393.3 million estimate in
order to avoid recording an expense adjustment related to catch-up.(1442)
Further, as discussed below, we do not consider the $393.3 million estimate to
be the correct estimate of the impact of Security Master, and we also note that
the Company could have selected the $393.3 million of additional expense and
still exceeded analysts' expectations that quarter.
The first of the three estimates prepared by Juliane and
LeRouzes(1443) compared actual recorded amortization for the affected securities
($783.8 million of expense) to the amortization that would have been recorded if
the securities had not been misclassified ($902.3 million of expense). The
result was an additional expense of $118.5 million, which management ultimately
chose. While this calculation appears to accurately identify the impact of
reclassifying these securities on actual recorded amortization, it ignores the
impact it would have on catch-up, since the catch-up generated using the old
classification would differ from the catch-up associated with the new
classification. In our view, this component should be included in the estimate
because the amount was ultimately incorporated into the catch-up framework.
The second of the three estimates(1444) compared actual recorded
amortization for these affected securities ($783.8 million of expense) to the
amortization that should have been recorded if the securities had not been
misclassified and if management used its most recent interest rate projections
to calculate amortization ($1,177.1 million of expense), resulting in an
adjustment that would reduce interest income by $393.3 million. In other words,
the additional expense of $393.3 million, which OFHEO concluded was the
appropriate estimate of the Security Master impact,
- ------------
that he prepared the estimates of Security Master, but that Juliane made
further modifications to which he was not privy. See E-mail from KPMG to
J. Juliane, dated July 10, 2003, FMSE-E 371464-65; see also E-mail from J.
Juliane to KPMG, dated July 9, 2003, FMSE-E 371347-92.
(1441) Undated MBS Reclass Summary Update, FMSE-SP 155-57.
(1442) OFHEO Report at 60.
(1443) Undated MBS Reclass Summary Update, FMSE-SP 155-57, at FMSE-SP 156.
(1444) Id. at FMSE-SP 155.
382
incorporated both the effect of the misclassifications on actual recorded
amortization and the total amount of catch-up associated with these securities.
We find that this calculation too is not correct because it accounts for the
total amount of catch-up, rather than the impact on catch-up, associated with
reclassifying these securities.
In our view, the third estimate,(1445) which was not selected by
either management or OFHEO, was the most accurate calculation of the three. It
compares the estimate of the amortization that the Company should have recorded
using its most recent interest rate projections, both before ($1,110.4 million
of expense) and after ($1,177.1 million of expense) the correction of the
security misclassifications. Since the $1,110.4 million of expense was
presumably already accounted for in either actual recorded amortization or the
calculation of catch-up, the impact of correcting the misclassified securities
appears to be the difference of $66.7 million of additional expense.
We cannot state with certainty what motivated management to select
$118.5 million as their best estimate of the impact of Security Master.(1446)
Had the Company included the $393.3 million expense estimate in its calculation
of catch-up, it would have caused catch-up to change from $177.2 million of
income to $216.1 million of expense and the Company would have had to recognize
$116.5 million of expense to get within the policy threshold of $99.6 million.
Recognizing the $116.5 million of additional expense would have reduced Core EPS
from $1.84 to $1.76 for the quarter (as compared to analysts' consensus
expectations of $1.73 for the quarter).(1447) Alternatively, had the Company
included the $66.7 million expense estimate in its calculation of catch-up, it
would have reduced catch-up from $177.2 million of income to $110.5 million of
income and the Company would have had to recognize $10.9 million of income to
get within the catch-up threshold of $99.6 million. Recognizing the $10.9
million of additional income would have increased Core EPS from $1.84 to $1.85
for the quarter.(1448) Analysts' consensus expectation for the quarter were
$1.73.(1449)
- -----
(1445) Id. at FMSE-SP 157.
(1446) Juliane declined to be interviewed further after he separated from the
Company, and we had not covered these areas with him prior to his
separation.
(1447) Assuming a thirty-five percent statutory tax rate, the after-tax income
impact of recording the $116.5 million on-top would have been $75.7
million. When divided by the Company's 990.2 million diluted average
shares outstanding for the first quarter of 2003, the after-tax impact
on EPS would have been a decrease of $0.08. Fannie Mae Selected
Financial Information as of Dec. 31, 2003, available at
http://www.fanniemae.com/ir/pdf/earnings/ 2003/iap123103.pdf.
(1448) Assuming a thirty-five percent statutory tax rate, the after-tax income
impact of recording the $10.9 million on-top would have been $7.1
million. When divided by the Company's 990.2 million diluted average
shares outstanding for the first quarter of 2003, the after-tax impact
on EPS would have been an increase of $0.01. Fannie
383
KPMG reviewed the estimates relating to Security Master and did not
object to the estimates themselves or their inclusion in catch-up.(1450)
However, KPMG did note that while management viewed "the change to be a change
in estimate resulting from an improved methodology permitted by the
implementation of a new computer software accounting system . . an alternate
case could be made that the adjustment resulted from an error."( 1451)
Nonetheless, KPMG did not believe that it would be necessary to correct previous
reporting periods for the Security Master impact.(1452)
2. Management's Inclusion of Realignment Impacts in Catch-up
Calculation Was Not Consistent with GAAP
Management's decision to include the impact of Security Master and
the cumulative realignment deferrals in the calculation of catch-up was
inconsistent with the Company's own Amortization Policy, and was also not in
accordance with GAAP. In addition, management's justification for including
realignment impacts in the calculation
- -------------
Mae Selected Financial Information as of Dec. 31, 2003, available at
http://www.fanniemae.com/ir/pdf/earnings/ 2003/iap123103.pdf.
(1449) Fannie Mae First Quarter Net Income Rises 60.5%, BLOOMBERG NEWS, Apr.
14, 2003.
(1450) Security Master - Post Implementation Review, Amortization Catch-Up
Analysis Impact, dated Dec. 9, 2003, FNMSEC 4507-08; See FAS 91 -
Amortization Catchup Adjustment for Net Interest Income, dated July
2003; Significant Issues and Decisions KPMG workpaper, dated Dec. 2003.
(1451) Significant Issues and Decisions KPMG workpaper, dated Dec. 2003.
(1452) Id. KPMG concluded that it would not be necessary to correct previous
reporting periods for two reasons. First, due to changing amortization
speeds over the course of the preceding ten years, it would be
impractical or impossible to identify the amount related to prior
periods. Second, since the Security Master realignment resulted in
additional amortization expense, it was likely that recording its impact
in any one quarter would have provided an offset to catch-up, which was
in a deferred income position over the past two years. Id.
We disagree with KPMG's views. First, APB 20 contemplates a scenario in
which the prior period effects are not determinable. "In those rare
situations, disclosure will be limited to showing the effect of the
change on the results of operations of the period of change (including
per share data) and to explaining the reason for omitting accounting for
the cumulative effect and disclosure of pro forma amounts for prior
years." APB 20 P. 26. Management did not make such disclosures in the
2003 Financial Statements. Second, we conclude, infra Subsection
III.C.2., that assessing realignment impacts in relation to the catch-up
amounts was not in accordance with GAAP and inconsistent with the stated
purpose of the Amortization Policy.
384
of catch-up is further evidence that it viewed the precision threshold as being
flexible enough to accommodate items that were unrelated to the imprecision of
estimating prepayment speeds.
Further, by including the realignment impacts, management did avoid
recognizing any catch-up income in the first quarter of 2003, and reduced the
amount of catch-up that should have been recorded in the second and third
quarters of 2003. Accordingly, we believe that management was motivated by a
desire to reduce or eliminate earnings volatility that would result if the full
calculated catch-up were recorded. By reducing the amount of additional interest
income recorded in those periods, the Company was able to avoid a spike in net
income that would have been difficult to replicate in future periods.
D. Findings Regarding Fannie Mae's Belated Proposal of a Realignment
Policy that Was Inadequate Under GAAP
As noted above, we saw no evidence of a clear policy or procedure at
the Company on how to account for realignment impacts. Evidence did show that as
early as 2001 and again in 2003, Internal Audit had noted as issues the lack of
a written policy or procedure for, and inconsistent practices with respect to,
realignments.(1453) Staff auditors within Fannie Mae raised the issues to
Jonathan Boyles, Eilers and Sam Rajappa.(1454) In early 2003, one staff auditor
even noted that she believed a realignment was an inadequate method for
resolving STATS differences and expressed concern over a $7.7 million STATS
adjustment that was posted to the 1201-07 (on-top) account instead of to
income.(1455) However, we saw no indication that any actions were taken to
address this concern.(1456)
- ----
(1453) E-mail from R. Barnes to J. Philip and P. Wells, dated Jan. 22, 2001,
FMSE-SP 12019-20.
(1454) We note, however, that Boyles did not recall anyone from Internal Audit
raising the issue to him. Tr. of Aug. 24, 2004 OFHEO Deposition of J.
Boyles at 95:11-99:16.
At least one Internal Audit workpaper questioned whether the accounting
treatment given to these amounts was appropriate. Amortization Audit,
Mortgage-Related Amortization Audit, dated July 7, 2003, FNMSEC 4484-86.
The final audit report did not convey the detailed concerns that the
audit found. Instead, the final report conveyed a concern that
amortization adjustments arising out of realignments were, in the
absence of a written policy, subject to management discretion. Audit
Report, Office of Auditing, Amortization Audit, dated July 9, 2003,
FNMSEC 4469-76.
(1455) E-mail from R. Barnes to M. Lewers, dated Jan. 3, 2003, FMSE-E 1691504.
(1456) An Internal Audit witness also stated her belief that the role of
Internal Audit did not extend to correcting or recommending substantive
changes.
385
It was not until 2004 that management drafted a written policy
addressing the accounting treatment for realignment differences.(1457) That
document was drafted as part of Fannie Mae's Sarbanes-Oxley documentation and
was based on historical practice.(1458) The draft policy was reviewed by
Juliane, Pennewell, and Wells before submitting the draft to Internal
Audit.(1459)
The "Policy and Operational Procedure" required that all "routine"
realignments - those that occurred on a quarterly schedule for STATS and an
annual LASER realignment - be recognized immediately on the income statement if
the "adjustment" was less than $3 million. If the "adjustment" exceeded $3
million, the policy required that it be recorded on the balance sheet, amortized
over time, and included in the quarterly catch-up analysis. Only "non-routine"
realignments would be subject to analysis by Financial Standards.(1460)
None of the purported "reviewers" of this draft policy could
identify any support for the policy in GAAP. In fact, Juliane acknowledged that
the policy was not consistent with GAAP. According to Juliane, the $3 million
threshold came from Financial Standards, but he said that the figure was the
only part of the policy that he recalled discussing with them.(1461)
Although the policy was not consistent with GAAP because it did not
require assessing realignment impacts as errors in accordance with APB 20, it
does not appear that the Company implemented the policy prior to the
commencement of the
- ----
(1457) See Mortgage Portfolio Deferred Price Adjustments Policy and Operational
Procedures, Realignment Policy, dated Apr. 30, 2004, FMSE 193585-86;
Mortgage Portfolio Deferred Price Adjustments Policy and Operational
Procedures P. 4.2.4, dated Aug. 31, 2004, FNMSEC 4169; Pennewell OFHEO
Testimony at 427:9-17.
(1458) See Mortgage Portfolio Deferred Price Adjustments Policy and Operational
Procedures, Realignment Policy, dated Apr. 30, 2004, FMSE 193585-86;
Mortgage Portfolio Deferred Price Adjustments Policy and Operational
Procedures P. 4.2.4, dated Aug. 31, 2004, FNMSEC 4169.
(1459) See E-mail from Emily Passeri to P. Wells and J. Juliane, dated May 3,
2004, FMSE-E 1363919-20.
(1460) Mortgage Portfolio Deferred Price Adjustments Policy and Operational
Procedures, Realignment Policy, dated Aug. 31, 2004, FNMSEC 4169.
(1461) A January 6, 2005 revision to the realignment policy identifies
Pennewell and Lewers as approvers. Mortgage Portfolio Deferred Price
Adjustments, Policy and Operational Procedures, Realignment Policy,
dated Jan. 6, 2005, FMSE-IR 483646-47. Pennewell said that while she was
not involved in drafting the realignment policy, she did review it.
386
Special Examination. Fannie Mae currently is focused on improving the accuracy
of its data and systems in order to avoid realignments.
PART P: ACCOUNTING FOR INVESTMENTS IN AFFORDABLE HOUSING PARTNERSHIPS
We address in this section of our Report Fannie Mae's accounting for
the tax credits generated by the Company's investments in affordable housing
partnerships.
I. INTRODUCTION
In Chapter IV, we discuss certain issues surrounding the Company's
accounting for its investments in affordable housing partnerships with respect
to its 1998 financial statements. Our investigation of those issues raised
additional questions concerning the Company's accounting in this area.
Our inquiry regarding affordable housing partnerships focused on
three issues: (1) the Company's accounting for its capital contributions to the
partnerships; (2) the methodology used to account for low income housing tax
credits ("LIHTC") and net operating losses associated with the partnerships; and
(3) the Company's policy and practice regarding the accounting for possible
impairment of these investments. In each of these areas, we conclude that the
Company's accounting policy and its financial reporting were inconsistent with
GAAP.
Excluding the events discussed in Chapter IV surrounding the
accounting for net operating losses and tax credits in 1998, we have seen no
evidence that the Company's accounting or reporting regarding affordable housing
partnerships was done with the intent to affect earnings in any period. Instead,
in our view, the problems associated with the Company's accounting in this area
stemmed from misinterpretations of certain accounting standards and a lack of
resources, particularly in the systems area, prior to the late 1990s.
II. BACKGROUND
A. Applicable Accounting Standards
Affordable housing partnerships are entities that invest, directly
or indirectly, in low income housing projects that meet certain statutory
criteria. Under the Internal Revenue Code, the partnership that sponsors a
housing project that meets the criteria is entitled to a tax credit (the LIHTC),
which is allocated to the partnership by a state agency. Subject to certain
terms and conditions, the investor is entitled to its proportionate share of the
partnership's LIHTC allocation.
- -----
(1462) This allocation is a direct (1462) Affordable housing partnerships and
low income housing tax credits are governed by 26 U.S.C. Section 42
(2000). For background and general information regarding the LIHTC
program, see Department of Housing and Urban Development, LIHTC Basics,
http://www.hud.gov/offices/cpd/affordablehousing/training/lihtc/basics/.
387
credit to the investor's income tax liability and is unrelated to any net income
or losses reported by the partnership to the investors.
Under current law, the investor is entitled to the LIHTC for up to
ten years.(1463) In certain circumstances, however, the tax credits are subject
to recapture if the project does not meet the statutory affordable housing
requirements for a fifteen-year "compliance period" (that is, the ten-year term
of LIHTC eligibility plus an additional five years).(1464)
Prior to 1994, the principal accounting standard for investments in
real estate partnerships generally was SOP 78-9.(1465) Under that standard,
"investments in noncontrolled real estate general partnerships should be
accounted for and reported under the equity method."(1466) Insofar as the
application of the "equity method" is concerned, SOP 78-9 refers to a separate
standard, APB 18,(1467) as the relevant "guide."(1468)
The equity method, as outlined in APB 18, entails the recognition of
an investment in the partnership at the investor's cost. At each reporting
period, the investor adjusts the carrying amount of the investment to recognize
the investor's share of the partnership's net income or loss.(1469) The investor
is required to consider whether the value of the investment has been impaired -
as by a series of operating losses or other factors - and whether any impairment
in the value of the investment should be recognized.(1470)
EITF 94-1, which addresses the accounting for investments in
affordable housing partnerships, was prompted in part by Congress's 1993
extension of the legislation authorizing tax credits for investments in
affordable housing partnerships.(1471)
- -----
(1463) 26 U.S.C. Section 42(f).
(1464) See 26 U.S.C. Section 42(i).
(1465) ACCOUNTING FOR INVESTMENTS IN REAL ESTATE VENTURES, Statement of
Position 78-9 (Am. Inst. of Certified Pub. Accountants 1978)
(hereinafter "SOP 78-9").
(1466) Id. P. .06.
(1467) THE EQUITY METHOD OF ACCOUNTING FOR INVESTMENTS IN COMMON STOCK, Opinion
No. 18 (Accounting Principles Bd. 1971) (hereinafter "APB 18").
(1468) SOP 78-9 P. .06.
(1469) See APB 18 P. 6(b).
(1470) APB 18 P. P. 6(a), 6(b).
(1471) ACCOUNTING FOR TAX BENEFITS RESULTING FROM INVESTMENTS IN AFFORDABLE
HOUSING PARTNERSHIPS, Emerging Issues Task Force Issue of the Fin.
Accounting Standards Bd., Issue No. 94-1 para. 1 (May 1995) (hereinafter
"EITF 94-1"). The
388
The consensus offers investors an option, in certain circumstances, to adopt an
"effective yield method" of accounting for investments in partnerships that
generate LIHTC.(1472) Under the effective yield method, "the investor recognizes
tax credits as they are allocated and amortizes the initial cost of the
investment to provide a constant effective yield over the period that the tax
credits are allocated to the investor."(1473) In determining whether the
investment qualifies for the use of the effective yield method, EITF 94-1
directs that only the tax credits be considered.(1474) Net operating losses
generated by the partnership do not figure into the determination of the
investor's net income or loss.(1475)
Under EITF 94-1, investors that choose not to use the effective
yield method are referred to SOP 78-9, which "generally requires use of the
equity method of accounting for limited partnership investments unless the
limited partner's interest is so minor as to give the partner virtually no
influence over partnership operating and financial policies."(1476) The
consensus further states that "a limited partnership investment in a qualified
affordable housing project should be reviewed periodically for
impairment."(1477)
B. Fannie Mae's Investments in Affordable Housing Partnerships
Fannie Mae made its first investment in an affordable housing
partnership in 1987.(1478) By 1990, the Company's aggregate equity commitment in
these partnerships was $176 million.(1479) The level of investment increased
significantly over the next twelve years, reaching $4.0 billion in 2000 and $6.4
billion in 2002.(1480)
- -------------
Revenue Reconciliation Act of 1993 retroactively extended and made
permanent prior legislation authorizing the tax credit. The prior
legislation had expired in 1992. Id.
(1472) Id. para. 4.
(1473) Id. para. 5.
(1474) Id. para. 4(b).
(1475) Id. para. 5-6.
(1476) Id. para. 7.
(1477) Id. para. 9.
(1478) Undated History of LIHTC Investment Accounting at Fannie Mae, Zantaz
document 1825606 (hereinafter "LIHTC History").
(1479) Id.
(1480) Id.
389
According to a Fannie Mae document, the Financial Reporting group of
the Controller's Office is responsible for: the accounting for affordable
housing partnerships.(1481) However, many of the accounting and financial
reporting functions regarding the investments, at least in recent years, have
been the responsibility of the LIHTC Financial Management group in the Housing
and Community Development ("HCD") Office.(1482) The Multifamily Controller
supports this work.(1483) Among other things, the groups in HCD are responsible
for the forecasts that Fannie Mae uses to recognize net income or losses on the
partnerships during the year; the reconciliations (or "true-ups") between the
projections and actual results as reflected on the partnerships' Form K-1s; and
for the calculations associated with the recognition of the LIHTC in Fannie
Mae's financial statements.(1484)
C. Fannie Mae's Partnership Accounting
1. Accounting for Capital Contributions
Under EITF 94-1, a company that is unconditionally obligated to make
a capital contribution to a partnership in the future should recognize that
obligation as a liability on its financial statements.(1485) A contingent
obligation should be recognized as a liability when the contingency becomes
probable of occurring.(1486) Prior to EITF 94-1, the accounting literature
provided that a company should record future capital contributions as a
liability if (1) a partnership's losses exceeded the amount of the partner's
investment, and (2) the investor was committed to provide additional financial
support to the partnership, either by a legal obligation to do so or by some
other indication of a commitment (such as past practice or a statement of intent
to provide additional support).(1487)
Fannie Mae's accounting policies did not provide guidance regarding
the proper accounting for the Company's capital contributions. According to
James Parks, a
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(1481) Undated Accounting Policies, Practices and Controls: LIHTC Investments,
Zantaz document 1722005, at 2.
(1482) See Low Income Housing Tax Credit Overview, dated Jan. 31, 2004, FMSE
179922-35 (hereinafter "LIHTC Overview") (discussing responsibilities of
LIHTC Financial Management).
(1483) Prior to 2000, the Multifamily Controller was part of the Controller's
Office.
(1484) LIHTC Overview at FMSE 179927-33.
(1485) EITF 94-1 para. 10.
(1486) Id.
(1487) SOP 78-9 P. .15.
390
Fannie Mae Vice President who became Multifamily Controller in 1994 (after
having been responsible for Financial Standards), Fannie Mae did not follow the
principles in SOP 78-9, or EITF 94-1 upon its adoption, with respect to capital
contributions the Company was committed to make. Specifically, Parks stated that
he was concerned regarding how Fannie Mae accounted for net operating losses of
a partnership that were in excess of the recorded investment when the Company
was committed to make additional capital contributions in the future. Parks said
that Fannie Mae reported partnership losses only to the extent of its net
investment (that is, the Company's capital contributions less previously
recognized operating losses), even if (1) the losses exceeded the net investment
and (2) Fannie Mae was obligated to make additional capital contributions to
those partnerships. Parks questioned whether Fannie Mae should have recognized
losses when it was obligated to make capital contributions in the future.
Fannie Mae's accounting when it was obligated to make future
contributions to affordable housing partnerships was inconsistent with the
relevant accounting guidance, including SOP 78-9 and EITF 94-1, as discussed
above. In addition, it appears that Company officials were aware of this
deviation from GAAP at least as of 1997. A memorandum drafted by Jonathan Boyles
and Brian Harris addresses the issue and concludes that "[i]f Fannie Mae has a
legally binding obligation to make future equity contributions [to an affordable
housing partnership], these amounts should be recorded immediately as a
liability."(1488)
Boyles drafted a virtually identical memorandum in 1999.(1489) That
memorandum is attached to a separate memorandum from Boyles to the file, in
which he reports on a conversation he had with Leanne G. Spencer, Parks, and
Richard DePetris. According to Boyles, all of the attendees agreed with the
accounting conclusions reflected in Boyles's memorandum, but "we decided not to
gross up Fannie Mae's balance sheet for future equity contributions because the
operational problems associated with adopting this accounting method outweighed
the benefits."(1490) Boyles reported that recording the future capital
contributions "would have added approximately $700 million in both assets and
liabilities, and it was decided that this was immaterial to a $500 billion
balance sheet."(1491)
As will be seen, however, this approach - which understated the
Company's obligations to the partnerships - affected more than just the
Company's balance sheet. The failure to "gross up" the balance sheet to reflect
future capital
- ----
(1488) Mem. from Jonathan Boyles and Brian Harris to Distribution, dated Nov.
18, 1997, FMSE 55229-31, at FMSE 55229 (hereinafter "Boyles & Harris
Mem.").
(1489) Mem. from J. Boyles to Distribution, dated Feb. 18, 1999, FMSE 46568-72
(hereinafter "Boyles Mem.").
(1490) Mem. from J. Boyles to File, dated Feb. 18, 1999, FMSE 46567.
(1491) Id.
391
contributions Fannie Mae was obligated to make resulted in the Company's failure
to recognize losses in the periods in which they were incurred if those losses
exceeded the Company's recorded investment.
2. The Company's Accounting Methodologies
(a) 1987 - 1995
Fannie Mae first invested in affordable housing partnerships in
1987.(1492) Its method of accounting for these investments has changed several
times. The history of the Company's accounting reflects the fact that the
Company began with a methodology that was not consistent with GAAP.
Prior to 1995, Fannie Mae accounted for its investments in
affordable housing partnerships on a cost recovery basis rather than the equity
method described in SOP 78-9.(1493) That situation arose because at least some
of those involved in the accounting for affordable housing partnerships were
unaware of the relevant accounting literature.(1494) According to a document
that we believe was drafted in 1998 or 1999, there were "[n]o explicit rules on
accounting for LIHTC investment until 1995."(1495) Jim Parks confirmed that, in
Fannie Mae's view at the time, there was no applicable accounting literature on
affordable housing partnerships until the release of EITF 94-1. Parks said that,
given the lack of relevant literature, Fannie Mae's accounting for its
investments in affordable housing partnerships under the modified cost recovery
method was "not inconsistent" with GAAP. Parks's view was that the differences
between applying the modified cost recovery method and the equity method were
immaterial, and that the modified cost recovery method was a more conservative
approach in any event.
The Company's 1994 Financial Accounting Policy Manual confirms that
Fannie Mae used a modified cost recovery methodology to account for these
investments, but it cites the relevant accounting literature. The policy refers
to SOP 78-9 as support for the Company's position and, in a separate comment,
states: "Fannie Mae does not consider use of the equity method of accounting or
consolidation appropriate for these investments because, while Fannie Mae may
have contributed capital significant to the partnership or joint venture, it
generally is not entitled to equity profits and does not have
- ----
(1492) LIHTC History at 1.
(1493) Id. It appears, based on the description in the document, that Fannie
Mae was applying a modified cost recovery method under which no income
was recognized until the Company recovered its full investment in the
partnership.
(1494) See Undated LIHTC Impairment Analysis, FMSE-IR 360283-300, at FMSE-IR
360283 (hereinafter "LIHTC Impairment Analysis").
(1495) Id.
392
significant influence over operations."(1496) The policy also states that the
modified cost recovery approach was more conservative than the equity
method.(1497)
Based on the available evidence, we question whether the Company's
accounting for its investments in affordable housing partnerships was consistent
with GAAP; moreover, given language in the Company's 1994 accounting policy and
its reference to SOP 78-9, we conclude that, prior to 1995, the Company made a
conscious decision not to use the equity method specified in the applicable
accounting literature. As noted, SOP 78-9 required that investors in real estate
partnerships use the equity method unless the partner's interest in the
partnership was "so minor that the limited partner may have virtually no
influence over partnership operating and financial policies."(1498) As the
Company's policy acknowledges, Fannie Mae's investments were not "minor."
Moreover, under SOP 78-9, an interest in a partnership is "minor" when the
investor "is, in substance, in the same position with respect to the investment
as an investor that owns a minor stock interest in a corporation . . ."(1499)
Although we have not independently reviewed records of the affordable housing
partnerships in which the Company invested during this period, we understand
that Fannie Mae holds partnership interests in excess of the level that would be
considered "minor" under SOP 78-9.(1500)
(b) 1995 - 1999
Documents in the Company's files indicated that the Company changed
its accounting methodology in 1995 to the equity method.(1501) In addition,
DePetris, who joined the Multifamily Controller's group in 1996, recalled using
the equity method to account for the partnership investments at that time. The
1996 version of the Financial
- -----
(1496) Financial Accounting Policy Manual Sections J.1-J.2, dated Oct. 20,
1994, FMSE-SP 79179-80, at FMSE-SP 79180 (emphasis added).
(1497) Id. ("Fannie Mae uses the cost recovery method of accounting because it
is a conservative method of revenue recognition and deemed appropriate
for these types of investments.").
(1498) SOP 78-9 P. .08.
(1499) Id. P. .08.
(1500) See LIHTC Overview at FMSE 179922. Fannie Mae's 2003 Financial
Accounting Policy Guide specifies that an investment in a partnership is
"minor" only if the Company's investment is "below 3-5%" of the
partnership capital. Financial Accounting Policy Guide Section J.1,
dated Dec. 2003 (hereinafter "2003 Financial Accounting Policy Guide").
We note, however, that, because of the transition rules for EITF
consensuses, EITF 94-1 effectively "grandfathered" prior accounting
treatments.
(1501) LIHTC History at 1; see also LIHTC Impairment Analysis at FMSE-IR
360283.
393
Accounting Policy Manual, however, did not reflect any change in the Company's
approach; in fact, the 1994 and 1996 versions of the policy are identical in
this respect.(1502)
The documents that describe the Company's application of the equity
method highlight aspects of the Company's approach that were inconsistent with
the applicable accounting standards. As an initial matter, the Company applied
the equity method "[o]ne year in arrears."(1503) That is, rather than recognize
its portion of the partnership's net income or loss in the year that the
partnership realized them, Fannie Mae would recognize them in the following
year. DePetris recalled that Fannie Mae could not recognize its portion of the
partnerships' net income or loss in the same year as the partnerships because
the Company could not always obtain financial statements from the partnerships.
Thus, the Company would not recognize gain or loss on its investments until it
received the K-1 in the following year. Parks recalled recommending that Fannie
Mae adopt accrual accounting for its investments (that is, that the Company
accrue for its portion of the partnership's net income or loss in the year they
are realized by the partnership), but he conditioned his recommendation on the
Company's implementing more sophisticated accounting systems.
The accounting literature specifies that, if the partnership's
financial statements are not timely, then the investor should record its share
of earnings or losses based on the most recent financial statements
available.(1504) Neither DePetris's nor Parks's explanation for the Company's
approach adequately explains the deviation from the requirements of the
standard. In light of Fannie Mae's ability to obtain timely financial statements
in recent years,(1505) it is not clear why it could not have obtained
partnership financial statements on a more timely basis.
As to Parks's explanation, the Company began to account for its
investments by accruing for its portion of the partnerships' net income or loss
in connection with its 1998 statements. However, according to KPMG, the primary
determinant of when Fannie Mae began to comply fully with GAAP with respect to
its equity method accounting was the improvement of processes surrounding the
inputting of data into spreadsheets, and not the implementation of new systems.
Moreover, Parks
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(1502) Financial Accounting Policy Manual Section J.1-J.2, dated July 1996.
(1503) LIHTC History at 1.
(1504) APB 18 P. 19(g) states: "If financial statements of an investee are not
sufficiently timely for an investor to apply the equity method
currently, the investor ordinarily should record its share of the
earnings or losses of an investee from the most recent available
financial statements. A lag in reporting should be consistent from
period to period."
(1505) According to DePetris, the decision was made in 2004 to use available
financial information from the partnerships, rather than to wait for the
K-1s.
394
acknowledged that the primary advantage of the new system was the ease with
which it allowed the user to change assumptions. It is not clear why Fannie
Mae's prior accounting system, which was based on spreadsheets, required final
data, rather than currently available data, to determine the Company's portion
of the partnership's net income or loss.
Fannie Mae's application of the equity method during this period was
inconsistent with the accounting standards in another respect. As an investor in
a partnership, Fannie Mae was required to recognize its portion of the
partnership's net operating losses ("NOLs"), if any, and deduct those losses in
determining the Company's net income.(1506) The NOLs in each period include
depreciation of the partnership's assets. Prior to 1998, Fannie Mae was
recognizing its share of NOLs using the K-1. The K-1 recognized depreciation
expense using a 27.5-year life, which differed from the term used for book
purposes.(1507) For accounting purposes, an investor is required to recognize
its portion of the GAAP basis net income or loss as reported by the
partnership.(1508)
The accounting literature applicable to partnership investments
requires that the earnings and losses on the investments be determined in
accordance with GAAP.(1509) During this period, however, Fannie Mae was applying
the equity method by recognizing "Tax basis NOLS."(1510) This issue was raised
to Financial Standards in 1997 and the Company concluded that, although GAAP on
this point was clear, the difference was immaterial.(1511) Early in 1999, Boyles
addressed the issue again and confirmed that "GAAP requires Fannie Mae to record
depreciation on a book basis for these investments. Fannie Mae has made the
change to book depreciation."(1512)
- -----
(1506) See APB 18 P. 19(c).
(1507) Mem. from Kimberly Rawls to File, dated Apr. 14, 1998, FMSE-IR
178260-21.
(1508) APB 18 P. P. 3(f), 19(c).
(1509) Id.; SOP 78-9 P. .06.
(1510) LIHTC History at 1.
(1511) See Boyles & Harris Mem. at FMSE 55231. The memorandum contains the
conclusion that "GAAP requires Fannie Mae to record depreciation on a
book basis for these investments," but continues: "however, since the
difference is likely to be immaterial to the financial performance of
the company, we would not be required to do so. The decision to switch
is more of a cost/benefit business decision because the tax department
will need to be provided the details of the book/tax differences on a
quarterly basis to complete the return." Id.
(1512) Boyles Mem. at FMSE 46570.
395
(c) Post-1999
By 2000, Fannie Mae's aggregate equity commitments in affordable
housing projects exceeded $4 billion.(1513) Two years later, the aggregate
equity commitments reached $6.4 billion.(1514)
In 2001, Fannie Mae adopted the effective yield method of accounting
for its guaranteed funds.(1515) Documents surrounding the decision focus on the
fact that the effective yield method is appropriate for guaranteed investments
and that, by using the method, there is a more direct relationship between the
returns and the net investment balance.(1516) It was also noted that, compared
to the equity method, the effective yield method generally results in higher
income recognition in the earlier years of an investment and lower income in
later years.(1517)
Fannie Mae's application of the effective yield method did not
follow the guidance in EITF 94-1 in all respects. The terms of the consensus
specify that, under the effective yield method, "the investor recognizes tax
credits as they are allocated and amortizes the initial cost of the investment .
.. ."(1518) Any other tax benefits, including benefits stemming from recognition
of the NOLs, are to be accounted for separately.(1519)
Fannie Mae's application of the effective yield method, however, was
based on both the guaranteed tax credits and the tax benefits that the Company
derived from the partnerships' NOLs. The Company's 2003 Financial Accounting
Policy Guide refers to an "internal rate of return considering the cost of the
investment and all tax benefits allocated to us."(1520) According to an exchange
between Parks and DePetris, the reference to "all" tax benefits includes NOLs:
- ----
(1513) LIHTC History at 1.
(1514) Id.
(1515) Id.
(1516) See Undated Low-Income Housing Tax Credits: Change in Accounting Method,
FMSE-IR 262406.
(1517) Id.
(1518) EITF 94-1 para. 5.
(1519) "The effective yield is the internal rate of return on the investment,
based on the cost of the investment and the guaranteed tax credits
allocated to the investor. Any expected residual value of the investment
should be excluded from the effective yield calculation." Id.
(1520) 2003 Financial Accounting Policy Guide Section J.1 (emphasis added).
396
EITF 94-1 explicitly requires that only tax credits be used in
calculating the IRR of a guaranteed LIHTC investment, which is then
used to amortize the cost of that investment. The current EYM
accounting model uses the tax benefits from both credits and NOLs,
which produces a different IRR and, consequently, a different cost
amortization pattern. Although our syndicator agreements calculate
the guaranteed rate of return by using both credits and NOLs, it's
not clear that that is sufficient justification for departing from
the explicit requirement in EITF 94-1 of using only credits in the
calculation.(1521)
This approach was inconsistent with GAAP.
3. Impairment Analysis
Both SOP 78-9 and EITF 94-1 require that investors in affordable
housing partnerships assess their investments to determine whether there has
been an other-than-temporary impairment in the investment's value.(1522) EITF
94-1 describes one method for assessing whether an investment in an affordable
housing partnership has been impaired.(1523) At each period, the investor
deducts from its net investment its portion of the expected future NOLs. The
investor compares that result to the partnership's expected benefits of the
investment, including both the LIHTC and any other tax benefits associated with
the investment. If the benefits are less than the adjusted basis in the
partnership, then the investment is impaired.
Prior to 2000, Fannie Mae did not have a formal policy regarding
impairment assessments for its investments in affordable housing partnerships.
The Company's informal policy was to write off any remaining net investment at
the end of the fifteen-year compliance period. That approach, however,
foreclosed an assessment of impairment during any prior period, including at the
end of the tenth year, when the project was no longer eligible for LIHTC. Given
that these credits were the principal economic benefit of the affordable housing
partnerships, it is reasonable to assume that many of the Company's investments
had been impaired before the fifteen-year period expired.
- ---
(1521) E-mail from James Parks to Richard DePetris, dated Dec. 2, 2004, FMSE-IR
262405.
(1522) SOP 78-9 P. .20 provides: "A loss in value of an investment other than a
temporary decline should be recognized." EITF 94-1 states: "The Task
Force reached a consensus that a limited partnership investment in a
qualified affordable housing project should be reviewed periodically for
impairment." EITF 94-1 para. 9.
(1523) EITF 94-1, Schedule 4.
397
The Company considered the impairment issue in 2000. Its analysis
noted the significant growth in the Company's affordable housing partnership
investment portfolio in the late 1990s and the fact that the affordable housing
partnership investments are impaired "probably by year 10 when credits expire
(possibly earlier)."(1524) The growth in the portfolio was significant because,
as various calculations in the analysis showed, recognition of impairments under
the pre-2000 method would result in ballooning losses. The fifteen-year policy,
for example, was projected to result in $4.1 million in impairment losses in
2002, $31.4 million in 2004, $38.7 million in 2010, and $190 million in 2014
(albeit with year-to-year fluctuations).(1525)
The analysis also noted that the Company's new automated accounting
system "allows easier partnership level analysis of investments."(1526) The
earlier spreadsheet system was "not able to do long-term earnings projections"
whereas the new system has "automated capability to do earnings estimates
scenarios beyond [the] forecast horizon."(1527)
The Company considered several different potential impairment
policies and evaluated the impact of each on the Company's partnership
investment portfolio.(1528) The options considered included writing off the
remaining book value of the investment at year ten or year fifteen, with or
without assuming that the partnership had a residual value at that time.(1529)
The Company also considered establishing a reserve for future impairments,
apparently analogous to a reserve for loan losses.(1530)
Fannie Mae chose to implement a policy premised on the impairment of
the investment by year ten. According to the 2003 policy: "Fannie Mae regularly
evaluates all of its investments for impairment, and any other-than-temporary
impairment in the value of such investments is recognized through earnings.
Typically, impairment
- -----
(1524) LIHTC Impairment Analysis at FMSE-IR 360285.
(1525) Id. at FMSE-IR 360300.
(1526) Id. at FMSE-IR 360284.
(1527) Id. This explanation of the advantages of the new tax system is similar
to Parks's assessment discussed above.
(1528) See id. at FMSE-IR 360287-300.
(1529) See id. at FMSE-IR 360287.
(1530) Id. Under "next steps," the LIHTC Impairment Analysis stated: "Decide
whether to establish reserve for LIHTC assets (Consider LIHTC reserve
while evaluating overall level of Fannie Mae loss allowances)." Id. at
FMSE-IR 360294. The various impairment options are reflected in charts
that project future impairment losses under each scenario. Id. at
FMSE-IR 360288-300.
398
is recognized in early years on tax credit investments because of minimal future
cash flow expectations. Additionally, unless a tax credit has projected future
cash flows after ten years, any remaining investment balance is written off in
year 10."(1531) According to DePetris, in practice all investments were
considered impaired at year ten, but not before.(1532)
The accounting literature, as well as the Fannie Mae internal
policy, requires that impairments be assessed on an individual investment
basis.(1533) The impact of the new policy, however, is unclear. As a general
matter, the policy of writing off the value of the investments in year ten
(versus year fifteen) increases losses in the short run, with a less dramatic
increase projected into the future. According to DePetris, however, in 2000,
Fannie Mae did not have a significant number of investments that were beyond
year ten, so the change in policy did not result in a significant, immediate
write-off.
A statement in the impairment analysis, under the heading "Next
Steps/Decisions" stated: "Decide whether/when to discuss with KPMG."(1534)
DePetris could not explain this reference and recalled that the Company had
consulted with KPMG on the impairment issue. In fact, DePetris recalled that
KPMG audited the ten-year impairment policy.
III. FINDINGS
Fannie Mae's accounting for investments in affordable housing
partnerships violated GAAP in several respects. This was particularly true in
the first half of the 1990s when the Company was, among other things, using an
inappropriate accounting methodology. We note that the Company is reviewing the
past several years' accounting for these partnerships as part of its restatement
effort.
With the exception of the 1998 accounting changes discussed
previously in Chapter IV, we see little evidence that any individual policy, or
the policies in the aggregate, were designed or implemented to manipulate Fannie
Mae's financial statements. Parks's statement regarding the lack of
sophisticated systems, although perhaps not a comprehensive explanation for the
Company's accounting in this area, is consistent with views expressed in other
areas during the course of our investigation. The spreadsheet system in place
prior to about 1997 apparently did restrict the Company's ability to handle more
complicated forecasts and projections. Finally, there is
- ---
(1531) 2003 Financial Accounting Policy Guide Section J.2.
(1532) DePetris also stated that the impairment analysis was based on an
evaluation of individual investments, but the policy was applied on a
portfolio-wide basis.
(1533) As the analysis acknowledges, one would expect investments in a number
of these partnerships to be impaired prior to year ten.
(1534) LIHTC Impairment Analysis at FMSE-IR 360294.
399
no indication of any pressure from senior officers to adopt different policies
or procedures to meet a desired outcome.
Our conclusion, therefore, is that the problems in this area stemmed
from misinterpretations of the applicable standards, a lack of focused attention
to the applicable standards, and inadequate resources to tackle some of the more
challenging aspects of the accounting for these partnerships as the program grew
during the 1990s.
400
CHAPTER VII: CORPORATE GOVERNANCE AND INTERNAL CONTROLS
This Chapter of the Report provides an overview of Fannie Mae's
Board of Directors, its Office of the Chairman and other elements of senior
management, and certain key internal control functions (ethics and compliance,
Office of Auditing, and the Office of the Controller) prior to the publication
of the OFHEO Report; sets forth our conclusions regarding these entities and
functions from the perspectives of corporate governance and internal controls;
and discusses the substantial changes that have taken place since the OFHEO
Report was released in September 2004.
I. BOARD OF DIRECTORS
A. Summary
With respect to the conduct of the Board prior to September 2004,
our findings and conclusions are as follows:
1. The Board endeavored to operate in a manner consistent with its
fiduciary obligations and evolving corporate governance standards. The Board was
open to examination by third parties and responsive to outside commentary, and
it generally received high marks from outside observers. The Board sought and
received support and advice from appropriate sources of expertise, including
Company management, internal and external auditors, and regulators. Prior to the
release of the OFHEO Report, the Board received substantial assurances from
internal and external sources that the Company was complying with applicable
rules and regulations and with best practices.
2. The Board (and especially the Audit Committee) was sensitive to
matters relating to accounting and financial reporting. The Audit Committee
requested and received briefings regarding the Company's critical accounting
policies, and was assured that Fannie Mae was acting in accordance with relevant
standards. The Board reacted quickly to the release of the announcement
concerning accounting issues at Freddie Mac, and requested and received updates
and assurances from management and KPMG on those issues, as well as advice as to
whether there might be similar issues at Fannie Mae. In response, management
provided the Audit Committee with a report identifying only minor and immaterial
issues at Fannie Mae.
3. The Board responded appropriately when it did receive indications
that there were significant issues at the Company. We believe that the Board has
made considerable effort to examine and, as warranted, improve its structure,
composition, policies, and practices. We believe that the separation of the
Chairman and CEO positions, the creation of the Risk Policy and Capital
Committee to oversee financial and operational risk management, the
transformation of the Compliance Committee into a permanent committee with broad
oversight of compliance matters, and the ongoing revamping of delegations of
authority, are all positive developments.
401
B. Overview Prior to September 2004
The past five years have seen a substantial transformation in the
legal environment in which corporate boards operate and in the benchmarks for
best practices in the corporate governance area. Among other developments,
Congress passed the Sarbanes-Oxley Act in 2002 ("SOX"), which imposed various
governance and internal controls requirements on companies that are SEC
registrants.(1535) Also in 2002, the New York Stock Exchange ("NYSE") proposed
new corporate governance standards for NYSE-listed companies.(1536) With respect
to Fannie Mae specifically, OFHEO, which conducts periodic examinations of
Fannie Mae's corporate governance practices, promulgated new corporate
governance regulations in 2002,(1537) and amended those regulations in
2005.(1538)
As we explain below, the Board and its Committees responded to each
of these pronouncements with (as appropriate) new membership criteria,
procedures, and responsibilities. The Company looked to outside guidance from
law firms and from rating agencies to advise on additional steps and to confirm
that the Board's practices were in line with applicable standards. The Board
received such confirmation from outside ratings agencies and other appropriate
sources, including - through 2003 - from OFHEO.
1. Overview of the Board
Although Fannie Mae's corporate governance differs in some respects
from that of other corporations due to its status as a government-sponsored
enterprise, the role of the Company's Board is typical of other companies: it
oversees the management of the Company and its business, and it represents the
interests of the Company's stockholders in optimizing the long-term value of the
Company.(1539)
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(1535) Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204, 116 Stat. 745 (2002).
(1536) NYSE, Inc. Corporate Governance Rule Proposals Reflecting
Recommendations from the NYSE Corporate Accountability and Listing
Standards Committee As Approved by the NYSE Board of Directors August 1,
2002, available at http://www.nyse.com/pdfs/corp_gov_pro_b.pdf (proposed
rules); NYSE, Inc., Final Corporate Governance Rules, dated Nov. 4,
2003, available at http://www.nyse.com/pdfs/finalcorpgovrules.pdf (final
rules).
(1537) See Corporate Governance Regulations, 12 C.F.R. Sections 1710.1-1710.20
(2005).
(1538) See Corporate Governance Regulations, 70 Fed. Reg. 17,310 (Apr. 6, 2005)
(to be codified at 12 C.F.R. Section 1710).
(1539) See Fannie Mae Corporate Governance Guidelines, dated Apr. 23, 2004,
Zantaz document 1454040. More formally, these Guidelines charged the
Board with: (1) selecting, compensating, and evaluating the performance
of the Chairman/CEO
402
The Charter Act provides that Fannie Mae's Board is to have eighteen
members, of whom five are to be appointed by the President.(1540) However, the
President has not appointed any directors since May 2004, thereby effectively
reducing the size of the Board to thirteen directors.(1541)
From 2000 through the end of 2004, three members of Company
management sat on the Board, one as Chairman/CEO (Franklin D. Raines) and the
other two as Vice Chairmen (at various times, Jamie S. Gorelick, Timothy Howard,
and Daniel H. Mudd).(1542) As of September 2004, the executive members of the
Board were Raines, Howard, and Mudd.(1543)
The Board included ten non-management directors. These directors in
2004 represented a cross-section of interests and backgrounds, including
academics, former senior government officials, individuals with experience at
other financial institutions, individuals with experience in the mortgage
banking industry, an expert in derivatives and financial risk, and the CEO of a
public company.(1544)
- ----------
of Fannie Mae, and planning for his or her succession; (2) overseeing
the election, retention, and compensation of qualified senior
executives; (3) reviewing and approving Fannie Mae's strategic and
annual operating plans, budget, and corporate performance; (4) advising
management on significant issues facing the Company; (5) reviewing and
approving significant corporate actions; (6) overseeing the financial
reporting process, communications with stockholders, and the
corporation's legal and regulatory compliance program; and (7)
nominating directors and overseeing effective corporate governance. Id.
As is discussed in greater detail below, the Board modified this
statement of its responsibilities in 2005 to reflect an expanded role in
overseeing management.
(1540) 12 U.S.C. Section 1723(b) (2000).
(1541) The last Fannie Mae Board meeting attended by Presidential appointees
was the meeting of May 10, 2004. See Minutes of the Meeting of the Board
of Directors of Fannie Mae, dated May 10, 2004, FMSE 504424-25 at FMSE
504424.
(1542) Prior to 2000, Lawrence M. Small, the former President and COO of Fannie
Mae, also served as a director. However, he was not a Vice Chairman of
the Board.
(1543) More detailed information regarding the management directors is provided
in Subsection II.B. below.
(1544) Since September 2004, new non-management members of the Board have
included: an accountant, former public company CFO, and former member of
the FASB; a senior executive at another public company with substantial
experience in credit management; and a financial services consultant and
former senior executive of an investment fund.
403
Fannie Mae's Corporate Governance Guidelines set forth the Board's
governance policies. The Board first adopted these Guidelines in 1995. It
substantially updated and revised them in January 2003 as an outgrowth of the
Nominating and Corporate Governance Committee's Corporate Governance
Benchmarking Project (discussed below);(1545) it did so again in early 2004 to
reflect final corporate governance standards adopted by the NYSE.(1546) The
Board included the Corporate Governance Guidelines in its shareholder proxy
statements and published them in a "Corporate Governance" section of Fannie
Mae's website.(1547)
The Board updated and revised these Guidelines in January 2003. The
Board also expanded its conflicts-of-interest policy to create a Code of
Business Conduct and Ethics for Directors.(1548) In addition to prescribing a
number of conflicts-of-interest policies, the Code required directors to comply
with, and to oversee compliance by Fannie Mae officers and other employees with,
all laws and regulations. The Code also obligated directors to promote ethical
behavior by: (1) encouraging employees to raise ethical concerns with
supervisors; (2) encouraging employees to report violations of law, regulation,
or Company policy, to appropriate personnel; and (3) emphasizing to employees
that they would not permit retaliation against employees who acted in good
- ----------
(1545) See Minutes of the Meeting of the Board of Directors of Fannie Mae,
dated Jan. 21, 2003, FMSE 504202-40, at FMSE 504220-21.
(1546) See Minutes of the Meeting of the Board of Directors of Fannie Mae,
dated Jan. 23, 2004, FMSE 504353-90, at FMSE 504363.
(1547) Over time, these Guidelines have: (1) outlined the responsibilities,
composition, size, qualifications, and election of the Board; (2) set
forth Board policies as to meeting schedules, quorums, attendance,
agendas, executive sessions, meeting materials, independence,
orientation and education, compensation, and performance evaluations;
(3) addressed the Board's committee structure, as well as policies
governing committee chairmanships, meeting schedules, agendas,
attendance, and reports to the full Board; (4) detailed the policies
governing performance reviews of the Chairman/CEO and senior management;
(5) set forth policies regarding director access to management and
outside advisors, as well as external communications with the Board and
with the Audit Committee regarding accounting, internal controls, and
auditing matters; and (6) described Fannie Mae's ethics guidelines for
directors and for employees. The current version of the Corporate
Governance Guidelines can be found at
http://www.fanniemae.com/governance/pdf/corpgovguidelines.pdf.
(1548) See Fannie Mae Code of Business Conduct and Ethics and Conflict of
Interests Policy for Members of the Board of Directors, dated Jan. 21,
2003, FMSE 13542-46; see also Minutes of the Meeting of the Board of
Directors of Fannie Mae, dated Jan. 21, 2003, FMSE 504202-40, at FMSE
504221.
404
faith in raising ethical issues.(1549) Each director was required to certify
compliance with this new Code of Business Conduct and Ethics on an annual
basis.(1550)
As of September 2004, the Corporate Governance Guidelines required
the Board to meet at least seven times per year.(1551) Between 1999 and 2002,
the Board met an average of eight times per year, either in person or by phone.
In 2003, in response to ongoing developments (such as the accounting issues at
Freddie Mac), the Board met nineteen times. In 2004, again in response to
ongoing developments (including
OFHEO's Special Examination), the Board met twenty-six times. One
meeting each year was a two-day retreat, with time set aside for the Board to
focus on a particular topic of interest, such as the market and long-term
financial outlook for the Company, the policy and political environment facing
the Company, risk management, and strategic planning issues.(1552)
The minutes of Board meetings reflect the formal portion of those
meetings, with presentations by Committee chairmen and by members of management.
The Board also allotted time at each Board meeting for informal discussion.
Beginning in January 2003, the Board's Corporate Governance Guidelines required
that it schedule time at each meeting for non-management members of the Board to
meet in executive
- ----------
(1549) See Fannie Mae Code of Business Conduct and Ethics and Conflict of
Interests Policy for Members of the Board of Directors, dated Jan. 21,
2003, FMSE 13542-46.
(1550) The Nominating and Corporate Governance Committee was and remains
responsible for enforcing this certification requirement. The current
version of this Code of Business Conduct and Ethics and Conflict of
Interests Policy for Members of the Board of Directors can be found at
http://www.fanniemae.com/governance/codeofethics/index.jhtml?p=
Corporate+Gov ernance&s=Codes+of+Ethics (last visited Feb. 17, 2006).
(1551) Fannie Mae Corporate Governance Guidelines, dated Apr. 23, 2004, Zantaz
document 1454040, at 54. In 2005, the Board amended the Corporate
Governance Guidelines to require the Board to meet at least eight times
per year. See Fannie Mae Corporate Governance Guidelines, available at
http://www.fanniemae.com/governance/pdf/corpgovguidelines.pdf/.
(1552) See Mem. from Thomas E. Donilon to the Board of Directors, dated July
15, 2004, FMSE-KD 48911-12; see also Minutes of the Meeting of the Board
of Directors of Fannie Mae, dated July 14-15, 2003, FMSE 504286-302, at
FMSE 504286; Minutes of the Meeting of the Board of Directors of Fannie
Mae, dated July 15-16, 2002, FMSE 504166-76, at FMSE 504167; Minutes of
the Meeting of the Board of Directors of Fannie Mae, dated July 16-17,
2001, FMSE 504074-84, at FMSE 504074.
405
session.(1553) In addition, the Chairman/CEO typically met alone with the
non-executive directors prior to Board meetings.(1554)
2. Committees of the Board
Fannie Mae's Bylaws authorized the Board to delegate its authority
to committees. As of September 2004, Fannie Mae had six standing committees:
Nominating and Corporate Governance; Audit; Compensation; Assets and Liabilities
Policy; Housing & Community Development; and Executive. Each of these committees
had written charters, approved by the full Board, that set forth its
responsibilities.(1555)
In conducting this part of our review, we focused primarily on the
Audit and Nominating and Corporate Governance Committees, which are discussed
below. As one would expect, each of these committees has evolved in the changing
environment of the past several years.
(a) The Audit Committee
The Audit Committee has a broad range of responsibilities, including
oversight of financial reporting, internal and external auditing, internal
controls, and regulatory and legal compliance.(1556) These responsibilities,
which are delineated in the Audit Committee Charter, were substantially
clarified and expanded in 2003 as an outgrowth of the Nominating and Corporate
Governance Committee's Corporate Governance Benchmarking Project. Subsequent
amendments were made in February 2004.(1557)
- ----------
(1553) Fannie Mae Corporate Governance Guidelines, dated Jan. 20, 2003, FMSE
111395-407, at FMSE 111402.
(1554) See, e.g., Moody's Investors Service, Corporate Governance Assessment
(Mar. 2004), FMSE 222925-32, at FMSE 222927.
(1555) Each of these committees continues to operate today, except for the
Assets and Liabilities Policy Committee, which was replaced by the Risk
Policy and Capital Committee in February 2005. In October 2004, the
Board also established a Compliance Committee to oversee the Company's
compliance with the September 2004 Agreement with OFHEO and related
matters. The Risk Policy and Capital and Compliance Committees are
discussed later in this Subsection.
(1556) In November 2005, the Audit Committee's regulatory and legal compliance
oversight responsibilities were more narrowly focused on accounting,
audit, and tax matters, and the responsibilities of the Compliance
Committee were correspondingly expanded to cover regulatory and legal
compliance matters.
(1557) See Minutes of the Meeting of the Board of Directors of Fannie Mae,
dated Feb. 17, 2004, FMSE 504391-406, at FMSE 504392-97.
406
As of September 2004, the Audit Committee Charter described the
purpose of the Committee to be as follows:
- oversee (a) the accounting, reporting, and financial practices
of the corporation and its subsidiaries, including the
integrity of the corporation's financial statements, (b) the
corporation's compliance with legal and regulatory
requirements, (c) the outside auditor's qualifications and
independence, and (d) the performance of the corporation's
internal audit function and the corporation's outside auditor;
and
- prepare the report required by the rules of the Securities and
Exchange Commission to be included in the corporation's annual
proxy statement. (1558)
Beginning in 2000, each member of the Audit Committee was required
to meet standards for director independence and experience established by the
NYSE.(1559) The Audit Committee thereafter provided written affirmations that
its members met these NYSE requirements.(1560) Subsequently, after enactment of
SOX, the Company was required to disclose in its annual Form 10-K whether the
Audit Committee consisted of at least one "Audit Committee Financial
Expert."(1561) In February 2004, the Board designated its first two Audit
Committee Financial Experts.(1562)
- ----------
(1558) Audit Committee Charter, dated Apr. 23, 2004, Zantaz document 1454040,
at 47-49. Beginning in 2004, the Audit Committee also absorbed the
functions of the Technology Committee, which the Board dissolved in
December 2003. See Minutes of the Meeting of the Board of Directors of
Fannie Mae, dated July 14-15, 2003, FMSE 504286-302, at FMSE 504296,
504298.
(1559) See Minutes of the Meeting of the Board of Directors of Fannie Mae,
dated July 17-18, 2000, FMSE 503999-4008, at FMSE 504005-06. See also
NYSE, Inc., Listed Company Manual Section 303A.07 (2004), available at
http://www.nyse.com/lcm.
(1560) See, e.g., Minutes of the Meeting of the Board of Directors of Fannie
Mae, dated July 14-15, 2003, FMSE 504286-302, at FMSE 504298-99; Minutes
of the Meeting of the Board of Directors of Fannie Mae, dated July
17-18, 2000, FMSE 503999-504008, at FMSE 504005-06.
(1561) Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204, Section 407, 116 Stat.
745, 790 (2002); 17 C.F.R. Section 229.401(h) (2005).
(1562) See Minutes of the Meeting of the Board of Directors of Fannie Mae,
dated Feb. 17, 2004, FMSE 504391-406, at FMSE 504398.
407
The Audit Committee Charter since January 2003 has required the
Committee to meet on at least a quarterly basis.(1563) In practice, Audit
Committee meeting minutes show that the Audit Committee held four meetings each
year between 1997 and 2001; seven meetings in 2002; nine meetings in 2003; and
seventeen meetings in 2004. The Committee met regularly in executive session
with representatives of management, the Office of Auditing ("Internal Audit"),
and KPMG (the Company's external Auditor prior to December 2004).(1564) Each
spring, the Audit Committee held a joint meeting with the Assets and Liabilities
Policy Committee to receive an annual examination report from OFHEO.
One of the primary duties of the Audit Committee was the
appointment, retention, compensation, and oversight of the work of the external
auditor.(1565) Beginning in January 2003, the Audit Committee Charter specified
the responsibilities of the Audit Committee with respect to its oversight of the
external auditor, including oversight of the external auditor's reviews of the
Company's financial statements, disclosures, internal controls, and risk
exposures.(1566) Also beginning in January 2003, the Committee Charter required
the Audit Committee Chairman and the external auditor to review the propriety of
earnings releases and other financial disclosures. Moreover, it required the
Committee to review with the external auditor and the CEO and CFO the bases for
the CEO's and CFO's certifications of the Company's financial statements. Beyond
the financial statements and releases, the Charter directed the Committee to
discuss with the external auditor, as well as the head of Internal Audit, the
adequacy and effectiveness of Fannie Mae's internal controls, including any
deficiencies in such controls. In addition, it directed the Committee to discuss
with the external auditor Company policies regarding risk assessment and
mitigation, and compliance with those policies.(1567)
- ----------
(1563) See Minutes of the Meeting of the Board of Directors of Fannie Mae,
dated Jan. 21, 2003, FMSE 504202-40, at FMSE 504228.
(1564) See, e.g., Audit Committee Charter, dated Apr. 23, 2004, Zantaz document
1454040, at 49 ("The Committee shall meet separately in executive
session, periodically, with each of management, the head of the internal
audit department, and the outside auditor."). This remains the
requirement today.
(1565) See id. This remains the case today.
(1566) See Minutes of the Meeting of the Board of Directors of Fannie Mae,
dated Jan. 21, 2003, FMSE 504202-40, at FMSE 504223-30. Previously, the
Audit Committee Charter contained a more general statement of the
Committee's responsibility to oversee the work of the external auditor.
See, e.g., Audit Committee Charter, dated Nov. 18, 2002, FMSE 15166-67.
(1567) See Minutes of the Meeting of the Board of Directors of Fannie Mae,
dated Jan. 21, 2003, FMSE 504202-40, at FMSE 504223-30 (containing
amended Audit Committee Charter).
408
Audit Committee minutes reflect that KPMG discussed these topics
with the Audit Committee during audit plan updates throughout the year, during
quarterly meetings to review CEO and CFO financial statement certifications, and
during the Committee's consideration of the annual financial statements in
February. It also appears that the Audit Committee established a formal "due
diligence" process prior to the annual reappointment of KPMG. This process
involved KPMG's written response to the Audit Committee's questions and a formal
meeting to discuss.(1568) The minutes also indicate that the Committee held
executive sessions with KPMG at most meetings. In addition, both Audit Committee
Chairman Thomas P. Gerrity and former Committee Chairman Vincent A. Mai stated
that they held informal meetings with KPMG once or twice a year to provide an
additional opportunity for KPMG to raise any concerns or irregularities outside
the presence of management.
In addition to overseeing the external auditor, the Audit Committee
also was charged with overseeing Fannie Mae's internal audit function.(1569) The
Committee Charter required the Committee to: appoint, and when appropriate,
replace, the head of Internal Audit; oversee its budget, staffing, and mission;
review the scope and performance of the Internal Audit function; review the
audit plan and performance against the plan; and discuss with the head of
Internal Audit whether there were any restrictions or limitations on Internal
Audit's ability to carry out its responsibilities. The Charter did not require
the head of Internal Audit to report directly to the Audit Committee. After the
publication of the September 2004 OFHEO Report, the Board amended the Audit
Committee Charter to state that "the head of the internal audit department shall
report directly to the [Audit] Committee.(1570)
The Audit Committee was also the primary overseer of the Company's
ethics and compliance functions. Historically, the Committee Charter required
the Committee: to review the status of the Company's compliance with legal and
regulatory developments; to receive periodic reports on the activities of
management's Business Conduct Committee, which oversaw ethics and compliance
activities; and to review the
- ----------
(1568) See, e.g., Minutes of the Meeting of the Audit Committee of the Board of
Directors of Fannie Mae, dated Nov. 17, 2003, FMSE 504796-805, at FMSE
504801; KPMG LLP Presentation to Fannie Mae's Senior Management and
Audit Committee Chair, dated Nov. 6, 2003, FMSE-IR 309205-23.
(1569) See, e.g., Audit Committee Charter, dated Apr. 23, 2004, Zantaz document
145040, at 49.
(1570) Minutes of the Meeting of the Board of Directors of Fannie Mae, dated
Oct. 19, 2004, FMSE 504466-85, at FMSE 504477. However, the Board's
Corporate Governance Guidelines at times in the past referenced this
direct reporting relationship, as did internal organizational charts.
See, e.g., Fannie Mae Corporate Governance Guidelines, dated Jan 20,
2003, FMSE 111395-407, at FMSE 111403 ("The corporation's Senior Vice
President for Operations Risk, who is responsible for Fannie Mae's
internal audit function, reports directly to the Audit Committee.").
409
Code of Business Conduct and monitor compliance with the Code.(1571) In January
2003, the Board amended the Charter to require the Committee to establish
procedures for the receipt and handling of complaints regarding accounting,
internal accounting controls, and auditing matters, including procedures for
confidential, anonymous submission of concerns by employees regarding accounting
or auditing matters.(1572)
(b) Nominating and Corporate Governance Committee
The Nominating and Corporate Governance Committee was (and continues
to be) responsible for overseeing both the nomination of the Board's directors
and the Board's corporate governance policies. As of September 2004, the
Committee's key responsibilities consisted of: (1) identifying and nominating
individuals to serve as members of the Board, recommending to the Board tenure
and retirement policies for directors, and reviewing memberships on outside
boards; (2) overseeing the Company's corporate governance policies and
compliance with the Corporate Governance Guidelines and the Code of Business
Conduct and Ethics for directors; and (3) evaluating annually the performance of
the Board and its committees.(1573)
In July 2002, Raines requested that the Committee launch a
comprehensive review of Fannie Mae's Board policies and practices with the goal
of ensuring that Fannie Mae was "best in class" in the corporate governance
area.(1574) The Committee conducted this project (which the Committee dubbed the
"Corporate Governance Benchmarking Project") with the assistance of an outside
law firm.(1575) The project included an assessment of Fannie Mae's corporate
governance policies and practices against the standards contained in SOX, NYSE
listing requirements, OFHEO and SEC regulations, and best practices.(1576)
- ----------
(1571) See, e.g., Audit Committee Charter, dated Nov. 18, 2002, FMSE 15166-68;
Audit Committee Charter, dated July 18, 2000, FMSE 14495-97.
(1572) See Minutes of the Meeting of the Board of Directors of Fannie Mae,
dated Jan. 21, 2003, FMSE 504202-40, at FMSE 504227 (containing amended
Audit Committee Charter).
(1573) See id. at FMSE 504231 (containing amended Nominating and Corporate
Governance Committee Charter).
(1574) See Minutes of the Meeting of the Nominating and Corporate Governance
Committee of the Board of Directors of Fannie Mae, dated July 16, 2002,
FMSE 505365-66, at FMSE 505365.
(1575) See Minutes of the Meeting of the Board of Directors of Fannie Mae,
dated Jan. 21, 2003, FMSE 504202-40, at FMSE 504220.
(1576) See Minutes of the Meeting of the Nominating and Corporate Governance
Committee of the Board of Directors of Fannie Mae, dated July 16, 2002,
FMSE
410
Based on the results of this project, the Committee recommended a
number of updates and additions to Fannie Mae's Bylaws, Board committee
charters, and policies. Notable recommendations included: (1) updating the
Bylaws to require that the Board maintain Audit and Compensation Committees and
to reflect the Company's choice to follow the corporate governance laws of the
State of Delaware; (2) updating the Audit Committee Charter to provide for
procedures to handle accounting/internal controls/audit complaints; (3) revising
the Corporate Governance Guidelines to require regular executive sessions of the
Board; (4) expanding the Board's conflicts-of-interest policy to create a code
of conduct and ethics for the Board; (5) increasing the frequency of Board
meetings; (6) requiring regular evaluations of the Board and Board Committees,
and of the Chairman/CEO; (7) addressing director compensation; (8) requiring
director consultation with the Nominating and Corporate Governance Committee
prior to accepting directorships at other public companies; (9) developing
internal procedures to support CEO and CFO certifications of financial
statements; (10) establishing a new Housing & Community Development Committee;
and (11) publishing Fannie Mae's corporate governance policies on its external
web site.(1577) These recommendations were subsequently acted upon by the
Board.(1578)
Beginning in early 2003, the Committee also began soliciting or
supporting assessments of Fannie Mae's corporate governance practices by third
party rating agencies, including Standard & Poor's ("S&P"), Governance Metrics
International, Moody's Investors Service, and the Corporate Library.(1579) As
described by the Company, the purpose of these rating exercises was to validate
the Company's actions
- ----------
505365-66, at FMSE 505365; Fannie Mae Corporate Governance Benchmarking
Project: Issues for Consideration, dated Aug. 6, 2002, FMSE 12859-87.
(1577) See Draft Working Scorecard for Benchmarking Project, dated Jan. 16,
2003, FMSE 13512-16 (detailing the status of recommended corporate
governance reforms); Minutes of the Meeting of the Board of Directors of
Fannie Mae, dated Jan. 21, 2003, FMSE 504202-40, at FMSE 504232.
(1578) See, e.g., Minutes of the Meeting of the Board of Directors of Fannie
Mae, dated Jan. 21, 2003, FMSE 504202-40, at FMSE 504220-21.
(1579) See, e.g., Standard & Poor's, Corporate Governance Score: Fannie Mae
(July 2, 2004), FMSE 224953-67; Moody's Investors Service, Corporate
Governance Assessment, dated Mar. 2004, FMSE 222925-32;
GovernanceMetrics International, Rating of Fannie Mae, dated June 27,
2003, FMSE-KD 17128-35; Standard & Poor's, Corporate Governance Score:
Fannie Mae, dated Jan. 30, 2003, FMSE-KD 17078-96; The Corporate
Library, Board Effectiveness Ratings, dated 2003, FMSE-KD 17121-27.
411
resulting from the Corporate Governance Benchmarking Project and to increase the
transparency of Fannie Mae's governance policies and practices.(1580)
In early 2004, the Committee recommended further changes to the
Company's corporate governance policies, mainly to reflect changes to the NYSE
listing requirements and SEC rules.(1581) The Committee also received briefings
from the Legal Department on a new set of corporate governance regulations that
OFHEO had proposed, and the Chairman of the Committee met with OFHEO's Director
to discuss corporate governance topics.(1582)
Beginning in 2003, as an outgrowth of the Corporate Governance
Benchmarking Project, the Nominating and Corporate Governance Committee adopted
a formal process for evaluating the performance of the Board and its committees,
as well as that of the Chairman/CEO. This included surveys to all directors that
requested comments in such areas as: (i) the quality of Board materials,
committee reports, and presentations to the Board; (ii) the length, number, and
use of time at Board meetings; (iii) the skills, experience, and diversity of
the Board; (iv) the balance between the Board and the CEO; and (v) Board access
to senior management.(1583) Committee-specific questionnaires were also
distributed to members of individual committees.(1584) Committee Chair Ann M.
Korologos presented summaries of the evaluations to the Board each year.(1585)
Our review of these director evaluations prior to September 2004
found that, overall, they were highly complimentary with respect to the
functioning of the Board and its committees. The one criticism that appeared
with any consistency is that
- ----------
(1580) Fannie Mae press release, dated Jan. 31. 2003, available at
http://www.fanniemae.com/newsreleases/2003/2369.jhtml?p=Media&s=
News+Rele ases.
(1581) Minutes of the Meeting of the Nominating and Corporate Governance
Committee of the Board of Directors of Fannie Mae, Mar. 30, 2004, FMSE
505435-37, at FMSE 505435.
(1582) 1582 Id. at FMSE 505437.
(1583) See, e.g., Board Self-Evaluation Summary, dated 2003, FMSE 13863-84.
(1584) See, e.g., id. at FMSE 13870-71.
(1585) See Minutes of the Meeting of the Board of Directors of Fannie Mae,
dated July 20, 2004, FMSE 504431-37, at FMSE 504436 ("Ms. Korologos
reviewed the Board's self-assessment results. All were very positive.
She stated that each Committee will review its respective results.");
Minutes of the Meeting of the Board of Directors of Fannie Mae, dated
July 14-15, 2003, FMSE 504286-302, at FMSE 504296.
412
too much time was being consumed at Board meetings by management presentations,
with insufficient time for open discussion.
3. Board Oversight of Accounting and Financial Reporting In Practice
We discuss elsewhere in this Report the principal accounting and
financial reporting issues that we have addressed in the course of our review.
We explain in those sections of the Report the extent to which the Board had
prior notice of, or involvement in, the decisions made in those areas. We did
not find evidence indicating that the Board knew of, or had reason to suspect,
the existence of significant accounting problems within the Company prior to the
beginning of OFHEO's Special Examination. On the contrary, the Board received
assurances in many instances from management, often from KPMG, and in some cases
from other advisers as well, that the Company's accounting was in accordance
with GAAP.(1586)
(a) General Oversight
As noted above, the responsibility for the Board's oversight
of accounting and financial reporting functions fell primarily on the Audit
Committee. The Audit Committee undertook that responsibility by looking to
appropriate expertise, including the Company's external auditors. For each year
prior to 2004, KPMG advised the Audit Committee that it had conducted an audit
in accordance with Generally Accepted Audit Standards and opined that the
Company's financial statements complied with GAAP. In addition, there were no
concerns noted in the required communications during the period.
A number of senior executives were regular participants at Audit
Committee meetings. Depending on the point in time, attendees included the
members of the Office of the Chairman, as well as the Controller, Leanne G.
Spencer, the General Counsel, Ann M. Kappler, and the head of Internal Audit,
Sam Rajappa. Spencer made presentations each February regarding the Company's
financial statements, as well as periodic presentations (at times accompanied by
the head of Financial Standards, Jonathan Boyles) regarding critical accounting
policies and emerging accounting issues. Kappler presented periodic updates on
litigation and compliance matters. Rajappa, along with Vice President--Audit Ann
Eilers, provided updates on Internal Audit's activities. Together with KPMG
(which also attended Committee meetings regularly), Rajappa and/or Eilers
provided quarterly updates on the status of the Internal Audit/KPMG Joint Audit
Plan and, more recently, compliance efforts with respect to Section 404 of SOX
("SOX 404"). Rajappa and/or Eilers also provided annual assessments of the
resources and budget available to Internal Audit to accomplish its audit plan.
These management presentations provided the Committee with regular assurances
that the Company's
- ----------
(1586) See, e.g., KPMG's Annual Report to the Audit Committee, dated Feb. 17,
2004, FMSE 222095-104; Minutes of the Meeting of the Audit Committee of
the Board of Directors of Fannie Mae, dated Feb. 17, 2004, FMSE
504818-30, at FMSE 504822-23.
413
accounting policies and practices were functioning properly and that critical
internal control functions were adequately staffed and resourced (even though,
as discussed below, this was not the reality in a number of important respects).
As a matter of style, the minutes of the Audit Committee meetings do
not include tremendous detail on back-and-forth discussions between the
management presenters and the members of the Committee. Committee
self-assessments contain a number of comments to the effect that its sessions
could have been longer to accommodate more discussion, particularly as the
Committee's responsibilities expanded in recent years.(1587) Nonetheless, the
minutes reflect the active involvement of Committee members who raised
questions, indicated areas of particular interest or concern, and requested
follow-up action by management. According to Committee Chairman Gerrity and
others, management communicated with the Audit Committee informally separate and
apart from the formal Committee meetings (although many of these communications
were not documented).
(b) The Board's Response to Freddie Mac's Restatement
In order to assess the role of the Board in the areas of accounting
and financial reporting in a concrete context, we considered, among other
things, its conduct in the wake of the accounting issues raised at Freddie Mac.
From the outset, the Audit Committee and the full Board received numerous
reports on developments at Freddie Mac over a thirteen month period, and paid
particular attention to the potential implications of those developments with
respect to Fannie Mae's accounting.(1588)
Throughout this period, and particularly in a report to the Audit
Committee in February 2004, management and KPMG assured the Board that the
matters raised in the Freddie Mac situation had no significant implications for
Fannie Mae.(1589)
- ----------
(1587) In the 2003 Audit Committee self-assessment, two of five respondents
"cautioned on the need to ensure sufficient time given the growing
agenda." Audit Committee Self Assessment Survey - 2nd QTR 2003, FMSE-IR
629619-25, at FMSE-IR 629622.
(1588) Freddie Mac announced that it would restate its financial statements in
January 2003. Freddie Mac then engaged the law firm of Baker Botts LLP
("Baker Botts") to conduct an internal review of the facts and
circumstances surrounding the accounting errors the Company had
uncovered. Baker Botts issued a report in June 2003, which the Company
released to the public in July of that year. In November 2003, Freddie
Mac issued a press release announcing the results of its restatement and
providing additional details on the accounting errors that it had
uncovered. See Freddie Mac press release, dated Nov. 21, 2003, available
at http://www.freddiemac.com/news/archives/investors/2003/
restatementa_112103.ht ml.
(1589) See KPMG's Annual Report to the Audit Committee, dated Feb. 17, 2004,
FMSE 222095-104; Minutes of the Meeting of the Audit Committee of the
Board of
414
Publicly available reports about Freddie Mac's restatement as of January 2003
concerned two types of transactions: the securitization of a mortgage security
and a spread lock. The Audit Committee received a report on these transactions
at its February 2003 meeting, and was told that neither of these issues affected
Fannie Mae. According to minutes of the meeting, Audit Committee members
requested and received confirmation on these points from Howard and from
KPMG.(1590)
The Board met three times by telephone in June 2003, and the Freddie
Mac situation was the major agenda item in the first two meetings,(1591) and led
the agenda in the third meeting. During the third meeting, Howard "discussed
seven Freddie Mac accounting issues disclosed in Freddie Mac's public
statements." The issues fell within four categories: security classification;
accounting for derivative instruments; asset transfers and securitizations; and
valuation issues. Howard "contrasted apparent Freddie Mac practices with Fannie
Mae's practices, concluding that Fannie Mae did not have the same practices and
approaches disclosed by Freddie Mac to date."(1592) Howard prepared a summary of
his conclusions on the seven issues, which Executive Vice President for Law and
Policy Thomas E. Donilon distributed to the Board on July 1, 2003.(1593)
Controller Leanne Spencer provided a similar report to the Audit
Committee following the release of the Baker Botts report in July 2003.
According to the minutes of the Committee meeting, Spencer reported that the
Company had "discovered that a small percentage of commitments (less than 2
percent in 2002, and 3.5 percent in 2001) did not settle within the allowable
period and therefore should have been marked to market." Spencer concluded that
the error "would have had an immaterial impact on financial reporting for any
relevant reporting period."(1594)
- ----------
Directors of Fannie Mae, dated Feb. 17, 2004, FMSE 504818-30, at FMSE
504822-23.
(1590) Minutes of the Meeting of the Audit Committee of the Board of Directors
of Fannie Mae, dated Feb. 18, 2003, FMSE 504756-62, at FMSE 504760.
(1591) Minutes of the Meeting of the Board of Directors of Fannie Mae, dated
June 9, 2003, FMSE 504274-75, at FMSE 504274; Minutes of the Meeting of
the Board of Directors of Fannie Mae, dated June 13, 2003, FMSE
504276-77, at FMSE 504276.
(1592) Minutes of the Meeting of the Board of Directors of Fannie Mae, dated
June 27, 2003, FMSE 504278-85, at FMSE 504279-80.
(1593) Mem. from T. Donilon to the Board of Directors, dated July 1, 2003,
FMSE-IR 244893.
(1594) Minutes of the Meeting of the Audit Committee of the Board of Directors
of Fannie Mae, dated July 15, 2003, FMSE 504780-87, at FMSE 504786.
Representatives of KPMG are listed as attendees of the meeting. Id. at
FMSE 504780.
415
By late November 2003, Fannie Mae was tracking thirty-one accounting
issues disclosed in Freddie Mac's restatement. Company management considered
whether Fannie Mae might have similar accounting issues. This effort culminated
in a presentation to the Audit Committee in February 2004.
Spencer's presentation to the Audit Committee in February 2004
highlighted the differences between Freddie Mac and Fannie Mae. She noted "major
structural differences in their securitization business" and other significant
differences in the companies's "business practices." Spencer reported that, "in
consultation with KPMG," Fannie Mae had considered the thirty-one issues
identified in connection with Freddie Mac's restatement; that eleven of the
issues were inapplicable to Fannie Mae; that eighteen of the issues were
applicable to Fannie Mae but raised "no concern"; and that four issues
(including two subtopics) required further diligence. As to the four issues that
required further diligence (buy-ups, commitments on purchases of AFS securities,
out-of-portfolio securitizations, and accounting for loan losses), Spencer
reported in each case either that the Company's accounting practice had been
reviewed by the SEC or that the impact of any errors appeared to be immaterial.
Spencer concluded by informing the Audit Committee that the Company would report
to the SEC on the results of its due diligence and would inform OFHEO as to the
results of the analysis.(1595)
C. Findings
1. The Board Sought to Meet Evolving Corporate Governance
Standards
Overall, we find that Fannie Mae's Board sought in good faith to
respond to evolving legal and other standards in the area of corporate
governance; that it sought appropriate internal and external support and advice
in meeting these standards; and that its aim was to establish governance
policies and practices at least in line with those of leading U.S. corporations
and peer institutions. The Corporate Governance Benchmarking Project, conducted
with the assistance of an outside law firm, reflects the Board's intent that the
Board remain up-to-date in the area of governance, consistent with its
obligations and responsibilities.
As noted above, we also find that the Corporate Governance
Benchmarking Project produced a number of meaningful improvements from a
- ----------
(1595) See Audit Committee Update: Understanding Freddie Mac's Accounting
Restatement as It Affects Fannie Mae, dated Jan. 23, 2004, FMSE-IR
331074-88, passim. The Company briefed the SEC on these issues in
February 2004. See SEC Briefing, dated Feb. 17, 2004, FMSE-IR 599847-62.
The Audit Committee was not listed as a recipient of a memorandum that
Boyles prepared in which he reported on the results of the briefing,
including certain SEC criticisms and his statement that, in one area,
"the process we have in place is not exactly what we showed the SEC
though it gets very close." Mem. from Jonathan Boyles to Leanne G.
Spencer, et al., dated Mar. 13, 2004, FMSE-IR 486916-18, at FMSE-IR
486917.
416
governance perspective. Moreover, based on the advice and reviews that it was
receiving from outside advisers, rating agencies, and OFHEO, the Board had every
reason to believe, up through release of the OFHEO Report, that it had put in
place an effective and highly regarded governance system.
In both 2003 and 2004, S&P gave Fannie Mae a score of 9.0 out of
10.0 on its corporate governance practices, stating that such practices were
"consistently strong or very strong" across each of S&P's areas of
analysis.(1596) In 2003, Governance Metrics International rated the Board an 8.0
out of 10, or "above average."(1597) Also in 2003, The Corporate Library rated
Fannie Mae's Board as the "best stakeholder board" it surveyed due to its
"explicit commitment to setting the standard for outstanding corporate
governance."(1598)
In addition, prior to the release of the OFHEO Report in September
2004, OFHEO consistently praised the operations of Fannie Mae's Board. In
OFHEO's 2003 Report to Congress, OFHEO assessed the Company's Board as follows:
- ----------
The Board of Directors discharges its duties and responsibilities
effectively and in accordance with the leading practices that are
evolving. The Board is appropriately engaged in the development of a
strategic direction for the company, and the Board ensures
management appropriately defines the operating parameters and risk
tolerances of the Enterprise in a manner consistent with the
strategic direction; legal standards; and ethical standards. The
Board has an effective process for hiring and maintaining a quality
executive management team, and the Board effectively holds the
executive management team accountable for achieving the defined
goals and objectives. The Board is appropriately informed of the
condition, activities and operations of the Enterprise, and has
(1596) See Standard & Poor's, Corporate Governance Score: Fannie Mae, dated
July 2, 2004, FMSE 224953-67, at FMSE 224953; Standard & Poor's,
Corporate Governance Score: Fannie Mae (Jan. 30, 2003), FMSE-KD
17078-96, at FMSE-KD 17078. Following the release of the OFHEO Report in
September 2004, S&P lowered Fannie Mae's governance rating twice, and
then altogether retracted the rating. See Phyllis Plitch, S&P Pulls Out
of Corporate Governance Scoring, ASSOCIATED PRESS, Sept. 9, 2005,
available at
http://www.mercurynews.com/mld/mercurynews/business/12604850.htm.
(1597) GovernanceMetrics International, Rating of Fannie Mae, dated June 27,
2003, FMSE-KD 17128-35, at FMSE-KD 17129.
(1598) The Corporate Library, Board Effectiveness Ratings (2003), FMSE-KD
17121-27, at FMSE-KD 17125.
417
sufficient, well-organized time and the necessary resources to carry
out its duties and responsibilities.(1599)
OFHEO offered the Board similar praise in its earlier reports to Congress.(1600)
2. The Board Was Engaged on Accounting and Financial Reporting
Issues
The Board and its Audit Committee had put in place systems and
support for overseeing the Company's accounting and financial reporting, and
reasonably relied upon these systems and support to remain engaged in overseeing
management's policies and practices in these areas. The Board, and especially
the Audit Committee, was responsive to issues relating to the Company's
accounting and financial reporting. The available evidence indicates that the
Audit Committee played an active role in the oversight of these areas and
received regular reports (and assurances) from management, internal auditors,
and outside auditors regarding these matters. The record of Fannie Mae's
reaction to the revelation of accounting problems at Freddie Mac confirms that
the Board was responsive to potential issues in these areas that were brought to
its attention, and that it consistently received assurances regarding Fannie
Mae's accounting practices.
D. Subsequent Developments
Since the end of 2004, the Board made a number of significant
changes to its structure, composition, and practices. Some of these steps were
taken at the behest of OFHEO, which required certain governance changes as part
of its September 2004 and March 2005 agreements with Fannie Mae, and which
issued revised corporate governance regulations in April 2005. Other reforms are
the product of the Board's own efforts, working with senior management and
outside consultants and advisors, to restructure Fannie Mae. As of the beginning
of 2006, some changes to the Board are still in the planning stages, while
others are only partially complete. The following reflects our current
understanding of these changes and their impact.
1. Separation of Chairman and CEO Functions
The most significant change to the structure of the Fannie Mae Board
of Directors occurred after the resignation of Chairman/CEO Raines on December
21, 2004. Rather than simply replacing Raines with another Chairman/CEO, the
Board separated
- ----------
(1599) OFHEO Report to Congress, dated June 2003, FMSE-IR 1180-84, at FMSE-IR
1183.
(1600) See, e.g., OFHEO Report to Congress, dated June 15, 2002, FMSE-IR
1170-79, at FMSE-IR 1172-73; OFHEO Report to Congress, dated June 15,
2001, FMSE-IR 1166-69, at FMSE-IR 1169.
418
the positions of Chairman and CEO.(1601) The Board amended the Company's Bylaws
in January 2005 to give the Board flexibility to split the Chairman and CEO
positions.(1602) The Board appointed Stephen B. Ashley as the non-executive
Chairman of the Board and Mudd as interim President and CEO of the
Company.(1603) In June 2005, after conducting a national search for a new CEO,
the Board appointed Mudd to the CEO position.(1604)
In splitting the roles of Chairman and CEO, the Board adopted a
position that OFHEO had been pressing since its Special Examination of Freddie
Mac in the second half of 2003. Whereas Raines stated that he opposed splitting
the functions because he believed that a unified Chairman and CEO served as a
vital bridge between management and the Board, Ashley stated that the separation
of CEO and Chairman allows the current Board to function more effectively
because the existence of a non-executive Chairman enables the Board to serve as
a stronger check on management.
Fannie Mae's most current position description for its non-executive
Chairman reflects a "checks and balances" concept:
The Chairman of the Board will provide leadership to the Board of
Directors, provide for the proper flow of information to and from
the Board, oversee closely management's implementation of Board
strategic decisions and other significant actions, assist and advise
the Chief Executive Officer, assist in promoting effective relations
between the company and its external stakeholders (in particular its
shareholders, investors, and OFHEO), and promote the highest
standards of ethical conduct and integrity by the company and its
employees.(1605)
Although we recognize that the relationship between the
non-executive Chairman and the CEO continues to evolve at Fannie Mae, and that
the current
- ----------
(1601) See Minutes of the Meeting of the Board of Directors of Fannie Mae,
dated Dec. 21, 2004, FMSE 504507-16, at FMSE 504508.
(1602) Unanimous Written Consent of the Fannie Mae Board of Directors, dated
Jan. 19, 2005, Zantaz document 1288950, at 1.
(1603) Minutes of the Meeting of the Board of Directors of Fannie Mae, dated
Dec. 21, 2004, FMSE 504507-16, at FMSE 504508.
(1604) Minutes of the Meeting of the Board of Directors of Fannie Mae, dated
June 1, 2005, FMSE 510877-78, at FMSE 510878.
(1605) Letter from Stephen B. Ashley to Armando Falcon, Jr., dated Apr. 19,
2005, FMSE-IR 314138-45 (attachment entitled "Duties of the
Non-Executive Chairman of the Board at Fannie Mae").
419
arrangement is dictated in part by the temporary circumstances in which the
Company finds itself, the separation of these two functions has given the Board
a more transparent view of the Company and a more direct role in the oversight
of Fannie Mae's management. This appears to have brought substantial benefits in
terms of Board oversight of management, information flow between the Board and
management, and the tone established and projected at the top of the enterprise.
2. Changes to Board Committee Structure
In addition to separating the CEO and Chairman functions, the Board
has created two new standing committees. The first is the Compliance Committee,
which the Board formed initially to monitor Fannie Mae's compliance with its
September 2004 Agreement with OFHEO. The Committee's responsibilities have since
expanded significantly. The Board also replaced the Assets and Liabilities
Policy Committee with a Risk Policy and Capital Committee in order to provide
broader and more effective oversight of the Company's risk management practices.
The Compliance Committee, through a combination of diligence in
carrying out the Company's commitments and openness in its communications,
appears to have improved Fannie Mae's relations with OFHEO.(1606) As a
consequence of the Committee's success and the current workload of the Audit
Committee, the Board recently gave the Compliance Committee a broader mandate to
oversee compliance matters within the Company.(1607) The Compliance Committee
now is responsible for "overseeing the corporation's legal and regulatory
compliance program, including reviewing and discussing the corporation's Code of
Business Conduct and the activities of management's Corporate Compliance
Advisory Committee and monitoring compliance with the Code, overseeing the
corporation's response to any regulatory examination or other inquiry, and
making periodic reports to the Audit Committee regarding legal and regulatory
compliance."(1608)
- ----------
(1606) This significant progress has been confirmed to us by senior OFHEO
officials as well as by Company management.
(1607) See Compliance Committee Charter, dated Nov. 15, 2005, FMSE 547749-50,
passim.
(1608) Id. at FMSE 547749. The Compliance Committee now shares responsibility
for oversight of the Code of Business Conduct and of compliance matters
with the Audit Committee, but, in practice (as noted above), the
latter's focus is now on compliance relating to financial reporting,
accounting, and audit and tax matters. See, e.g., Audit Committee
Charter, dated Nov. 15, 2005, FMSE 547741-45, at FMSE 547744. The
Nominating and Corporate Governance Committee remains responsible for
overseeing compliance with the Code of Business Conduct for directors.
See, e.g., Fannie Mae Corporate Governance Guidelines, dated Nov. 15,
2005, FMSE 547726-40, at FMSE 547739.
420
The Board has established a new Risk Policy and Capital Committee.
This Committee is an outgrowth of the Company's retention of Mercer Oliver Wyman
Consulting ("Mercer") to review the organizational design of the Company.(1609)
As part of its review, Mercer observed that the Assets and Liabilities Policy
Committee's oversight of the Company's risk management policies and practices
could be strengthened, and that, in particular, the Board needed a better
structure for overseeing operational risk.( ) Mercer recommended revamping the
Assets and Liabilities Policy Committee for this purpose.(1610) In February
2005, the Board adopted Mercer's recommendation by reconstituting the Assets and
Liabilities Policy Committee as the Risk Policy and Capital Committee.(1611) The
Board subsequently approved a charter for the new Committee designed to reflect
comprehensive risk oversight responsibilities, including oversight of credit
risk, market risk, liquidity risk, and operational risk.(1612)
Among other things, the Risk Policy and Capital Committee has worked
to develop comprehensive risk policies for the Company, in consultation with
management and outside consultants, with a focus during 2005 on policies
covering interest rate risk, counterparty risk, credit risk, private label
securities, liquidity risk, model validation, derivatives, and the methods of
setting risk policies.(1613) A second set of policies is
- ----------
(1609) The Mercer engagement fulfilled an obligation set forth in the OFHEO
agreement. Paul, Weiss has received periodic briefings from Mercer and
the Fannie Mae team with which Mercer has been working, throughout the
course of Mercer's organizational design work.
(1610) See Mercer Oliver Wyman Consulting, Organization Design Project:
Discussion Notes Regarding the Proposed Risk & Capital Committee of the
Board, dated Feb. 8, 2005, FMSE-IR 417687-97, at FMSE-IR 417689-90.
(1611) See Minutes of the Meeting of the Board of Directors of Fannie Mae,
dated Feb. 17, 2005, FMSE 503339-50, FMSE 503343-44.
(1612) See Minutes of the Meeting of the Board of Directors of Fannie Mae,
dated Apr. 19, 2005, FMSE-IR 440463-82, at FMSE-IR 440476-77.
Responsibility for overseeing political and reputational risk remains
with the full Board. See Minutes of the Board of Directors of Fannie
Mae, dated Apr. 19, 2005, FMSE-IR 440463-82, at FMSE-IR 440471.
(1613) See Minutes of the Meeting of the Board of Directors of Fannie Mae,
dated July 19, 2005, FMSE 519390-400, at FMSE 519394. Although each of
these policies has been drafted, not all of them had been approved by
the end of 2005. Of those requiring full Board approval, both the credit
and interest rate risk policies have been approved. See Minutes of the
Meeting of the Board of Directors of Fannie Mae, dated Nov. 15, 2005,
FMSE 638723-44, at FMSE 638726; see also Minutes of the Meeting of the
Board of Directors of Fannie Mae, dated Sept. 20, 2005, FMSE 534653-62,
at FMSE 534657.
421
expected to follow that will cover foreign exchange, operational risk, and new
product approvals.
3. Changes to Policies and Practices
(a) Delegations of Authority
At a meeting in May 2005, the Nominating and Corporate Governance
Committee revisited the issue of the Board's delegations of authority to
management. At that meeting, Board Chairman Ashley expressed the view that
reforming current delegations is necessary to "ensure . . . proper management
and oversight of such a large and complex organization." General Counsel Kappler
also briefed the Committee on steps being taken by management to work "from the
lower levels of management upward to ensure proper delegations of signature
authority to bind the Company, and other similar internal controls within the
business units."(1614)
The Board subsequently enlisted Mercer to assist it in restructuring
delegated authorities from the Board to the CEO, and from the CEO to management.
It is our understanding that Mercer conducted a benchmarking study as part of
its work. As of the end of 2005, the Company's work in this area is continuing.
(b) Other Changes
Fannie Mae's Corporate Governance Guidelines now require, in
accordance with the 2005 OFHEO corporate governance regulations, that the Board
meet at least eight times annually, and no less than once a calendar
quarter.(1615) In practice, the Board continues to meet with greater frequency
than is dictated by OFHEO or Board guidelines, and much more frequently than it
did prior to the onset of OFHEO's Special Examination.
The same basic trend is evident in the Board committees. Whereas the
Audit Committee Charter previously required that it meet no less than once a
quarter, it now requires that the Committee meet at least six times per
year;(1616) and while the charters of the Nominating and Corporate Governance
and Assets and Liabilities Policy Committees previously did not set forth a
minimum number of meetings, the relevant
- ----------
(1614) Minutes of the Meeting of the Nominating and Corporate Governance
Committee of the Board of Directors of Fannie Mae, dated May 23, 2005,
FMSE 511232-38, at FMSE 511235.
(1615) See Fannie Mae Corporate Governance Guidelines, dated Nov. 15, 2005, FMSE
547726-40 at FMSE 547734.
(1616) See Audit Committee Charter, dated Nov. 15, 2005, FMSE 547741-45, at FMSE
547744.
422
committee charters now require at least four meetings per year.(1617) In
practice, like the full Board itself, these Committees are meeting more
frequently than required.
In addition, it is our understanding that Board and Board committee
meetings now involve, overall, a high level of discussion and debate. In the
Board's 2005 self-evaluation, many Board members noted "the candid and open
atmosphere that currently exists in the Board and Committee meetings."(1618)
Board committee minutes in 2005 reflect directors' asking management probing
questions and challenging management's assertions.(1619) For example, Audit
Committee minutes in 2005 reflect directors questioning Internal Audit as to
audit planning and findings and questioning the Controller's Office as to its
accounting practices.(1620) Minutes of the Risk Policy and Capital Committee
reflect a similar tone.(1621) Indeed, former interim Chief Risk Officer Adolfo
Marzol characterized Risk Policy and Capital Committee meetings as involving
"robust" discussions led by Committee Chair Leslie Rahl.
We recommend that the Board continue to review its own practices and
procedures in the coming months and years, and to solicit candid evaluations
from
- ----------
(1617) See Nominating and Corporate Governance Committee Charter, dated Nov. 15,
2005, FMSE 547753-54, at FMSE 547754.
(1618) Mem. from John K. Wulff to S. Ashley, dated Oct. 16, 2005, FMSE
535798-800, at FMSE 535798 (summarizing comments of Audit Committee
members).
(1619) Minutes for the Board, by contrast, still exhibit a more
minimalist approach to reflecting discussion and debate.
(1620) See, e.g., Minutes of the Audit Committee of the Board of Directors of
Fannie Mae, dated Jun 20, 2005, FMSE 510748-62, at FMSE 510749
(questioning scope of the Internal Audit Plan for 2005); Minutes of the
Audit Committee of the Board of Directors of Fannie Mae, dated May 23,
2005, FMSE 510105-23, at FMSE 510111- 12 (questioning by several Board
members of the Vice President -- Audit, Ann Eilers, as to actions taken
by Internal Audit to address negative audit findings); Minutes of the
Meeting of the Audit Committee of the Board of Directors of Fannie Mae,
dated Feb. 17, 2005, FMSE 503025-503034, at 503028 (asking how the
Committee could be assured that Fannie Mae has "best in class"
implementation of accounting standards).
(1621) See, e.g., Minutes of the Meeting of the Risk Policy and Capital
Committee of the Board of Directors of Fannie Mae, dated May 19, 2005,
Zantaz document 1465929, at 3 (asking Peter Niculescu to discuss
procedures and controls used to make certain calculations); id. at 4
(asking that management report on the private label securities portfolio,
with specific information on impairment); Minutes of the Meeting of the
Risk Policy and Capital Committee of the Board of Directors of Fannie
Mae, dated Apr. 18, 2005, FMSE 509916-27, at FMSE 509927 (asking that
more work be done before management asks for support for a permanent
increase in the portfolio limit).
423
OFHEO, from outside consultants, and from within the Company. We think it is
particularly important for the Board to monitor closely ongoing improvements in
the areas of the Company's accounting and internal control functions and in
related information technology systems. It is important for the Board to
complete its ongoing effort to revise delegations of authority to management; to
oversee corresponding revisions in the delegations from the CEO to other
officers of the Company; and to review how well both sets of delegations are
working on a periodic basis.
II. OFFICE OF THE CHAIRMAN
A. Summary
With respect to the function of the Office of the Chairman ("OOC")
and other elements of the senior management structure at Fannie Mae through the
end of 2004 (when the OOC was dissolved), we conclude that: (1) management did
not fully inform the Board of accounting issues, internal control deficiencies,
or the inadequacies of internal systems; (2) although Fannie Mae espoused a
corporate culture of openness, intellectual honesty, and transparency, the
actual environment suffered from (i) an attitude of arrogance (both internally
and externally), (ii) an absence of cross-enterprise teamwork (with a "siloing"
of information), and (iii) a culture that discouraged dissenting views,
criticism, and bad news; and (3) the enterprise lacked appropriate structure and
personnel for adequate risk management across risk areas (with an extremely
broad collection of functions and authorities residing in the CFO, and the
absence of an effective cross-enterprise approach to operational risk
management).
Since the end of 2004, we believe that Mudd and other senior
officers of the Company, with the active engagement of the Board, have made a
concerted effort to reform the management structure and the "tone at the top."
As discussed above, these changes have included: (1) redefining management
committees and lines of reporting with a view to improving internal controls,
management of risks, and horizontal and vertical information flow; (2) adopting
a management style that seeks to be more open, collaborative, and humble; (3)
establishing a Chief Risk Officer position (with an independent Risk
organization); (4) revamping the CFO position with a set of responsibilities
more appropriate for the position; (5) eliminating the Law and Policy group
(with the movement of core compliance functions to a new, independent Office of
Compliance, Ethics & Investigations); (6) integrating the Company's businesses
(including the Mortgage Portfolio business, which historically reported to the
CFO) under a new Chief Business Officer position; and (7) shifting the Company's
external relations toward a more cooperative relationship with OFHEO, Congress,
and customers (with a substantial reduction in the size and aggressiveness of
Fannie Mae's lobbying and grassroots activities).
Our sense, as of the date of this Report, is that meaningful,
substantive, and tonal changes are well underway at the senior management level
of Fannie Mae, and that these changes have improved the functioning of the
enterprise both internally and externally.
424
B. Overview Prior to September 2004
The OOC was the center of management power at Fannie Mae. It
consisted of Fannie Mae's Chairman/CEO, the various vice chairmen of the Board
(who also served as the Company's most senior executives), and the Executive
Vice President -- Law and Policy. The OOC was phased out as an organizational
unit after December 2004, when Chairman/CEO Raines retired and the positions of
Chairman and CEO were separated.
1. Chairman and Chief Executive Officer
James A. Johnson served as Chairman and CEO of Fannie Mae from
February 1991 until December 1998. Raines succeeded Johnson as Chairman and CEO
in January 1999, and served in this capacity through December 2004.
Raines first joined Fannie Mae in 1991 as Vice Chairman, reporting
to Johnson. From 1991 to 1996, he was part of the OOC and oversaw the Company's
finance, legal, and corporate development operations. In September 1996, he left
Fannie Mae to become the Director of the Office of Management and Budget. In May
1998, he returned to Fannie Mae as CEO-designate. Upon Johnson's retirement as
Chairman/CEO at the end of 1998, Raines assumed the title of Chairman/CEO, and
he served in this capacity until he retired on December 21, 2004.(1622)
In his capacity as Chairman, Raines presided over meetings of the
Board of Directors. He was also authorized to determine agendas for Board
meetings, in consultation with the chairs of the Board committees.(1623) At
Board meetings, he periodically delivered the Chairman's Report, which addressed
a broad range of topics, including strategic initiatives, regulatory and
legislative developments, Fannie Mae's charitable activities, and annual meeting
proposals contained in proxy statements. He attended meetings of the Audit,
Technology, Compensation, Assets and Liabilities Policy, Nominating and
Corporate Governance, and Housing & Community Development Committees of the
Board.
Raines was also responsible for managing the day-to-day affairs of
the Company. The Company's Bylaws granted the Chairman/CEO "plenary authority to
perform all duties ordinarily incident to the office and such other duties as
may be assigned to him from time to time by the Board." He had authority to
"prescribe, amend and rescind requirements and procedures governing the manner
in which the general
- ----------
(1622) See Fannie Mae press release, dated Dec. 21, 2004, available at
http://www.fanniemae.com/newsreleases/2004/3405.jhtml.
(1623) See Fannie Mae Corporate Governance Guidelines, dated Apr. 23, 2004,
Zantaz document 1454040, at 54.
425
business of the corporation shall be conducted." He also had authority to
appoint all officers and employees of the Company other than the most senior
officers.(1624)
Raines acknowledged that Fannie Mae had a significant history of
"CEOcentered" decision-making.(1625) Raines and then COO Mudd attempted to
broaden decision-making authority in 2000 as part of a corporate reorganization,
but subsequent comments from other senior officers reflect ongoing concern about
the degree to which Raines delegated authority in practice and his level of
involvement in the details of decision-making.(1626)
Raines's direct subordinates varied during his tenure as
Chairman/CEO. Originally reporting to Raines in 1999 were President and COO
Small, Vice Chair Gorelick, Executive Vice President and Chief Credit Officer
Marzol, and the Senior Vice Presidents for Corporate Development and
Communications. Mudd began reporting to Raines after Mudd replaced Small as COO
in 2000.(1627) Also in 2000, CFO Howard began reporting directly to Raines,
after having previously reported to Small. In 2003,
- ----------
(1624) See Fannie Mae Bylaws, Section 4.08 (2004). With the recent split of the
Chairman and CEO positions, the CEO is now limited to the powers
historically provided to Fannie Mae's President - namely, such powers "as
the Board of Directors may prescribe, or as the Chairman of the Board may
delegate to him." Fannie Mae Bylaws, Section 5.06 (2005).
(1625) See Remarks at the Mid-Year Officers Meeting: Getting to 2003, dated July
18-19, 2000, FMSE-IR 675181-534, at FMSE-IR 675227-29 ("One of the things
I said to the Operating Committee in our retreat was that Fannie Mae for
twenty years has been a CEO-centered company. The magic words have always
been, `blank wants it this way.' . . . `Frank wants it this way.' End of
discussion.").
(1626) See, e.g., Leadership Perspectives: Report on Frank Raines, dated Nov.
2003, FNMSEC 44110-156, at FNMSEC 44128 (Chief Credit Officer Adolfo
Marzol commented that Raines "does not seem to delegate as well as he
should given his responsibilities. Too many issues are decided by him or
by group votes of the SLT."); Officer Year-End Leadership Survey: Rater
Feedback Summary on Franklin D. Raines, dated Oct. 2002, FNMSEC
44077-109, at FNMSEC 44087 (Senior Vice President -- Missions and Markets
Michael Quinn stated that "[m]icromanaging on such issues as budget,
hiring and immaterial credit decisions is what Frank's organizational
structure is geared for and that is not conducive to accelerating
change."); id. at FNMSEC 44107 (Senior Vice President -- Housing and
Community Development Robert J. Levin stated that "Frank is almost always
the smartest person in the room on virtually any subject. This can cause
him to `take over' almost any project in the Company.")
(1627) The title of "President" was not used between 2000 and June 2005, when it
was combined with the CEO title rather than the COO title (with Mudd's
appointment as President and CEO).
426
when Gorelick resigned as Vice Chair, Executive Vice President -- Law and Policy
Donilon began reporting directly to Raines. At the time of the publication of
the OFHEO Report in September 2004, only Howard, Mudd, and Donilon reported
directly to Raines.(1628)
Raines participated in a number of management committees. As of
2004, these committees included the Senior Leadership Team, the Operating
Committee, the Assets & Liabilities Committee, and the Credit Committee - each
of which Raines chaired. He also participated as a member of the External
Affairs Committee and the Risk Policy Committee.(1629) These committees are
discussed below.
2. Vice Chairmen of the Board
Prior to 2000, Fannie Mae's Bylaws authorized the Board to elect a
single vice chairman. When Mudd joined the Company in 2000, the Bylaws were
changed to provide for one or more vice chairmen, each of whom was to perform
such duties as the Board prescribed or as the Chairman/CEO delegated.(1630)
During Raines's tenure as Chairman/CEO, the Board usually had two vice chairmen
at any given time. In addition to serving as Board directors, the vice chairmen
also served as the most senior members of management (other than the
Chairman/CEO).
Timothy Howard served as Vice Chairman of the Board, as well as
Executive Vice President and CFO of the Company, at the time he resigned in
December 2004.(1631) Howard joined Fannie Mae as Vice President and Chief
Economist in 1982, and he subsequently served as Senior Vice President --
Economics and Planning. He was appointed Executive Vice President -- Economics,
Strategic Planning, and Financial Analysis in September 1987, and became
Executive Vice President -- Asset Management in January 1988. He was named CFO
in February 1990, began reporting directly to
- ----------
(1628) See Officers Organization Chart, dated Nov. 19, 1999, FMSE-IR 1199;
Officers Organization Chart, dated Nov. 21, 2000, FMSE-IR 1197; Officers
Organization Chart, dated Nov. 21, 2000, FMSE-IR 1196; Officers
Organization Chart, dated Nov. 18, 2003, FMSE-IR 1192; Officers
Organization Chart, dated Oct. 19, 2004, FMSE-IR 1190.
(1629) See List of all Officer Meetings and Standing Participants 2004, dated
Nov. 8, 2004, FMSE-IR 2821-24.
(1630) See Minutes of the Meeting of the Board of Directors of Fannie Mae, dated
Feb. 23, 2000, FMSE 503977-82, at FMSE 503978-79 (amending section 4.08a
of the Bylaws).
(1631) See Fannie Mae press release, dated May 20, 2003, available at
http://www.fanniemae.com/newsreleases/2003/2553.jhtml?p=Media&s=News+Rele
ases; http://www.fanniemae.com/newsreleases/2004/3405.jhtml.
427
Raines in 2000, and became a member of the OOC in November 2000. He was named
Vice Chairman of the Board in May 2003.(1632)
At Board meetings, Howard delivered periodic reports concerning the
Company's financial performance and its stock price performance. In January of
each year, he reviewed with the Board the Company's annual business plan. On
occasion, he also briefed the Board on such topics as the impact of new
accounting pronouncements,(1633) risk management,(1634) manufactured housing
bonds,(1635) and derivatives.(1636)
Howard also attended meetings of the Assets and Liabilities Policy,
Audit, Compensation, and Technology Committees of the Board. At meetings of the
Assets and Liabilities Policy Committee, Howard provided regular reports on the
Company's capital account and its use of derivatives. Howard also regularly made
recommendations to that Committee concerning equity issuance and repurchase and
the payment of dividends on the Company's preferred and common stock. At Audit
Committee meetings, Howard introduced proposed resolutions to appoint the
external auditor for the coming year. He also provided occasional briefings on
the impact of key accounting changes (e.g., the
- ----------
(1632) See E-mail from Lindsay Conway to Steven Fisher, et al., Speaker Bios,
dated Apr. 16, 2004, Zantaz documents 1161976, 1161977; Fannie Mae press
release, dated May 20, 2003, available at
http://www.fanniemae.com/newsreleases/2003/2553.jhtml?p=Media&s=News+Rele
ases.
(1633) See, e.g., Minutes of the Meeting of the Board of Directors of Fannie
Mae, dated Feb. 20, 2001, FMSE 504046-58, at FMSE 504054.
(1634) See, e.g., Minutes of the Meeting of the Board of Directors of Fannie
Mae, dated July 14-15, 2003, FMSE 504286-302; Minutes of the Meeting of
the Board of Directors of Fannie Mae, dated July 15-16, 2002, FMSE
504166-76, at FMSE 504174.
(1635) See, e.g., Minutes of the Meeting of the Board of Directors of Fannie
Mae, dated Jan. 21, 2003, FMSE 504202-40, at FMSE 504238.
(1636) See, e.g., Minutes of the Meeting of the Board of Directors of Fannie
Mae, dated Apr. 16, 2002, FMSE 504147-59, at FMSE 504156.
428
advent of FAS 133(1637)), as well as on the Company's risk assessment and risk
management practices.(1638)
When Raines became Chairman/CEO in 1999, Howard's direct reports
included the Senior Vice Presidents for Financial and Structured Transactions,
Financial Information, Portfolio Management, Portfolio Strategy, and Investor
Relations, as well as the Treasurer and the Controller. In 2002, the reporting
line for Executive Vice President and Chief Credit Officer Marzol shifted from
Mudd to Howard, as did that for the head of Internal Audit, Rajappa (on a
"dotted line" basis).(1639)
As of the fall of 2004, Howard oversaw financial risk policy,
corporate financial strategy, credit finance, accounting and budget functions,
procurement, and investor relations, as well as the Company's Mortgage Portfolio
business (which included portfolio transactions, portfolio strategy, and the
Treasurer's Office). He also served on a number of management committees. In
addition to being chairman of the Risk Policy Committee, he was a member of the
Senior Leadership Team, the Operating Committee, the External Affairs Committee,
the Operations, Transactions, and Investments Committee, the Assets &
Liabilities Committee, and the Credit Committee.(1640) The functions of these
committees are described below.
Mudd joined Fannie Mae in 2000 as Vice Chairman and COO (replacing
Small). He served in this capacity until December 2004, when he replaced Raines
as CEO on an interim basis.(1641) On June 1, 2005, the Board of Directors
unanimously approved Mudd's appointment as President and CEO, thereby ending his
"interim" status.(1642)
- ----------
(1637) See, e.g., Minutes of the Meeting of the Audit Committee of the Board of
Directors of Fannie Mae, dated Feb. 20, 2001, FMSE 504659-65, at FMSE
504661-62; Minutes of the Meeting of the Audit Committee of the Board of
Directors of Fannie Mae, dated Feb. 16, 1999, FMSE 504603-17, at FMSE
504606-07.
(1638) See, e.g., Minutes of the Meeting of the Audit Committee of the Board of
Directors of Fannie Mae, dated Apr. 14, 2003, FMSE 504767-75, at FMSE
504771-72.
(1639) See Officers Organization Chart, dated Nov. 16, 1999,
FMSE-IR 1198; Officers Organization Chart, dated Nov. 19, 2002, FMSE-IR
1193.
(1640) See Officers Organization Chart, dated Oct. 19, 2004, FMSE-IR 1190; List
of All Officer Meetings and Standing Participants 2004, dated Nov. 8,
2004, FMSE-IR 2821-25, at FMSE-IR 2821.
(1641) See Fannie Mae press release, dated Dec. 21, 2004, available at
http://www.fanniemae.com/newsreleases/2004/3405.jhtml.
(1642) See Minutes of the Meeting of the Board of Directors of Fannie Mae, dated
June 1, 2005, FMSE 510877-78.
429
At Board meetings through the end of 2004, Mudd periodically
presented the COO's Report, which discussed budget and compensation issues and
reviewed the achievement of annual corporate objectives. At the first Board
meeting of each year, he presented the Corporate Performance Review, which
discussed the Company's performance in such areas as earnings and revenues, HUD
housing goals, workplace issues, and technology improvements. Mudd also
regularly attended meetings of the Assets and Liabilities Policy, Audit,
Compensation, Housing & Community Development, and Technology Committees of the
Board.
When Mudd became COO in 2000, his direct reports included Executive
Vice President and Chief Technology Officer Julie St. John, Executive Vice
President and Chief Credit Officer Marzol, Executive Vice President --
Single-Family Mortgage Business Louis Hoyes, the Senior Vice President -- Human
Resources, and the Vice President -- Diversity.(1643) In addition, the head of
Internal Audit, Rajappa, reported to Mudd on a "dotted line" basis. In 2002,
Executive Vice President -- Housing and Community Development Robert J. Levin
and e-Business President Michael Williams began reporting to Mudd, while (as
noted above) Marzol's reporting line and Rajappa's "dotted line" reporting
relationship shifted to Howard.(1644)
As of the fall of 2004, Mudd oversaw the Single-Family Mortgage, e-
Business, and Housing & Community Development businesses, as well as contracts
and procurement, facilities management, corporate training and education,
organizational development, recruiting, compensation and benefits, and
employment practices. He also served on a number of management committees. In
addition to chairing the Operations, Transactions, and Investments Committee, he
was a member of the Senior Leadership Team, the Operating Committee, the Risk
Policy Committee, the External Affairs Committee, the Assets & Liabilities
Committee, and the Credit Committee.(1645) These committees are described below.
3. Other Members of the Office of the Chairman
Donilon served as Fannie Mae's Executive Vice President -- Law and
Policy from May 2000 until April 2005. Previously, from 1999 to 2000, Donilon
served as the Senior Vice President and General Counsel of the Company.
Initially, Donilon reported to Vice Chair Gorelick; after she left the Company
in 2003, Donilon reported directly to Raines. Donilon became part of the OOC in
2003.
- ----------
(1643) See Officers Organization Chart, dated Nov. 21, 2000, FMSE-IR 1196-97.
(1644) See Officers Organization Chart, dated Nov. 19, 2002, FMSE-IR 1193.
(1645) See Officers Organization Chart, dated Oct. 19, 2004, FMSE-IR 1189-90;
List of All Officer Meetings and Standing Participants 2004, dated Nov.
8, 2004, FMSE-IR 2821-25, at FMSE-IR 2821.
430
Donilon served as the Corporate Secretary, and was responsible for
facilitating, and creating a record of, meetings of the Board. Donilon attended
most Board meetings, as well as meetings of all Board committees with the
exception of the Housing & Community Development Committee. Donilon periodically
briefed the Board on legislative and regulatory developments and corporate
governance matters.
As head of Law and Policy, Donilon supervised the Legal Department,
Regulatory Policy, Government and Industry Relations, and Communications. His
principal responsibilities included managing Fannie Mae's relationships with its
regulators, Congress, the media, and the housing and mortgage finance industry.
He chaired meetings of the External Affairs Committee and served on a number of
other management committees, including the Senior Leadership Team, the Operating
Committee, the Risk Policy Committee, the Operations, Transactions, and
Investments Committee, and the Credit Committee.(1646) The functions of these
committees are described below.
4. Management Committees
Members of the Office of the Chairman chaired or otherwise
participated in a number of senior management committees that served
information-sharing, advisory, and/or decision-making functions within the
Company. Many of these committees do not appear to have had charters or other
formal organizing documents.
The structure of these committees changed significantly over time as
part of various management reorganizations. As of September 2004, the most
important of these committees consisted of the Senior Leadership Team, the
Operating Committee, the External Affairs Committee, the Assets & Liabilities
Committee, the Disclosure Committee, and several committees devoted to risk
management.
(a) Senior Leadership Team
The Senior Leadership Team ("SLT") was a senior management committee
created by Chairman/CEO Raines. As described by Mudd, the SLT was intended to
"build alignment, integration and teamwork for the entire enterprise."(1647) The
SLT typically met once a week, until its dissolution in December 2004 when
Raines and Howard left the Company.
Members of the SLT included the members of the OOC, along with each
of the Executive Vice Presidents and the President of the Company's e-Business
- ----------
(1646) See, e.g., Officers Organization Chart, dated Oct. 19, 2004, FMSE-IR
1189-90; List of All Officer Meetings and Standing Participants 2004,
dated Nov. 8, 2004, FMSE-IR 2821-25, at FMSE-IR 2821.
(1647) Notes from Dec. 9, 2003 SLT Meeting, dated Dec. 12, 2003, FMSE-IR 273713.
(1648) See id.; Organization Charts, 2004, FMSE-IR 1188-201, at FMSE-IR 1193.
431
Non-SLT members (including, for example, General Counsel Kappler and Senior Vice
President -- Operations Risk Rajappa) also attended occasionally to brief the
SLT on topics related to their particular areas of responsibility. Depending on
the issue area, the SLT served an informational, advisory, and/or
decision-making role.
The SLT discussed a variety of topics at its meetings. It frequently
discussed human resource issues (including officer promotions and staff
reorganizations, employee performance evaluations, and benefits) and, in 2004,
compliance with SOX.(1649) Other periodic topics included the Company's progress
in achieving annual HUD housing goals, competition from other financial
institutions, planning for quarterly business reviews and year-end officers'
meetings, stock price goals, corporate expense and budget targets, and tax
issues related to the relationship of the Company with the Fannie Mae
Foundation.
(b) Operating Committee
The Operating Committee was an information-sharing committee
designed to address cross-divisional issues and the goals and strategic plans
for the Company.(1650) The Committee discussed a broad range of issues,
including housing goals, debt market conditions, portfolio projections,
political and regulatory developments, and financial and business results.
Operating Committee meetings were chaired by Raines and were
attended by the other members of the OOC, the Executive Vice Presidents, and
select Senior Vice Presidents. The committee met once a week.
(c) External Affairs Committee
The External Affairs Committee was not a formal committee, but
rather a weekly informal session in which senior management discussed Fannie
Mae's important external relationships, including those with Congress, the
mortgage industry, and OFHEO. Representative topics of discussion included:
pending legislation and contacts with legislators and other officials; public
relations and industry outreach; developments regarding Freddie Mac and Ginnie
Mae; and campaign contributions and other politically-oriented funding
activities.
- ----------
(1649) The SLT's review of SOX 404 compliance included at least two instances
when it met with representatives of KPMG, the Company's outside auditor.
See, e.g., Minutes of the Meeting of the Senior Leadership Team, dated
Dec 13, 2004, FMSE-IR 140294, at FSME-IR 140294; Minutes of the Meeting
of the Senior Leadership Team, dated Sept. 13, 2004, FMSE-IR 264568.
(1650) See, e.g., Mem. from Hal Gann to F. Raines, dated Dec. 6, 2002, FMSE-IR
272863-64, at FMSE-IR 272863.
432
Donilon chaired meetings of the External Affairs Committee,
succeeding Vice Chair Gorelick when she left the Company in 2003. Regular
attendees included the members of the OOC, Executive Vice President -- Housing
and Community Development Levin, Senior Vice President -- Investor Relations
Jayne Shontell, and select officers from the Law and Policy Division (including
General Counsel Ann Kappler and the Senior Vice Presidents for Regulatory
Policy, Communications, and Government and Industry Relations).(1651)
(d) Assets & Liabilities Committee
The Assets & Liabilities Committee served to update senior
management as to the Company's overall market position and its business results
versus projections. The members of the Committee consisted of Raines (who served
as Chairman), Mudd, Howard, the Executive Vice Presidents who headed the
Mortgage Portfolio and Single-Family businesses, the Executive Vice President --
Housing & Community Development, the Controller, the Treasurer, and certain
other senior officers.(1652)
The Committee met once a week. A typical meeting would include
reports on (i) the Company's position in the mortgage market and the overall
market environment, (ii) the Mortgage Portfolio business (including the mortgage
portfolio's duration gap, options purchases, and forecasts of the Company's
regulatory capital), (iii) the Single-family and Multifamily businesses
(including mortgage acquisitions, progress in achieving regulatory housing
goals, and the status of minority lending initiatives), and (iv) the e-Business.
(e) Disclosure Committee
The Disclosure Committee was established in October 2002, with a key
goal of advising the Chairman and CEO and the CFO regarding their certifications
as to the accuracy of Fannie Mae's quarterly and annual financial
disclosures.(1653) The Committee met several times per quarter. The members of
the Disclosure Committee included General Counsel Kappler (who served as Chair),
Controller Spencer, Senior Vice President -- Investor Relations Shontell, Senior
Vice President -- Operations Risk Rajappa, Senior Vice President --
Communications Charles Greener, Senior Vice
- ----------
(1651) See, e.g., E-mail from T. Donilon to William Maloni, dated May 22, 2004,
Zantaz document 1698424.
(1652) See, e.g., Undated Management Committee Structures and Membership, Zantaz
document 553142, at 1; List of All Officer Meetings and Standing
Participants 2004, dated Nov. 8, 2004, FMSE-IR 2821-25, passim.
(1653) See Minutes of the Meeting of the Audit Committee of the Board of
Directors of Fannie Mae, dated Oct. 15, 2002, FMSE 504723-29, at FMSE
504724. These certifications were required by SOX. Fannie Mae voluntarily
certified its financial statements in 2002, prior to registering its
common stock with the SEC in 2003.
433
President and Treasurer Linda K. Knight, and Senior Vice President -- Policy and
Standards Robert Englestad.(1654)
In January 2004, the Audit Committee approved a charter for the
Disclosure Committee.(1655) This charter charged the Disclosure Committee with,
among other things: (1) designing, implementing, and monitoring controls and
policies sufficient to ensure that information contained in the Company's
financial statements was reported accurately and within time frames established
by the SEC; (2) reviewing the Company's financial disclosures for accuracy and
completeness, and approving these disclosures prior to their release; (3)
discussing the preparation of the Company's financial disclosures with the
Chairman/CEO, and CFO, and reviewing with the Chairman/CEO and CFO any
significant disagreements among management, the outside auditor, internal
auditors, or other employees in connection with the financial disclosures; and
(4) facilitating open communication about disclosure among management, Internal
Audit, the external auditors, the Audit Committee, and key employees.(1656)
The due diligence process in preparation for Chairman/CEO and CFO
certifications as to Fannie Mae's financial reports flowed up to the Disclosure
Committee, with oversight by the Audit Committee. First, Senior Vice Presidents
representing key business units provided certifications to Raines and Howard
regarding their knowledge of any untrue statements or omissions of material fact
in the financial reports. Controller Spencer provided a similar certification as
to whether the financial reports fairly presented in all material respects the
financial condition of the Company. In addition, as the head of Internal Audit,
Rajappa obtained "Internal Control Representation Letters" from the Senior Vice
Presidents addressing the adequacy of internal controls over financial reporting
and the existence of any significant deficiencies or material weaknesses in
those controls that could have a material impact on the Company's financial
reporting. Based on these reports, Rajappa certified to Raines and Howard
whether the Company's internal controls over financial reporting were adequate.
After these certifications had been provided, the Disclosure
Committee met to evaluate the financial reports and certifications and to
provide its own certification to Raines and Howard.(1657) Raines and Howard then
met with members of the Disclosure
- ----------
(1654) See Fannie Mae Disclosure Committee Charter, dated Jan. 23, 2004, FMSE-IR
253048-50, at FMSE-IR 253048.
(1655) See Minutes of the Meeting of the Audit Committee of the Board of
Directors of Fannie Mae, dated Jan. 23, 2004, FMSE 504806-15, at FMSE
504811. Prior to January 2004, the Disclosure Committee appears to have
operated under a draft charter that had not been approved by the Board.
(1656) See Fannie Mae Disclosure Committee Charter, as amended on Jan. 23, 2004,
FMSE-IR 253048-50.
(1657) See, e.g., Certification of the Members of the Disclosure Committee,
dated May 10, 2004, Zantaz document 1920088.
434
Committee to review the procedures undertaken to prepare the financial reports,
and to discuss any outstanding concerns. At such meetings, Kappler indicated her
assessment as to whether the due diligence process supported the assertions
contained in the Chairman/CEO and CFO certifications. Based on these
certifications and assessments, Raines and Howard would decide whether to
certify the financial reports.(1658)
(f) Risk Management Committees
Fannie Mae employed an evolving set of management committees to
oversee the various risks facing the Company. The Board formally approved a
broad reorganization and expansion of the risk management committee structure in
October 2000, with the creation of three new management-level committees: the
Operations, Transactions, and Investments Committee ("OTIC"); the Portfolios and
Capital Committee; and the Credit Risk Policy Committee.(1659) At a January 2004
meeting, the Board approved the dissolution of the Credit Risk Policy Committee
and the Portfolios and Capital Committee and consolidation of their functions
into a new Risk Policy Committee ("RPC"). The Board also approved the
re-chartering of the OTIC and creation of a new top-level Credit Committee to
resolve disputes arising at RPC and OTIC meetings.(1660)
(1) Risk Policy Committee
The RPC was broadly responsible for overseeing the Company's
financial risks. Among other things, the RPC was charged with: (1) discussing
and deciding key corporate policies relating to the management of interest rate
and credit risk; (2) defining the Company's financial risk tolerance, reviewing
risk management strategies adopted by the business units for consistency with
this tolerance, and resolving any inconsistencies; (3) ensuring reasonableness
of assumptions and consistency of structure in major corporate models used to
measure, evaluate, and price financial risk; (4) achieving consensus on risk
assessments, capitalization, hurdle rates, and pricing targets for all new
products or initiatives that could potentially affect the risk profile of the
Company; and
- ----------
(1658) Audit Committee minutes set forth the due diligence process for each
certification. See, e.g., Minutes of the Meeting of the Audit Committee
of the Board of Directors of Fannie Mae, dated Mar. 12, 2004, FMSE
504834-37, at FMSE 504835; Minutes of the Meeting of the Audit Committee
of the Board of Directors of Fannie Mae, dated Nov. 13, 2003, FMSE
504792-95, at FMSE 504793; Minutes of the Meeting of the Audit Committee
of the Board of Directors of Fannie Mae, dated Aug. 12, 2003, FMSE
504788-91, at FMSE 504789.
(1659) See Minutes of the Meeting of the Board of Directors of Fannie Mae, dated
Oct. 17, 2000, FMSE 504009-18, at FMSE 504010-14.
(1660) See Minutes of the Meeting of the Board of Directors of Fannie Mae, dated
Jan. 23, 2004, FMSE 504353-90, at FSME 504371-73.
435
(5) ensuring adequate and efficient capitalization of the Company and its
business units.(1661)
Howard chaired the RPC. The members of the RPC were selected by the
CFO and approved by the SLT. Besides Howard, members of this Committee included
the Executive Vice Presidents for the Mortgage Portfolio and Single-Family
businesses, Chief Credit Officer Marzol, e-Business President Williams, and
several Senior Vice Presidents. Mudd and Donilon served ex officio.( 1662) In
fulfilling its mandate, the RPC was supported by Senior Vice President --
Corporate Financial Strategy Thomas A. Lawler and his Risk Policy group.
The full RPC exercised direct oversight of interest rate risk. Other
risk policy matters were handled by one of three subcommittees of the RPC: the
Credit Risk Subcommittee (chaired by Marzol); the Analytics and Capital
Subcommittee (chaired by Lawler); and the Corporate Reporting and Standards
Subcommittee (chaired by Spencer).
(2) Operations, Transactions and Investments Committee
As originally established in 2000, the OTIC was charged with
evaluating new investments, large transactions, and new business initiatives, as
well as "requests for commitments of resources, monies, or investments that
involve[d] cross-sectional departments" within the Company.(1663) The mission of
the OTIC expanded in January 2004, when it was charged by the Board with
"oversee[ing] the management of all operational risk throughout the Company" and
"oversee[ing] security and privacy management."( 1664)
- ----------
(1661) Risk Policy Committee Charter, dated Feb. 15, 2004, Zantaz document
738653.
(1662) See Overview of Current Risk Policy Organization and Recommendations for
Interim Steps in Transition to CRO Organization, dated Jan. 5, 2005,
Zantaz document 1331424, at 17; Fannie Mae's Risk Oversight Structure,
dated July 30, 2004, Zantaz document 1219244.
(1663) See Minutes of the Meeting of the Board of Directors of Fannie Mae, dated
July 17-18, 2000, FMSE 99407-16, at FMSE 99410; Minutes of the Assets and
Liabilities Policy Committee of the Board of Directors of Fannie Mae,
dated Oct. 17, 2000, FMSE 504917-504924, at FMSE 504917-18.
(1664) Minutes of the Assets and Liabilities Policy Committee of the Board of
Directors of Fannie Mae, dated Jan. 22, 2004, FMSE 504986-504994, at FSME
504991; see also Operations, Transactions, and Investments Committee
Charter, dated Jan. 13, 2004, Zantaz documents 882230, 882233. The
re-chartered OTIC remained responsible for acting as a forum to resolve
issues related to transactions or investments.
436
The OTIC was chaired by Mudd. Other members of the Committee
included Howard, Donilon, Marzol, Levin, Hoyes, Williams, Kappler, Rajappa,
Spencer, and St. John.(1665)
After the OTIC was re-chartered in January 2004, it formed two
working groups: one for operational risk, and another for security and privacy.
The main task completed by the operational risk working group in 2004 was a
benchmarking project that compared Fannie Mae's operational risk management
practices with those of other large financial institutions (discussed below).
(3) Credit Committee
The main function of the Credit Committee was to resolve disputes
over credit, interest rate, and operational risks that had not been resolved in
the RPC or OTIC. Raines presided over Credit Committee meetings, which met
quarterly or, when necessary, more frequently. The other members of the Credit
Committee consisted of Howard, Mudd, Donilon, and Marzol.(1666)
C. Findings
1. Management Did Not Fully Inform the Board of Accounting Issues
or Internal Control Deficiencies
Our investigation found that management's reports to the Board
sometimes omitted critical adverse information and thereby left directors with a
false sense of reassurance concerning the Company's policies and practices, the
level and nature of internal resources, and the degree to which the Company
genuinely met "best practices."( 1667)
- ----------
(1665) Overview of Current Risk Policy Organization and Recommendations for
Interim Steps in Transition to CRO Organization, dated Jan. 5, 2005,
Zantaz document 1331424, at 14, 18.
(1666) See id.; An Overview of Fannie Mae's Risk Oversight Committee Framework,
dated 2004, Zantaz document 2229168, at 2-3.
(1667) In the Board's 2003 self-assessments, all fourteen directors rated their
access to management, the quality of management presentations to the
Board, and the adequacy of pre-meeting information to be "good" or "very
good." See Board of Directors Evaluation - Compilation of Results, dated
2003, FMSE 81544-49. However, some comments by Board members reflected a
belief that management presentations should have included more financial
and operational detail. See Board Self-Evaluation Summary, dated 2003,
FMSE 13872-78, at FMSE 13875. Directors' comments in the 2004
self-assessments reflected a similar combination of overall satisfaction
with the quality of management presentations and sporadic
437
For example, we can find no evidence indicating that the Board
(including Board committees) was briefed in any meaningful fashion concerning:
(1) the existence of significant resource deficiencies in Internal Audit, the
Controller's Office, or the Office of Corporate Compliance; (2) the fact that
the Company's central compliance offices (the Office of Corporate Compliance and
the Office of Corporate Justice) were housed in the litigation section of the
General Counsel's office, with a Chief Compliance Officer who managed key
litigation functions for the Company (including employment practices
litigation); (3) the absence of a meaningful cross-enterprise approach to
operational risk management; or (4) the broad absence of documented corporate
policies and procedures within the Company.(1668) As a consequence, the Board
lacked the information necessary to assess the claims of senior management that
the Company possessed a first-rate accounting operation and robust internal
control and compliance functions.
Specific examples of management communications to the Board
regarding significant accounting and financial reporting issues are discussed in
other Chapters of this Report.
2. Management Created an Environment that was not Conducive to
Open Discussion and Exchange of Views
The Company espoused a corporate culture that lauded intellectual
honesty, openness, and transparency. Corporate culture was a frequent topic of
Frank
- ----------
suggestions that heightened financial detail would be helpful. See Board
Self-Evaluation Summary, dated 2004, FMSE-KD 26204-12.
(1668) We also note that, on two occasions, management received, but it did not
share with the Board, recommendations to reform the Board's delegations
of authority to management to conform to best practices. An outside law
firm first presented these recommendations to management in a 2001
memorandum. See Mem. from O'Melveny & Meyers LLP to A. Kappler and
Anthony Marra, dated Nov. 30, 2001, Zantaz document 1217433. A Deputy
General Counsel in the Legal Department prepared a second memorandum in
2003 and presented it (in draft form) to senior management. See Draft
mem. from T. Marra to T. Donilon, A. Kappler, Monica Medina, and Iris
Aberbach, dated Nov. 2003, FMSE-KD 17042-50, at FMSE-KD 17044. It appears
that management did not forward the 2003 memorandum to the Board.
However, it did inform the Nominating and Corporate Governance Committee
in August 2004 that it was undertaking a benchmarking project to review
the Board's delegation practices. See Minutes of the Meeting of the
Nominating and Corporate Governance Committee of Fannie Mae, dated July
14, 2004, FMSE 505440-43, at FMSE 505440-41. This project soon was
overtaken by the events that followed the OFHEO Report in September 2004.
438
Raines's speeches to the business community,(1669) as it was a frequent topic of
his weekly messages to employees. For example, in a September 4, 2003 message to
employees, Raines encouraged employees to maintain an open working environment:
Our openness and intellectual honesty with each other helps to make
us the quick, creative, fast, agile, and successful company we are.
Just as we aim for best-in-class transparency externally, and
welcome the toughest questions from all of our stakeholders, we need
to be transparent and address the tough questions internally as
well.(1670)
Fannie Mae's senior management also discussed from time to time the
need to encourage internal honesty and openness. For example, the minutes of a
2003 SLT meeting state that:
Mr. Raines asked the other SLT members for advice about how he can
encourage employees to ask questions, share doubts, and discuss
problems with their managers promptly? How can he get managers to
create an atmosphere that encourages employees to share their
thoughts more promptly?(1671)
Fannie Mae's Code of Business Conduct and associated policies also
emphasized the importance of openness and honesty. For example, the Code
required managers to "[maintain] a workplace environment that encourages open
communication about and compliance with the Code."(1672) Similarly, Fannie Mae's
Ethical Responsibility Policy stated that "Fannie Mae's policy is to maintain a
corporate culture characterized by openness, integrity, responsibility, and
accountability."(1673) This policy required:
- ----------
(1669) See, e.g., Remarks Inaugurating the Business Roundtable Institute of
Business Ethics at the University of Virginia (Jan. 14, 2004), available
at http://www.darden.virginia.edu/corporate-ethics/
media-rainesremarks040114.htm/.
(1670) HomeSite News: Frank Asks Us to Speak Up in His Sept. 5 Weekly Message,
dated Sept. 4, 2003, FMSE 22935-37, at FMSE 22936.
(1671) Minutes of the Meeting of the Senior Leadership Team, dated Sept. 15,
2003, FMSE-IR 273609.
(1672) Code of Business Conduct, dated May 11, 2004, FMSE-IR 36806-30, at
FMSE-IR 36809.
(1673) Fannie Mae Ethical Responsibility Policy, dated June 25, 2004, FMSE-IR
36624-26, at FMSE-IR 36624.
439
all Fannie Mae people managers to create and maintain an open
working environment that invites and entertains discussion on a wide
range of issues relevant to Fannie Mae's operations and compliance
with the Law and the Code. Managers are expected to achieve such an
environment by leading by example (1674)
Measures were also used to test how well these standards were being
met in practice. For example, officers were required to complete regular
self-assessments in which they explained how they maintained the appropriate
"tone at the top" in their business units.(1675) In addition, Human Resources
used outside resources to conduct periodic surveys of employee sentiment to
gauge the corporate culture.(1676)
Based upon the results of these employee surveys (which, as
discussed below, were generally poor), management introduced a variety of
measures aimed at improving honesty and openness. For example, after a 1999
employee survey revealed concerns about leadership, communication, and culture,
Vice Chair Gorelick outlined a series of corrective measures that included
training managers on leadership qualities, requiring them to "attend coaching
workshops to . . . ensure open and honest dialogue with their staff," and
requiring them to hold breakfast and lunch meetings and open office hours with
staff.(1677)
After the 2001 employee survey failed to demonstrate a significant
improvement in employee sentiment,(1678) management promised to introduce a
series of measures that were rather similar to those it promised in 1999,
including "regular and interactive employee communications with Dan and Tim,"
brown bag lunches, walk-
- ----------
(1674) Id. at FMSE-IR 36625.
(1675) See, e.g., Fannie Mae Self Assessment Questionnaire: Legal Department,
dated 2003, Zantaz document 4129242 (asking "[h]ow do you establish the
appropriate `tone at the top' and ensure it is followed in your
department?").
(1676) See, e.g., Culture Scan Preliminary Results: Fannie Mae, dated Nov. 2004,
FMSE-IR 208890-952; Hewitt, EPS Survey Results - Overall Corporate
Findings, dated Aug. 2001, FMSE-IR 308768-80.
(1677) Mem. from Jamie S. Gorelick to the Operating Committee, dated Feb. 28,
2000, Zantaz document 738059.
(1678) See Hewitt, Fannie Mae: EPS Survey Results - Overall Corporate Findings,
dated Aug. 2001, FMSE-IR 308768-80, at FMSE-IR 308777; 2001 Employee
Perspectives Survey, dated Aug. 23, 2001, FMSE-IR 308757.
440
arounds, and "gab sessions" with employees.(1679) Similar measures were proposed
yet again in 2004.(1680)
While it is fair to say that speeches, statements, and policies
issued by senior management over time emphasized the importance of an open and
honest atmosphere, it is not clear that this was the message received by
employees. Rather, what was commonly described to us was a set of information
"silos" within the Company, with skepticism expressed as to how well those silos
connected even at the top of the enterprise.
(a) A Culture that Discouraged Dissenting Views, Criticism,
and Bad News
Mudd acknowledged to us that, generally speaking, Fannie Mae's prior
leadership was not good at listening to ideas and issues raised by people at the
middle and lower levels of the Company, and senior management meetings often
were too formal and scripted and did not present enough opportunity for open
debate. Mudd's view was echoed by other members of management. For example, a
2004 working group of Senior Vice Presidents urged senior leadership to
"encourage a culture of greater directness in communications." The working group
noted that "[i]t is great that we are, as a Company, very polite, but when
politeness is a mask for passive/aggressive behavior it retards genuine
progress."(1681)
These types of observations were widespread in employee responses to
a 2004 Human Resources survey (known as the "Culture Scan").(1682)
Representative responses included comments that the decisions and styles of
senior leadership "cannot be criticized"; that "we don't value dissenting
opinions and protect dissenters"; and that "[w]e need a more open culture that
welcomes honest open critics and a diversity of thought styles."( 1683) A number
of employees complained of having to do things the "Fannie Mae Way," which was
described as "not publicly disagreeing and working it out
- ----------
(1679) See 2001 Corporate EPS Action Plan, dated Jan. 27, 2002, FMSE-IR
308667-68, at FMSE-IR 308667; Undated EPS Divisional Action Plan,
FMSE-IR 308831-32.
(1680) See Mem. from Rebecca Senhauser to the Office of the Chairman, dated
Apr. 14, 2004, Zantaz document 818391 (proposing efforts to address
culture and morale that included a town hall meeting, an employee
culture survey, and forums with the Office of the Chairman).
(1681) Presentation of Senior Vice President Working Group, dated Mar. 16,
2004, FMSE-IR 468570-577, at FMSE-IR 468577.
(1682) See Culture Scan Preliminary Results: Fannie Mae, dated Nov. 2004,
FMSE-IR 208890-952.
(1683) Id. at FMSE-IR 208899, 913, 919.
441
behind the scenes in an indirect way."(1684) One employee in the Legal
Department commented that "[t]he culture of `making nice' really exists. Many
folks are not willing/comfortable to tell senior management what they don't want
to hear."(1685) Other employees cited difficulties in confronting differences or
suggested that candor was lacking because management disliked bad news.(1686)
(b) Absence of Cross-Enterprise Teamwork
Fannie Mae's corporate culture also was characterized by a lack of
teamwork at the senior management level. Chairman Ashley observed the issue as
one of compartmentalization of information at senior levels.( 1687) Mudd stated
that senior managers tended to defend their territories and to integrate
vertically rather than across the enterprise. As far back as 2000, Mudd
described a "horizontal problem of silos and a lack of cooperation and flow of
information across Fannie Mae."(1688) A number of other senior officers stated
that management exhibited a "silo" mentality and did not readily share
information among its members.
In her 2002 evaluation of Fannie Mae's leadership, Spencer urged
Raines to "do more to force team work with his team" because "[t]hey still are
not operating as a cohesive unit."(1689) Similarly, at the SLT's December 2003
retreat, certain SLT members commented that they needed to "work together more";
to wear their "enterprise" hats (rather than their "function" hats) more often;
and to reduce "competition among SLT members."( 1690) Some SLT members said that
they were reluctant to give up some of their decision-making autonomy by
bringing issues for decision before the SLT, and others
- ----------
(1684) Id. at FMSE-IR 208900.
(1685) Id. at FMSE-IR 208913.
(1686) See id. at FMSE-IR 208904-14. Raines himself observed during the
previous year that "employees sometimes sit on a question for months or
years before raising it, or raise it with [the Office of] Corporate
Justice or the Office of the Chairman before raising it with their own
managers." Minutes of Senior Leadership Team Meeting, dated Sept. 15,
2003, FMSE-IR 273609.
(1687) See S. Ashley, 2003-CEO Evaluation Form, FMSE 220631-50, at FMSE 220649.
(1688) Remarks at the Mid-Year Officers Meeting: Getting to 2003, dated July
18-19, 2000, FMSE-IR 675181-534, at FMSE-IR 675396.
(1689) Officer Year-End Leadership Survey: Rater Feedback Summary on Franklin
D. Raines, dated Oct. 2002, FNMSEC 44077-109, at FNMSEC 44095.
(1690) Handwritten Notes of Jane Hopkins at Dec. 9, 2003 SLT Offsite Meeting,
FMSE-IR 273714-22, at FMSE-IR 273712, 273714, 273718.
442
expressed concern that their decision-making authority would be "hijacked" by
the SLT.(1691)
Although concerns about coordination and information-sharing appear
to have existed across the enterprise, a number of senior officers directed
specific criticisms at Howard's Finance organization. These criticisms related
not only to relations between Finance and other parts of the Company,(1692) but
also within Finance itself.(1693)
(c) A Culture of Arrogance
The 2004 Culture Scan also contained employee comments from almost
every department expressing concern that the outside world perceived Fannie Mae
to be "arrogant" and inflexible.(1694) Ashley commented during his interview
that he had
- ----------
(1691) Id. at FMSE-IR 273717, 273720.
(1692) See, e.g., Leadership Perspectives: Report on Tim Howard, dated Nov.
2003, FNMSEC 43958-86, at FNMSEC 43975 (Senior Vice President--Investor
Relations Shontell noted that Howard was "proud of finance and it shows.
(His pride, in turn, supports an arrogance within Finance towards others
in the Company.)."); E-mail from Kathy G. Gallo to F. Raines, dated Apr.
15, 2003, Zantaz documents 827452, 827454 (Gallo summarized comments in
Howard's 2003 leadership perspectives survey, which included "Tim could
benefit by increasing the amount of networking he does with all of
Fannie Mae's constituencies"); Officer Year-End Leadership Survey: Rater
Feedback Summary on John T. Howard, dated Oct. 2002, FNMSEC 43939-57, at
FNMSEC 43944 (Treasurer Linda K. Knight said that "I think Tim could
improve his interactions with the other Executive Vice Presidents to
ensure Finance is fully in synch with the other departments."); id. at
FNMSEC 43945 (Chief Credit Officer Adolfo Marzol said that "Tim has
enjoyed the luxury of the `self-containment' of the Finance division. He
does not, for example, have to deal with an independent `chief
prepayment risk' officer. For these reasons, I think Tim is good at
making change within the Finance division but struggles a little bit
more when issues get very cross-functional.").
(1693) See, e.g., Leadership Perspectives: Report on Tim Howard, dated Nov.
2003, FNMSEC 43958-86, at FNMSEC 43971 (Controller Spencer said that
"employees (below rank of officer) would benefit from hearing from
[Howard] more The `I' in him holds him back from being an `initiator' of
communication or an `articulator' of vision"; and that "Tim is reluctant
to get [the] whole team together and deliver communication and messaging
that everyone can hear and understand their part and where they fit
in").
(1694) See Culture Scan Preliminary Results: Fannie Mae, dated Nov. 2004,
FMSE-IR 208890-952, at FMSE-IR 208912 (Multifamily comments); id. at
FMSE-IR 208913 (Legal Department comments); id. at FMSE-IR 208915
(Single-Family comments); id. at FMSE-IR 208916 (comments from
Controller's Office, Investor Relations,
443
perceived this arrogance when he served as President of the Mortgage Bankers'
Association of America prior to joining Fannie Mae's Board.(1695) Duane Duncan,
the Senior Vice President--Government and Industry Relations, acknowledged that
many in Congress and at OFHEO held this same perception of Fannie Mae, due to
the Company's combative stance towards its critics and its aggressive lobbying
and grass roots campaigns. Fannie Mae apparently exhibited this same attitude
even to consultants that it hired to critique and help reorganize the
Company.(1696)
In a 2003 letter to Raines, Rajappa described the problem as
follows:
Finally, we are perceived to be arrogant. Our own surveys have
shown that, my former colleagues now at Wells, B of A, and
Citi Mortgage tell me that. We briefly discussed this at
Homestead, but more needs to be done on a day-in-day-out basis
by everyone who has contact with the public We must learn to
listen effectively, answer the question asked, not just
deliver the message we have prepared.(1697)
- ----------
Credit Finance, and Strategy); id. at FMSE-IR 208918 (Law and Policy
comments); id. at FMSE-IR 208921 (e-Business comments).
(1695) See also D. Mudd, Remarks at the Mid-Year Officers Meeting: Getting to
2003, dated July 18-19, 2000, FMSE-IR 675181-534, at FMSE-IR 675376-77
(". . . the customer is not always referred to in Fannie Mae in the
respectful terms that somebody that is paying our revenues and enabling
us to meet our payroll should be.").
(1696) In a July 2000 speech at an Officer's Retreat, Mudd chided management
for being unwilling to accept criticism:
If we're such a great employer, why aren't we facing the
reality of the hard questions and the poor ratings that come
in some of the employee surveys? We make a sport, it seems, of
paying consultants a lot of money, bringing them in, baiting
them, laughing at them and then kicking them out and bringing
a new set in at some point later . . . [A] lot of those
outside observers trying to present us with a mirror
reflection of ourselves have said the same thing. And we keep
saying that there's something wrong with the mirror and
writing a check for that honor.
Id. at FMSE-IR 675376.
(1697) Letter from S. Rajappa to F. Raines, dated Aug. 19, 2003, at FMSE-IR
503417-18, at FMSE-IR 503417.
444
Raines seemed to acknowledge this problem, at least by late 2004. In
talking points for his remarks at a November 2004 officers' meeting, Raines
said:
[w]e need to be candid about the fact that we are not perfect. We
may have believed our own PR a little too much. We allowed ourselves
to be arrogant. We thought we had a lot to teach and little to learn
from others.(1698)
When we asked Raines about Fannie Mae's perceived arrogance, he acknowledged
that there were some employees who felt it was easier to dictate terms to others
than to treat them as individuals with worthwhile views. However, Raines also
noted that charges of arrogance could be seen as extensions of critics'
frustrations with Fannie Mae's success.(1699)
Fannie Mae's perceived arrogance helped to sour its relationship
with its safety and soundness regulator. Mudd stated that many members of senior
management believed that OFHEO had no right to question Fannie Mae's policies in
light of the Company's years of sustained success.(1700) Board member Kenneth
Duberstein observed that senior management, and in particular Raines and Howard,
did not respect OFHEO's views and treated OFHEO dismissively. According to
Duberstein, management's low regard for OFHEO was not lost on OFHEO's then
Director, Armando Falcon, Jr., who complained during a spring 2004 meeting with
Duberstein about the arrogance exhibited toward OFHEO by Raines and Howard, and
about Fannie Mae's unwillingness to cooperate fully in the Special Examination.
Duberstein said that he approached Raines about what he heard during this
meeting, and that Raines dismissed it out-of-hand.
Fannie Mae's perceived arrogance also extended to Congress, where
Fannie Mae had a reputation for lecturing lawmakers and for employing a massive
lobbying network to impose its views upon them. The Company's Law and Policy
division included a sophisticated lobbying organization that was known to be
aggressive. The aggressive tactics appear to have included vigorous use of grass
roots and media campaigns.(1701) On occasion, Fannie Mae directed this apparatus
toward OFHEO as well.(1702)
- ----------
(1698) FDR Context Setting: 2004 Officers Meeting, dated Nov. 18, 2004, FMSE-IR
674388-94, at FMSE-IR 674389.
(1699) Raines also said that he made an effort to retrain employees to listen
effectively and to answer the questions asked of them.
(1700) Mudd also said that some in management resented OFHEO's sudden
assertiveness, after years of passivity, in the wake of the Freddie Mac
scandal.
(1701) See, e.g., Jeffrey H. Birnbaum and Annys Shin, Fannie Mae Dissolving
Grass-Roots Lobbying Network, WASH. POST, Sept. 16, 2005, at D01
(discussing Fannie Mae's use of its regional partnership offices to
conduct grassroots campaigns to lobby
445
Although such tactics often proved effective in protecting the
Company against perceived legislative threats in the short run, the view has
been expressed inside the Company and elsewhere that they did long-term harm to
important Fannie Mae relationships on Capitol Hill.(1703)
3. Inadequate Management of Corporate Risks
(a) Interest Rate and Credit Risk
Beginning in 2000, management began consolidating its credit and
interest rate risk policy functions under Howard. Howard historically was
responsible for overseeing interest rate risk policy, insofar as the Mortgage
Portfolio business reported to him.(1704) At Raines's request, Howard assumed
oversight of the credit policy function as well in 2002, "in order to put all of
the Company's financial risk and strategy responsibilities under a single direct
report to the Chairman and CEO."(1705) In 2004, Howard also became chairman of
the Risk Policy Committee, which (as noted above) replaced the Credit Risk
Policy Committee and set both credit and interest rate risk policy. Howard's
responsibility for credit risk policy increased further after Marzol resigned as
Chief Credit Officer in the summer of 2004. Senior management decided not
- ----------
legislators in their home districts); Bethany McLean, The Fall of Fannie
Mae, FORTUNE, Jan. 10, 2005, available at
http://www.pbs.org/wsw/news/fortunearticle_20050110_01.html (describing
a March 2004 television advertisement directed at defeating a GSE reform
bill).
(1702) See, e.g., E-mail from W. Maloni to T. Donilon, dated Oct. 31, 2003,
FMSE-E 2284626-27 (recommending that Fannie Mae contact friends in
Congress "suggesting why more money for an agency that never put enough
money into exams wouldn't resurrect them. Have a Democrat nail [OFHEO
Deputy Director] Blumenthal, suggesting that he is setting up the
Company in the coming accounting audit.").
(1703) See, e.g., Jeffrey H. Birnbaum and Annys Shin, Fannie Mae Dissolving
Grass-Roots Lobbying Network, Wash. Post, Sept. 16, 2005, at D01.
(1704) According to former Chief Credit Officer Marzol, Fannie Mae did not
traditionally have a separate interest rate risk policy function.
(1705) Mem. from T. Howard to All Employees, dated Aug. 26, 2004, Zantaz
documents 1237574, 1237575. As noted above, Marzol began reporting
directly to Howard in 2002, after having reported previously to COO
Mudd. Marzol stated that he asked Raines not to shift his reporting line
to Howard, because much of his work as Chief Credit Officer related to
the credit guaranty business, which reported to Mudd. Marzol said that
Raines denied his request because he wanted to give a single executive
officer oversight of both credit and interest rate risk.
446
to replace Marzol,(1706) and instead divided Marzol's responsibilities among
various groups, most of which reported to Howard.(1707)
By the late summer of 2004, Howard's authority over financial risk
had consolidated to the point where he(1708) and Raines(1709) both referred to
Howard as Fannie Mae's "Chief Risk Officer." This process reportedly occurred
despite disagreement among senior officers as to whether this combination of
functions within Howard's portfolio was good for the Company - and despite
concern being expressed by Ashley at the time about the failure to replace
Marzol as Chief Credit Officer.(1710) According to the Vice President and
Assistant to the Chairman Jill Blickstein, Raines's view was that
- ----------
(1706) After Marzol announced his intention to resign as Chief Credit Officer,
management discussed the possibility of replacing Marzol, or instead
replacing the Chief Credit Officer function, with a more robust chief
risk officer function. Management ultimately decided not to pursue
either option, but instead to wait and see what types of risk management
requirements might be imposed by OFHEO.
(1707) As explained by Howard in a memorandum to employees announcing Marzol's
resignation, Marzol's responsibilities were divided "among the business
units, [Howard] as chair of the Risk Policy Committee, a new group in
the finance division called Credit Finance, and Thomas A. Lawler's
group, which we will rename Risk Policy to reinforce its connection with
the Risk Policy Committee." Mem. from T. Howard to All Employees, dated
Aug. 26, 2004, Zantaz documents 1237574, 1237575.
(1708) See Tr. of OFHEO Dep. of T. Howard, dated Aug. 5, 2004, at 8:7-8 ("I
also serve informally as the Company's chief risk officer"); see also
Draft mem. from T. Howard to All Employees, dated Aug. 2, 2004, FMSE-IR
681436 (in this draft of Howard's memo to employees announcing the
reorganization of risk management functions, he noted that "[i]n
November 2002 the credit policy function moved from single-family into
finance, putting all of the Company's financial risk assessment and
strategy responsibilities under me as the Company's chief risk
officer.").
(1709) In an August 2004 e-mail exchange between Vice President and Assistant
to the Chairman Jill Blickstein and Senior Vice President--Human
Resources Rebecca Senhauser, Blickstein relayed a conversation in which
Raines dismissed the need to create a new Chief Risk Officer function
because he considered Howard to be the Chief Risk Officer. See E-mail
from J. Blickstein to R. Senhauser, et al., dated Aug. 13, 2004, Zantaz
document 722473.
(1710) See E-mail from D. Mudd to F. Raines, dated Aug. 10, 2004, Zantaz
document 723716 (in which Mudd recounted a phone call from Ashley in
which the latter asked whether, in failing to replace Marzol, the
Company was "replacing accountability with succotash," and expressed the
view that "we can't be ad hoc" in addressing important credit
decisions).
447
Fannie Mae was unlike other companies in that Howard occupied a more senior
position than did most CFOs.(1711)
Although there is logic in having the Company's financial risk
functions report to a single senior executive, that executive should not have
been Howard. The CFO, whose primary responsibility was to oversee the Company's
financial reporting, should not have had primary responsibility for overseeing
its financial risk policies as well. The convergence of functions within the CFO
presented inherent conflicts of interest. The critical checks-and-balances
function of having a vibrant, independent risk organization was undermined by
the convergence of powers and responsibilities in Howard. Indeed, Fannie Mae
benchmarked this issue, and reportedly found no other comparable Company that
had a CFO who was also its Chief Risk Officer.(1712)
(b) Operational Risk
Responsibility for overseeing operational risk resided primarily
with COO Mudd.(1713) As discussed above, at the management committee level this
responsibility was vested in the OTIC, which Mudd chaired.(1714) In practice,
however, it appears that the Company did not have an effective cross-enterprise
approach to managing operational risk.
In 2004, the OTIC benchmarked Fannie Mae's approach to operational
risk as part of a reassessment of Fannie Mae's risk management practices. The
OTIC concluded that Fannie Mae's existing operational risk management structure
was too decentralized and too uneven in coverage among the business units. The
OTIC also concluded that risk management practices were not guided by a standard
framework to
- ----------
(1711) See E-mail from J. Blickstein to R. Senhauser, et al., dated Aug. 13,
2004, Zantaz document 722473.
(1712) See id.; see also E-mail from Barbara Ryan to Scott Lesmes and A.
Marzol, dated Aug. 11, 2004, Zantaz document 723440.
(1713) Responsibility for managing certain operational risk resided in the
Senior Vice President--Operations Risk, Rajappa. Rajappa's main function
was to lead Internal Audit, but, as reflected by his title, he had
broader responsibilities that included ensuring business continuity and
generating and tracking Key Performance Indicators for senior management
and the Board. As noted above, Internal Audit was also assigned
responsibility for design and implementation of the Company's compliance
with SOX 404.
(1714) As noted above, broad responsibility across the full range of
operational risk issues was not formally set forth in the OTIC's Charter
until January 2004.
448
identify, measure, and track risks, and no formal mechanism existed to escalate
and resolve problems.(1715)
In June 2004, the OTIC recommended to the SLT that the Company
approve a plan for operational risk management oversight that included (1)
direct oversight of operational risk within the OOC; (2) development of
forward-looking and uniform operational risk measures linked to business
management and performance; (3) creation of a central unit responsible for
enterprise-wide operational risk assessment, reporting, and management; and (4)
development of common standards and tools with defined escalation triggers,
protocols, and loss/incident tracking.(1716) In July 2004, the OTIC further
recommended to the SLT the creation of a new operational risk unit reporting to
the COO, and led by a new Senior Vice President--Enterprise Operational Risks.
D. Subsequent Developments
Fannie Mae's top-level management has undergone dramatic changes in
the aftermath of the OFHEO Report. As a result of a series of personnel changes
and reorganizations (notably including the separation of the CEO and Chairman
functions), the OOC no longer exists as a management institution and senior
management structure and tone has changed significantly.
The effects of this transformation thus far appear to be positive.
First, the relationship between the CEO and the Board, and between the CEO and
other senior officers, is healthier. The current and planned reorganization of
functions and lines of reporting appears designed to enhance internal controls,
management of risks, and the flow of information both vertically and
horizontally within the Company. In addition, the new management team, led by
the new CEO, appears so far to be exhibiting a "tone at the top" that is more
open, collaborative, and humble. This new management team seems to be better
positioned than its predecessors to achieve the elusive but important goal of
transforming the corporate culture of Fannie Mae.
- ----------
(1715) See D. Mudd, Presentation to the SLT on Operational Risk at Fannie Mae,
dated June 7, 2004, FMSE-IR 272016-40, at FMSE-IR 272028-29.
(1716) See id. at FMSE-IR 272030.
449
1. Personnel and Structural Changes to Senior Management
(a) Changes to Chief Executive Officer Position
Chairman/CEO Raines retired from the Company in December 2004.(1717)
As noted above, the Board decided in the aftermath of Raines's retirement to
split the roles of Chairman and CEO, and to name Mudd the interim CEO.(1718)
Although the parameters of the new CEO position continue to evolve
to some degree, a formal job description was prepared in March 2005. This
document is interesting not only because there appears to have been no formal
description of the CEO position at Fannie Mae prior to this point in time, but
also because of the document's emphasis on (i) communications with the Chairman
and the Board, (ii) accounting and financial reporting, (iii) internal controls
and compliance, (iv) relations with regulators, and (v) "tone at the top."(1719)
In practice as well as on paper, it seems clear that the Company
intends to depart from the "CEO-centric" organization that characterized Fannie
Mae in the past. As discussed above, Ashley appears to have cast the
non-executive Chairman position as a strong independent check upon the CEO.
(b) Changes to the Chief Financial Officer Position
In December 2004, Vice Chairman and CFO Howard resigned from the
Company.(1720) To replace Howard, the Board named Executive Vice
President--Housing and Community Development Levin to serve as interim CFO.
After an extensive search process, the Board announced its selection of Robert
Blakely to serve as CFO in November 2005. Blakely had been serving as Executive
Vice President and CFO at
- ----------
(1717) See Minutes of the Meeting of the Board of Directors of Fannie Mae, dated
Dec. 21, 2004, FMSE 504507-16, at FMSE 504507; Fannie Mae press release,
dated Dec. 21, 2004, available at
http://www.fanniemae.com/newsreleases/2004/3405.jhtml.
(1718) See Minutes of the Meeting of the Board of Directors of Fannie Mae, dated
Dec. 21, 2004, FMSE 504507-16, at FMSE 504508. As also noted above, after
serving in an interim capacity for almost six months, Mudd was named
President and CEO by the Board in June 2005. See Fannie Mae press
release, dated June 1, 2005, available at
http://www.fanniemae.com/newsreleases/2005/3530.jhtml?p=Media&s=News+Rele
ases.
(1719) See Letter from S. Ashley to A. Falcon, Jr., dated Apr. 19, 2005 FMSE-IR
314138-45 (attachment entitled "Duties of the Chief Executive Officer").
(1720) See Fannie Mae press release, dated Dec. 21, 2004, available at
http://www.fanniemae.com/newsreleases/2004/3405.jhtml.
450
MCI, where he oversaw MCI's restatement and the restructuring of its finance,
accounting, and controls functions.(1721)
Under the new Fannie Mae management structure, Blakely's duties are
significantly narrower than Howard's were, and are more typical of a CFO.
Blakely's primary responsibility will be to ensure the accuracy, integrity, and
timeliness of the Company's financial reporting, accounting, and related control
functions, and to oversee the development and enhancement of automated financial
reporting systems.(1722) He will report directly to the CEO, and his direct
reports will consist of the Senior Vice President and Controller, the Senior
Vice President--Accounting Policy, and the head of Investor Relations.(1723)
Internal Audit will not report on a dotted line basis to Blakely (as it did to
Howard).(1724) Moreover, as discussed below, primary responsibility for
overseeing interest rate and credit risk policy now lies with the Chief Risk
Officer. Finally, the Mortgage Portfolio business, which previously reported to
Howard, now reports to Levin, who (with the appointment of Blakely as CFO) has
been named the first Chief Business Officer of the Company.
(c) Changes to Chief Operating Officer Position
Also in November 2005, the Board named Michael Williams, the
President of Fannie Mae's e-Business unit, to serve as COO (as successor to
Mudd). As COO, Williams is responsible for operations management, including the
"administrative functions in the areas of technology systems, business
operations, and human resources."(1725) His direct reports consist of Executive
Vice President and CIO St. John, Senior Vice President--Human Resources Rebecca
Senhauser, and the Vice Presidents for Corporate Facilities Services, Pricing
Restatement, and Regulatory Agreements and Restatement.(1726)
- ----------
(1721) See Fannie Mae press release, dated Nov. 10, 2005, available at
http://www.fanniemae.com/newsreleases/2005/3641.jhtml?p=Media&s=News+Rele
ases/.
(1722) See id.
(1723) See Officers Organization Chart, dated Nov. 15, 2005, FMSE 537763-64, at
FMSE 537763.
(1724) As discussed below, the new Chief Audit Executive, Jean Hinrichs, reports
to the Chairman of the Audit Committee of the Board, with a limited
"dotted line" to CEO Mudd for certain administrative purposes.
(1725) See Fannie Mae press release, dated Nov. 10, 2005, available at
http://www.fanniemae.com/newsreleases/2005/3641.jhtml?p=Media&s=News+Rele
ases/. Blakely joined Fannie Mae in January 2006.
(1726) See Officers Organization Chart, dated Nov. 15, 2005, FMSE 537763.
451
Under this new structure, the COO no longer oversees the operation
of Fannie Mae's Single-Family Mortgage and Housing and Community Development
businesses. Instead, this responsibility belongs to Chief Business Officer
Levin. In addition, the COO no longer bears responsibility for overseeing
operational risk policy; this task, as explained below, now falls to the Chief
Risk Officer.
(d) Changes to Law and Policy Group
In April 2005, Executive Vice President--Law and Policy Donilon
resigned from Fannie Mae.(1727) The Company thereafter eliminated Donilon's
position, as well as the Law and Policy group itself. The Company decided to
reconstitute the key elements of the Law and Policy group - namely, the Legal
Department, Government and Industry Relations, and Communications - as
independent organizations reporting directly to the CEO. In addition, as is
discussed below, the functions of the Office of Corporate Justice and the Office
of Corporate Compliance are in the process of being moved from the Legal
Department to the new Office of Compliance, Ethics & Investigations, along with
most of the functions from Regulatory Policy. Moreover, we understand that the
lobbying activities of Government and Industry Relations have been substantially
reduced.
(e) Establishment of the Chief Business Officer Position
In November 2005, Fannie Mae established a Chief Business Officer
("CBO") position and appointed interim CFO Levin to that position.(1728) As CBO,
Levin is responsible for overseeing the Single-Family Mortgage, Housing and
Community Development, and Mortgage Portfolio businesses.(1729) According to
Levin, one of the central missions in his new role is to eliminate the silos
that previously encased the business units and to create in their stead an
integrated business that is "one Fannie Mae." Levin has taken steps in this
regard, including the establishment of new management-level committees designed
to coordinate activities across the business units (e.g., activities relating to
capital management and mortgage-backed securities).
- ----------
(1727) See Fannie Mae press release, dated Apr. 15, 2005, available at
http://www.fanniemae.com/newsreleases/2005/3498.jhtml?p=Media&s=News+Rele
ases/.
(1728) See Fannie Mae press release, dated Nov. 10, 2005, available at
http://www.fanniemae.com/newsreleases/2005/3641.jhtml?p=Media&s=News+Rele
ases/.
(1729) See id.; see also Officers Organization Chart, dated Nov. 15, 2005, FMSE
537764. As discussed above, the Mortgage Portfolio business reported to
the CFO (Howard) prior to 2005, while the Single-Family and Housing and
Community Development businesses reported to the COO (Mudd).
452
(f) Establishment of the Chief Risk Officer Position
As required by its September 2004 Agreement with OFHEO, Fannie Mae
established a separate Risk organization in early 2005.(1730) The Chief Risk
Officer ("CRO") oversees officers who have responsibility for interest rate and
other market risk, credit risk, and operational risk, as well as risk policy,
risk capital, model validation, and analytics. In addition, the business unit
risk officers, who report to business unit management, also report on a "dotted
line" basis to the CRO, as does the new Price Verification unit in the
Controller's Office.
At the Board level, the CRO reports on risk issues to the Risk
Policy and Capital Committee, and also delivers a risk oversight report to a
joint meeting of the Risk Policy and Capital and Audit Committees at least once
a year.(1731) At the management level, the CRO reports directly to the CEO,
chairs the Risk Policy Committee, and participates in a number of other senior
management committees.
Although the organizational design of the CRO function continues to
evolve, we understand that the CRO expects the Risk organization to grow to
approximately 115 employees over the coming year. Some of this staffing
represents new functions within the Company, while some of it represents a shift
in responsibilities from other parts of the Company - for example, the shift of
responsibility for Key Performance Indicators, and SOX 404 design/implementation
from Internal Audit.
In January 2005, Fannie Mae appointed former Chief Credit Officer
Marzol as its interim CRO.(1732) Marzol left this position in November 2005 and
was replaced by Deputy CRO Mark Winer, who had been Vice President--Portfolio
Strategy in the Company's Mortgage Portfolio business (and had previously
overseen
- ----------
(1730) See Agreement between Fannie Mae and OFHEO, dated Sept. 27, 2004
(requiring the Board to "direct the appointment of a chief risk officer,
to be independent of other corporate responsibilities and to have duties
crafted in consultation with OFHEO"); see also Minutes of the Meeting of
the Board of Directors of Fannie Mae, dated Feb. 17, 2005, FMSE
503339-50, at FMSE 503340-41 (approving implementation plan and job
description for the CRO).
(1731) See Audit Committee Charter, dated Nov. 15, 2005, FMSE 547741-45, at FMSE
547745; Risk Policy and Capital Committee Charter, dated Nov. 15, 2005,
FMSE 547755-56, at FMSE 547756.
(1732) See Fannie Mae press release, dated Jan. 4, 2005, available at
http://www.fanniemae.com/newsreleases/2005/3415.jhtml?p=Media&s=News+Rele
ases.
453
management of interest rate, liquidity, and market risks at PNC Financial
Services).(1733) As of the beginning of 2006, the Company had not yet named a
permanent CRO.
(g) Changes to Management Committee Structure
Fannie Mae's management committee structure remains in flux as this
Report is written, with ongoing reassessment and restructuring. Although the
outcome and impact thus remain unclear, the changes made and contemplated appear
designed to enhance cross-enterprise coordination.
Among other changes, the SLT has been replaced by the Executive
Committee, which now consists of Mudd's direct reports and those Executive Vice
Presidents who are not direct reports to Mudd. The Executive Committee meets
twice as frequently as the SLT and, as described to us, is less driven by set
agendas and presentation materials, with deliberate opportunity for impromptu
discussion.
In addition, the OTIC has been replaced by the Business Operations
Committee ("BOC"), which is now described as a cross-enterprise forum to discuss
compliance, risk, and internal controls issues, including audit issues (internal
and external), legal and regulatory issues, OFHEO exams and reports, and reports
from the CRO.(1734) The BOC, which meets approximately once a month, has a broad
cross-enterprise membership that includes the CEO, CFO, CRO, CIO, Chief Audit
Executive, General Counsel, Treasurer, business unit Executive Vice Presidents,
and Vice President--Regulatory Agreements & Restatement.
2. Changes to Corporate Culture
Upon assuming the role of CEO, Mudd resolved to change the corporate
culture at Fannie Mae. For example, Mudd has said that he intends to establish
"an attitude of service" towards Fannie Mae's customers and investors.(1735) He
also has said that he wants the Company to be less combative toward critics and
more open to change; as he put it recently, "[w]e need to realize that not every
contrary opinion is a direct
- ----------
(1733) See Fannie Mae press release, dated Nov. 3, 2005, available at
http://www.fanniemae.com/newsreleases/2005/3637.jhtml?p=Media&s=News+Rele
ases/.
(1734) See Minutes of the Meeting of the Business Operations Committee, dated
July 7, 2005, FMSE-IR 699289 ("Business Operations Committee (formerly
OTI)").
(1735) Annys Shin, Mudd Vows to Change Fannie Mae Culture, WASH. POST, June 3,
2005, at D04.
454
attack on the Company."(1736) In addition, Mudd has emphasized the need for
Fannie Mae to have a more open and candid internal environment.
Past efforts to reform Fannie Mae's corporate culture have not
received high marks from employees. As Mudd himself noted in launching a reform
initiative back in 2000, Fannie Mae has had a tendency to "make a sport" of
hiring consultants to make reform proposals and then disregarding
recommendations for change.(1737)
Comments we have received from Fannie Mae employees, directors, and
regulators suggest a widespread perception that the "tone at the top" has
improved since Mudd took over as CEO. Mudd is commonly credited with an open and
engaging management style, which encourages senior management to engage in more
candid exchanges of views and information than it did before. He also appears to
be working to improve communications with the Chairman and the rest of the
Board; to break down the "silo" mentality; to increase the resources committed
to internal control and compliance functions; and to solicit the views and
concerns of employees using town hall meetings, visits to employee offices, and
other outreach efforts.
Mudd also appears to have made progress in improving Fannie Mae's
external relations, including with customers, OFHEO, and Congress. Part of this
progress appears to be related to changing both the size and aggressiveness of
the Company's lobbying and grass roots activities; and part of it appears to be
attributable to the Company's willingness to admit mistakes and to work with
OFHEO and Congress in
- ----------
(1736) Annys Shin, Fannie Mae's Repairman: CEO Daniel H. Mudd Must Fix Problems
With Accounting and Culture, WASH. POST, Nov. 16, 2005, at D1 (also
quotes Mudd as saying that, while management's prior approach to
criticism was to "shut[] the doors and huddl[e] and navel gaz[e]," his
approach now is to "open the doors and get out and ask people bluntly,
right up front . . . `What have we gotten wrong?'").
(1737) See D. Mudd, Remarks at the Mid-Year Officers Meeting: Getting to 2003,
July 18-19, 2000, FMSE-IR 675181-534, at FMSE-IR 675376.
455
addressing problems.(1738) Even former regulators reportedly have expressed
appreciation for the changes in the Company's position and attitude under
Mudd.(1739)
The demands of OFHEO and of the Board have played a major role in
creating the structural and cultural changes that appear to have occurred at
Fannie Mae so far. As of the date of this Report, meaningful substantive and
tonal changes have occurred at the senior management level of Fannie Mae, and
these changes have improved the functioning of the enterprise both internally
and externally.
III. OFFICE OF AUDITING
A. Summary
With respect to the functioning of the Office of Auditing ("Internal
Audit") prior to release of the OFHEO Report in September 2004, our conclusions
are as follows:
1. The head of Internal Audit lacked the requisite expertise and
experience, including prior professional experience or training as an auditor,
to lead Internal Audit at an organization as large and complex as Fannie Mae.
Moreover, on more than one occasion, the head of Internal Audit took steps that
suggest he did not fully appreciate his organization's role within the Company
or his relationship with senior management.
2. Internal Audit did not possess a sufficient number of auditors
with the requisite mix of technical accounting expertise and auditing experience
to carry out its responsibilities related to Fannie Mae's increasingly complex
business. Although Internal Audit's workload increased substantially in the
years prior to 2005, Internal Audit requested only modest increases in
headcount. In addition, the department's training programs were inadequate to
compensate for these deficiencies.
- ----------
(1738) We note that Mudd began his tenure as CEO by acknowledging to Congress
Fannie Mae's mistakes and by pledging cooperation with Congress and the
Company's regulators. See Regulatory Reform of the Housing
Government-Sponsored Entities: Hearing Before the S. Comm. on Banking,
Housing, and Urban Affairs, 109th Cong.(2005) (statement of D. Mudd)
("Let me say right here at the outset: Fannie Mae understands that we
have disappointed a lot of people - people who count on us to get things
right . . . people, such as the members of this Committee, who have a
right to expect that our books and our internal controls are above
reproach.").
(1739) For example, former OFHEO Director Armando Falcon, Jr. recently praised
Mudd's approach. Annys Shin, Fannie Mae's Repairman: CEO Daniel H. Mudd
Must Fix Problems With Accounting and Culture, WASH. POST, Nov. 16, 2005,
at D1 (saying of Mudd: "[h]e seems earnest and well intentioned. He's
trying hard to do all the right things and turn the Company around.").
456
3. Internal Audit's communications with the Board and management
were deficient and, at times, inaccurate. On a number of occasions, Internal
Audit provided assurances to the Audit Committee that Internal Audit's staffing
was adequate in terms of quantity and quality (when it had told management
otherwise) and that it had audited Fannie Mae's accounting for compliance with
GAAP (when it actually audited only for compliance with Fannie Mae policies
interpreting GAAP). In addition, Internal Audit's reporting of its audit issues
to the Audit Committee (and to members of senior management) lacked clarity and
did not succinctly prioritize the findings or the subsequent remediation.
4. The assignment of the lead on SOX 404 design/implementation to
Internal Audit was poorly conceived and executed. It caused a substantial
diversion of Internal Audit resources away from performing audits, and produced
results that were largely discarded by the Company's new Risk organization and
its new external auditor.
The Audit Committee and senior management have acted to address many
of these deficiencies. They have taken steps to replace Internal Audit's
leadership, restructure its organization, focus its responsibilities on its core
audit mission, and reform its processes and procedures. Substantial progress is
underway in each of these areas.
B. Overview Prior to September 2004
1. Functions and Responsibilities
Internal Audit's official functions and responsibilities were set
forth in the Internal Audit Manual, which included the Internal Audit
Charter.(1740) Internal Audit's mission statement provided that it was to (1)
"[c]ontribute to the achievement of Fannie Mae's objectives, by promoting
effective management of financial and operational risks and maintenance of an
effective internal control environment"; and (2) support the Board of Directors
by providing independent and objective audit, assurance, and risk assessment
services, and the prompt communication of audit and follow-up results to senior
management and the Board.(1741)
- ----------
(1740) See Fannie Mae Office of Auditing: Audit Manual, dated 2004, Zantaz
document 574585.
(1741) See, id. at 8. In addition, Internal Audit was subject to (1) the
"Standards for the Professional Practice of Internal Auditing" and the
"Code of Ethics" promulgated by the Institute of Internal Auditors; (2)
the standards set forth by the Committee on Sponsoring Organizations in
its publication, "Internal Control - Integrated Framework"; (3) the
standards for information technology control set forth in "Cobit Control
Objectives"; and (4) "Generally Accepted Auditing Standards" published
by the American Institute of Certified Public Accountants. Id. at 8-10,
19.
457
2. Organization and Structure
(a) Senior Vice President--Operations Risk
From January 1999 through January 2005, Rajappa headed Internal
Audit.(1742) Prior to heading Internal Audit, Rajappa was Fannie Mae's
Controller from 1994 through 1998. Rajappa did not have a formal background in
auditing or training as an auditor.(1743) According to Rajappa, former COO Small
asked him to take the reins of Internal Audit after he made comments to Small
regarding a lack of checks and balances at Fannie Mae.
Rajappa assumed the title of Senior Vice President--Operations Risk.
In addition to Internal Audit, he was also responsible for managing certain
elements of operational risk, including Fannie Mae's Y2K preparedness program
and its business continuity planning. Under Rajappa's leadership, Internal
Audit's responsibility included certain operational risk tasks, such as
developing and monitoring the Company's "Key Performance Indicators" ("KPIs")
and design/implementation of SOX 404.
During his tenure as head of Internal Audit, Rajappa had a direct
reporting line to the Audit Committee. He attended Audit Committee meetings and
briefed the Committee on such topics as the development and implementation of
the annual audit plan and SOX 404 compliance measures (in combination with
KPMG); remediation of audit issues; monitoring of KPIs; and the adequacy of
Internal Audit's resources. He occasionally provided reports to the Audit
Committee on the results of discrete audits, such as the annual Derivatives
Control Audit. He also communicated regularly with Audit Committee Chairman
Gerrity.
Rajappa had a "dotted line" reporting relationship to senior
management, initially to the COO (Small followed by Mudd) and subsequently (from
2002 on) to CFO Howard.(1744) Rajappa stated that he met with Howard on a
monthly basis, and also met
- ----------
(1742) See Fannie Mae press release, dated Nov. 17, 1998, available at
http://www.fanniemae.com/newsreleases/1998/0072.jhtml (noting Rajappa's
transition to Senior Vice President--Operations Risk, effective on Jan.
1, 1999); Minutes of the Meeting of the Board of Directors of Fannie Mae,
dated Jan. 18, 2005, FMSE-IR 422501-15, at FMSE-IR 422512 ("Mr. Gerrity
reported that the [Audit] Committee had decided to move the current head
of Internal Audit out of that position.").
(1743) Rajappa holds a bachelor's degree and a master's degree in mechanical
engineering and an MBA in finance. Prior to joining Fannie Mae, he worked
in the controller's offices of several companies.
(1744) Rajappa recalled having reservations about reporting to the CFO from a
best practices perspective, and having expressed such reservations to
Howard. But he also recalled having an understanding at the time that
OFHEO had approved this reporting relationship.
458
with him on an ad hoc basis as necessary to discuss such administrative issues
as staffing, vacations, and expense reports. Howard also addressed certain
budget and personnel review issues with Rajappa, as Howard reviewed and approved
Internal Audit's budget (in combination with Human Resources, the Controller's
Office, and the COO), and prepared Rajappa's annual performance review (in
consultation with Audit Committee Chairman Gerrity). Rajappa also stated that
Howard was involved in the development and implementation of Internal Audit's
approach to SOX 404 compliance. According to Rajappa, however, Howard did not
exercise substantive oversight of Internal Audit and did not exert influence
over the annual audit plan.
(b) Vice President--Audit
Rajappa's deputy was the Vice President--Audit, Ann Eilers. Eilers
assumed the Vice President position in 2003, having served previously as
Director of Internal Audit's Finance group for several years.(1745) Eilers's
role was described to us as akin to a chief operating officer of Internal Audit.
She managed Internal Audit's day-today operations, ensured that the Internal
Audit directors properly executed the annual audit plan, and oversaw Internal
Audit's SOX 404 compliance efforts. She regularly joined Rajappa at Audit
Committee meetings, and they both participated in Internal Audit's monthly
meeting with KPMG.
(c) Auditing Groups
Various Internal Audit directors who reported to Eilers headed
groups responsible for executing the annual audit plan. As of September 2004,
Internal Audit had five groups responsible for auditing Fannie Mae's businesses:
(1) the Finance group (which audited Portfolio and Treasurer's Office operations
and performed the annual derivatives audits); (2) the Technology group (which
audited business applications and technology infrastructure); (3) the Housing
and Community Development group (which audited the Housing and Community
Development business); (4) the Single-Family Business group (which audited the
guaranty fee business and conducted lender audits); and (5) the Credit and
Portfolio Analytics group (which audited financial models, credit risk and
portfolio strategy functions, and the capital management area in the Treasurer's
Office).(1746)
(d) Audit Activities
According to employees, Internal Audit policy required that business
processes determined to be high risk (i.e., high inherent risk and high control
risk) were
- ----------
(1745) Eilers joined Fannie Mae in 1997, serving initially as an auditor in
Internal Audit's Housing and Community Development group.
(1746) A new group, Accounting and Auditing Standards, was established in late
2004. This group was assigned responsibility for auditing the development
of the Company's accounting policies.
459
to be audited annually; those determined to be low risk (i.e., low inherent risk
and low control risk) were to be audited every three years; and other processes
were to be audited between every one and three years. Audit teams had
discretion, however, to adjust risk profiles based on past audit findings and
their knowledge of risks in their assigned business units.
After consultation and coordination with KPMG, an annual audit plan
was presented to the Audit Committee jointly with KPMG. The audit plan linked
each audit project to one or more of the Company's top risks, and provided an
estimate of the staffing and budgetary resources required to execute the plan.
Internal Audit would then update the Audit Committee from time to time as to its
progress in executing the annual audit plan.(1747)
Once an audit was complete, an audit report was prepared and the
business unit subject to audit was given an opportunity to comment. If the
business unit disputed the audit findings, it could raise its concerns with the
auditor-in-charge, with the Director, or with Eilers or Rajappa. In rare cases,
disagreements were reportedly elevated to COO Mudd or CFO Howard. However, no
Internal Audit employee we interviewed recalled modifying the substance of audit
findings in response to business unit concerns.
Audit reports were labeled with color codes to communicate the
nature of Internal Audit's findings. "Red" indicated deficiencies requiring
immediate management attention; "yellow" indicated controls that needed
strengthening; and "green" indicated that controls were effective. Internal
Audit transmitted copies of red and yellow audit reports to Raines and Howard.
After issuance of an audit report, Internal Audit monitored the
business unit's effort to address any audit issues and reported the status of
such remediation efforts using two reports, both of which went to senior
management and the first of which also went to the Audit Committee. The first
was a monthly report called the "Audit Tracking List" ("ATL"), which identified
and monitored "higher risk" control issues.(1748) The second was a quarterly
report called the "Audit Issues Follow-Up" ("AIF"), which tracked the status of
all open audit issues.
- ----------
(1747) See, e.g., Office of Auditing and KPMG: 2003 November Update, dated Nov.
17, 2003, FMSE 15583-91; Office of Auditing and KPMG: 2003 Mid-Year
Status, dated July 15, 2003, FMSE 15944-50.
(1748) Audit deficiencies were entered on the ATL if they were (1) likely to
cause a financial loss equal to or greater than $1 million; (2) likely to
cause harm to Fannie Mae's external customers or negatively impact Fannie
Mae's public image; (3) likely to prevent Fannie Mae from meeting
corporate goals; (4) believed to violate the Charter, Code of Business
Conduct, or laws and regulations; or (5) believed to require the
attention of the Audit Committee. Fannie Mae Office of Auditing: Audit
Manual, dated 2004, Zantaz document 574585, at 46-47.
460
(e) Other Activities
(1) Certification of Internal Controls
As discussed above, beginning in the third quarter of 2002, Internal
Audit assisted the Chairman/CEO and the CFO in preparing their quarterly
certifications as to the effectiveness of Fannie Mae's internal controls. These
certifications were required by Section 302 of SOX, and they accompanied Fannie
Mae's quarterly and annual financial disclosures. On a quarterly basis, Internal
Audit received "Internal Control Representation Letters" from the heads of the
business units; it then provided Raines and Howard with a certification as to
the adequacy and effectiveness of the Company's internal controls.(1749)
(2) Self Assessment Questionnaires
Internal Audit sought to monitor the Company's internal control
environment throughout the year by means of "Self Assessment Questionnaires"
("SAQs"). SAQs asked business unit managers how they maintained an effective
control environment, and asked them to self identify internal control weaknesses
of which they were aware. Responses were prepared by business unit managers in
coordination with Internal Audit, with Internal Audit investigating any
responses that indicated control weakness or high-risk activities.
(3) Key Performance Indicators
Internal Audit also monitored "significant business or operational
activities and trends" throughout the year through so-called "Key Performance
Indicators" ("KPIs"). Internal Audit generated KPIs by working with the business
units to identify key operations and to establish thresholds against which to
measure performance. Internal Audit provided monthly KPI reports to the Audit
Committee and senior management.
- ----------
(1749) See, e.g., Mem. from S. Rajappa to F. Raines and T. Howard, dated Aug.
2004, Zantaz document 545500; Mem. from S. Rajappa to F. Raines and T.
Howard, dated May 2004, Zantaz document 545031; Mem. from S. Rajappa to
F. Raines and T. Howard, dated Aug. 2003, FMSE 83158.
461
(4) Sarbanes-Oxley Section 404
Design/Implementation(1750)
As noted above, Internal Audit was assigned the task of leading the
Company's SOX 404 compliance effort.(1751) According to Rajappa, Internal Audit
received this assignment because it already had extensive knowledge of Fannie
Mae's internal controls through its audit work, and because it had become
familiar with SOX 404 through research it had conducted. To support this
substantial assignment, Internal Audit obtained $1 million in supplemental
funding, the majority of which was allocated to hiring outside contractors to
document controls and business processes, and to generate flow charts of
controls.(1752) Nonetheless, much of the SOX 404 work fell on Internal Audit
personnel, who also had responsibility for their regular audit workload.
Deficiencies identified during testing of the controls were placed
on a tracking list known as the "S-Ox Issues Follow-Up" ("SIF"). Rajappa updated
the SIF monthly and also periodically updated the Audit Committee on the
progress of Internal Audit's SOX 404 work.(1753) Internal Audit also classified
internal control deficiencies based on their seriousness and likelihood to
occur.(1754) Internal Audit reported "Significant Deficiencies" (i.e., internal
control problems that had more than a remote
- ----------
(1750) Section 404 requires issuers to provide, as part of their annual report
to the SEC on Form 10-K, an assessment by management "of the
effectiveness of the internal control structure and procedures of the
issuer for financial reporting," with annual testing and attestation by
the issuer's external auditors as to both management's methodology and
its results. 15 U.S.C. Section 7262 (2002).
(1751) See Minutes of the Meeting of the Audit Committee of the Board of
Directors of Fannie Mae, dated Apr. 19, 2004, FMSE 504838-46, at FMSE
504840 ("Mr. Rajappa added that the Office of the Chairman had asked
internal audit to lead all project management efforts for the Company in
the area of S-Ox 404 implementation.").
(1752) See Minutes of the Meeting of the Audit Committee of the Board of
Directors of Fannie Mae, dated Apr. 19, 2004, FMSE 504838-46, at FMSE
504840; Sarbanes-Oxley Section 404 Compliance Project: Project
Methodology and Management, dated Mar. 14, 2004, FMSE-IR 467104-270, at
FMSE-IR 467110.
(1753) See, e.g., Minutes of the Meeting of the Audit Committee of the Board of
Directors of Fannie Mae, dated July 19, 2004, FMSE 504860-69, at FMSE
504861-62.
(1754) See, e.g., Office of Auditing and KPMG, 2004 Mid-Year Status, dated July
19, 2004, FMSE 224862-70, at FMSE 224867-68.
462
likelihood of occurrence and a dollar impact that could be more than
inconsequential) to senior management and to the Audit Committee.(1755)
(5) Consulting Projects
Internal Audit also performed occasional consulting projects for
business units.(1756) This was one of Rajappa's initiatives, as he wanted
Internal Audit to have "a strong internal consulting role in addition to
internal audit role."(1757) Typically, these projects did not result in an audit
opinion.
3. Past Evaluations of the Office of Auditing
Prior to the end of 2004, Internal Audit regularly received praise
for the manner in which it conducted its work. OFHEO's examinations and annual
reports to Congress commonly concluded that Internal Audit's practices were
"effective" and/or exceeded safety and soundness standards.(1758) Internal Audit
also received high marks in
- -----------
(1755) See, e.g., S. Rajappa, 404 Implementation Plans: Senior Leadership Team
Presentation, dated Oct. 11, 2004, FMSE-IR 1606-77, at FMSE-IR 1610;
Office of Auditing and KPMG, 2004 November Update, FMSE-IR 143534-44, at
FMSE-IR 143539.
(1756) See Fannie Mae Office of Auditing: Audit Manual, dated 2004, Zantaz
document 574585, at 159-60.
(1757) Mem. from S. Rajappa to D. Mudd, dated Sept. 28, 2000, FMSE-IR
537926-29, at FMSE-IR 537928.
(1758) For example, OFHEO's June 2003 Report to Congress stated that:
Internal audit appropriately identifies and communicates control
deficiencies to management and the Board of Directors. There are
established policies and procedures that delineate internal control
process and standards for the control environment. Management
effectively ensures compliance with established internal controls
The audit functions are independent and effective and adhere with
the standards that are evolving. The Internal and External Audit
functions have the appropriate independence. Auditors performing the
work possess appropriate professional proficiency. The scope of
internal audit work performed is appropriate, and the internal audit
work is complete. The management of the Internal Audit department is
effective. The Board of Directors are appropriately involved with
and follow up on identified audit issues. The auditor's risk
assessment process is
463
a 2002 evaluation by the Investment Training and Consulting Institute.(1759) In
addition, the Institute of Internal Auditors cited Internal Audit's SAQ and KPI
processes as examples of best practices in 2002.(1760)
C. Findings
Notwithstanding the praise it received, Internal Audit suffered from
a number of deficiencies with respect to its leadership, its relationship with
management, its resources, and its communications with management and with the
Audit Committee.
1. Leadership
As noted above, Fannie Mae appointed Rajappa to head Internal Audit
even though he had no experience or formal training as an auditor. Board minutes
do not reflect any presentation or discussion concerning Rajappa's
qualifications when he was appointed Senior Vice President--Operations
Risk,(1761) but both Raines and Small stated that they thought he was qualified
to oversee Internal Audit.(1762)
Given the importance of the internal audit function in a Company as
large, complicated, and heavily regulated as Fannie Mae, the Company would have
been better served with leadership by a professional auditor with significant
expertise and experience in that field.
- ----------
effective. Internal Audit is appropriately involved in new products
and new initiatives.
OFHEO Report to Congress, dated June 2003, FMSE-IR 1180-84, at FMSE-IR
1183.
(1759) The Investment Training and Consulting Institute gave Internal Audit its
highest overall rating of "generally conforms," concluding that "Fannie
Mae's Internal Audit Team has developed and supports many leading
practices throughout their processes." Quality Assessment Review: Fannie
Mae Internal Audit Department, dated Sept. 2002, FMSE-IR 467089-103, at
FMSE-IR 467091.
(1760) See Institute of Internal Auditors Research Foundation, Adding Value:
Seven Roads to Success (2002), FMSE-IR 990-97.
(1761) See Minutes of the Meeting of the Board of Directors of Fannie Mae,
dated Nov. 17, 1998, FMSE 6-18, at FMSE 15; see also Minutes of the
Meeting of the Audit Committee of the Board of Directors of Fannie Mae,
dated Feb. 16, 1999, FMSE 504603-17, at FMSE 504603-04.
(1762) Raines stated he was unaware that Rajappa lacked certification as an
auditor, but that the absence of such a qualification did not concern
him.
464
2. Relationship with Management
During our investigation, we have found several instances that raise
questions regarding Internal Audit's relationship with senior management and the
business units it was responsible for auditing. Although we have not identified
evidence that Internal Audit compromised its audit work, there is troubling
evidence that Internal Audit's leadership viewed itself as accountable to senior
management, rather than the Audit Committee. In addition, Internal Audit
fostered an environment of collaboration with the business units, rather than
objective assessment.
We view these instances, as described below, in the context of
Rajappa's relationship to Howard. It is neither unusual nor inherently improper
for the head of internal audit to report to a member of senior management on a
"dotted line" basis for administrative purposes, and many companies have chosen
to have this reporting line go to the CFO.(1763) However, Rajappa had been
Howard's direct subordinate for several years while Rajappa was Controller. The
change in Rajappa's position, therefore, required that both he and Howard
acknowledge their new reporting relationship.
It does not appear that Rajappa fully made, or understood, the
implications of that transition.Rajappa sought to expand his role beyond the
leadership of Internal Audit and into management functions. As Senior Vice
President -- Operations Risk, he proposed the establishment of an operations
risk oversight committee that would create a framework for the identification
and analysis of operation risks; according to Rajappa's proposal, the committee
would have a "strong functional reporting to the office of the chairman" in
addition to the Audit Committee.(1764) When Rajappa was asked about the possible
conflict of interest between his role with the Committee and his role as head of
Internal Audit, he responded: "...[N]ot sure; company's call. Ann [Eilers] is
the auditor, I am ops. risk, she reports to me, we both report to the AC of the
Board. I think there's enough independence."(1765)
On another occasion, Howard (with Rajappa's apparent acquiescence)
treated the head of Internal Audit as a direct subordinate on matters relating
to communications with the Audit Committee. Rajappa was contacted directly by
Audit
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(1763) See, e.g., Presentation, Institute of Internal Auditors Global Auditing
Information Network, Reporting Lines and Scope of Work (July 6, 2003),
available at http://www.theiia.org/?doc_id-4366 (noting that, of 303
chief audit executives surveyed, approximately forty-two percent reported
administratively to the CFO, thirty-two percent reported to the
CEO/President, and the remainder reported to others).
(1764) S. Rajappa, Operations Risk - Oversight, dated Mar. 6, 2000, FMSE-IR
563552-66, at FMSE-IR 563567.
(1765) E-mail from S. Rajappa to J. Morgan Whitacre, dated Mar. 4, 2004, FMSE-E
699855.
465
Committee Chairman Gerrity regarding OFHEO's finding in 2004 that the Company
had numerous outmoded manual accounting systems. Rajappa responded to Gerrity.
Howard heard what Rajappa had done and made the following report to Spencer:
I just got off the phone with Sam. I made it "blisteringly clear" to
him that on any future calls he gets from the Chairman of our Audit
Committee on accounting-related issues he must run the question or
issue by you before he or anyone else gets back to Gerrity. He said
he got the message and would do so in the future. (He said that he'd
agreed to call Tom back before realizing you weren't here on Friday,
so he spoke with Janet instead. I responded that going forward that
wouldn't be good enough. He had to reach either you or me before
responding to Gerrity on any accounting-related question he was
asked. He said he understood.)(1766)
In our interview with Gerrity, he said that he had no knowledge of
any limitation on Rajappa's ability to communicate with him directly. He said
that he would have been "shocked" to learn that Rajappa had to clear
communications through senior management.
Structurally, the Company's bonus compensation program treated
Internal Audit as it did any other business unit, with bonuses (for directors
and above) linked to earnings per share targets. Although we found no evidence
to suggest that management intended this compensation system to affect the
aggressiveness of Internal Audit, or that it led auditors to minimize audit
issues, this compensation structure was not conducive to maintaining the
appearance and fact of Internal Audit's independence and objectivity.(1767)
- ----------
(1766) See E-mail from T. Howard to L. Spencer, dated Mar. 3, 2004, FMSE-E
1808128-29.
(1767) A 2004 study by compensation consultants, which focused on compensation
of the Company's management level employees, recommended (among other
things) that bonus compensation for the head of Internal Audit should not
be tied to earnings. See Fannie Mae and Semler Brossy Report to the
Compensation Committee: Appropriate Compensation Structure and Incentives
for Fannie Mae Management, dated Feb. 23, 2005, FMSE-IR 241780-946, at
FMSE-IR 241863, 241901. We believe Internal Audit's annual incentive
compensation should be based on individual and departmental goals
unrelated to corporate earnings, including but not limited to training,
achievement of audit plan, and retention. A comprehensive
performance-based compensation process would have enabled the Audit
Committee to assess Internal Audit more accurately by measuring its
performance in relation with the critical functions of Internal Audit.
466
On one occasion, Rajappa emphasized to Internal Audit staff the link
between compensation and hitting earnings targets. For example, in early 2000,
Rajappa made a presentation to Internal Audit staff entitled "Address To Audit
Group On What We Can Do To Help Achieve $6.46 EPS." The talking points for that
address included the following:
By now every one of you must have 6.46 branded in your brains. You
must be able to say it in your sleep, you must be able to recite it
forwards and backwards, you must have a raging fire in your belly
that burns away all doubts, you must live, breathe and dream 6.46.
You must be obsessed on 6.46 . . . After all thanks to Frank we all
have a lot of money riding on it.(1768)
Although these talking points also instructed Internal Audit staff
to "be fair but tough where there are serious control issues" and to "never
compromise or dilute your conclusion even if your customers get mad at you,"
Rajappa's message can, at best, be described as mixed.(1769) Moreover, Rajappa
forwarded his presentation to Raines (not Gerrity) with a handwritten note
saying "I thought you may be interested in knowing what I told my Audit group
about how they can help achieve $6.46."(1770)
Although Rajappa and Eilers informed us that Rajappa's relationship
to Howard was in fact only administrative in nature,(1771) these incidents
suggest a disturbing pattern in which the "dotted line" nature of Rajappa's
reporting relationship to Howard, and Internal Audit's relationship to senior
management, was not understood or honored.
Similarly, Internal Audit's leadership did not try to maintain an
appropriate distance from the business units, notwithstanding the critical
internal control functions for which they had responsibility. Rajappa stated
that he and his staff deliberately pursued good relationships with the business
units. Internal Audit employees generally insisted that this cooperative
approach did not compromise their independence, but there was broad
acknowledgment that it caused Internal Audit to be perceived as "business
friendly," perhaps at the expense of objectivity. In a January 2005 review of
- ----------
(1768) Address to Audit Group on What We Can Do to Help Achieve $6.46 EPS, dated
Feb. 16, 2000, FMSE-IR 265330-32, at FMSE-IR 265331.
(1769) Id. at FMSE-IR 265330-32. Rajappa was unable to identify for us any steps
he took to ensure that Internal Audit staff did not misconstrue his
remarks.
(1770) Id. at FMSE-IR 265330. Raines stated that he did not view Rajappa's
remarks as inappropriate because they simply informed Internal Audit
staff that they have a role to play in advancing corporate goals.
(1771) Both Rajappa and Ann Eilers stated that Howard approved such things as
Internal Audit's staffing, vacations, and expense reports.
467
Internal Audit's operations, E&Y provided the Audit Committee with a list of
recommendations. One recommendation was that "Internal Audit personnel should
push back more with management, be tougher and sharper in exchanges." E&Y
reported that "there was no evidence of management coercion, but rather it
appeared that Internal Audit was working with management in a collaborative
approach that could be more independent."(1772) Although there is no benefit to
hostile relations between an internal audit department and the business units to
be audited, the evidence strongly suggests that Internal Audit's "business
friendly" philosophy undercut perceptions of Internal Audit's toughness and
effectiveness.(1773)
3. Resource Deficiencies
During Rajappa's tenure as Senior Vice President -- Operations Risk,
Internal Audit's workload increased significantly as Fannie Mae's business grew
larger and more sophisticated. During this period, Internal Audit also faced new
demands arising from Fannie Mae's reporting to the SEC and its assumption of
responsibility for SOX 404 design/implementation. Internal Audit staffing was
not commensurate with these demands, in terms of numbers or qualifications.
(a) Headcount
For most of Rajappa's tenure, staffing levels in Internal Audit were
essentially stagnant. Between 1999 and 2002, authorized headcount increased by
only one employee, while actual headcount increased by only three
employees.(1774) In 2003, Rajappa sought only a modest increase in authorized
headcount (three employees), even while informing management that (i) in the
previous five years, virtually no new auditors had been added to accommodate
increases in "outputs by our department . . . in audits (120 [vs.] 70) and
reporting (Audit Issues Tracking, Dashboards, Risk Assessment Model and Audit
Plan, etc.)," and (ii) staffing constraints were forcing Internal Audit to limit
the scope of its reviews, to combine, postpone, or cancel audits, to delay
department
- ----------
(1772) Minutes of the Meeting of the Audit Committee of the Board of Directors
of Fannie Mae, dated Jan. 17, 2005, FMSE 516154-65, at FMSE 516162-63.
(1773) For example, the director of the Office of Corporate Compliance said that
she wished Internal Audit's auditors were more like "junkyard dogs."
(1774) During this period, authorized headcount increased from 53 to 54, while
actual headcount increased from 49 to 52. See Fannie Mae Office of
Auditing: Completion of 1999 Audit Plan, dated Feb. 15, 2000, FMSE
14703-12, at FMSE 14712; Office of Auditing and KPMG: Joint Audit Plan
2002, dated Apr. 16, 2002, FMSE 15305-12, at FMSE 15309; Office of
Auditing and KPMG: Joint Audit Plan 2003, dated Apr. 14, 2003, FMSE
16114-20, at FMSE 16117.
468
initiatives such as updates to the audit manual, and to work in some cases
excessive overtime.(1775)
At the beginning of 2004, despite Internal Audit's recognition that
staffing shortages would require a reduction in its audit activities for
2004,(1776) and despite the challenges posed by Internal Audit's new
responsibility for SOX 404 design/implementation, the 2004 audit plan called for
no further increase in authorized headcount.(1777) Instead, the 2004 audit plan
reduced the number of planned audits to half of what was planned for 2003.(1778)
It was not until the middle of 2004 that Rajappa requested from senior
management another increase in authorized headcount.(1779)
Internal Audit's authorized headcount increased from fifty-seven to
sixty-five employees during the second half of 2004 (although actual headcount
only increased from fifty-three to fifty-eight employees).(1780) Nonetheless,
Internal Audit had difficulty completing its tasks for the year. By the end of
2004, Internal Audit had cancelled five audits and postponed or delayed
completion of 11 audits (despite its substantially scaled back audit plan for
2004).(1781) Whereas Internal Audit issued ninety-six audit reports and
- ----------
(1775) Undated Head Count Request for 3 FTE in 2003 (appears to have been
drafted in February 2003), FMSE-IR 284780-82, at FMSE-IR 284781-82.
(1776) See Fannie Mae Office of Auditing: 2004-2005 Audit Plan Time Line, dated
Oct. 2003, Zantaz document 2912971, at 2 ("When selecting the audits for
2004, keep in mind the number of audits that had to be recast this year
[2003] due to resource issues.").
(1777) Compare Office of Auditing and KPMG: Joint Audit Plan 2004, dated Apr.
19, 2004, FMSE 223834-45, at FMSE 223842, with Office of Auditing and
KPMG: Joint Audit Plan 2003, Apr. 14, 2003, FMSE-IR 646655-62, at FMSE-IR
646658.
(1778) Compare Office of Auditing and KPMG: Joint Audit Plan 2003, Apr. 14,
2003, FMSE-IR 646655-62, at FMSE-IR 646656 (stating plans to conduct more
than 100 audits), with Office of Auditing and KPMG: Joint Audit Plan
2004, dated Apr. 19, 2004, FMSE 223834-45, at FMSE 223837 (stating plans
to conduct fifty-four audits).
(1779) See Mem. from S. Rajappa to T. Howard, D. Mudd, L. Spencer, and R.
Senhauser, dated June 18, 2004, FMSE-IR 423231-35, at FMSE 423233
(requesting authority to hire six new employees).
(1780) See Office of Auditing: Completion of 2004 Internal Audit Work, dated
Jan. 17, 2005, FMSE-IR 219782-90, at FMSE-IR 219789.
(1781) See id. at FMSE-IR 219788.
469
memoranda in 1999, and more than one hundred in each year from 2000 to
2003,(1782) output declined dramatically in 2004 to forty-four audit reports and
memoranda.(1783)
(b) Qualifications and Experience
Internal Audit not only lacked a sufficient number of employees, but
also lacked employees with certain critical skill sets. In particular, while a
significant number of Internal Audit employees possessed advanced degrees and
professional certifications,(1784) employees inside and outside Internal Audit
observed that Internal Audit's accounting expertise was uneven if not
inadequate.(1785) Due to the limited number of employees with public accounting
background or equivalent experience at other financial institutions, Internal
Audit did not have the necessary resources to audit effectively aspects of
Fannie Mae's business operations that were heavily influenced by accounting
principles and policies.(1786) As noted above, Internal Audit did not have a
- ----------
(1782) See Fannie Mae Office of Auditing and KPMG: Completion of the 2003 Audit
Plan, dated Jan. 23, 2004, FMSE 221354-61, at FMSE 221356-57; Fannie Mae
Office of Auditing and KPMG: Completion of the 2002 Audit Plan, dated
Feb. 21, 2003, FMSE 16278-85, at FMSE 16282; Fannie Mae Office of
Auditing: Completion of the 2001 Audit Plan, dated Feb. 19, 2002, FMSE
15517-21, at FMSE 15520; Fannie Mae Office of Auditing: Completion of
2000 Audit Plan, dated Feb. 20, 2001, FMSE 15058-63, at FMSE 15061;
Fannie Mae Office of Auditing: Completion of 1999 Audit Plan, dated Feb.
15, 2000, FMSE 14703-12, at FMSE 14711.
(1783) See Office of Auditing: Completion of 2004 Audit Work, dated Jan. 17,
2005, FMSE-IR 219782-90, at FMSE-IR 219788.
(1784) Between 2002 and 2004, the number of Internal Audit employees holding
advanced degrees increased from fifty-five percent to fifty-eight
percent, and the number holding certified internal auditor, certified
public accountant, or certified information systems auditor
certifications increased from fifty-one percent to sixty percent. See
Office of Auditing and KPMG, Joint Audit Plan 2004, dated Apr. 19, 2004,
FMSE 223834-45, at FMSE 2233842; Office of Auditing and KPMG, Joint Audit
Plan 2002, dated Apr. 16, 2002, FMSE 15305-12, at FMSE 15312. Eilers and
Rajappa reported to us in January 2005 that twenty to thirty percent of
Internal Audit's auditors were certified public accountants.
(1785) For example, Wall cited poor or average accounting expertise of several
audit directors. Karen McBarnette, the Director for the Single-Family
business audit group, stated that Internal Audit needs to hire more
individuals with accounting expertise.
(1786) For example, Leah Malcolm, the Internal Audit Director who oversaw the
annual derivatives audits, stated that Internal Audit did not identify
problems with the Company's derivatives accounting policies against which
it conducted its audits because no one in Internal Audit had sufficient
FAS 133 expertise.
470
group with assigned responsibility for auditing the development of the Company's
accounting policies until late 2004.
Uneven accounting and auditing expertise also created key person
dependencies. For example, in June 2004, Rajappa warned senior management that
Internal Audit only had one employee with the public accounting background
necessary to audit the Financial Reporting function in the Controller's Office,
and that public accounting skills "cannot be cross trained given that it takes
many years to acquire knowledge.(1787) Rajappa also noted that only one level 5
employee was qualified to audit all aspects of Fannie Mae's derivatives
operations.(1788) Moreover, a significant majority of the auditors had no prior
audit experience before joining Internal Audit.(1789)
Recognizing that workload demands undoubtedly presented challenges
to improving training programs, neither the deficiencies in skill sets within
Internal Audit nor the changing external expectations for public companies
appear to have generated a sense of urgency with respect to ongoing training of
Internal Audit staff. Internal Audit directors expressed concern that management
had historically placed too little emphasis on audit training, with insufficient
allocation of time for this purpose.(1790) In July 2003, when Rajappa received
an e-mail from an Internal Audit employee suggesting the need to toughen
continuing education requirements for internal auditors, Rajappa responded that
he was "not sure" he wanted to "legislate anything such as CE Credits" and that,
"[i]f the directors, managers, and the employees all do the right thing, it
should happen."(1791) Subsequently, in June 2004, he informed senior management
that, whereas internal audit departments in peer institutions provided, on
average, sixty hours of training annually (with forty hours generally required
to maintain most technical licenses), "we have had to cut back significantly due
to workload (currently most staff have less than 20 hours of
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(1787) See Mem. from S. Rajappa to T. Howard, D. Mudd, L. Spencer, and R.
Senhauser, dated June 18, 2004, FMSE-IR 423231-35, at FMSE-IR 423232.
Rajappa asked for authority only to hire a replacement employee, because
the existing employee intended to move to a business unit in 2005. See
id.
(1788) Id.
(1789) A study conducted by E&Y in the spring of 2005 found that sixty-two
percent of Fannie Mae's auditors had no prior audit experience. See Ernst
& Young, Fannie Mae Office of Auditing: Internal Audit Transformation -
Recommendations, dated June 30, 2005, FMSE 510811-33, at FMSE 510822.
(1790) Quality Assessment Review: Fannie Mae Internal Audit Department, dated
Sept. 2002, FMSE-IR 467089-103, at FMSE-IR 467096.
(1791) E-mail from S. Rajappa to Shazia Khurshid, dated July 7, 2003, FMSE-E
572488-91, at FMSE-E 572488.
471
training)."(1792) Nonetheless, by the end of 2004, Internal Audit staff appears
to have met this minimum forty hour requirement. Internal Audit reported that
its staff had ultimately amassed, on average, forty-two hours of training for
the year.(1793)
4. Inadequate Communications
(a) Failure to Communicate Staffing Problems to the Audit
Committee
Although Rajappa had a direct reporting line to the Audit Committee,
communications with the Audit Committee and with senior management were
inconsistent and, with respect to the Audit Committee, ineffective.
Up through August 2004,(1794) there is no evidence that Internal
Audit conveyed information to the Audit Committee concerning staffing shortages
and attrition problems. On the contrary, Rajappa and Eilers consistently assured
the Audit Committee that Internal Audit possessed adequate resources to
accomplish its mission.(1795)
- ----------
(1792) Mem. from S. Rajappa to T. Howard, D. Mudd, L. Spencer, and R. Senhauser,
dated June 18, 2004, FMSE-IR 423231-35, at FMSE-IR 423234.
(1793) See Office of Auditing: Completion of 2004 Internal Audit Work, dated
Jan. 17, 2005, FMSE-IR 219782-90, at FMSE-IR 219790.
(1794) In August 2004, Eilers informed Gerrity that Internal Audit was canceling
five audits and postponing six audits due to the demands of SOX 404 work.
See E-mail from A. Eilers to T. Gerrity, dated Aug. 23, 2004, FMSE-IR
543704.
(1795) See Minutes of the Meeting of the Audit Committee of the Board of
Directors of Fannie Mae, dated Apr. 19, 2004, FMSE 504838-46, at FMSE
504840 ("Mr. Rajappa then briefly described his organization and said
that the company had provided him with sufficient resources and budget to
complete both audit and the S-Ox 404 work."); Minutes of the Meeting of
the Audit Committee of the Board of Directors of Fannie Mae, dated Jan.
23, 2004, FMSE 504806-15, at FMSE 504807 ("In response to a question from
Mr. Gerrity, Mr. Rajappa reported that for 2004, the department headcount
was adequate and if more resources were needed this issue would be raised
with executive management."); Minutes of the Meeting of the Audit
Committee of the Board of Directors of Fannie Mae, dated Apr. 14, 2003,
FMSE 504767-75, at FMSE 504768 ("[Eilers] stated that the Company had
provided appropriate budget and resources to complete the Internal Audit
plan."); Minutes of the Meeting of the Audit Committee of the Board of
Directors of Fannie Mae, dated Feb. 19, 2002, FMSE 504690-700, at FMSE
504695 ("Ms. Eilers noted that the Company has provided adequate
headcount and funding to conduct an effective internal audit program.");
Minutes of the Meeting of the Audit Committee of the Board of Directors
of Fannie Mae, dated Apr. 17, 2001, FMSE 504666-71, at FMSE 504668 ("Mr.
Rajappa stated that the company had provided the audit
472
From late 2003 on, the difference between the messages conveyed to
the Audit Committee and those conveyed to management and Internal Audit staff is
striking. In January 2004, Rajappa informed Howard that "[w]e are bleeding from
inside and outside recruitment" and identified the "need for a temporary
moratorium on hiring from Internal Audit."(1796) Despite the message to Howard
(and also despite having identified a need to reduce planned audits in 2004 due
to resource issues), Rajappa went on to report to the Audit Committee, in
January 2004, that Internal Audit "headcount was adequate."(1797) In April 2004,
Rajappa reported to the Audit Committee that he had "sufficient resources and
budget to complete both audit and SOX 404 work,"(1798) even though, in February
2004, he had warned Howard that (i) Internal Audit had experienced a
twenty-three percent attrition rate during the prior year, including the loss of
key staff with critical skills, and (ii) "[g]iven the external pressures created
by Sarbanes-Oxley 404, it is imperative that we stabilize staffing levels within
the division."(1799)
In June 2004, in a headcount request to senior management, Rajappa
included summarized results of a benchmarking study relating to staffing. This
study found (using 2003 data) that the Company's internal auditors covered
"significantly higher revenue and assets than the industry average auditor," and
that its "ratio of auditors to total number of Company employees is lower than
the industry average." Although Rajappa expressed the view that, "due to our
solely domestic operations and core business lines we feel that neither of these
statistics is a perfect fit," he concluded that "[o]ur current staff level
should be increased to be more in line with the complexity of our business to
help us meet current demands."(1800) There is no evidence that Rajappa ever
informed the Audit Committee of the results of this benchmarking project - even
- ----------
department with sufficient budget and headcount to do the department's
work effectively.").
(1796) See E-mail from S. Rajappa to T. Howard, dated Oct. 24, 2003, Zantaz
document 4260093, at 1.
(1797) Minutes of the Meeting of the Audit Committee of the Board of Directors
of Fannie Mae, dated Jan. 23, 2004, FMSE 504806-15, at FMSE 504807.
(1798) Minutes of the Meeting of the Audit Committee of the Board of Directors
of Fannie Mae, dated Apr. 19, 2004, FMSE 504838-46, at FMSE 504840.
(1799) Mem. from S. Rajappa to T. Howard, dated Feb. 11, 2004, FMSE-IR
509886-87, at FMSE-IR 509886.
(1800) See Mem. from S. Rajappa to T. Howard, D. Mudd, L. Spencer, and R.
Senhauser, dated Jan. 18, 2004, FMSE-IR 423231-35, at FMSE-IR 423233.
473
though Rajappa had informed the Audit Committee the previous year that Internal
Audit's headcount was in line with staffing at comparable institutions.(1801)
In this same headcount request, Rajappa warned senior management
(but not the Audit Committee) that "[c]ontinued high attrition rates in the
audit department (23% for 2003 and 10% YTD for 2004) [were resulting in] fewer
experienced auditors, challenges in cross training staff, and difficulties in
transition responsibilities to existing staff."(1802) He went on to note that
two of Internal Audit's five Directors had left Internal Audit in 2003, and
warned that turnover was resulting in inexperience that risked "an increased
possibility of errors".(1803)
From late 2003 through August 2004, the updates senior management
received on resource issues were simply inconsistent with the markedly more
positive messages conveyed to the Audit Committee.
(b) Failure to Communicate Audit Standards
Rajappa and Eilers stated that Internal Audit did not audit Fannie
Mae's accounting practices for compliance with GAAP; rather, Internal Audit
audited the accounting practices for compliance with the accounting policies
developed by the Financial Standards group in the Controller's Office. Rajappa
said that, in line with the standards for internal audit functions issued by the
Institute of Internal Auditors, responsibility for ensuring compliance with GAAP
rested with the Controller's Office and with KPMG. Nonetheless, Internal Audit
informed the Audit Committee on a number of occasions that it did, in fact,
audit Fannie Mae's accounting practices to determine if they were in accordance
with GAAP, including in areas critical to the Company's financial
reporting.(1804) For example, in both 2002 and 2003, Rajappa reported to the
Audit Committee that Internal Audit's annual derivatives audits had tested
transactions for compliance with FAS 133.(1805)
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(1801) See Minutes of the Meeting of the Audit Committee of the Board of
Directors of Fannie Mae, dated Apr. 14, 2003, FMSE 504767-75, at FMSE
504768 ("In response to a question from Mr. Malek, Mr. Rajappa noted that
the department headcount was in line with other institutions and provided
examples.").
(1802) Mem. from S. Rajappa to T. Howard, D. Mudd, L. Spencer, and R. Senhauser,
dated June 18, 2004, FMSE-IR 423231-35, at FMSE-IR 423231.
(1803) Id. at FMSE-IR 423233.
(1804) Rajappa stated, however, that he did not know if the Audit Committee
understood that Internal Audit did not audit the Company's accounting
practices to GAAP.
(1805) See Minutes of the Meeting of the Audit Committee of the Board of
Directors of Fannie Mae, dated Apr. 16, 2002, FMSE 504701-13, at FMSE
504703 (Rajappa reported that, "through data mining techniques, Audit was
able to test 100 percent of
474
Similar problems appear in Internal Audit's communications with
management, again in areas critical to the Company's financial reporting. For
example, during an August 8, 2003 meeting to discuss Internal Audit's
investigation into Roger Barnes's accounting-related allegations, Rajappa
reported that Internal Audit had concluded that the Company's amortization
practices conformed to GAAP.(1806) Similarly, in a December 2003 e-mail to
Spencer and Kappler, Eilers informed them that Internal Audit reviewed
accounting entries to ensure compliance with FAS 133 and FAS 91.(1807)
(c) Inadequate Communication of Audit Findings and Control
Deficiencies
Although the reports that Internal Audit circulated to the Audit
Committee and/or senior management (i.e., the ATL and AIF) identified and
tracked audit issues, they did not effectively prioritize findings by importance
or severity. Nor did these reports provide a broader perspective - for example,
trends in audit reports or common weaknesses identified across business units.
5. Deficiencies in the Office of Auditing's SOX 404 Work
By December 2004, Internal Audit reported to the SLT that it had
completed documenting and testing 99% of the Company's key financial reporting
controls and that 86% of the identified issues had been remediated and retested.
Despite the near completion of its work, Internal Audit had not identified any
controls as having "Material Weaknesses" (defined by Fannie Mae as internal
control problems material to the Company's financial statements with more than a
remote likelihood of occurrence). It was not until the SEC concluded that the
Company had failed to comply with FAS 133 and FAS 91 that any internal controls
were classified as Material Weaknesses.
After Fannie Mae agreed to restate its financial statements and
terminated its relationship with KPMG in December 2004, the Company suspended
Internal Audit's SOX 404 work, and sought external assessments of the
reliability of that work. As a result of these assessments, Fannie Mae's
management concluded that Internal Audit's
- ----------
the derivatives transactions for compliance with FAS 133 and hedging
effectiveness"); Minutes of the Meeting of the Audit Committee of the
Board of Directors of Fannie Mae, dated Apr. 14, 2003, FMSE 15928-33, at
FMSE 15931 (Rajappa reported that "100% of the derivative transactions
were tested for compliance with certain elements of FAS 133").
(1806) See Summarized Minutes of the Meeting Regarding Unamortized Balances and
Factor Analysis, dated Aug. 8, 2003, FMSE 24417-19.
(1807) See E-mail from A. Eilers to A. Kappler and L. Spencer, et al., dated
Dec. 10, 2003, FMSE-E 910150-51, at FMSE-E 910150 ("Additionally we
review accounting entries to ensure financial reporting is in compliance
with Generally Accepted Accounting Principles (i.e. FAS 133, FAS 115, FAS
91, etc.).").
475
work did not satisfy SOX 404 requirements, and engaged PricewaterhouseCoopers
("PWC") to re-perform the Company's SOX 404 design/implementation project (under
the supervision of the Operational Risk unit in the Company's new Risk
Organization, which, as noted above, took over responsibility for SOX 404
compliance from Internal Audit).(1808)
Not only was the work performed by Internal Audit inadequate, but it
also had the effect of significantly reducing Internal Audit's output in other
areas.
D. Subsequent Developments
Since the publication of the September 2004 OFHEO Report, Fannie Mae
has taken a number of steps to reorganize Internal Audit, to upgrade the
quantity and quality of its staff, and to reform Internal Audit's auditing and
audit reporting processes. In 2005, the Company drew upon external expertise in
this effort, retaining E&Y to perform an assessment of Internal Audit's
functions, structure, and personnel,(1809) and engaging PWC to perform an
analysis of Internal Audit's organization, staffing needs, and skill
requirements.(1810)
1. Changes in Leadership and Reporting Line
The Board hired Jean Hinrichs in June 2005 to replace Rajappa.
Unlike Rajappa, Hinrichs has had professional training and experience as an
internal auditor. She is certified both as an internal auditor and as a fraud
examiner. Prior to joining Fannie Mae, Hinrichs served from 1999-2004 as the
Managing Director for Risk at Barclays Global Investors, and from 1997-1999 as
Barclays's Managing Director for Internal Audit.(1811)
Hinrichs reports directly to the Audit Committee, while also
reporting to CEO Mudd for certain administrative purposes.
- ----------
(1808) During the course of its work, PWC identified hundreds of potential
control problems that Internal Audit had not identified in 2004. See Mem.
from Kathryn Rock to R. Levin, dated Aug. 12, 2005, FMSE 519599-616, at
FMSE 519606.
(1809) See Minutes of the Meeting of the Audit Committee of the Board of
Directors of Fannie Mae, dated Mar. 28, 2005, FMSE 503042-47, at FMSE
503042-43; see also Ernst & Young, Fannie Mae Office of Auditing:
Internal Audit Transformation - Recommendations, dated June 30, 2005,
FMSE 510811-83, at FMSE 510813.
(1810) See Minutes of the Meeting of the Audit Committee of the Board of
Directors of Fannie Mae, dated Oct. 17, 2005, FMSE 537768-75, at FMSE
537769.
(1811) See Fannie Mae press release, dated June 27, 2005, available at
http://www.fanniemae.com/newsreleases/2005/3552.jhtm;?p=Media&s=News+Rele
ases.
476
Unlike Rajappa, Hinrichs stated to us that none of her compensation
is linked to the Company's annual financial performance.
2. Focus on Core Audit Mission
Internal Audit is no longer responsible for such operational risk
activities as KPIs, SAQs, and SOX 404 compliance, which have moved to the new
Risk organization. In addition, lender audits have been moved from Internal
Audit to the Single-Family Mortgage business.
3. Internal Structure and Staffing
In June 2005, E&Y recommended to the Audit Committee that Internal
Audit revise its internal structure to better align with the organizational
structure of Fannie Mae; that it raise the status of the heads of each of
Internal Audit's audit groups to Vice President level positions; and that it
establish an "Audit Practices" function to develop Internal Audit's audit
methodology, its policies and procedures, and its technology support tools, and
to oversee quality assurance and auditor training.(1812) In September 2005,
Hinrichs discussed with the Audit Committee her goals for a new organizational
structure for Internal Audit.(1813)
During the course of 2005, and despite the reduced scope of its
responsibilities, the authorized headcount for Internal Audit increased from
sixty-five to seventy employees, and increased its actual headcount from
fifty-eight to sixty employees.(1814) It also retained eight full-time
contractors to augment Internal Audit's existing staff.(1815)
With respect to training, E&Y recommended not only that Internal
Audit create a Vice President for Professional Audit Practices, but also that
Internal Audit increase its budget, establish training goals, require that
internal auditors receive a minimum number of continuous professional education
credits, and develop programs
- ----------
(1812) See Ernst & Young, Fannie Mae Office of Auditing: Internal Audit
Transformation - Recommendations, dated June 30, 2005, FMSE 510811-33, at
FMSE 510823.
(1813) See Minutes of the Meeting of the Audit Committee of the Board of
Directors of Fannie Mae, dated Sept. 19, 2005, FMSE 535007-15, at FMSE
535008-09.
(1814) See Org. Chart Internal Audit, dated Nov. 30, 2005, FMSE-IR 699356.
(1815) See Mem. from J. Hinrichs to the Members of the Audit Committee, dated
Nov. 9, 2005, FMSE 537789-90, at FMSE 537790. Hinrichs stated that she
had Audit Committee support to grow as necessary, and that she might need
to seek additional staff once she finalized the 2006 audit plan.
477
tailored to each auditor's needs.(1816) Hinrichs stated that she is in the
process of implementing E&Y's recommendations. She said that she has already
increased Internal Audit's budget for training from $50,000 in 2005 to $250,000
in 2006, and is in the process of developing individualized training programs
for Internal Audit staff.
4. Changes to Audit Reporting
Hinrichs stated that one of her priorities upon assuming the helm of
Internal Audit was to overhaul the systems by which Internal Audit communicated
its findings to the Audit Committee, senior management, and the business units.
The Audit Committee is now provided a monthly package including a prioritized
list of audit issues. In 2005, Internal Audit has worked to improve its system
of reporting audit findings in order to provide the Board and management with a
clearer and more concise picture of the nature of these findings and their
priority. More work remains to be done, but some meaningful changes have already
taken place.
IV. ETHICS AND COMPLIANCE FUNCTIONS
A. Summary
In reviewing the Company's ethics and compliance programs as they
existed prior to the publication of the September 2004 OFHEO Report, we found
programs with a number of positive attributes. For more than a decade, Fannie
Mae had maintained a Code of Business Conduct, provided Code-related training to
employees, and investigated violations of the Code and other corporate policies.
The Company also had a longstanding and experienced investigative unit to handle
employee complaints. Moreover, at the beginning of 2003, Fannie Mae acted to
enhance the centralization and profile of its ethics and compliance program, by
(1) pulling together ethics and compliance functions within the Legal
Department; (2) creating the Office of Corporate Compliance ("OCC") to develop
and monitor business unit compliance plans, administer employee training, and
otherwise provide central management of ethics and compliance matters; (3)
appointing a Chief Compliance Officer to oversee the existing investigative unit
(the Office of Corporate Justice ("OCJ")) and the new OCC; and (4) replacing the
old Business Conduct Committee (which had been chaired by the head of Human
Resources) with a new management-level compliance committee chaired by the
General Counsel.
Although these accomplishments are worthy of note, and although we
believe that the ethics and compliance functions contained a number of
well-meaning and dedicated professionals, the Company's ethics and compliance
program as of late 2004 continued to suffer from the following deficiencies:
- ----------
(1816) See Ernst & Young, Fannie Mae Office of Auditing: Internal Audit
Transformation - Recommendations, dated June 30, 2005, FMSE 510811-33, at
FMSE 510823.
478
1. The level and nature of reporting to the Board on Fannie Mae's
ethics and compliance functions were unstructured, with a lack of the type of
systematic, written reporting that would permit the Board to assess how well the
ethics and compliance offices and related management committees were
functioning.
2. Management devoted too few resources to Fannie Mae's ethics and
compliance functions (and especially the OCC).
3. Management undermined the perceived independence and impartiality
of the Company's ethics and compliance functions by housing them within a
litigation section of the Legal Department, headed by a Chief Compliance Officer
who also served as the head of the employment practices litigation group
responsible for defending the Company against employee complaints.
4. Management failed to invest appropriate responsibilities and
stature in its Chief Compliance Officer, who did not hold a dedicated position;
was subordinate to the General Counsel; did not report to the Board of
Directors; and had no discernable compliance responsibilities other than to
supervise the activities of the OCC and the OCJ.
5. Without an active management-level oversight committee, and with
an under-resourced and relatively low-stature OCC, the Company lacked an
effective mechanism for coordinating compliance matters across the enterprise.
Since September 2004, Fannie Mae has taken important steps to
rectify deficiencies in, and perceptions of, its ethics and compliance
functions. Most notably, it has created a new Office of Compliance, Ethics &
Investigations ("OCEI"), which (1) is independent of the Legal Department, (2)
reports directly to the CEO and the Compliance Committee, (3) is led by a new
Chief Compliance Officer who is committed full-time to ethics and compliance
functions, and (4) will not only absorb the functions and resources of the OCC
and the OCJ, but will also have a dedicated ethics unit. Moreover, management
now provides the Board with detailed written reports on ethics and compliance
programs and activities.
Fannie Mae has selected the first head of the OCEI and has begun to
build-out this new office. We view these structural reforms as very positive,
and we encourage the Board and senior management to provide the OCEI with the
necessary resources.
B. Overview Prior to September 2004
1. Code of Business Conduct
The Code was (and remains) the primary policy document that sets
forth the ethical obligations of Fannie Mae employees. Fannie Mae first
published the Code in
479
1992.(1817) It was substantially reorganized and updated in January 2003 to make
it more user-friendly and accessible to employees and to better align it with
legal developments over the prior decade (including enactment of SOX).(1818) It
was amended again in April 2004 to reflect the role of the OCC as well as new
NYSE rules requiring the Company to notify stockholders if provisions of the
Code were waived for certain executives.(1819)
Despite these amendments, the core principles of the Code have
remained largely the same, including the basic duty to conduct Fannie Mae's
business affairs in a responsible and ethical fashion. The Code required
employees to report any departure from or violation of the Code, and prohibited
retaliation against employees who made such reports.(1820)
In addition, the Code required employees to be open and trustworthy
in Fannie Mae's financial reporting and public communications. Prior to 2003,
the Code directed employees who were involved in approving transactions,
supplying supporting documentation, or determining account classification to
comply with laws and regulations requiring the Company's financial statements,
books, and records to accurately reflect all transactions, with prompt and
proper recordation of all disbursements and receipts of funds.(1821) As amended
in 2003, the Code also directed (1) officers to "make sure that the internal
accounting, operational, and disclosure controls and procedures in [their]
business area are in place, understood, and followed"; (2) employees involved in
preparing Fannie Mae's financial disclosures to make sure that
- ----------
(1817) See Mem. from Doug Bibby to the Audit Committee, dated Apr. 9, 1997,
FMSE-IR 368-69.
(1818) See Minutes of the Meeting of the Audit Committee of the Board of
Directors of Fannie Mae, dated Jan. 21, 2003, FMSE 504743-55, at FMSE
504754. This amendment restated the Code in terms of seven "Key
Principles" of ethical behavior: (1) "[b]e accountable"; (2) "[u]phold
Fannie Mae's core commitment to diversity"; (3) "[p]rotect Fannie Mae's
corporate assets"; (4) "[b]e open and trustworthy in all financial
reporting and public communications"; (5) "[a]void conflicts between
Fannie Mae interests and personal interests"; (6) "[o]bey the laws and
regulations governing [Fannie Mae's] business transactions"; and (7)
"[f]oster a safe, healthy and productive workplace." Code of Business
Conduct, dated Jan. 21, 2003, FMSE 9782-98.
(1819) See Minutes of the Meeting of the Audit Committee of the Board of
Directors of Fannie Mae, dated Apr. 19, 2004, FMSE 504838-46, at FMSE
504844-45.
(1820) See, e.g., Code of Business Conduct, dated May 11, 2004, FMSE-IR
36806-30, at FMSE-IR 36809; Code of Business Conduct, dated Jan. 2000,
FMSE-IR 36924-78, at FMSE-IR 36931.
(1821) See, e.g., Code of Business Conduct, dated Jan. 2000, FMSE-IR 36924-78,
at FMSE-IR 36952.
480
they "comply with Fannie Mae's disclosure controls and procedures"; and (3) all
officers and employees to cooperate fully with internal and external
auditors.(1822)
The Code also instructed employees to avoid conflicts of interest,
and to abide by various laws and regulations that govern Fannie Mae's business
transactions.(1823) In addition, employees were instructed as to how to respond
appropriately to government investigations of Fannie Mae.(1824)
2. Structure of Board Oversight
Until November 2005, the Audit Committee was the Board committee
primarily responsible for overseeing Fannie Mae's ethics and compliance
program.(1825) Among other things, its Charter required the Audit Committee to
approve all substantive changes to the Code of Business Conduct, and to monitor
compliance with the Code.(1826) Prior to 2005, Audit Committee minutes do not
tend to reflect discussion by the Committee regarding specific internal
investigations of alleged legal or Code violations by employees of the
Company.(1827) General Counsel Kappler informed us that such
- ----------
(1822) Code of Business Conduct, dated Jan. 21, 2003, FMSE 9781-98, at FMSE
9790.
(1823) See, e.g., Code of Business Conduct, dated May 11, 2004, FMSE-IR
36806-30, at FMSE-IR 36816-17, 36819-20; Code of Business Conduct, dated
Jan. 2000, FMSE-IR 36924-79, at 36933-40, 36953-58.
(1824) Employees were directed to refer to the Legal Department any government
investigative request for information, access to files, or an interview,
and never to: (1) destroy or alter documents in anticipation of a
document request from the government or a court; (2) lie or make
misleading statements to government investigators; or (3) cause anyone to
give false or misleading information to any government investigator or to
destroy or conceal information that a government investigator requests.
See, e.g., Code of Business Conduct, dated May 11, 2004, FMSE-IR
36806-30, at FMSE-IR 36820-21; Code of Business Conduct, dated Jan. 2000,
FMSE-IR 36924-78, at FMSE-IR 36960.
(1825) As discussed above, the Board in November 2005 gave the Compliance
Committee primary responsibility for overseeing Fannie Mae's ethics and
compliance program.
(1826) See, e.g., Audit Committee Charter, dated Apr. 23, 2004, Zantaz document
1454040, at 49; Audit Committee Charter, dated July 18, 2000, FMSE
14495-97, at FMSE 14496.
(1827) One exception was the internal investigation of the allegations raised by
Roger Barnes in August 2003. See Minutes of the Meeting of the Audit
Committee of the Board of Fannie Mae, dated Aug. 12, 2003, FMSE
504788-91, at FMSE 504791. For a discussion of the allegations raised by
Barnes and the Company's responses to those allegations, see Chapter IX
of this Report.
481
discussions did occur, but that they occurred during executive session where no
minutes were kept.
The Audit Committee Charter also required the Audit Committee to
oversee the activities of management committees related to ethics and
compliance, including the work of management's Business Conduct Committee
("BCC") and its successor, the Corporate Compliance Advisory Committee
("CCAC").(1828) The Audit Committee received reports each year from the chairman
of the BCC (and in 2003, from the General Counsel) regarding ethics and
compliance matters, including Code training and awareness activities, Code
certification efforts, and changes and proposed changes to the Code.(1829) The
Audit Committee does not appear to have received a similar annual report from
the CCAC since its inception in January 2004.
After the enactment of SOX, the Audit Committee Charter also
required the Committee to "[e]stablish procedures for the receipt, retention and
treatment of complaints received by the corporation regarding accounting,
internal accounting controls or auditing matters, including procedures for
confidential, anonymous submission of concerns by employees regarding accounting
or auditing matters."(1830) As noted above, the Committee adopted such
procedures in January 2004.(1831) These procedures required management to
establish various routes by which employees and members of the public could file
complaints with the Audit Committee (including mail, e-mail, and a phone "hot
line").(1832) They also charged the General Counsel with processing and
conducting
- ----------
(1828) See, e.g., Audit Committee Charter, dated Feb. 17, 2004, FMSE 504391-97,
at FMSE 504396; Audit Committee Charter, dated July 18, 2000, FMSE
14495-97, at FMSE 14496.
(1829) See, e.g., Mem. from the Business Conduct Committee to the Audit
Committee, dated July 10, 2003, FMSE 16005-07; Mem. from K. Gallo to the
Audit Committee, dated Apr. 9, 2002, FMSE 15391-93.
(1830) Audit Committee Charter, dated Jan. 21, 2003, FMSE 504223-28, at FMSE
504227.
(1831) See Minutes of the Audit Committee of the Board of Directors, dated Jan.
23, 2004, FMSE 504806-15, at FMSE 504809-10; Fannie Mae Audit Committee,
Complaint Procedures for Accounting, Internal Accounting Controls and
Auditing Matters, dated Jan. 23, 2004, FMSE 221378-80. When Kappler
proposed that the Audit Committee adopt this set of procedures, she noted
that most employee complaints in the past had concerned human resources
matters that would not have been subject to the new procedures. See
Minutes of the Meeting of the Audit Committee of the Board of Directors
of Fannie Mae, dated Jan. 23, 2004, FMSE 504806-15, at FMSE 504810.
(1832) See Fannie Mae Audit Committee, Complaint Procedures for Accounting,
Internal Accounting Controls and Auditing Matters, dated Jan. 23, 2004,
FMSE 221378-80, at FMSE 221379.
482
preliminary reviews of such complaints,(1833) but left the Audit Committee
responsible for directing and overseeing all subsequent investigations, with
assistance from the General Counsel, the head of Internal Audit, or such other
persons as the Committee determined to be appropriate. The head of Internal
Audit was required to verify that the Audit Committee received all reports or
descriptions of complaints related to accounting, internal controls, and
auditing matters.(1834)
3. Management Oversight and Activities
(a) The Business Conduct Committee and the Corporate
Compliance Advisory Committee
(1) Business Conduct Committee
Prior to 2004, the BCC was the management committee primarily
responsible for overseeing the development of the Code and for its
enforcement.(1835) Specifically, the BCC was tasked with: (1) recommending to
the Audit Committee substantive amendments and revisions to the Code (and,
beginning in 1998, approving technical and administrative amendments to the
Code); (2) overseeing the publication and distribution of, and the process for
certifying compliance with, the Code; (3) overseeing Code training and awareness
programs; and (4) reviewing with the OCJ the status of investigations, suspected
violations, and other enforcement matters relating to the Code."(1836) The BCC
was chaired by the Senior Vice President for Human Resources.
- ----------
(1833) Under these procedures, all complaints received by the Audit Committee
were to be forwarded to the General Counsel and the head of Internal
Audit. After conducting a preliminary review of the Complaint, the
General Counsel was required to submit a copy (or a description of the
complaint) to the Committee, together with any recommendations as to
appropriate handling. The General Counsel was also charged with
maintaining a log of all complaints received that tracked their receipt,
investigation, and resolution, and with preparing a report to the
Committee on at least a semi-annual basis summarizing the contents of
this log. See id.
(1834) See id.
(1835) See, e.g., Business Conduct Committee Charter, dated Jan. 2003, FMSE-IR
36608-09, at FMSE-IR 36608.
(1836) See id. at FMSE-IR 36608-09. The BCC also had responsibility for setting
policy on appropriate penalty levels for Code violations and addressing
"new or complex issues" that might arise from OCJ investigations. See
Roles and Responsibility in Fannie Mae's Ethics Compliance Program, dated
Feb. 7, 2001, FMSE-IR 36610-14, at FMSE-IR 36613. In addition, when a
complaint raised allegations against a Fannie Mae officer, the Office of
the Chairman was charged with resolving the matter, but was required to
present its proposed resolution to the BCC for its concurrence or
alternate recommendation. See Roles and Responsibilities in Fannie
483
The BCC Charter required the Committee to deliver an annual report
to the Audit Committee detailing "matters that arise under the Code, including
any pertinent issues involved in distributing and certifying compliance with the
Code as well as any significant violations."(1837) These reports, which were
usually delivered in April, discussed technical amendments and proposed
substantive changes to the Code, Code training and awareness activities, annual
Code certification updates, and, on some occasions, gave overviews of select OCJ
investigations.(1838)
The BCC Charter required the BCC to meet at least twice each
year.(1839) Based on the BCC minutes, it appears that the Committee met between
two and six times each year from 1998 to 2003.
(2) Corporate Compliance Advisory Committee
In July 2003, the Audit Committee agreed with management's proposal
to replace the BCC with the CCAC.
The Audit Committee intended the CCAC to assume the BCC's responsibilities for
"providing guidance as to adherence to the Code," and to also assume additional
responsibility "as to matters related to corporate compliance that are not
related to the Code."(1840)
The CCAC Charter required the Committee to oversee the activities of
the newly-created OCC in addition to the investigative activities of the
OCJ.(1841) Among
- ----------
Mae's Code Compliance Program, dated Jan. 2003, FMSE-IR 36615-20, at
FMSE-IR 36620.
(1837) Business Conduct Committee Charter, dated Jan. 2003, FMSE-IR 36608-09, at
FMSE-IR 36609.
(1838) See, e.g., Mem. from the Business Conduct Committee to the Audit
Committee, dated July 10, 2003, FMSE 16005-07; Mem. from K. Gallo to the
Audit Committee, dated Apr. 9, 2002, FMSE 15391-93; Mem. from Thomas R.
Nides to the Audit Committee, dated Apr. 6, 2001, FMSE 14926-29; Mem.
from T. Nides to the Audit Committee, dated Apr.18, 2000, FMSE 14552-56;
Mem. from T. Nides to the Audit Committee, dated Apr.14, 1999, FMSE
14195-98, at FMSE 14197 (with overview of OCJ investigation of Code
violations by a Vice President).
(1839) See Business Conduct Committee Charter, dated Jan. 2003, FMSE-IR
36608-09, at FMSE-IR 36608.
(1840) Minutes of the Meeting of the Audit Committee of the Board of Directors
of Fannie Mae, dated July 15, 2003, FMSE 504780-87, at FMSE 504784.
(1841) See Undated Corporate Compliance Advisory Committee Charter, FMSE-IR
698349-50, at FMSE-IR 698349. We can find no evidence that the CCAC
Charter was ever presented to the Audit Committee.
484
other things, the CCAC was charged with reviewing the OCC's proposed business
plan for the coming year and its report of activities in the preceding year
(including Code awareness and training programs).(1842) The CCAC was also
charged with reviewing annual reports of the past and pending activities of the
OCJ, including summaries of OCJ investigations for the prior year.(1843) Unlike
the BCC, the CCAC was chaired by the General Counsel (Kappler).
In practice, the CCAC did not end up functioning as had been
envisioned when it was established. Although the CCAC was established as a
standing committee with quarterly meetings, it appears to have met only three
times during 2004, with no meetings during the second half of the year. Several
planned meetings were reportedly cancelled when no issues were pending before
the CCAC.(1844) Finally, although the CCAC Charter specified that the Chair of
the CCAC was to provide an annual report to the Audit Committee on compliance
matters, including "any significant violations of laws, regulations or the Code,
and significant monitoring and enforcement efforts,"( 1845) we found no evidence
that such a report was presented to the Audit Committee in 2004 (or in
2005).(1846)
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(1842) Although not mentioned specifically in the Charter, the responsibilities
of the OCC in practice included the development of business unit
compliance plans, which sought to facilitate business unit compliance
with laws and regulations specifically applicable to each such unit. The
director of the OCC, Deborah House, stated that she sought guidance from
the CCAC as to the OCC's role in developing these business unit
compliance plans.
(1843) See Undated Corporate Compliance Advisory Committee Charter, FMSE-IR
698349-50, at FMSE-IR 698349.
(1844) We understand that the Committee remains in existence, at least formally,
and that it met at least once in 2005. See, e.g., Minutes of the Meeting
of the Corporate Compliance Advisory Committee, dated Mar. 9, 2005,
Zantaz document 1074379.
(1845) Undated Corporate Compliance Advisory Committee Charter, FMSE-IR
698349-50, at FMSE-IR 698349.
(1846) The CCAC Charter also required a quarterly report to the COO on "any
violations of applicable laws, regulations, or the Code of Business
Conduct (Code) and the corrective actions that were taken." Id. Kappler's
quarterly litigation reports to the Office of the Chairman (which
included appendices containing OCJ data) appear to have addressed this
reporting requirement.
485
(b) Roles of the General Counsel and the Chief Compliance
Officer
At the officer level, lead responsibility for Fannie Mae's ethics
and compliance program rested with General Counsel Kappler and Deputy General
Counsel and Chief Compliance Officer Remy.
(1) General Counsel
Kappler served as Fannie Mae's General Counsel from May 2000 until
December 2005.(1847) In that capacity, she supervised the activities of the OCJ
upon its migration to the Legal Department in 2001, as well as the activities of
the OCC upon its creation in late 2002. As of 2004, both the OCJ and OCC
reported to Kappler through the Chief Compliance Officer.
Kappler stated that she received information about employee
complaints and OCJ investigations from the director of the OCJ, from Remy, and
from OCJ logs that were distributed to her on a periodic basis. According to
Kappler, she received copies of final OCJ investigatory reports, but she said
that she did not recall reviewing any drafts of those reports.(1848)
Kappler provided quarterly litigation reports to members of the
Office of the Chairman that contained appendices summarizing the investigatory
activities of the OCJ. She also presented information to the Senior Leadership
Team from time to time concerning OCJ activities.(1849)
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(1847) In November 2004, Kappler was promoted from Senior Vice President to
Executive Vice President, while remaining General Counsel. See Minutes of
the Meeting of the Board of Directors of Fannie Mae, dated Nov. 16, 2004,
FMSE 504488-94, at FMSE 504493-94. In August 2005, she announced her
resignation from Fannie Mae, effective at the end of 2005. See Fannie Mae
press release, dated Aug. 24, 2005, available at http://www.fanniemae.com
/newsreleases/2005/3589.jhtml?p=Media&s=News+Releases.
(1848) Kappler stated that she did review a draft of the OCC's report on the
Barnes investigation.
(1849) See, e.g., Office of Corporate Justice: Appendix to Litigation Report,
dated second quarter 2004, FMSE-IR 209678-79; Office of Corporate
Justice: Appendix to Litigation Report, dated fourth quarter 2003,
FMSE-IR 209693-96; see also Office of Corporate Justice: 2003
Year-in-Review, dated Mar. 16, 2004, FMSE-IR 264175-97 (presented to the
Senior Leadership Team by Kappler and Donald M. Remy).
486
Kappler took the lead in reporting to the Audit Committee on ethics and
compliance matters in 2003.(1850) In January 2003, she submitted a revised Code
for the approval of the Committee.(1851) In July 2003, she delivered the final
report of the BCC and presented plans for its replacement with the CCAC.(1852)
In August 2003, she briefed the Audit Committee on an investigation conducted by
the OCC and Internal Audit into the accounting and other allegations associated
with Roger Barnes.(1853)
In the first half of 2004, Kappler presented the Audit Committee with
further proposed revisions to the Code(1854) and a new whistleblower complaint
policy.(1855) In January 2004, as noted above, she also became responsible for
providing the Audit Committee with preliminary reviews of all complaints
involving accounting- and audit-related matters, and with preparing a
semi-annual report showing the status of all such complaints. As of August 2004,
she also was charged with reporting to the Audit Committee any OCJ findings of
employee fraud, as well as the initiation of any fraud-related investigation
involving a Fannie Mae officer.(1856)
With the exception of her August 2003 briefing on the Barnes
investigation, Audit Committee minutes prior to September 2004 do not reflect
briefings
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(1850) Prior to 2003, the lead effectively rested with the head of the Human
Resources department, who, as noted above, chaired the BCC. Kappler did
provide annual litigation updates to the Audit Committee prior to 2003.
(1851) See Minutes of the Meeting of the Audit Committee of the Board of
Directors of Fannie Mae, dated Jan. 21, 2003, FMSE 504743-55, at FMSE
504754 (Kappler noted that the prior version of the Code had been
written ten years earlier and needed to be updated, in part to reflect
SOX).
(1852) See Minutes of the Audit Committee of the Board of Directors, dated July
15, 2003, FMSE 504780-87, at FMSE 504784.
(1853) See Minutes of the Audit Committee of the Board of Directors of Fannie
Mae, dated Aug. 12, 2003, FMSE 504788-91, at FMSE 504791. This
investigation is discussed in Chapter IX of this Report.
(1854) See Minutes of the Meeting of the Audit Committee of the Board of
Directors of Fannie Mae, dated Apr. 19, 2004, FMSE 504838-46, at FMSE
504844-45.
(1855) See Minutes of the Meeting of the Audit Committee of the Board of
Directors of Fannie Mae, dated Jan. 23, 2004, FMSE 504806-15, at FMSE
504809-10.
(1856) See Anti-Fraud Policy, dated Aug. 19, 2004, Zantaz document 1371602, at
4.
487
by Kappler as to the outcome of specific internal investigations of employee
complaints.(1857)
(2) Chief Compliance Officer
As part of Fannie Mae's efforts to update its ethics and compliance
program to address amendments to the U.S. Sentencing Guidelines that concerned
corporate governance programs,(1858) Fannie Mae created a Chief Compliance
Officer position in November 2002 and named Vice President and Deputy General
Counsel Donald Remy to that position (simultaneously promoting him to Senior
Vice President).(1859) His duties as Chief Compliance Officer supplemented his
existing responsibilities as Deputy General Counsel, which included managing the
employment law, antitrust, and general insurance practice groups in the Legal
Department.
Fannie Mae publicly described Remy as being responsible for "the
development, implementation, maintenance and enforcement of a comprehensive
program for managing Fannie Mae's legal and regulatory compliance risk."(1860)
Kappler, however, did not recall any wider role for the Chief Compliance Officer
than overseeing the activities of the OCJ and the OCC.(1861) Remy described his
oversight of OCJ and
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(1857) Kappler stated that, to the extent that investigations or complaints
pertained to accounting improprieties or fraud, she was required to, and
did, report such matters to the Audit Committee. She said that she
informed the Audit Committee of allegations against senior officers of
the Company, and of alleged violations of law. She also said that she
tended to present Committee members with oral rather than written
briefings on special complaints or investigations.
(1858) In 2002, House suggested to Kappler that a Chief Compliance Officer be
designated in order to comply with recommendations of the U.S.
Sentencing Guidelines. However, she suggested that the General Counsel
serve as Fannie Mae's Chief Compliance Officer. See Mem. from D. House
to A. Kappler and T. Marra, dated Sept. 9, 2002, FMSE-IR 672285-90, at
FMSE-IR 672287.
(1859) See Fannie Mae press release, dated Nov. 19, 2002, available at
http://www.fanniemae.com/newsreleases/2002/2269.jhtml?p=Media. Remy
joined Fannie Mae as Vice President and Deputy General Counsel in 2000
with responsibility for the litigation, antitrust, insurance coverage,
and employment matters practice groups.
(1860) Id.
(1861) Although some employees considered the Chief Compliance Officer to be
the Company's "Chief Ethics Officer," Remy himself disagreed with this
characterization and acknowledged that no identifiable Chief Ethics
Officer existed at the Company.
488
OCC as broad in nature; he stated that he reviewed reports and policies
generated by the OCJ and OCC, but he did not necessarily exercise day-to-day
control over their activities.
Kappler stated that, as Chief Compliance Officer, Remy had authority to go
directly to the Audit Committee to report on compliance matters, but she did not
recall his ever doing so. Instead, as discussed above, Kappler, rather than
Remy, typically reported to the Audit Committee (and, as necessary, the full
Board) on compliance matters.
4. Office of Corporate Justice
The OCJ was (and continues to be) responsible for investigating and
resolving employee complaints of violations of the Code and other Company
policies, as well as violations of laws and regulations. The functions of the
OCJ have evolved over time, and, at times some of those functions were shared
with other offices.
(a) Organization and Function
In early 2001, Fannie Mae reorganized a pre-existing Human Resources
department into two separate units: the OCJ and the Office of Employment
Practices ("OEP"). At this time, the OCJ became part of the Legal Department and
was granted authority to investigate and resolve not only workplace-related
allegations, but also alleged legal violations and violations of the Code and
Fannie Mae policies.(1862)
Alan Tanenbaum became Director of the new OCJ. As OCJ Director, Tanenbaum
supervised a staff of between two and four full-time attorneys.(1863) He
reported directly to Remy, who in turn reported to Kappler. Tanenbaum (and/or
one of his subordinates) attended meetings of the BCC to report on the
activities of the OCJ.(1864) Tanenbaum did not report to the Audit Committee or
to the full Board.
(b) Overview of Investigative Activities
The primary activities of the OCJ have involved the solicitation of
complaints from employees, the processing and investigation of complaints, the
reporting of investigative findings, and the resolution of complaints (including
the formulation of
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(1862) See Mem. from T. Nides to the Audit Committee, dated Apr. 6, 2001, FMSE
14926-29, at FMSE 14928. The OEP remained in Human Resources and had
responsibility for drafting Code of Business Conduct policies and
amendments, promoting ongoing employee Code awareness and education, and
conducting the annual Code certification process until the OCC was
created at the end of 2002.
(1863) As of September 2004, the OCJ employed four full-time attorneys.
(1864) See, e.g., Minutes of the Regular Meeting of the Fannie Mae Business
Conduct Committee, dated Mar. 8, 2002, FMSE-IR 209623-24 (attended by
Tanenbaum).
489
remedial actions). The following summarizes the policies and procedures by which
the OCJ accomplished these activities.
(1) Policies for Directing Complaints to the OCJ
For a number of years, Fannie Mae's Complaint Process Policy has directed
employees to report improper behavior either directly to the OCJ (or its
predecessor), or to the employees' managers, their Human Resources
representatives (their "HR Talent Team"), or to Fannie Mae officers (all of
whom, in turn, were directed to refer such matters to the OCJ). Beginning in
2001, this Policy covered all alleged violations of the Code of Business
Conduct.(1865) By 2004, this Policy also encompassed other Company policies
beyond those set forth in the Code.(1866)
In June 2004, Fannie Mae issued its Ethical Responsibility Policy, which
directed employees to report not only violations of the law and the Code, but
also improprieties in accounting, internal accounting controls, or auditing
matters.(1867) Employees were encouraged to report such violations or
improprieties to their supervisors, but they were informed that they could also
report their concerns to the OCJ, the OCC, or the Audit Committee. This policy
also informed employees that failure to report violations or improprieties could
result in remedial or disciplinary action up to and including termination of
employment.(1868)
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(1865) See Complaint Process Policy, dated Dec. 10, 2001, FMSE-IR 36634-35; see
also Complaint Process Policy, dated Jan. 6, 2004, FMSE-IR 36627-30.
(1866) See Complaint Process Policy, dated Jan. 6, 2004, FMSE-IR 36627-30, at
FMSE-IR 36627. On the other hand, employees were instructed to work with
their managers or HR Talent Team representatives (rather than the OCJ)
to resolve matters involving employment performance reviews and ratings;
compensation decisions; or "interpersonal, communication, or
employee-relations matters that do not involve alleged violations of the
Code or Company policy." Id. at FMSE-IR 36628-29.
(1867) See Ethical Responsibility Policy, dated June 25, 2004, FMSE-IR
36624-26, at FMSE-IR 36624. Examples of such improprieties included: (1)
"fraud, deliberate error, or misrepresentation (oral or written) in the
preparation, maintenance, evaluation, review, or audit of any Fannie Mae
financial statement, operational results, or financial records"; (2)
"deficiencies in or noncompliance with Fannie Mae's internal accounting
controls"; (3) "misrepresentations or false statements by a Fannie Mae
employee to a senior Officer or to external or internal auditors
regarding Fannie Mae's finances or any aspect of Fannie Mae business
that they are examining"; or (4) "deviation from full and fair reporting
of Fannie Mae's financial condition." Id.
(1868) See id. at FMSE-IR 36625.
490
Lastly, as part of the annual Code certification process, employees were
required to disclose any activities that they observed or engaged in during the
prior year that they believed to violate the Code. These disclosures also were
forwarded to the OCJ for investigation.(1869)
(2) Means of Processing and Investigating Complaints
Fannie Mae offered employees a number of means by which to file complaints
with the OCJ. Fannie Mae publicized these means through references in the Code,
in OCJ materials, in complaint policies posted on Fannie Mae's intranet, in
communications from senior management, and in promotional campaigns.(1870)
Employees could raise complaints by: (1) visiting the OCJ's office and filling
out a Workplace Dispute/Claim Form (which was the means by which the OCJ
historically received most of its complaints);(1871) (2) raising a complaint at
the OCJ's annual outreach sessions with Fannie Mae's business units and regional
offices;(1872) (3) reporting to their supervisors, to Fannie Mae officers, or to
their HR Talent Team representatives (who were then obliged to refer such
reports to the OCJ); or (4) contacting OCJ by e-mail, by phone, or by a
toll-free phone hotline (the "Hotline"). The Hotline was significantly upgraded
in 2004, after the OCJ became concerned with statistics indicating that
employees scarcely utilized the existing system.(1873)
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(1869) See Roles and Responsibilities in Fannie Mae's Code Compliance Program,
dated Jan. 2003, FMSE-IR 36615-20, at FMSE-IR 36617.
(1870) See, e.g., HomeSite News: Compliance Office Outlines Reporting Options,
dated Oct. 3, 2003, FMSE 24386.
(1871) See Corporate Justice System Process, dated Nov. 11, 2003, Zantaz
document 1736411, at 1.
(1872) See, e.g., Office of Corporate Justice: 2004 Year-in-Review, dated Feb.
17, 2005, Zantaz document 438055; Office of Corporate Justice: 2003
Year-in-Review, dated Mar. 16, 2004, FMSE-IR 264175-97; Office of
Corporate Justice, 2002 Year-in-Review, dated Mar. 2003, FMSE-IR
192850-71, at FMSE-IR 192857.
(1873) One member of the OCJ informed us that employees did not use the old
Hotline because they did not trust its ability to preserve anonymity.
She noted, for example, that the Hotline phone in the OCJ had Caller-ID,
and thus could identify the phone number of a caller. In both 2003 and
2004, only seventeen percent of OCJ complaints were received through the
Hotline. See Office of Corporate Justice: 2004 Year-in-Review, dated
Feb. 17, 2005, Zantaz document 438055, at 20.
491
(3) Policies and Procedures for the Intake and Processing of
Complaints
The OCJ maintained logs to record incoming complaints and reports of
violations and to track their status, including a log of open and pending cases.
On this open case log, OCJ attorneys entered the names of the complainant (if
known) and the accused, the date of the report or complaint, an assigned case
number, and a description of the allegations.(1874)
Beginning in the summer of 2004, whenever an employee alleged fraud or an
accounting impropriety, the OCJ also entered information about the complaint in
a second log.(1875) If fraud was alleged, Fannie Mae's Anti-Fraud Policy
required the OCJ to make an initial assessment of the viability of the
allegation, and, if determined to be viable, to notify in writing the Chief
Compliance Officer, the General Counsel, and the head of Internal Audit.(1876)
Once a complaint was received and logged, the OCJ made a determination as
to how to address it. If the OCJ chose to act on a complaint,(1877) it decided
whether to: (1) provide informal guidance to assist the parties in resolving
their dispute on their own;
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(1874) The OCJ also generated a log listing cases as they closed, as well as a
log that listed remedial actions directed by the OCJ but not yet carried
out by the relevant business units. The latter log was forwarded to the
OCC, which tracked implementation of overdue remedial actions in the
relevant business units.
(1875) This log was distributed on a monthly basis to Chief Compliance Officer
Remy, General Counsel Kappler, and OCC Director House. The OCJ also
prepared and delivered to the head of Internal Audit and the General
Counsel a quarterly report summarizing all complaints and reports of
fraud or accounting impropriety that were received and/or closed by the
OCJ during that quarter. See Draft Office of Corporate Justice: Policy
and Procedures Manual, dated Dec. 7, 2004, Zantaz document 1371031, at
49.
(1876) The Anti-Fraud Policy defined "fraud" broadly to include "any
intentional act or omission affecting or involving, or potentially
affecting or involving, Fannie Mae, that is committed or attempted for
the purpose of securing an improper or unlawful gain or benefit for
Fannie Mae or any other individual or entity, regardless of whether the
gain or benefit is actually realized." Anti-Fraud Policy, dated Aug. 19,
2004, Zantaz document 1371602, at 1.
(1877) Under the Complaint Process Policy, the OCJ had discretion to "decide
not to address any portion or all of a report, complaint, or referral
that it [determined did] not sufficiently allege a violation of Code or
policy, or that [was] more suitable for the employee's supervisory chain
of command or HR Talent Team to address." Complaint Process Policy,
dated Jan. 14, 2004, FMSE-IR 36627-30, at FMSE-IR 36628.
492
(2) offer to mediate the dispute without issuing any formal decision; or (3)
initiate an investigation, with interviews, other fact-gathering, and issuance
of a written decision that could be accompanied by a directive for remedial
action.(1878) Some types of complaints, however, required or almost invariably
led to investigations.(1879) The OCJ investigated thirty-four percent of the
complaints it received in 2003, and forty-one percent of the complaints it
received in 2004.(1880)
(4) Policies and Procedures for Investigating Complaints
If the OCJ chose to conduct an investigation, Tanenbaum assigned one or
more OCJ attorneys to the case. OCJ protocol directed the investigating attorney
to notify the accused of the allegations against him or her, to schedule a time
to review the allegations with the accused, and to provide the accused with an
opportunity to respond to the allegations and to present evidence and
documentation in his or her defense. The investigating attorney also was
required to notify the management chain of the accused (to the extent that doing
so would not compromise the investigation), as well as the relevant practice
group attorney and HR Talent Team member.(1881)
If the OCJ concluded that it did not have the expertise or resources to
conduct the investigation, the OCJ Director could obtain assistance from
external sources, such as forensic accounting firms or outside counsel, or from
internal departments, such as Internal Audit. Although the OCJ and the OCC (when
it briefly conducted investigations in 2003) occasionally utilized Internal
Audit for investigative purposes,(1882) Remy stated that Internal Audit was not
suited for this role because it did
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(1878) See Corporate Justice System Process, dated Nov. 24, 2003, Zantaz
document 1736411, at 1-2.
(1879) For example, in the event that the OCJ determined an allegation of fraud
to be viable, the Anti-Fraud Policy required the OCJ to conduct an
investigation (or engage outside counsel to do so) and/or to "direct
prompt action to ensure that Fannie Mae derives no unlawful or improper
gain or benefit from the activity." Anti-Fraud Policy, dated Aug. 19,
2004, Zantaz document 1371602, at 3.
(1880) See Office of Corporate Justice: 2004 Year-in-Review, dated Feb. 17,
2005, Zantaz document 438055, at 20. We had an opportunity to review the
OCJ's files, and we did not encounter accounting issues similar to those
addressed elsewhere in the Report.
(1881) See Protocol for OCJ Attorneys, dated Aug. 25, 2003, FMSE 24368-85, at
FMSE 24370.
(1882) For example, as discussed in Chapter IX of this Report, the OCC sought
Internal Audit's assistance in investigating Barnes's accounting-related
allegations in August 2003.
493
not possess forensic auditing expertise.(1883) In addition, Tanenbaum observed
that perhaps Internal Audit was reluctant to become involved in investigative
work due to a lack of available staff.
The OCJ reported that the average amount of time from receipt to closure
for investigated cases was 105 days in 2004, down from 129 days in 2003.(1884)
(5) Investigative Findings
The OCJ found violations in sixty-six percent of the cases it investigated
in 2004, up from forty-six percent in 2003, forty-four percent in 2002, and
thirty-two percent in 2001. Most violations concerned misuse of Fannie Mae
technology or harassment of employees.(1885)
When the OCJ concluded an investigation, it prepared a Decision Memorandum
that set forth its investigative findings. A second type of report, called an
"Action Memorandum," often accompanied the Decision Memorandum, setting forth
any disciplinary or remedial measures that the OCJ prescribed. Action Memoranda
most often directed counseling, additional training, or a formal reprimand, but
it also directed a variety of other measures, including suspension without pay
or termination of employment in some cases.(1886)
According to Tanenbaum, no one outside the OCJ provided substantive input
into the preparation of Decision Memoranda or Action Memoranda. However, the OCJ
occasionally shared draft reports with Remy, who provided editorial comments.
According to Remy, he did not typically review draft OCJ reports unless they
involved allegations against officers or allegations involving fraud or
accounting issues. As noted above, Kappler stated that she did not recall
reviewing any drafts of OCJ reports.
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(1883) Nonetheless, Internal Audit was brought in to investigate Roger Barnes's
accounting allegations as discussed in Chapter IX of this Report.
(1884) See Office of Corporate Justice: 2004 Year-in-Review, dated Feb. 17,
2005, Zantaz document 438055, at 23.
(1885) See id. at 27; Office of Corporate Justice: 2003 Year-in-Review, dated
Mar. 16, 2004, FMSE-IR 264175-96, at FMSE-IR 264187.
(1886) In 2004, for example, of the cases that led to Action Memoranda, the OCJ
directed counseling in approximately twenty-seven percent of cases,
additional training in approximately twelve percent of cases, formal
reprimands in approximately eleven percent of cases, memoranda of
concern in approximately nine percent of cases, termination of
employment in approximately five percent of cases, suspension without
pay in approximately four percent of cases, and miscellaneous actions in
other cases. See Office of Corporate Justice: 2004 Year-in-Review, dated
Feb. 17, 2005, Zantaz document 438055, at 33.
494
Final copies of OCJ decisions that included an Action Memorandum were
distributed to: (1) the management chain of the accused; (2) the HR Talent Team
representative of the accused; (3) the employment group attorney assigned to the
accused's business unit; and (4) the OCJ Director. The complainant and the
accused received final copies of the Decision Memorandum, but not the Action
Memorandum.(1887) Remy and Kappler stated that they also received final copies
of these OCJ decision documents.
In the event that the OCJ directed disciplinary or other remedial action,
the OCJ could set a deadline for the action to be taken. If management did not
act before the deadline and/or failed to notify the OCJ of its action, the OCJ
referred the matter to the OCC for follow-up using tracking reports.(1888)
5. Office of Corporate Compliance
In December 2002, Fannie Mae established the OCC as part of a more formal,
centralized compliance program.(1889) Initially, the OCC was charged with four
main responsibilities: (1) overseeing the development of business unit
compliance plans and monitoring adherence to those plans; (2) recommending
changes to the Code of Business Conduct; (3) devising and conducting
Code-specific and other compliance training for employees; and (4) investigating
employee allegations of Code violations and other non-workplace-related
complaints. As discussed below, the Company removed the OCC's investigative
function in early 2004 and returned it to the OCJ.
Deborah House was appointed as the first director of the OCC, reporting to
Remy. She came to that position after working as a Vice President and counsel in
the Legal Department's multifamily products practice group. As of late 2004,
House's staff consisted of four director-level attorneys, three senior managers
(one of whom was an attorney), and a paralegal. House did not report to the
Audit Committee or the full Board
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(1887) See Protocol for OCJ Attorneys, dated Aug. 25, 2003, FMSE 24368-85, at
FMSE 24373. In cases involving alleged fraud, the Anti-Fraud policy
required the OCJ to notify the OCC, the Chief Compliance Officer, the
General Counsel, and Internal Audit of all findings and any actions
directed as a result of the investigation. The General Counsel was then
required to report to the Audit Committee any findings of fraud. See
Anti-Fraud Policy, dated Aug. 19, 2004, Zantaz document 1371602, at 4.
(1888) See, e.g., Draft Office of Corporate Justice: Policies and Procedures
Manual, dated Dec. 7, 2004, Zantaz document 1371031, at 38.
(1889) See Legal Department: Presentation on Corporate Compliance, dated Nov.
2002, Zantaz document 2298837, at 3. Kappler stated that she wanted to
consolidate compliance programs that spanned the Legal Department and
Human Resources and place them under the control of the Legal
Department. But she said that she hoped eventually to migrate the OCC
out of the Legal Department and establish it as an independent office.
495
on the OCC's activities,(1890) but she did, on at least one occasion, update the
CCAC on the status of the OCC's efforts to develop business unit compliance
plans.(1891)
(a) Compliance Activities
A primary focus of OCC's efforts in 2004 was the development of business
unit compliance plans. The goal of these plans was to enhance compliance
throughout the Company by identifying the laws, regulations, Code provisions,
and Fannie Mae policies applicable to each business unit and setting forth
specific policies and procedures for ensuring compliance. The concept was that
business units would "own" their individual compliance plans, but with central
oversight, monitoring, and assistance by the OCC.
By the end of 2004, OCC attorneys, working with the individual business
units, had completed the drafting and approval of compliance plans covering each
of the business units (forty plans in total).(1892) Each compliance plan
contained a description of the business unit, a schedule of the laws and
regulations that specifically affected the business unit, a chart of Code
provisions that were of particular concern to the business unit, and a schedule
of both Company-wide and customized training that each employee in the business
unit had to complete. The plan also listed an inventory of policies or
procedures that either existed or needed to be developed and implemented by the
business unit to facilitate compliance, and identified any outstanding
directives of the OCJ or OCC that remained unfulfilled.(1893)
The OCC also worked during 2004 to develop programs to train employees on
the laws and regulations listed in the business unit compliance plans. By the
end of 2004, the OCC had rolled out an internet-based training program (covering
the Code of Business Conduct). The OCC also conducted classroom training
sessions in
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(1890) Kappler stated that she provided oral briefings to the Audit Committee
regarding the activities of the OCC. Kappler also stated that Internal
Audit updated the Audit Committee on the status of the OCC's business
compliance plans as part of Internal Audit's periodic SOX 404 updates.
(1891) See Corporate Compliance Advisory Committee Agenda, dated Apr. 29, 2004,
FMSE-IR 209667 (includes "Status Report on Business Unit Compliance
Plans").
(1892) See Mem. from D. Remy and D. House to the Audit Committee, dated June
15, 2005, FMSE 510176-78 (reporting on the activities of the OCC).
(1893) See, e.g., Treasurer's Office Business Unit Legal and Regulatory
Compliance Plan, dated first quarter 2005, FMSE-IR 228686-719.
496
2004 in certain areas of law, including antitrust, fair employment practices,
and fair lending.(1894)
The OCC was also responsible for monitoring each business unit's adherence
to its compliance plan. The OCC was required to report significant violations
"first to senior management and then, absent resolution, to the Audit
Committee."(1895)
(b) Activities Relating to the Administration of the Code of
Business Conduct
OCC's administration of the Code involved Code awareness, certification,
interpretation, and training. With respect to Code awareness efforts, the OCC
published the Code on Fannie Mae's internet and intranet sites. The OCC also
gave new employees copies of the Code with their offer letters and required them
to sign forms acknowledging their receipt and review of the Code. In addition,
the OCC ensured that the Office of the Chairman routinely published messages on
the importance of compliance, and was involved in drafting some of the weekly
messages from Raines relating to ethics and compliance matters.
With respect to Code certification, employees were required to certify
annually their compliance with the Code and to disclose any known violations of
the Code.(1896) In 2004, the OCC introduced an online version of the annual
certification.(1897)
With respect to Code interpretation, the OCC administered a database of
the Code and Code-related policies, and provided Code-related guidance to
employees by e-mail and phone.(1898) The OCC also developed and disseminated new
Company policies that expanded upon and interpreted the Code.(1899)
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(1894) See Mem. from D. Remy and D. House to Members of the Board of Directors,
dated Feb. 10, 2005, Zantaz document 1074343.
(1895) Id.
(1896) See, e.g., Code of Business Conduct, dated May 11, 2004, FMSE-IR
36806-30, at FMSE-IR 36824. As part of the certification process,
employees were given an opportunity to disclose Code violations.
(1897) See Fannie Mae Self-Assessment Questionnaire (SAQ): SAQ Responses -
Legal Department, fourth quarter 2004, Zantaz document 1188629, at 4.
(1898) See id.
(1899) For example, the OCC in 2004 developed the Ethical Responsibility and
Anti-Fraud policies. See id. at 5.
497
With respect to Code training, the OCC rolled-out an internet-based
version of mandatory Code training in November 2004.(1900) All Fannie Mae
employees were required to complete the training by the end of 2004, and the OCC
tracked their compliance with this requirement.(1901)
(c) Investigative Activities
In the first year of its existence, the OCC shared investigatory
responsibilities with the OCJ. According to Remy, the OCC was assigned to
investigate Code violations and other non-workplace-related complaints, while
the OCJ remained responsible for investigating workplace-related complaints
(such as alleged discrimination or sexual harassment).
The OCC's first investigative effort was the Roger Barnes case, commencing
in August 2003. The OCC investigated Barnes' allegations of accounting
improprieties, as well as his allegations concerning an adverse working
environment in the Controllers' Office; the OCJ investigated Barnes' allegations
of discrimination and harassment.(1902)
Aside from the multi-pronged Barnes investigation, the OCC conducted only
a few minor investigations before the Legal Department, in early 2004, removed
the investigative function from the OCC and returned it to the OCJ. According to
Remy, the Company removed the OCC's investigative responsibilities because: (1)
the OCJ had more resources and expertise than the OCC to commit to investigatory
work; and (2) there was too much confusion between the OCJ and OCC as to their
respective investigatory responsibilities. Remy also explained that employees
traditionally recognized the OCJ as the "cop" of the Company, and that he was
concerned about this perception becoming muddled.
C. Findings
By late 2004, Fannie Mae had established an ethics and compliance program
that had a number of positive attributes. For more than a decade, Fannie Mae had
maintained a Code of Business Conduct, provided Code-related training to
employees, and investigated violations of the Code and other corporate policies.
The Company also had a longstanding and experienced investigative unit to handle
employee
- ------------
(1900) See id.
(1901) See id.
(1902) The OCC performed another investigation arising out of Barnes's
allegations several months later, after KPMG asked the Company to
investigate whether other accounting-related concerns had been raised by
employees but ignored by Controllers' Office management. Each of these
investigations arising out of Barnes's allegations is discussed in
Chapter IX of this Report.
498
complaints. Moreover, beginning in late 2002, Fannie Mae acted to enhance the
centralization and profile of its ethics and compliance program, by: (1) pulling
together ethics and compliance functions within the Legal Department; (2)
creating the OCC to develop and monitor business unit compliance plans,
administer employee training, and otherwise provide central management of ethics
and compliance matters; (3) appointing a Chief Compliance Officer to oversee OCJ
and the new OCC; and (4) replacing the BCC with a new management-level
compliance committee chaired by the General Counsel (rather than the head of
Human Resources) as well as business unit representation.
Although these accomplishments are worthy of note, and although we believe
that the ethics and compliance functions were overseen by well-meaning and
dedicated professionals, the Company's ethics and compliance functions as of
late 2004 suffered from: (a) unstructured information flow to the Board; (b)
inadequate commitment of resources; (c) inappropriate placement of the ethics
and compliance functions within the organization; (d) inappropriate placement of
the Chief Compliance Officer position; and (e) insufficient cross-enterprise
coordination.
1. Unstructured Information Flow to the Board
Prior to 2005, we can find no evidence of systematic, written reporting by
management to the Board concerning ethics and compliance matters. Except for the
annual high-level report from the BCC to the Audit Committee concerning ethics
and compliance activities (which does not appear to have been continued by its
successor, the CCAC), information concerning ethics and compliance matters
appears to have been conveyed largely in oral briefings that were driven by
events (e.g., a particular employee complaint). In particular, we do not find
evidence of the type of information flow that would permit the Board to assess
how well the ethics and compliance offices and related management committees
were functioning, in terms of such core areas as resources, independence,
central coordination, trends in reported matters, and strategic planning. Major
structural changes, such as the manner in which ethics and compliance functions
were centralized in the Legal Department in late 2002, do not appear to have
been presented for Board-level review.
2. Insufficient Resources
Both the OCJ and the OCC suffered from resource deficiencies. It appears,
however, that that the OCJ addressed to a significant degree its resource
problems by outsourcing complex or sensitive investigations over the past few
years (which had the additional benefit of allowing the OCJ to draw upon outside
expertise and independence). The OCC, by contrast, did not have the resources
necessary to match its mission, and the goal of creating a vibrant,
cross-enterprise overseer of ethics and compliance had not been realized.
Although generating forty business unit compliance plans with a handful of
attorneys in the space of a year is impressive, the lack of resources resulted
in drawing personnel away from training and guidance activities, and
499
does not appear to have promoted a broad willingness on the part of business
unit personnel to look to the OCC for support.(1903)
3. Inappropriate Placement of the Ethics and Compliance Functions
Management's decision to house the OCC and the OCJ in a litigation section
of the Legal Department was inappropriate, in that it appeared to compromise the
independence of the ethics and compliance program and limited its status and
visibility within the organization. This placement was particularly troublesome
for the OCJ. The OCJ's placement undercut employee confidence by raising at
least the possibility that OCJ investigations could be tainted by management's
litigation strategies. This potential conflict of interest was exacerbated by
the fact that Remy, the Chief Compliance Officer and supervisor of OCJ, was also
the Deputy General Counsel in charge of the Legal Department's employment
practice group - a practice group that was responsible for defending the
Company's interests against claims brought by Fannie Mae employees.
4. Weakness of the Chief Compliance Officer Position
As noted above, when Fannie Mae announced the appointment of Remy as its
first Chief Compliance Officer in late 2002, it described Remy as being
responsible for "the development, implementation, maintenance and enforcement of
a comprehensive program for managing Fannie Mae's legal and regulatory
compliance risk."(1904) In reality, Remy did not have the authority, visibility,
or range of functions appropriate to a Chief Compliance Officer. He did not
appear as Chief Compliance Officer before the Board or the Audit Committee, nor
did he chair the Company's management-level compliance committee. Remy had
substantial responsibilities within the Legal Department that were not related
to his ethics and compliance responsibilities, including some responsibilities
that conflicted with his duties as Chief Compliance Officer. As noted above, a
number of employees and Board members did not know that Remy was the Company's
Chief Compliance Officer.
Although it is not unusual for a company to have a chief compliance
officer who is situated in the legal department,(1905) it is both unusual and
undesirable for
- ------------
(1903) Mercer came to a similar conclusion after surveying a number of business
unit managers in 2004. See Mercer Oliver Wyman Consulting, Report on
Compliance, Ethics & Investigation, dated June 30, 2005, Zantaz document
1963752, at 7 (noting a "[h]igh degree of business unit frustration with
degree and quality of corporate-level compliance support - compliance
plans viewed as lists of laws and regulations to be complied with, with
limited `how to' support.").
(1904) Fannie Mae press release, dated Nov. 19, 2002, available at
http://www.fanniemae.com/newsreleases/2002/2269.jhtml?p=Media.
(1905) See, e.g., Corporate Executive Board, The Role of the Chief Compliance
Officer (May 2004) at 6 (in a survey of chief compliance officer
functions at sixteen companies, the chief compliance officer reported to
the general counsel in nine
500
a chief compliance officer not to report directly to a company's board on
compliance matters;(1906) and it is highly unusual for a chief compliance
officer to have responsibility for supervising a company's employment practices
litigation.
5. Insufficient Cross-Enterprise Coordination
From 1993 through 2003, the BCC recommended revisions to the Code of
Business Conduct, oversaw management's compliance training and employee
certification programs, reviewed the activities of ethics and compliance
personnel, and reported annually on compliance matters to the Audit Committee.
Although the CCAC took over responsibility for many of these same functions, it
appears to have become largely moribund by the second half of 2004. We cannot
identify any meetings in the last six months of 2004, nor can we find any
evidence that an annual report was delivered to the Audit Committee in 2004 (or
2005). When we met with Kappler in early 2005, she acknowledged that the CCAC
had not functioned as intended, and she noted that management was considering
its dissolution. Without an active CCAC, and with an under-resourced and
relatively low-stature OCC, the Company lacked an effective mechanism for
coordinating compliance matters across the enterprise as of the second half of
2004.
D. Subsequent Developments
1. Creation of an Independent Ethics, Compliance & Investigations
Organization
In the wake of the September 2004 OFHEO Report and subsequent interaction
with OFHEO, Fannie Mae's Board agreed to conduct a review of the Company's legal
and regulatory compliance structures and to establish a separate Office of
Compliance, Ethics & Investigations that would report directly to the CEO and
the Board.(1907) The head of this new office was to be hired and removed only
with the
- ------------
instances; in three other instances, the general counsel was the chief
compliance officer).
(1906) See id. at 9 (noting in only one of sixteen companies surveyed did the
chief compliance officer not report to the Board).
(1907) To assist in the process of redesigning Fannie Mae's ethics and
compliance program, the Company engaged Mercer, which also worked on
redesign efforts for other parts of the Company (and especially the
Finance organization). Mercer's report setting forth its design and
staffing recommendations for the new ethics and compliance organization
was completed and submitted to OFHEO in June 2005. See Mercer Oliver
Wyman Consulting, Report on Compliance, Ethics & Investigation, dated
June 30, 2005, Zantaz document 1963752; see also Minutes of the Meeting
of the Compliance Committee of the Board of Directors of Fannie Mae,
dated June 22, 2005, FMSE 538347-48.
501
approval of the Board; to have no other responsibilities at the Company; and to
operate independently, with the authority to communicate directly with the Board
and OFHEO.(1908)
As designed by Mercer (working with Company management), the Company's
OCC, OCJ, and Regulatory Reporting functions will be wrapped into the new OCEI
with a proposed minimum fifty percent increase in staffing and regular reporting
to the Audit and/or Compliance Committee, the CEO, the management-level Business
Operations Committee, and OFHEO. The OCEI will be situated outside the Legal
Department, with the head of OCEI reporting directly to the CEO and the Board.
The head of OCEI will be a dedicated position at the Senior Vice President
level, with hiring and removal subject to Board approval. As contemplated, the
head of the OCEI would report to the CEO at least monthly, and to the Board at
least quarterly, on his or her compliance risk assessment, on investigations
conducted, and on identified breaches or deficiencies and corrective measures
recommended or taken. The head of the OCEI would also be expected to report to
OFHEO on major issues and developments, including whistleblower cases.(1909) On
December 20, 2005, the Company announced that William Senhauser had been
selected as the Company's new Chief Compliance Officer and the
- ------------
In addition, the Board engaged Hildebrandt International ("Hildebrandt")
to review Fannie Mae's legal and regulatory compliance structures.
Hildebrandt's report concerning the Company's legal and regulatory
compliance structures was completed and delivered to OFHEO in September
2005. See Hildebrandt International: Legal and Regulatory Compliance
Structures Review: Final Report, dated Sept. 9, 2005. With respect to
design and staffing of the new ethics and compliance organization,
Hildebrandt largely absorbed the recommendations coming out of Mercer's
work.
(1908) See Supplemental Agreement between the SRC and OFHEO, dated Mar. 7,
2005, at 4, available at
http://www.ofheo.gov/media/pdf/fannie05agreement.pdf.
(1909) See Mercer Oliver Wyman Consulting, Report on Compliance, Ethics &
Investigation, dated June 30, 2005, Zantaz document 1963752. As designed
by Mercer, the OCEI will consist of: (i) a Compliance unit, headed by a
Vice President for Compliance, which will absorb most of the functions
of the OCC (but with over twice the staffing level); (ii) an
Investigations unit, headed by a Vice President for Investigations,
which will absorb the functions of the OCJ (and which will have
authority to engage external investigators); (iii) a Complaint
Evaluation unit (to receive employee complaints and direct them, as
appropriate, to the Investigations unit, HR, or elsewhere); (iv) an
Ethics unit, headed by a Vice President for Ethics, which would absorb
Code-related and other ethics functions from the OCC; and (v) a
Regulatory Reporting unit, to oversee reporting to OFHEO and HUD and to
coordinate examinations by these agencies.
502
first head of the OCEI, with direct reporting to the CEO and the Compliance
Committee.(1910)
As of the beginning of 2006, the build-out of the OCEI is just commencing.
Thus, while we believe that the contemplated design and staffing for the new
organization should represent considerable improvement, it is too early to
assess the functioning of the OCEI. We agree with both Mercer and Hildebrandt,
which recommended the establishment of a "Control/Coordination Committee,"
composed of the head of the OCEI, the General Counsel, the CRO, and the Chief
Audit Executive, in order to ensure cross-enterprise coordination of legal,
compliance, ethics, and risk management programs and activities.(1911)
2. Expanded Role of Compliance Committee
In its September 2005 report, Hildebrandt recommended that Fannie Mae
consider establishing a permanent Board committee specifically to oversee the
legal and regulatory compliance functions of the Company.(1912) The Board
accepted this recommendation in November 2005 and shifted primary responsibility
for ethics and compliance oversight from the Audit Committee to the Compliance
Committee (whose mandate had previously been focused on ensuring implementation
of the Company's agreements with OFHEO). The Audit Committee remains responsible
for overseeing compliance matters relating to financial reporting, accounting,
audit, and tax matters.(1913) This appears to be a suitable means of
accomplishing more direct interaction between the Board and management on ethics
and compliance matters, especially given the success that the Compliance
Committee appears to have had over the past year in rebuilding the Company's
relationship with OFHEO.
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(1910) See Fannie Mae press release, dated Dec. 20, 2005, available at
http://www.fanniemae.com/newsreleases/2005/3660.jhtml;jsessionid=3ND
P2WGQQTTQ1J2FQSISFGI?p=Media&s=News+Releases.
(1911) See Mercer Oliver Wyman Consulting, Report on Compliance, Ethics &
Investigation, dated June 30, 2005, Zantaz document 1963752, at 40;
Hildebrandt International: Legal and Regulatory Compliance Structures
Review: Final Report, dated Sept. 9, 2005, at 9.
(1912) Hildebrandt International: Legal and Regulatory Compliance Structures
Review: Final Report, dated Sept. 9, 2005, at 9. This recommendation is
in line with a trend among U.S. public companies, whose audit committees
have faced substantially increased demands in recent years.
(1913) See Compliance Committee Charter, dated Nov. 15, 2005, FMSE 547749-50;
Audit Committee Charter, dated Nov. 15, 2005, FMSE 547741-45, at FMSE
547744.
503
3. Enhanced Reporting to the Board
Even prior to the Mercer and Hildebrandt reports and the effort to create
an new ethics and compliance organization, the Company took some significant
steps to improve the quality and quantity of reporting to the Board on ethics
and compliance matters. In a February 2005 memorandum to the Audit Committee,
Kappler acknowledged that it would be prudent to adopt a more "formalized
reporting mechanism" to report OCJ investigations to the Audit Committee in
light of the rising frequency of whistleblower and accounting-related complaints
since the publication of the OFHEO Report.(1914) The same month, Remy briefed
the Audit Committee for the first time on OCJ matters.(1915) Subsequently, Audit
Committee minutes indicate that Kappler briefed the Audit Committee regularly on
internal complaints and OCJ investigations. On at least one occasion, Kappler
discussed resourcing problems with the Audit Committee.(1916)
It also appears that, in 2005, management began to provide systematic
reports to the Board on the activities of the OCC. For example, Remy and House
- -------------
(1914) Mem. from A. Kappler to the Audit Committee, dated Feb. 11, 2005,
FMSE-KD 28309-17, at FMSE-KD 28309. Kappler proposed to provide to the
Audit Committee written reports detailing (1) significant violations of
the Code, (2) terminations of employment directed by the OCJ, and (3)
OCJ investigations involving whistleblower claims and allegations of
accounting-related impropriety. See id.
(1915) See Minutes of the Meeting of the Audit Committee of the Board of
Directors of Fannie Mae, dated Feb. 17, 2005, FMSE 503025-34, at FMSE
504034 ("Mr. Remy provided highlights of the 2004 Year-in-Review report
of the Office of Corporate Justice."). Audit Committee minutes reflect
that Remy appeared before the Committee on one other occasion in 2005,
to report on the Company's anti-fraud policy and program. See Minutes of
the Meeting of the Audit Committee of the Board of Directors of Fannie
Mae, dated Oct. 17, 2005, FMSE 537768-75, at FMSE 537773-74.
(1916) See Minutes of the Meeting of the Audit Committee of the Board of
Directors of Fannie Mae, dated Oct. 17, 2005, FMSE 537768-75, at FMSE
537774-75 ("Ms. Kappler reviewed activities of the Office of Corporate
Justice. She said that some inquiries are lagging due to the need for
more resources and that she and Mr. Williams were planning how to
address the issue.").
504
provided written reports to the full Board on OCC matters in February and June
2005,(1917) and Kappler briefed the Audit Committee on the activities of the OCC
in June 2005.(1918)
The February 2005 report from Remy and House outlined the OCC's progress
in 2004 in such areas as developing business unit compliance plans, adoption of
new corporate policies (the Ethical Responsibility Policy and the Anti-Fraud
Policy), and the rolling out of the Company's new computerized Code training
program. In addition, the February report attached a sample business unit
compliance plan for review, and recommended that the Audit Committee receive a
report from management concerning the functioning of the Company's ethics and
compliance program at least once a year.(1919)
In our view, this represents progress in enabling meaningful Board
engagement on ethics and compliance matters. Going forward, we think it is
especially important for management reporting in these areas to provide
meaningful risk assessments and discussion of perceived resource or other
deficiencies.
V. OFFICE OF THE CONTROLLER
A. Summary
With respect to the functioning of the Office of the Controller (the
"Controller's Office") prior to the release of the OFHEO Report in September
2004, our conclusions are as follows:
1. The Controller's Office suffered from significant resource
deficiencies. The headcount of the Controller's Office increased only modestly
during the years prior to 2005, even as the Controller's Office experienced
dramatic increases in workload stemming from the introduction of new and complex
accounting standards, the Company's decision to become an SEC registrant, and
the growth of Fannie Mae's business. The Controller's Office leadership lacked
adequate staffing and sufficient accounting and financial reporting expertise
and experience for a financial services company as complex as Fannie Mae. In
addition, the Controller's Office relied to a substantial degree on inadequate
systems that required considerable manual effort, further straining the already
overburdened staff.
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(1917) See Mem. from D. Remy and D. House to Members of the Board of Directors,
dated Feb. 10, 2005, Zantaz document 1074343; Mem. from D. Remy and D.
House to Members of the Board of Directors, dated June 15, 2005, FMSE
510176-78.
(1918) See Minutes of the Audit Committee of the Board of Directors of Fannie
Mae, dated June 20, 2005, FMSE 510748-62, at FMSE 510760.
(1919) See Mem. from D. Remy and D. House to Members of the Board of Directors,
dated Feb. 10, 2005, Zantaz document 1074343.
505
2. The closing process was manually intensive and unduly susceptible to
human error. The relevant computer systems were not integrated and,
consequently, the process of preparing the Company's monthly financial
information required significant manual processes, including numerous manual
journal entries to the general ledger. In addition, prior to the middle of 2004,
the Controller's Office lacked formal written procedures on journal entries and
account reconciliations, had no standardization for documentation to support
journal entries, and permitted employees to sign off on journal entries for
other employees.
Since the release of the OFHEO Report, Fannie Mae has made changes to the
structure and personnel of the Controller's Office, and to the Company's
approach to the development of accounting policy. The Controller's Office, with
active support from senior management and considerable reliance on outside
expertise, has made significant efforts to augment its resources and the
procedures and systems used in the development and oversight of accounting
policies and financial reporting.
B. Overview Prior to September 2004
1. Range of Responsibilities
As of September 2004, the Controller's Office had responsibilities that
included the preparation of the Company's financial statements and its external
and internal financial reporting. It handled Fannie Mae's accounting, payroll,
tax, insurance, and procurement activities, managed the Company's budget and
expenses, and performed business planning.(1920)
2. Senior Vice President and Controller
From 1999 through the beginning of 2005, Spencer served as Senior Vice
President and Controller of Fannie Mae. Spencer joined Fannie Mae in 1991 as a
Director in the Financial Information division of the Controller's Office. She
became a Director in the Financial Reporting division in 1993, and a Vice
President one year later, reporting to former Controller Michael Quinn. She
began reporting to Rajappa when he replaced Quinn as Controller in 1994, and,
from 1994 to 1999, she was responsible for managing Financial Reporting (as well
as Financial Standards for a brief period of time). In 1999, she succeeded
Rajappa as Controller. Spencer reported to CFO Howard during her tenure as
Controller.
Prior to joining Fannie Mae in 1991, Spencer worked at KPMG and as the
controller of a professional services firm that provided temporary office help.
She holds a bachelor's degree in accounting, but she is not a certified public
accountant.
As Controller, Spencer appeared regularly before the Audit Committee to
discuss the Company's financial statements. She briefed the Audit Committee as
to the
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(1920) See, e.g., Undated L. Spencer: Job Description, Zantaz document 126448.
506
structure and content of the Company's annual report on Form 10-K,(1921) and she
met with the Audit Committee Chairman at the end of each quarter to review the
quarterly earnings reports before their release.(1922) She also participated in
periodic presentations to the Audit Committee concerning the critical accounting
policies of the Company.(1923)
3. Key Units within Controller's Office
As of September 2004, the Controller's Office was divided into six units:
(1) Accounting Policy and Corporate Tax ("Financial Standards"); (2) Financial
Reporting and Planning ("Financial Reporting"); (3) Operations & Systems; (4)
Financial & Procurement Services; (5) Corporate Risk & Insurance Management; and
(6) Housing & Community Development.(1924) Of these units, Financial Standards,
Financial Reporting, and Operations & Systems are described briefly below.
(a) Financial Standards
(1) Functions and Responsibilities
Aside from its tax functions, Financial Standards was responsible
primarily for formulating Fannie Mae's accounting policies by interpreting and
applying rules promulgated by the FASB, the Emerging Issues Task Force, and the
SEC. Financial Standards also provided accounting training for employees, and
helped Financial Reporting draft language for Fannie Mae's periodic financial
disclosures (including annual and quarterly reports).
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(1921) See, e.g., Minutes of the Meeting of the Audit Committee of the Board of
Directors of Fannie Mae, dated Feb. 17, 2004, FMSE 504818-30; Audit
Committee Update: Financial Statement Review, dated Feb. 17, 2004, FMSE
221811-15; Minutes of the Meeting of the Audit Committee of the Board of
Directors of Fannie Mae, dated Feb. 18, 2003, FMSE 504756-62.
(1922) See, e.g., Minutes of the Meeting of the Audit Committee of the Board of
Directors of Fannie Mae, dated Jan. 23, 2004, FMSE 504806-15, at FMSE
504806.
(1923) See, e.g., Minutes of the Meeting of the Audit Committee of the Board of
Directors of Fannie Mae, dated Feb. 17, 2004, FMSE 504818-30, at FMSE
504820-21 (Spencer presentation on other than temporary impairment);
Minutes of the Meeting of the Audit Committee of the Board of Directors
of Fannie Mae, dated Nov. 17, 2003, FMSE 504796-805, at FMSE 504800
(Spencer presentation on amortization of deferred price adjustments);
Minutes of the Meeting of the Audit Committee of the Board of Directors
of Fannie Mae, dated Feb. 18, 2003, FMSE 504756-62, at FMSE 504759
(Spencer presentation on allowance for losses, deferred premium discount
and deferred guaranty fees, and fair value of purchased options).
(1924) See Controller's Department - Overview, dated Sept. 2004, FMSE-IR 1550.
507
(2) Senior Vice President -- Accounting Policy and
Corporate Tax
Jonathan Boyles served as the head of Financial Standards from 1997
through the beginning of 2005. He joined Fannie Mae in 1994 as a manager in
Financial Standards. He was promoted to Director in 1998; to Vice President in
2000; and to Senior Vice President in May 2004.
Prior to joining Fannie Mae, Boyles spent four years as an
accountant at Grant Thornton, serving clients in the construction, retail,
banking, and not-for-profit sectors. He also worked at KPMG for two years,
providing auditing and consulting services to mortgage banks. He holds a
bachelor's degree in accounting and is a certified public accountant.(1925)
Boyles reviewed all significant accounting policies and generally
had final say at Fannie Mae on accounting issues. He provided accounting advice
to all areas of Fannie Mae, including advice to the business units on how to
account for new types of transactions. In some cases, his advice took the form
of a memorandum; in other cases, it was informal and undocumented.
(3) Process of Developing Accounting Policies
Fannie Mae's accounting policies were set forth in formal memoranda
compiled in an accounting policy manual. As a matter of course, Financial
Standards sought KPMG's approval prior to finalizing or amending these
accounting policies.(1926)
Also as a matter of course, Financial Standards briefed Howard and
Spencer on significant accounting policies. According to Boyles, Howard and
Spencer did not provide formal written approval of these policies; rather,
Boyles deemed the policies to be approved unless Howard or Spencer voiced
concerns with them.(1927)
On occasion, Financial Standards also consulted with the FASB, the
SEC, and/or OFHEO prior to finalizing accounting policies. In these instances,
Financial Standards typically presented these bodies with an issue raised by a
Fannie Mae transaction or practice and sought guidance as to whether the
Company's approach conformed to accounting standards.
Financial Standards lacked sufficient staffing to be engaged in any
systematic way in the implementation of accounting policies by Controller's
Office or business unit personnel. As noted above, Financial Standards was
available as a resource
- ----------
(1925) See Tr. of Aug. 3, 2004 OFHEO Dep. of J. Boyles, at 8:7-12.
(1926) See id. at 30-32, 34.
(1927) See id. at 20-24.
508
if employees wanted to consult with it on the implementation of its accounting
policies (e.g., development of business unit practices and procedures), but it
rarely took the initiative in monitoring such implementation, and did not view
this as part of its responsibility.
(b) Financial Reporting
(1) Functions and Responsibilities
Financial Reporting oversaw the monthly general ledger closing
process and prepared reports and analyses necessary to compile monthly,
quarterly, and annual reports for both internal and external reporting. It also
participated in the implementation of new accounting policies and served as an
accounting liaison for the various portfolio investment and credit guaranty
business units.(1928)
(2) Senior Vice President -- Financial Reporting and
Planning
Janet L. Pennewell led Financial Reporting from 1999 through early
2005. Pennewell joined Fannie Mae in 1984 as a financial analyst in Financial
Reporting, but she moved to Investor Relations for a number of years before
returning to the Controller's Office in 1996. Pennewell became Vice President --
Financial Reporting in 1999, and was promoted to Senior Vice President --
Financial Reporting and Business Planning in May 2004. Pennewell holds a
bachelor's degree in accounting and a master's degree in finance and is a
certified public accountant.(1929)
(3) Closing Process
Financial Reporting managed the closing process in support of Fannie
Mae's internal financial reports and its external financial statements,
quarterly reports, and annual reports. During the closing process, accounting
information for a particular month was loaded to, and finalized in, the general
ledger system. In general, journal entries were to be prepared by one person
(usually the person responsible for the activity) and approved by another
person. The level of approval required varied depending on the amount of an
entry and the time frame in which it was submitted for approval.
- ----------
(1928) See Controller's Business Unit Finance Compliance Plan
2004-2005, dated Dec. 29, 2004, FMSE-IR 227416-59, at FMSE-IR 227417.
Financial Standards supported this effort, providing Financial Reporting
with inserts for Fannie Mae's various financial reports and with blank
templates and tables to populate with financial data. Financial
Reporting, in turn, supplied data to Investor Relations for inclusion in
the Company's earnings releases.
(1929) See Tr. of June 15, 2004 OFHEO Dep. of Janet L. Pennewell, at 6:19-9:14.
509
In addition to the reconciliation of general ledger accounts,
Financial Reporting performed ongoing analyses of the income statement,
including interest income and expense, guaranty fees, administrative expenses,
and debt extinguishment gains and losses. These analytical procedures functioned
as reasonableness tests and were designed to ensure completeness and accuracy,
proper classification, and the substantiation of account balances.(1930)
(c) Operations & Systems
(1) Functions and Responsibilities
Operations & Systems performed the majority of accounting for the
Company's transactions, including debt issuance, derivatives, and securities
held in the mortgage and liquid investment portfolios. These accounting
responsibilities included application of FAS 91 and FAS 133.
(2) Senior Vice President -- Operations & Systems
This position was created in May 2004 and had not been filled as of
September 2004. Mary Lewers, who became Vice President -- Financial Accounting
in May 2004, served as the acting head of Operations & Systems,reporting
primarily to Spencer (with reporting on certain matters to Pennewell).(1931)
Lewers joined Fannie Mae in 1983 as a financial analyst in the Controller's
Office. She became a Director in 1991, and, from 1993 to 2000, she supervised
the development of various accounting systems, including debt, premium/discount
amortization, derivatives, and liquid investment portfolio systems. In 2002,
Lewers assumed responsibility for securities accounting. Lewers holds a master's
degree in finance and a bachelor's degree in accounting and is a certified
public accountant.
C. Findings
In performing its critical responsibilities, the Controller's Office
was hindered by significant understaffing, a lack of personnel with the
requisite experience and expertise to handle the complex accounting tasks
required of Fannie Mae's Controller's Office, and poorly integrated computer
systems that required significant human intervention.
- -------------
(1930) See Financial Reporting, Monthly Financial Analytics to Support Closing
Policies and Procedures, dated Aug. 17, 2004, FNMSEC 2392-98, at FNMSEC
2396.
(1931) See Organizational Chart, dated Sept. 2004, FMSE-IR 1555.
510
1. Inadequate Resources
(a) Working Environment
During Spencer's tenure as Controller, the Controller's Office
assumed substantial new responsibilities. It absorbed a number of functions from
other areas of the Company, including e-business billing, processing of accounts
receivable, securities accounting, and procurement. It also became subject to
new reporting requirements arising from the Company's registration with the SEC.
Moreover, the Controller's Office had to accommodate Fannie Mae's growing
business and the introduction of such complex new accounting standards as FAS
133, FAS 149, and others. As Spencer acknowledged in 2004, the consequence of
these increasing demands was that the "workload has quadrupled for many of our
areas in a very short time."(1932)
Prior to 2004, Spencer accommodated this increase in workload with
only marginal increases in headcount. Between 2000 and 2003, headcount in the
Controller's Office increased by only 13 employees.(1933) The resulting strains
on Controller's Office personnel were recognized by Internal Audit.(1934)
Spencer acknowledged that she tried to run the Office very
efficiently from a resource perspective. She said that she looked closely at
requests to increase headcount to determine if needs were permanent or whether
they resulted from high-intensity but temporary surges in workload. Although
some employees attributed understaffing to management's perception of them as
non-revenue-generating "overhead" that should not be increased unless absolutely
necessary, Spencer said that no one directed her to maintain lean staffing.
It was not until late 2003 - after the Roger Barnes investigation,
revelations of accounting problems at Freddie Mac, and the onset of OFHEO's
Special Examination of Fannie Mae subjected the Controller's Office to
heightened scrutiny - that Spencer acknowledged that the rising tide of work was
not a temporary surge and that more staff was necessary to accommodate it.(1935)
As Spencer later noted in a 2004
- ----------
(1932) See Communication from L. Spencer to All Controller Staff, dated Apr. 22,
2004, Zantaz document 907239.
(1933) See Controllers Headcount 1999-2004, dated Oct. 3, 2004, FMSE-IR 379167.
(1934) In a departure message in October 2003, Paul Jackson, the Internal Audit
Director for Finance, warned Rajappa that "staffing is way to [sic] low
[in the Controller's Office] to support business needs, including internal
audit regulatory examinations, etc." See E-mail from P. Jackson to S.
Rajappa, dated Oct. 17, 2003, FMSE-E 1031680-81, at FMSE-E 1031681.
(1935) See L. Spencer: 2003 Performance - Self Assessment, dated 2003, FMSE-E
22031-38, at FMSE-E 22031 ("The unfolding accounting and control problems
at Freddie Mac have been a drain on us during the year.... I have come to
accept that [our]
511
memorandum to Howard and Mudd, "[w]e now acknowledge that the world with our
regulator has changed and the workload will not abate in the near future."(1936)
Spencer met with Human Resources in November 2003 to obtain
recruiting assistance; launched a project with HR to recruit candidates for key
positions within the Controller's Office,(1937) and committed herself, as one of
her 2004 corporate goals, to "[r]eview the organizational structure of the
Controller's Department to ensure the company is positioned to handle the
increasing complexity of accounting requirements while continuing to meet the
needs of the business."(1938) From November 2003 through September 2004, the
number of employees in the Controller's Office increased from 206 to 233 (with
56 new employees hired, but approximately half that number lost to attrition).
Most of the new hires were placed in Financial Reporting, Financial Standards,
and Operations & Systems.(1939)
The Controller's Office faced morale issues as well. Employee survey
data from as far back as 1999 reveal widespread employee concerns about the
culture within the Controller's Office.(1940) Despite adoption of an action plan
to address employee concerns, employee ratings of the Controller's Office in
2001 declined from 1999 levels in numerous survey categories.(1941) Another
action plan was adopted, similar
- ------------
new responsibilities will not lighten up in the near future, so I am
adjusting our staffing plans accordingly so that we can address these
needs without sacrificing our accounting work.").
(1936) See Mem. from L. Spencer to T. Howard and D. Mudd, dated July 9, 2004,
FMSE-IR 381407-08, at FMSE-IR 381407.
(1937) See Controller's Top Gun Project, dated Nov. 4, 2003, FMSE-IR 375611-12.
(1938) E-mail from L. Spencer to J. Pennewell, dated Dec. 16, 2003, Zantaz
document 4155147.
(1939) See Controller's Organizational Overview, dated Sept. 22, 2004, FMSE-IR
361514-25.
(1940) See Focus Group Meeting - Controller's Level 4, dated Nov. 15, 1999,
FMSE-IR 522215-17; 2001 Employee Perspectives Survey: Controller's Office,
dated Aug. 2001, FMSE-IR 308623-26.
(1941) See 2001 Employee Perspectives Survey: Controller's Office, dated Aug.
2001, FMSE-IR 308623-26, at FMSE-IR 308624; see also EPS Follow-up
Meetings, FMSE-IR 308743-55.
512
in many respects to that adopted back at the end of 1999 (increased
accessibility to Spencer, and steps to encourage information flow and discourage
fear of retaliation).(1942)
In the late summer of 2003, the OCC investigated the allegations by
Roger Barnes of substantial cultural problems in the Controller's Office,
including his allegation that he had been ostracized and retaliated against for
raising questions about Fannie Mae's accounting practices. In its October 2003
investigative report, the OCC found, among other things, that: (1) "for a
significant number of employees in the Controller's Office the Reporting
Environment is unacceptable"; (2) while not a universal view within the Office,
significant numbers of staff felt that "the environment there is not conducive
to the full, open and frank discussion of issues and concerns relating to
accounting issues and practices" and "to be successful in the Controller's
Office `you are either on the team or not'"; (3) some managers were viewed as
lacking "people skills" such that "when issues are raised it is taken as a
challenge to the manager's integrity rather than as an opportunity for full and
frank discussion"; and (4) "there is not wide communication as to why things are
done the way they are done and . . . some employees may work in silos which may
unnecessarily create issues and concerns."(1943)
As a result of its findings, the OCC prescribed a series of
remedies, including full implementation of the 2001 action plan, an "all hands"
meeting with Spencer, and training for certain managers within the Controller's
Office.(1944) Many of these prescribed steps were ultimately taken.(1945)
Spencer provided updates on the status of the plan to the Legal Department,
acknowledging that progress was being made.(1946)
- ----------
(1942) See Undated Controller EPS Draft Action Plan, FMSE-IR 308741-42; Undated
EPS Divisional Action Plan, FMSE-IR 308831-32.
(1943) See Office of Corporate Compliance: Decision # 2003-1 (Part B, Reporting
Environment), dated Oct. 6, 2003, FMSE 24562-66, at FMSE 24563-64. This
OCC report, and other investigatory activities related to Barnes's
allegations, are discussed at length in Chapter IX of this Report.
(1944) See id. at FMSE 24566.
(1945) See Controllers Plan, dated May 5, 2004, FMSE-E 37819-22.
(1946) In response to concerns expressed by Chief Compliance Officer Remy that
Spencer still had not fully implemented the OCC's remedies several months
after the OCC issued its report, Spencer acknowledged that, "with the
demands of the various audits and OFHEO reviews, the overspill from the
Freddie Mac restatement, and the work we've been supporting with the
performance calibration season, I have had reduced time to spend on
implementing the plan." Mem. from L. Spencer to D. Remy, dated Feb. 5,
2004, FMSE-E 37823-25, at FMSE-E 37824.
513
(b) Expertise and Experience
The Controller's Office in a number of cases employed individuals in
senior positions who lacked the requisite expertise to perform or supervise the
complex tasks that they were assigned.
Although Boyles was the Company's designated expert on accounting
policy, he had only limited experience in consulting on technical accounting
matters prior to joining Fannie Mae. Boyles was the ultimate approver of
accounting policy and his supervisor (Spencer) did not have the requisite
accounting expertise to act as a meaningful check on his development of
accounting policies. Moreover, Boyles stated that he hired individuals based
upon their policy and industry experience rather than their accounting
expertise, and that he did not have anyone on his staff with prior hedging or
derivatives experience.
Similarly, as Vice President -- Financial Accounting, Lewers was
responsible for supervising debt accounting, derivatives accounting, securities
accounting and portfolio analytics, and for developing systems that supported
accounting in these areas. Yet she acknowledged, for example, that she relied
heavily upon Financial Standards and her staff to ensure that the accounting for
Fannie Mae's derivatives portfolio complied with GAAP.(1947)
2. Deficiencies in the Closing Process
(a) Inadequate Policies and Procedures
Until 2004, Financial Reporting lacked formal written policies and
procedures to support the closing process, analytical review, journal entries,
or account reconciliations. It was not until the summer of 2004, as
implementation of SOX 404 required the Company to formally document policies and
procedures, that Financial Reporting took action to address these
deficiencies.(1948)
Prior to May 2004, the Controller's Office lacked standard
requirements for documentation to support journal entries. As a result,
Controller's Office staff employed inconsistent practices as to the amount of
supporting detail that they provided.(1949) In some instances, no meaningful
supporting documentation (or no supporting documentation at all) was provided
for the journal entry.(1950)
- ----------
(1947) See Tr. of July 13, 2004 OFHEO Dep. of M. Lewers, at 152:15-154:14,
215:21-216:22, 257:1-259:5.
(1948) See Financial Reporting Monthly Financial Analytics to Support Closing
Policies and Procedures, dated Aug. 17, 2004, FNMSEC 2392-430, at FNMSEC
2396.
(1949) There was also no requirement to store supporting documentation in a
central location; instead, these documents remained with the business
units. See
514
In addition, up until the end of 2004, individuals other than the
listed preparer of a journal entry were permitted to sign off on the preparer's
behalf. Members of the Controller's Office acknowledged that there were
instances when employees signed journal entry forms on behalf of preparers who
were not present in the office. Typically, the person signing indicated that he
or she was doing so on behalf of the preparer. However, during the period 1998
through 2002, a number of "on top" adjustments were entered on behalf of an
employee who had not prepared them, although her name appears on them.
(b) Inadequate Technological Support
The Controller's Office failed to support the closing process with
adequate technology. The Controller's Office maintained numerous spreadsheets
(commonly referred to at Fannie Mae as "End-User Controls" or "EUCs") and ad-hoc
reporting tools to compensate for poorly integrated systems.(1951)
Extensive reliance on EUCs and the manual processing and analysis of
data created a weak control environment conducive to errors. Errors arose not
only from manual activity, but also from the challenges of creating adequate
levels of employee knowledge across a multitude of EUCs and systems. An example
of the resulting control risks occurred in October 2003, when manual entries on
an EUC and a lack of familiarity with the procedures associated with a new
accounting standard contributed to an approximately $1.1 billion computational
error in Fannie Mae's third quarter earnings press release.(1952)
- ----------------
BearingPoint Review of Current Controls and Processes Within Fannie Mae's
Controller's Office, dated Apr. 5, 2005, FMSE-IR 281271-93, at FMSE-IR
281280.
(1950) For example, a January 1999 journal entry in the amount of $3.9 million -
an entry that helped Fannie Mae to meet its 1998 EPS target for bonus plan
(AIP) purposes - was entered for the stated purpose of "record[ing]
miscellaneous income," with no further supporting documentation. This is
discussed further in the FAS 91 section of this Report. When BearingPoint
reviewed the Company's closing process in the spring of 2005, it found a
number of journal entries to be inadequate or could not recreate them
based on the backup provided to it. See id.
(1951) In its Spring 2005 review of the Company's closing process, BearingPoint
found more than fifty EUCs that were deemed to be critical. See id.
(1952) In this instance, a Controller's Office employee who normally performed
calculations to capture the fair value of certain instruments was on
vacation during the September 2003 month-end closing process. Another
employee performed the analysis in lieu of the vacationing employee, and
adjusted a spreadsheet without realizing that the spreadsheet had already
been updated to incorporate the impact of FAS 149. The resulting error was
a $1 billion understatement of total assets and stockholders equity in the
Company's earnings press release, which the Company
515
D. Subsequent Developments
Since the publication of the September 2004 OFHEO Report, Fannie Mae
has undertaken significant reforms of the structure, composition, policies, and
practices of the Controller's Office. A number of these reforms are the product
of recommendations provided by outside consultants retained by the Company - and
especially Mercer (with respect to changes to structure and staffing) and
BearingPoint (with respect to the closing process).
Although substantial personnel and structural changes have taken
place, a number of important areas of reform (such as systems upgrades and
staffing increases) remain very much in process.
1. Change in Leadership
Spencer resigned as Controller on January 17, 2005, and Fannie Mae
appointed David Hisey, a certified public accountant, to replace her.(1953)
Prior to joining the Company, Hisey was a managing director at BearingPoint and
an audit partner at KPMG.(1954)
2. Structural and Related Personnel Changes
Following the Company's September 2004 agreement with OFHEO(1955)
and the resulting organizational redesign work by Mercer, the Company has
undertaken a broad reorganization of the Controller's Office, including the
movement of some functions outside the Controller's Office (including accounting
policy and business planning and forecasting functions) and restructuring of
functions within the Office.
(a) Accounting Policy
In January 2005, Boyles resigned as head of Financial Standards.
Fannie Mae subsequently split Financial Standards into two separate functions:
Accounting
- ------------
subsequently corrected by filing an amended 8-K with the SEC. See Mem.
from J. Wall, dated Dec. 3, 2003, FMSE-E 1090737-40; Fannie Mae, Current
Report on Form 8-K, dated Oct. 29, 2003, available at
http://www.fanniemae.com/ir/sec/index.jhtml?p=Investor+Relations&s=
SEC+Filing s(follow hyperlink to "All SEC Filings," then "Form 8-K)".
(1953) See Fannie Mae, Current Report on Form 8-K, filed Jan. 21, 2005,
available at http://ccbn.10kwizard.com/cgi/convert/pdf/
FEDERALNATIONAL8K.pdf?pdf=1&repo=tenk&ipage=3208349&num=2&pdf=1&xml=
1&odef=8&dn=2&dn=3.
(1954) See id.
(1955) See Agreement between the SRC and OFHEO, dated Sept. 27, 2004, available
at http://www.ofheo.gov/media/pdf/fnmagreement92704.pdf.
516
Policy (reporting to the CFO) and Corporate Tax (reporting to the Controller).
In contrast to Financial Standards, the new Accounting Policy unit is
responsible for ensuring consistent understanding and implementation of
accounting standards across the Company.(1956)
In June 2005, Fannie Mae appointed Scott Blackley as the Senior Vice
President -- Accounting Policy. He is now responsible for ensuring consistent
understanding and implementation of accounting standards across the Company.
Prior to joining Fannie Mae, Blackley worked at America Online, where he was
Vice President -- Accounting Policy and Assistant Controller. Previously, he
served as a partner at KPMG, and as a professional accounting fellow in the
SEC's Office of the Chief Accountant. Blackley is a certified public accountant,
and he is a technical expert on derivatives, business combinations, and revenue
recognition.(1957)
In addition to Blackley, Fannie Mae appointed Eric Schuppenhauer, a
certified public accountant, as Senior Vice President -- Accounting Policy in
August 2005. Schuppenhauer will have responsibility for evaluating Fannie Mae's
prior accounting policies and practices relating to financial restatements as
well as implementing new or changed accounting standards.
Prior to joining Fannie Mae, Schuppenhauer worked at Credit Suisse
First Boston as a managing director for Global Accounting Policy and Assurance.
Previously, he was a senior advisor to the Chief Accountant of the SEC, an SEC
Professional Accounting Fellow, and a senior manager in KPMG's Department of
Professional Practice.(1958)
(b) Financial Reporting
Pennewell resigned as Senior Vice President for Financial Reporting
and Planning in January 2005. Fannie Mae named Paul Noring to replace Pennewell
in May 2005. Prior to joining Fannie Mae, Noring was an audit partner at PWC. At
PWC, Noring developed considerable experience in derivatives risk management
operations,
- ------------
(1956) See Mercer Oliver Wyman Consulting, Organizational Design Project -
Organization Redesign Discussion Notes - Corporate Senior Vice President
Meeting, dated May 4, 2005, FMSE-IR 552781-96, at FMSE-IR 552791.
(1957) See Fannie Mae press release, dated May 18, 2005, available at
http://www.fanniemae.com/newsreleases/2005/3519.jhtml?p=Media&s=News+Rele
ases.
(1958) See Fannie Mae press release, dated Aug. 24, 2005, available at
http://www.fanniemae.com/newsreleases/2005/3589.jhtml?p=Media&s=News+Rele
ases.
517
controls and business process environments surrounding financial instrument
accounting, fair-value measurements, and allowance for loan loss
methodologies.(1959)
(c) Operations & Systems
Lewers departed Fannie Mae in 2005. Subsequently, Fannie Mae split
Operations & Systems into two separate offices that each report directly to the
Controller: Accounting and Financial Controls & Systems.
In May 2005, Fannie Mae appointed Greg Kozich to serve as Senior
Vice President -- Accounting. Prior to joining Fannie Mae, Kozich was an audit
partner at PWC where he managed complex technical accounting, auditing, and
operational matters relating to financial instruments, with an emphasis on
derivatives and mortgage-backed security accounting.(1960)
Financial Controls & Systems is responsible for financial process
controls, accounting systems, infrastructure, information technology, and
automation.(1961) In June 2005, Fannie Mae appointed Mary Doyle to serve as
Senior Vice President -- Financial Controls & Systems. Previously, Doyle was
Vice President -- Corporate Accounting at Sallie Mae and a tax partner at Arthur
Anderson.(1962)
(d) Valuation & Price Verification
As part of the reorganization, Fannie Mae has established an
independent price verification and valuation function that reports directly to
the Controller. This function is intended to provide an independent review of
fair values derived by the Mortgage Portfolio business before they are included
in the Company's audited financial statements.(1963)
- ------------
(1959) See Fannie Mae press release, dated May 18, 2005, available at
http://www.fanniemae.com/newsreleases/2005/3519.jhtml?p=Media&s=News+Rele
ases.
(1960) See id.
(1961) See Controllers Business Reporting, dated Dec. 9, 2005, at FMSE-IR
699236-38.
(1962) See Fannie Mae press release, dated May 18, 2005, available at
http://www.fanniemae.com/newsreleases/2005/3519.jhtml?p=Media&s=News+Rele
ases.
(1963) See Mercer Oliver Wyman Consulting, Organizational Design Project -
Organization Redesign Implementation Supporting Materials and Discussion
Notes Prepared for the Compliance Committee, dated Mar. 24, 2005, FMSE-IR
289760-804, at FMSE-IR 289773.
518
3. Staffing Levels
As a result of both the organizational redesign build-out and the
restatement effort, the Company is in the process of substantially increasing
the size of the Controller's Office. As of December 2005, headcount was
approximately 260 (versus approximately 230 in September 2004). According to
Hisey, headcount is expected to increase by 150 employees in 2006 (of whom
approximately sixty percent will be dedicated to accounting operations), with a
long-term goal of growing to 450 employees.(1964)
4. Changes to the Closing Process
As noted above, Fannie Mae retained BearingPoint in the spring of
2005 to conduct a review of the Company's systems and procedures related to the
closing process.(1965) BearingPoint found that Fannie Mae's closing process
required excessive reliance on human intervention, lacked appropriate policies
governing journal entries, and needed to fill key vacancies.(1966) BearingPoint
recommended that the Controller's Office (1) "[i]ncrease automation and develop
Company standards for journal entry approval and support retention"; (2) "[a]dd
centralized review and develop standard policies for
adjustments/reconciliations"; (3) "[f]ill crucial vacancies and formalize
training programs"; and (4) "[r]educe use of EUCs and [database] mods, and
increase core system capabilities."(1967) The Company hopes to implement the
majority of the recommendations by the end of 2006.
According to Hisey, the Controller's Office has begun implementing
BearingPoint's recommendations. He stated that, as of December 2005, the closing
process remained a fairly manual process, but that work was underway to automate
most of it by the end of 2006. Hisey also noted ongoing efforts to standardize
the journal entry process, and to improve the overall functionality and
capability of Controller's Office computing systems.
The Company has also initiated a broader multi-year effort to
overhaul and fully integrate the various systems within the Finance group
(dubbed the "Finance Transformation Project") which currently remains in the
planning stages.
- ------------
(1964) Update Briefing with David Hisey, dated Dec. 13, 2005.
(1965) See BearingPoint, Review of Current Controls and Processes Within Fannie
Mae's Controller's Office: Presentation to the Audit Committee, dated
Apr. 18, 2005, FMSE 503077-88, at FMSE 503079.
(1966) See id. at FMSE 503084-87.
(1967) Id. at FMSE 503079.
519
CHAPTER VIII: EXECUTIVE COMPENSATION
I. INTRODUCTION
In the September 27, 2004 Agreement between Fannie Mae and OFHEO,
Fannie Mae agreed to report on the Company's "compensation regime and its
relation to strategic plans and their impact on accounting and transaction
decisions and any revisions to avoid inappropriate incentives."(1968) In
accordance with this undertaking, the SRC initiated a two-part review: (1) a
historical analysis of Fannie Mae's executive compensation structure and its
relationship to efforts to meet financial goals (such as earnings per share
("EPS") targets); and (2) a prospective assessment of the Company's compensation
structure and recommendations for revisions thereto. The SRC assigned to Paul,
Weiss the historical analysis; specifically, the SRC asked Paul, Weiss to review
Fannie Mae's compensation programs and to assess the role of EPS or other
financial indicators as a compensation trigger.(1969) The SRC engaged Semler
Brossy Consulting Group ("Semler Brossy") to evaluate the Company's current
compensation structure and to make recommendations on revisions thereto.(1970)
During the course of our review, OFHEO requested, and the SRC
agreed, that we also review the role that the Legal Department played in
compensation decisions. OFHEO's request stemmed from two anonymous letters that
accused Fannie Mae's Legal Department attorneys of excessive and inappropriate
involvement in compensation decisions and, specifically, of improperly
attempting to cloak compensation decisions with confidentiality under the guise
of the attorney-client privilege.(1971)
On the issues assigned to us by the SRC, we reach the following
conclusions:
- ----------------------
(1968) September 2004 Agreement P. IV.
(1969) Paul, Weiss was not asked to review or analyze employment contract
issues or individual compensation issues involving Franklin D. Raines or
Timothy Howard. Paul, Weiss also did not review compensation plans for
employees below the Director level and did not consider individual
compensation decisions for employees at any level. For our analysis of
the relationship at Fannie Mae between executive compensation and FAS 91
accounting methods in 1998, see supra Chapter IV.
(1970) Semler Brossy Report on Appropriate Compensation Structure and
Incentives for Fannie Mae Management, dated Feb. 23, 2005, FMSE-KD
25819-985 (hereinafter "Semler Brossy Report"). Semler Brossy presented
its report and recommendations to OFHEO on February 24, 2005.
(1971) Letter from OFHEO to Alex Young K. Oh, dated Feb. 2, 2005 (requesting
that the two anonymous letters remain confidential).
520
- Between 1998 and 2003, Fannie Mae's target compensation levels
consistently lagged behind those of the Company's "comparator
corporations." Therefore, to facilitate payment of
market-competitive compensation for executives, Fannie Mae
intentionally set its "maximum" EPS target at levels that the
Company expected to achieve. Because the expected EPS number was not
an aggressive goal, the Company regularly exceeded it. Consequently,
maximum bonus, stock, and stock option awards were triggered, but
this did not result in payment of executive compensation in excess
of levels specified by the Company's formal compensation philosophy.
Beginning in 2002, Fannie Mae attempted to set EPS targets to
coincide with target bonuses pursuant to Fannie Mae's written
compensation philosophy. However, due to unanticipated shifts in
executive compensation generally, Fannie Mae's executive
compensation continued to lag behind market levels, and Fannie Mae
executives received total compensation at market levels only if the
maximum EPS bonus targets were met.
- Beginning in 1999, the Company aligned its compensation practices
with its business objective to double EPS in five years. The
Company's use of EPS as the sole determinant for whether bonuses
would be awarded and the size of these bonus awards, as well as for
determining its performance-based stock grant plan award
("Performance Share Plan" or "PSP"(1972)), was not a best practice.
Fannie Mae should have (and has since) developed additional
financial and non-financial measures for its bonus awards and PSP to
reduce reliance on EPS in determining compensation.
- Non-financial corporate performance goals (as well as EPS) played a
part in executives' long-term compensation through the Company's
PSP. These goals were set, and performance against them was
assessed, by the Compensation Committee of Fannie Mae's Board of
Directors (the "Compensation Committee") based on a report from
management. Management consistently tendered excessively positive
self-analyses to the Compensation Committee in these areas. The
failure to present a balanced view of the Company's performance
leaves the impression that management did not provide full and
complete information to the Compensation Committee.
- ----------------------
(1972) Fannie Mae alternately refers to the PSP as the "Performance Share
Program."
521
- We found no evidence to support the allegations that the Legal
Department was inappropriately involved in executive compensation
decisions.
II. PAUL, WEISS'S INVESTIGATION
A. Document Review
Paul, Weiss has reviewed approximately 235,000 pages of documents
relating to executive compensation issues, including all executive compensation
documents in the Legal Department's files. We reviewed both paper and electronic
documents, consisting primarily of (1) correspondence among Fannie Mae
management regarding compensation issues, and (2) material prepared by Fannie
Mae management and provided to Fannie Mae's Board of Directors and Compensation
Committee. We focused our review on the period between and including 1998 and
2004.(1973) In addition, we reviewed documents prepared by Semler Brossy,
including its February 23, 2005 report to the SRC on the Company's then present
compensation structure and recommendations for reform.
B. Interviews
We conducted thirteen interviews concerning executive compensation
issues. Two of these interviews were with Fannie Mae's compensation consultants:
Alan Johnson, compensation consultant to the Company's management, and Roger
Brossy, consultant to the Compensation Committee.(1974) The remainder of the
interviews were with current or former Fannie Mae employees and directors with
responsibilities relating to executive compensation.(1975) The former head of
Fannie Mae's Human Resources
- ----------------------
(1973) Due to the events surrounding the Special Examination, the Company did
not award bonuses to Senior Vice Presidents and above for 2004. Other
incentive-based compensation plans were decreased and/or suspended
pending the release of Fannie Mae's restatement. Minutes of the Meeting
of the Board of Directors of Fannie Mae, dated Jan. 18, 2005, FMSE-IR
422500-15, at FMSE-IR 422505.
(1974) In addition to these interviews, we met with Roger Brossy and his team
from Semler Brossy both at the commencement of Semler Brossy's review
and prior to the issuance of the February 23, 2005 report. Paul, Weiss
reviewed Semler Brossy's draft report before it was transmitted to the
Board of Directors and was satisfied with the modifications to Fannie
Mae's executive compensation proposed therein. Paul, Weiss also
consulted with Brossy several times by telephone during the course of
the investigation.
(1975) We interviewed Lorrie Rudin, Emmanuel Bailey, Rebecca Senhauser, Anne M.
Mulcahy (former Chair of the Compensation Committee), Thomas E. Donilon,
Donald M. Remy, Judith Dunn, Anthony Marra, and Daniel H. Mudd. Rudin is
Fannie Mae's Director -- Executive Compensation and Benefits. Paul,
Weiss interviewed Rudin on three occasions: Two interviews were
conducted at Fannie
522
Department, Kathy G. Gallo, and former CFO, Timothy Howard, declined our
requests for an interview.
III. EXECUTIVE COMPENSATION AT FANNIE MAE
A. Executive Compensation Overview
1. Fannie Mae's Charter
Fannie Mae's compensation philosophy and practices were (and
continue to be) driven in large part by its Charter, which is set by federal
statute. In relevant part, the Charter provides that the Board of Directors:
shall have the power . . . to fix and to cause the corporation to
pay such compensation [to Fannie Mae employees] for their services,
as the board of directors determines reasonable and comparable with
compensation for employment in other similar businesses (including
other publicly held financial institutions or major financial
services companies) involving similar duties and responsibilities,
except that a significant portion of potential compensation of all
executive officers . . . shall be based on the performance of the
corporation.(1976)
The Charter thus provided the framework that Fannie Mae used in setting
executive compensation programs and levels, including the requirements (1) that
an individual officer's compensation be "comparable" to that for an equivalent
position at other diversified financial institutions, and (2) that a
"significant portion" of such compensation be tied to Fannie Mae's corporate
performance.
2. Fannie Mae's Compensation Philosophy
Fannie Mae implemented its Charter through a "compensation
philosophy" that Fannie Mae management provided to, and that was approved by,
the Compensation Committee of the Board of Directors.(1977) Although the Company
revised
Mae to coordinate document production in response to Paul, Weiss's
requests and to review the structure of Fannie Mae's executive
compensation programs; the final interview was conducted at Paul,
Weiss's offices. Paul, Weiss also spoke several times with a Fannie Mae
employee who requested anonymity.
(1976) 12 U.S.C. Section. 1723a(d)(2), Fannie Mae Charter Act Section.
309(d)(2) (2000) (emphasis added).
(1977) Compensation Philosophy, in EXECUTIVE COMPENSATION PROGRAMS, dated Sept.
2003, FMSE-IR 283130-228, at FMSE-IR 283141 (hereinafter "SEPT. 2003
EXECUTIVE COMPENSATION PROGRAMS"). The Compensation Committee approved
523
the document over the years, the basic philosophy, as summarized in the
materials management provided to the Compensation Committee, remained
substantially the same during the relevant time period (1998-2004):
FANNIE MAE'S PHILOSOPHY OF EXECUTIVE COMPENSATION
The central tenets of Fannie Mae's compensation philosophy are pay
for performance and comparability. Pay for performance is reflected
strongly in the structure of Fannie Mae's compensation programs. It
is the core principle underlying the programs. Other than base
salary, all major elements of Fannie Mae's compensation program are
tied to annual and long-term performance goals. Furthermore, through
the use of stock vesting over multi-year terms, Fannie Mae tightly
aligns the interest of executives with those of shareholders.
Comparability is reflected in both the design of the compensation
programs and in the levels of pay delivered to executives.(1978)
Fannie Mae implemented this philosophy by engaging third party
compensation consultants to gather data on compensation at corporations with
which Fannie Mae competed in the employee market (the "comparator group" or
"comparator corporations"). The compiled data included information on salary,
annual bonus, and long-term incentives. The Company then set its target cash
compensation level (salary plus annual bonus) for each executive at the median
(fiftieth percentile) of the executive's peer group, and set his/her total
compensation target (salary, annual bonus, and long-term incentives) at the peer
group's sixty-fifth percentile.(1979)
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the 2003 philosophy in its January 20, 2003 meeting. Minutes of the
Meeting of the Compensation Committee of the Board of Directors of
Fannie Mae, dated Jan. 20, 2003, FMSE 505241-271, at FMSE 505242-44.
(1978) 2003 Executive Compensation Program Overview, in AGENDA - COMPENSATION
COMMITTEE OF THE BOARD OF DIRECTORS - FANNIE MAE, dated Nov. 17, 2003,
FMSE-IR 17540-625 (hereinafter "NOV. 2003 AGENDA"), at FMSE-IR 17595. We
chose 2003 as representative of the statements provided to the Board on
an annual basis, although some changes had been made prior to that time.
(1979) Compensation Philosophy, in SEPT. 2003 EXECUTIVE COMPENSATION PROGRAMS,
at FMSE-IR 283141-42; see also Overview of Executive Compensation
Recommendations, in AGENDA - COMPENSATION COMMITTEE OF THE BOARD OF
DIRECTORS - FANNIE MAE, dated Nov. 16, 1998, FMSE-IR 14335-480, at
FMSE-IR 14339-40 (hereinafter "NOV. 1998 AGENDA") ("Stock-based
incentives are to be used to make up the balance between 50th percentile
cash compensation and the 65th percentile total compensation
objective.").
524
3. Components of Compensation
Fannie Mae's executive compensation structure (for director-level
employees and above) traditionally has had two components: cash and "variable
long-term awards" (also known at Fannie Mae as "long-term incentives," or
"LTI").(1980)
The cash component consists of (1) annual salary and (2) a year-end
bonus under a program known as the "Annual Incentive Plan" or "AIP." The size of
the Company's AIP pool was determined by a formula based exclusively on EPS. As
EPS increased from a minimum threshold to a maximum ceiling, the pool of funds
available for award increased commensurately. The fund-target was the sum of all
of the individual officers' and directors' target bonuses, which in turn were
calculated to bring each individual's cash compensation to the fiftieth
percentile of the relevant peer group and the sixty-fifth percentile of total
compensation for that group.
The LTI portion of the compensation package was entirely
equity-based. For Senior Vice Presidents and above, the LTI was divided between
stock options and what Fannie Mae referred to as "performance shares" under the
PSP.(1981) The size of each year's award under the PSP was determined in equal
measure by the Company's EPS results and by certain non-financial performance
measures.
Fannie Mae also offered other long-term compensation programs
dependent on the employee's level within the Company. For example, Fannie Mae
sponsored an Executive Pension Plan ("EPP") for Executive Vice Presidents and
above; a Supplemental Pension Plan for Company officers who did not participate
in the EPP; a general deferred compensation plan for directors and above; an
Employee Stock Ownership Plan ("ESOP") for all employees except those who
participated in the EPP; and an Employee Stock Purchase Plan ("ESPP") for those
individuals at the Vice President level or below.(1982)
- ----------------------
(1980) Minutes of the Meeting of the Compensation Committee of the Board of
Directors of Fannie Mae, dated Jan. 20, 2003, FMSE 505241-71, at FMSE
505243-44.
(1981) Fannie Mae Performance Share Program - Summary, in NOV. 2003 AGENDA, at
FMSE-IR 17603-04 ("Performance shares are long-term incentive awards
with a target payout value equal to a number of Fannie Mae common
shares. The number of shares `earned' depends upon Fannie Mae achieving
certain measures of long-term performance."). For these executives, the
total value of the LTI was divided in half between stock options and
performance shares. Performance Shares, in SEPT. 2003 EXECUTIVE
COMPENSATION PROGRAMS at FMSE-IR 283205-07. Vice Presidents and
Directors did not participate in the PSP. Id.
(1982) Employee Stock Purchase Plan, in SEPT. 2003 EXECUTIVE COMPENSATION
PROGRAMS, at FMSE-IR 283225-26.
525
The EPP, ESOP, and ESPP generally constituted a very small portion
of executive compensation, and we accordingly did not focus our review on these
programs.(1983) Instead, we concentrated on the funding for the AIP and PSP
awards, each of which was determined by Fannie Mae's EPS results. We also
considered certain non-financial performance measures used to analyze the
non-EPS-based criteria for half of the PSP award.(1984)
B. The Annual Incentive Plan
1. Calculation of the AIP Pool and Individual Awards
According to Company policy, "[t]he purpose of the [AIP was] to
encourage greater focus on performance among the [management] of Fannie Mae by
relating a significant portion of [executives'] total compensation to the
achievement of annual financial, strategic or operational objectives."(1985) The
"annual objective" to which the size of the AIP award was correlated changed
several times after the plan was implemented in 1985.(1986) Initially, AIP was
tied to the Company's return on equity
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(1983) For example, Rudin recalled the amount of the ESOP contribution rarely
exceeded two percent of the aggregate compensation of all eligible
employees. See also Minutes of the Meeting of the Board of Directors of
Fannie Mae, dated Jan. 20, 1998, FMSE-IR 660-75, at FMSE-IR 662
(resolving to set the ESOP pay out at two percent if financial
performance is within the minimum and maximum targets set for the year's
Annual Incentive Plan); Minutes of the Meeting of the Board of Directors
of Fannie Mae, dated Jan. 19, 1999, FMSE 503872-89, at FMSE 503877
(same); Minutes of the Meeting of the Board of Directors of Fannie Mae,
dated Jan. 18, 2000, FMSE 503953-67, at FMSE 503954-55 (same); Minutes
of the Meeting of the Board of Directors of Fannie Mae, dated Jan. 16,
2001, FMSE 504031-44, at FMSE 504036 (same); Minutes of the Meeting of
the Board of Directors of Fannie Mae, dated Jan. 15, 2002, FMSE
504117-32, at FMSE 504121 (same); Minutes of the Meeting of the Board of
Directors of Fannie Mae, dated Jan. 21, 2003, FMSE 504202-40, at FMSE
504210 (same); Minutes of the Meeting of the Board of Directors of
Fannie Mae, dated Jan. 23, 2004, FMSE 504353-90, at FMSE 504385 (same).
The Compensation Committee could recommend to the Board different
contributions if the minimum EPS was not achieved or the maximum EPS was
exceeded. See, e.g., Minutes of the Meeting of the Board of Directors of
Fannie Mae, dated Jan. 20, 1998, FMSE-IR 660-75, at FMSE-IR 662.
(1984) We did not identify any concerns regarding the award of stock options,
and no one raised any such concerns to us during our investigation.
Accordingly, this Chapter does not address them.
(1985) Fannie Mae Annual Incentive Plan, as amended through Jan. 16, 2001,
FMSE-IR 598523-49, at FMSE-IR 598523.
(1986) Annual Incentive Plan, in AGENDA - COMPENSATION COMMITTEE OF THE BOARD
OF DIRECTORS - FANNIE MAE, dated Jan. 2000, FMSE-IR 16333-392, at
FMSE-IR
526
(rather than to EPS).(1987) Then, beginning in 1991, it was tied to net
income.(1988) In 1995, the Company moved to an EPS measure "both to bring this
measure into conformity with [Fannie Mae's] PSP target (which also is EPS-based)
and to provide [the Company] with the flexibility to repurchase shares without
penalizing AIP participants."(1989)
Since that time, the Company-wide bonus pool from which individual
AIP bonus awards were drawn was determined by a formula dependent upon EPS.
Fannie Mae's AIP-EPS measure consisted of minimum, target, and maximum EPS
figures, which, until 2002, correlated to an AIP pool of 50 percent of the
target amount, 100 percent of the target amount, and 150 percent of the target
amount, respectively, and, after 2002, to 75 percent, 100 percent, and 125
percent.(1990) The "target" AIP pool was to be the sum of eligible executives'
target bonuses (as determined by the fiftieth percentile of their respective
peer groups) and was set to correspond to a specific EPS figure. For example, in
1998, Fannie Mae planned to distribute a bonus pool of $17.3 million if the
Company hit its EPS target of $3.18.(1991) If EPS hit $3.23 (the maximum), then
the bonus pool would increase to $25.9 million. If EPS dropped to the threshold
level of $3.13, the bonus pool was expected to be $8.6 million.(1992)
Once the size of Fannie Mae's bonus pool was determined, the pool
was allocated among the Company's departments; each department head then was
responsible for dividing the department's portion of the pool among its eligible
officers. Until 2001, executives determined their subordinates' bonus payouts
based on a combination of each
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16340 (hereinafter "JAN. 2000 AGENDA") (noting that the AIP was
instituted in 1985).
(1987) Id.
(1988) Id.
(1989) Id. Beginning in 2001, the AIP (like all of the Company's internal
goals) switched from being tied to GAAP EPS to the Company's "core" EPS.
For discussion of this change, see supra Chapter V.
(1990) 2004 Executive Compensation Program Overview, FMSE-IR 18087-99, at FMSE-
IR 18091; Annual Incentive Plan, in AGENDA - COMPENSATION COMMITTEE OF
THE BOARD OF DIRECTORS - FANNIE MAE, dated Jan. 20, 1998, FMSE-IR
14826-74, at FMSE-IR 14836 (hereinafter "JAN. 1998 AGENDA").
(1991) JAN. 1998 AGENDA at FMSE-IR 14836. The estimated $17.3 million was the
sum of all eligible officers' and directors' target bonuses. The sum was
based on the current number of participants and could change based on
changes in the number of participants, their employment levels, or their
salaries.
(1992) JAN. 1998 AGENDA at FMSE-IR 14836.
527
subordinate's personal performance and the Company's performance overall.(1993)
For example, for the 1997 AIP payout, one Vice President in Financial Reporting
received a bonus of 45.11% of base salary in recognition of individual
performance;(1994) the Company awarded all Vice Presidents an additional bonus
of 9.62% of base salary as a result of the Company's EPS results.(1995)
Beginning with the 2001 AIP award, the Compensation Committee
eliminated individual goals, made the entire AIP pool dependent upon achievement
of the EPS targets, and delegated to management the allotment of that
pool.(1996) This change was based on management's desire for increased
flexibility in awarding bonuses.(1997) Management reasoned that, "[u]nder the
current structure, the corporate component of the AIP becomes a floor that all
officers get, despite their personal performance By eliminating the
corporate/personal AIP split and making the entire bonus pool available for
management's discretion, management could better recognize distinctions in both
performance and job scope."(1998) As management recognized, however, "AIP pool
funding" would continue to be "a function of corporate financial
performance."(1999)
2. Maximizing AIP Funding Pools
For each year between 1995 and 1999, the Compensation Committee
concluded that the Company had exceeded its target EPS goals for determining the
AIP pool:
- ----------------------
(1993) See, e.g., Annual Incentive Plan, in JAN. 1998 AGENDA, at FMSE-IR 14839.
(1994) Id.
(1995) Id.
(1996) Minutes of the Meeting of the Compensation Committee of the Board of
Directors of Fannie Mae, dated Nov. 10, 2000, FMSE 505167-85, at FMSE
505176. The Committee retained authority to determine the AIP payouts
for the members of the Office of the Chairman. Cf. Annual Incentive
Plan, in FANNIE MAE EXECUTIVE COMPENSATION PROGRAMS, dated Feb. 2004,
FMSE-EC 1-100, at FMSE-EC 3, 47- 49 (hereinafter "FEB. 2004 EXECUTIVE
COMPENSATION PROGRAMS").
(1997) Proposal for 2001 Annual Incentive Plan, in AGENDA - COMPENSATION
COMMITTEE OF THE BOARD OF DIRECTORS - FANNIE MAE, dated Nov. 20, 2000,
FMSE-IR 15877-16060, at FMSE-IR 15954 (hereinafter "NOV. 2000 AGENDA").
(1998) Id.
(1999) Id.
528
Minimum Maximum
(Threshold) Target (Ceiling) Actual EPS Achievement Against
Year EPS EPS EPS Goals
1995 $ 2.0975 $ 2.1475 $ 2.195 $ 2.1515 8% of range between target
and maximum (above target)(2000)
1996 $ 2.380 $ 2.430 $ 2.480 $ 2.4764 93% of range between target
and maximum (above target)(2001)
1997 $ 2.740 $ 2.790 $ 2.840 $ 2.8325 85% of range between target
and maximum (above target)(2002)
1998 $ 3.130 $ 3.180 $ 3.230 $ 3.2309 Above maximum(2003)
1999 $ 3.590 $ 3.640 $ 3.690 $ 3.7199 Above maximum(2004)
The AIP funding pool was funded at greater than the target for each of these
years.
In 2000, Fannie Mae changed its corporate performance measure from
an EPS dollar figure to a percentage representing the "increase in EPS" over the
prior year.(2005) As noted below, Fannie Mae continued to exceed its maximum AIP
goals following this change, resulting in maximum, or near-maximum, AIP bonus
pools.
- ------------------
(2000) Annual Incentive Plan, in AGENDA - COMPENSATION COMMITTEE OF THE BOARD
OF DIRECTORS - FANNIE MAE, dated Oct. 19, 2004, FMSE-IR 18046-102, at
FMSE-IR 18090 (hereinafter "OCT. 2004 AGENDA").
(2001) Id.
(2002) Id.
(2003) Id.
(2004) Id.
(2005) This change was made to be consistent with Raines's business goal of
double-digit earnings growth and doubling EPS over five years. See
Annual Incentive Plan, in JAN. 2000 AGENDA, at FMSE-IR 16341;
Performance Share Program, in JAN. 2000 AGENDA, at FMSE-IR 16366.
529
Achievement
Minimum Target Maximum Actua_EPS Against
Year EPS_Growth EPS_Growth EPS_Growth Growth Goals
2000 12.3% 13.6% 14.9% 15.3% Above maximum(2006)
2001 12.3% 13.6% 14.9% 21.2% Above maximum(2007)
2002 15.0% 18.0% 21.0% 21.3% Above maximum(2008)
2003 10.0% 12-13% 16.0% 15.5% 86% of range between target and
maximum (above target)(2009)
2004 8.0% 10.0% 12.0% - - (2010)
Fannie Mae's record of consistently hitting the maximum bonus level
was noted by Alan Johnson when Fannie Mae's management first engaged him to
consult on compensation issues.(2011) Johnson believed that the Company's prior
compensation consultant erroneously had conflated various distinct executive
positions when assessing market compensation. To provide the Company with what
he believed was more accurate market data, Johnson redesigned Fannie Mae's
compensation system into forty-one "levels" and provided market compensation
data for each level.(2012) Each employee
- ----------------
(2006) Annual Incentive Plan, in NOV. 2003 AGENDA at FMSE-IR 17596.
(2007) Id.
(2008) Id.
(2009) Annual Incentive Plan, in AGENDA - COMPENSATION COMMITTEE OF THE BOARD
OF DIRECTORS - FANNIE MAE, dated Jan. 22, 2004, FMSE-IR 18215-343, at
FMSE-IR 18231-34 (hereinafter "JAN. 22, 2004 AGENDA").
(2010) These results have not been determined because the Company has not
issued financial statements for the 2004 fiscal year.
(2011) This issue apparently predated Alan Johnson's engagement. In 1997, the
Company found that compensation for members of the Office of the
Chairman and Executive Vice Presidents had lagged behind comparator
group levels. 1997 Annual Incentive Plan, in AGENDA - COMPENSATION
COMMITTEE OF THE BOARD OF DIRECTORS - FANNIE MAE, dated Nov. 17, 1997,
FMSE-IR 14905-15063, at FMSE-IR 15034 (hereinafter "NOV. 1997 AGENDA").
The Company proposed to address this by expanding bonus ranges for these
officers. Id. In 1998, the issue arose again. See Overview of Executive
Compensation Recommendations, in NOV. 1998 AGENDA at FMSE-IR 14339. That
same year, the Company's then compensation consultant found that target
total compensation for SVPs was too low. To close the gap, the Company
recommended awarding additional stock grants to the SVPs, rather than
recommending long-term or structural revisions. Id.; see also Johnson
Associates, Inc., Officer Compensation Review Initial Discussion
Outline, dated July 30, 2002, FMSE-EC 7875-912, at FMSE-EC 7901
(demonstrating base salary below market median).
(2012) Under Johnson's system, level forty-one corresponded to the CEO,
Executive Vice Presidents were assigned to levels in the mid-to-high
thirties, Senior Vice Presidents
530
was assigned a level and paid in accordance with that level. Fannie Mae also
assigned each officer level a bonus target, which was calculated as a percentage
of that level's target salary. As discussed below, however, this leveling
process did not succeed in aligning Fannie Mae's compensation targets with the
market.
It appears that management was aware that target compensation lagged
behind the market and used achievable EPS targets as a way of responding to
this. In a separate report issued by Johnson as part of his initial analysis,
Johnson cited several management interviewees who noted that the Company's
executive compensation reached competitive levels only when the Company attained
its maximum EPS targets, and thus its maximum bonus payouts.(2013)
An e-mail chain among individuals in Fannie Mae management from
early January 2002 confirms that management was aware that AIP-EPS targets were
set at achievable levels so as to increase the likelihood of maximizing the AIP
payout.(2014) According to the e-mail, Franklin D. Raines wanted AIP-EPS bonus
targets to be set such that an individual would receive cash compensation
(salary and bonus) at the fiftieth percentile of his/her peers in the comparator
group if the Company reached its expected EPS figure.(2015) However, the
Compensation Committee materials already prepared for the January 2002 Committee
meeting had set the expected EPS figure for 2002 as theUnder Johnson's system,
level forty-one corresponded to the CEO, Executive Vice Presidents were assigned
to levels in the mid-to-high thirties, Senior Vice Presidents to levels
twenty-three and higher, Vice Presidents to levels seventeen and higher, etc.
maximum AIP-EPS achievement, rather than the target.(2016) Thus, if maximum EPS
were achieved or exceeded, then the bonus only would pay employees at the
fiftieth percentile
- ----------
to levels twenty -three and higher , Vice Presidents to levels seventeen
and higher, etc.
(2013) See Update on Executive Compensation Study, dated July 1, 2002, FMSE-EC
14739-42, at FMSE-EC 14741 ("Incentive plans have `always' hit max.
Acknowledgement by some that easier goals are designed to generate
needed compensation."); Johnson Associates, Inc., Compensation Committee
Update, dated Nov. 19, 2002, FMSE-EC 3076-100, at FMSE-EC 3080 ("Maximum
bonus pay-out needs to reach competitive compensation levels."); Johnson
Associates, Inc., Compensation Committee Update, dated Nov. 19, 2002,
FMSE-EC 3022-51, at FMSE-EC 3031 ("Actual bonuses competitive; target
bonus low vs. market."); see also Johnson Associates, Inc., draft
Detailed Compensation Review Information, dated Aug. 9, 2002, FMSE-EC
7952-80, at FMSE-EC 7964 ("No more `lay-up' goals to get to 150%
payout.").
(2014) E-mail from Beverly Fitzgerald to L. Rudin, dated Jan. 11, 2002, FMSE-IR
633763-64.
(2015) Id. at FMSE-IR 633763.
(2016) See Annual Incentive Plan - 2002 Plan Year, in AGENDA - COMPENSATION
COMMITTEE OF THE BOARD OF DIRECTORS - FANNIE MAE, dated Jan. 15, 2002,
FMSE-IR 17493-534, at FMSE-IR 17502 (hereinafter "JAN. 2002 AGENDA").
531
of cash compensation. If less than the maximum EPS were achieved, then
executives' cash compensation would be below the fiftieth percentile, contrary
to Fannie Mae's compensation philosophy (and Raines's instruction). Given the
Committee's schedule, however, the 2002 materials were not changed to align the
target EPS with the Company's expected results.(2017)
According to Johnson, and as reflected in the e-mail chain discussed
above, the Company attempted to change this pattern of aligning competitive
compensation with maximum EPS targets by adjusting the target EPS to coincide
with the fiftieth percentile of cash compensation for each level among
comparator corporations. Each year, however, the success of the mortgage and
financial services markets led to increases in comparators' compensation
(salaries, bonuses, and long-term incentives). Fannie Mae did not forecast for
the increases in its January projections. Thus, although the Company tried to
respond to this pattern by increasing compensation, it nonetheless continued to
need to award maximum AIP payouts through achievable EPS goals to keep its cash
compensation in the competitive fiftieth-percentile range.
In January 2004, management recommended that the Compensation
Committee increase compensation and change the compensation structure to keep
pace with the market.(2018) The Compensation Committee declined to change the
structure at that time, choosing instead to raise all compensation by four
percent.(2019)
We conclude that Fannie Mae knowingly set maximum EPS goals at
levels management believed it would achieve, but that this situation originated
and persisted because Fannie Mae used flawed data to set compensation for its
officers. Specifically, as discussed above, the market data failed to reflect
the full effect of increases in comparator group compensation between the
setting of compensation targets in January of each year and the determination of
the size of the bonus pool at the end of each year. As a consequence, Fannie
Mae's target cash pay (as a combination of salary and bonus) consistently was
below the fiftieth percentile of cash compensation and the
- ----------
(2017) E-mail from B. Fitzgerald to L. Rudin, dated Jan. 11, 2002, FMSE-IR
633763-64, at FMSE-IR 633763.
(2018) Minutes of the Compensation Committee of the Board of Directors of
Fannie Mae, dated Jan. 22, 2004, FMSE-IR 276449-72, at FMSE-IR 276450
("The Committee decided not to make changes to the award structure going
forward at this time but to review it and the market at mid-year.").
(2019) Id. at FMSE-IR 276450-51; cf. 2004 Accomplishments - Lorrie Rudin,
FMSE-E_EC 145400-02, at FMSE-E_EC 145400 (referring to executive
compensation increase of three percent). According to Johnson, Fannie
Mae eventually will experience officer retention problems if it does not
keep pace with its peers in the realm of compensation.
532
sixty-fifth percentile of total compensation within the comparator group.(2020)
Each year, when the Company recognized flaws in that year's market data, it
attempted to adjust for these inaccuracies by setting the following year's
maximum EPS goals at achievable levels.(2021) When Fannie Mae's EPS for the year
reached the maximum point, executives were paid larger bonuses, such that their
overall compensation was in line with comparators' compensation as specified in
the Company's compensation philosophy.
3. The Role of the EPS Incentive
Under Raines's leadership, the Company developed EPS-driven business
goals. Given the link between EPS and the AIP bonus pool, achievement of these
business goals was inextricably linked to achieving maximum bonus pools.
Moreover, as discussed above, only by reaching the maximum bonus pool could the
Company reach the competitive executive compensation levels consistent with its
philosophy. However, our review reveals that Fannie Mae determined its business
goals in advance of the compensation goals, and the latter then were set to
correlate with the former.
In May 1999, Fannie Mae announced its goal to double EPS in five
years, from $3.23 in 1998 to $6.46 by the end of 2003.(2022) Beginning with the
2000 award year, the Company sought to align the AIP targets with this long-term
objective.(2023) The same year, the Company changed the EPS measure from a
strict numerical measure to a measure of percentage increase over the previous
year,(2024) and set its maximum EPS target at the exact growth level (14.9%)
that, if sustained, would result in doubling EPS in five years.(2025) The
Company also established an EPS Challenge Option Grant, which
- ----------
(2020) See Minutes of the Compensation Committee of the Board of Directors of
Fannie Mae, dated Jan. 22, 2004, FMSE-IR 276449-72, at FMSE-IR 276456.
(2021) Id.
(2022) See Special Stock Option Grant Tied to Earnings Per Share Goals, FMSE-IR
15458-63, at FMSE-IR 15459; see also Remarks by Timothy Howard,
Nationsbanc Montgomery Securities Growth Stock Conference, May 12, 1999,
FMSE-IR 34614-23, at FMSE-IR 34623; Remarks Delivered by Frank Raines,
Merrill Lynch Investor Conference, Sept. 14, 1999, FMSE-IR 34584-602, at
FMSE-IR 34584.
(2023) Annual Incentive Plan, in JAN. 2000 AGENDA at FMSE-IR 16341.
(2024) Minutes of the Meeting of the Compensation Committee of the Board of
Directors of Fannie Mae, Jan. 18, 2000, FMSE 505139-48, at FMSE 505140
("Mr. Raines noted that the goal is in line with the Company's overall
performance goals.").Rudin recalled that Howard played a role in the
process of seeking approval from the Compensation Committee for the
change from a strict numerical measure to a measure of annual percentage
growth.
533
vested stock options in all employees upon the Company's reaching the $6.46 EPS
level in or before 2003.(2026)
This structure did not necessarily create an incentive to maximize
the AIP bonus pool each year. First, the size of the bonus pool was on a sliding
scale; thus, the actual compensation at stake in hitting maximum EPS goals,
versus slightly missing them, could be small.(2027) For each percentage point
increase or decrease between the minimum and the maximum, the pool was adjusted
accordingly. Thus, if EPS results were halfway between the EPS target and the
maximum, the bonus pool would be funded halfway between the payout target and
the maximum (i.e., 112.5 percent). Second, as noted above, any individual's
bonus was subject in whole (or, prior to 2001, in part) to management
discretion.(2028) The existence of a larger bonus pool did not guarantee any
individual officer a larger bonus. Finally, as noted by Johnson, Fannie Mae's
range of potential bonus payouts (i.e., seventy-five percent to 125 percent of
target bonuses) was narrow, and Semler Brossy found that range was narrower than
the equivalent ranges at Fannie Mae's peer financial institutions.(2029) Johnson
had expressed concerns to the Company that its bonus range was too narrow to
provide effective financial incentives for executives to exceed their goals.
This same concern regarding overly narrow bonus ranges is echoed throughout many
reports and internal documents in which Fannie Mae
- ----------
(2025) Annual Incentive Plan, in JAN. 2000 AGENDA at FMSE-IR 16340-41; E-mail
from T. Howard to L. Rudin and Thomas R. Nides, dated Jan. 7, 2000, FMSE
560402 (noting 14.9% EPS growth target resulting from "Frank's setting
of public goals"); Undated, untitled document labeled "Source: LS FNM
Computer," FMSE-IR 379280-83, at FMSE-IR 379281 ("In the AIP program,
the rewards tie to the earnings goals set by the company to be on the
path to doubling earnings per share by the end of 2003 or 14.9% as
max."). The PSP goal also was changed to be "fully consistent with our
pledge to maintain double digit earnings growth." Recommendation - PSP16
(2000-2002 Cycle) Performance Criteria, in JAN. 2000 AGENDA at FMSE-IR
16366.
(2026) See EPS Challenge Option Grant, in FEB. 2004 EXECUTIVE COMPENSATION
PROGRAMS FMSE-EC at 81. The reward for the EPS Challenge Grant was stock
options, but, because Fannie Mae's stock price has fallen, these options
are currently underwater.
(2027) Proposal for 2001 Annual Incentive Plan, in NOV. 2000 AGENDA at FMSE-IR
15955.
(2028) The Compensation Committee, rather than management, determined bonus
payouts for members of the Office of the Chairman. See FEB. 2004
EXECUTIVE COMPENSATION PROGRAMS at FMSE-EC 3, 47-49.
(2029) See Semler Brossy Report at FMSE-KD 25905 ("[T]he payout range
associated with these performance levels is narrower than prevailing
practice.").
534
executives note the lack of correlation between personal performance and
compensation at the Company.(2030)
In sum, during the period from 1998 through 2003, the Company's
bonus structure placed significant importance on achieving, or coming close to,
the EPS that would result in the maximum AIP pool. Fannie Mae management well
understood this situation, which was driven by the need to keep executive
compensation competitive.
4. Reducing the Influence of EPS on Compensation
Toward the end of the period under review, the Company became aware
that using EPS as a compensation trigger was being questioned in the
marketplace. In or about mid-2003, management, as a result of increasing public
commentary on the issue, as well as the implementation of new corporate
governance guidelines under the Sarbanes-Oxley Act, asked Johnson to review the
Company's use of EPS as the sole performance measure for the AIP. Johnson
conducted a market study on this question and issued a report to the Company in
October 2003.(2031)
Johnson concluded that many financial companies used EPS as a
component of their financial performance measures, but few used EPS as their
sole performance measure for determining compensation elements.(2032) Johnson
also studied alternative performance measures and concluded that, although EPS
is an imperfect measure of financial performance, all other financial
performance measures also were imprecise.(2033) In addition, he emphasized that,
regardless of the performance measure used, the Compensation Committee had
complete discretion to adjust awards above or
- ----------
(2030) E.g., Johnson Associates, Inc., Detailed Compensation Review
Information, draft dated Aug. 9, 2002, FMSE-EC 7952-80, at FMSE-EC 7960
("Our highest priority should be to motivate contributors and help poor
contributors exit - Need process to get there."), FMSE-EC 7962 ("Broader
range doesn't exist within levels to reward super performance and
penalize low-end: . . . super performer not paid much more than
average."), FMSE-EC 7963 ("[L]ittle meaningful distinctions on
performance. Few have compensation reduced or receive large
increases."); Compensation Committee Discussion, dated Oct. 15, 2002,
FMSE-IR 17377-400, at FMSE-IR 17389 ("Target bonus percentages
[a]rtificially low vs. market . . . Odd dynamic where `overachieve'
needed to be competitive"); Semler Brossy Report at FMSE-KD 25905
("[T]he payout range associated with these performance levels is
narrower than prevailing practice.").
(2031) Johnson Associates, Inc., Fannie Mae Performance Metrics study, dated
Oct. 9, 2003, FMSE-IR 293968-77.
(2032) See id. at FMSE-IR 293973-74.
(2033) Id. at FMSE-IR 293977 ("Study of comparator performance measures did not
clearly demonstrate other metrics better than those currently
available.").
535
below the amount indicated by the Company's numerical results. In theory, this
discretion reduced incentives for manipulation because management simply could
ask the Compensation Committee for a greater award, or the Compensation
Committee could authorize a larger bonus pool on its own.
In January 2004, following OFHEO's release of its report on Freddie
Mac's accounting and compensation, the Compensation Committee (specifically,
then Compensation Committee Chair Anne M. Mulcahy) asked whether Fannie Mae
should consider moving away from EPS as the sole determinant of the size of the
AIP pool.(2034) The Company provided Mulcahy with a copy of Johnson's earlier
EPS study.(2035) Despite Johnson's conclusion that using EPS was appropriate,
Mulcahy, after consulting with Brossy, tasked Company management with developing
new performance measures(2036) that potentially would include not only an
earnings measure (EPS) but also a risk management measure and a mission
measure.(2037) The Company did not seek to eliminate the use of EPS all
together. As Brossy has noted, "as a for-profit company by definition, Fannie
Mae has an obligation to drive shareholder value, and the Company and its Board
cannot ignore the importance of earnings performance over time."(2038)
In July 2004, after several months of work and consultations with
other compensation experts, management and Johnson presented recommendations to
the Compensation Committee for changing the AIP measures for the 2005 AIP year
to a combination of EPS (weighted fifty percent), a risk management measure
(twenty-five percent), and a mission measure (twenty-five percent).(2039) The
Committee approved this
- ----------
(2034) See Minutes of the Meeting of the Compensation Committee of the Board of
Directors of Fannie Mae, dated Jan. 22, 2004, FMSE-IR 276449-72, at
FMSE-IR 276458.
(2035) See id.; Mem. from Kathy G. Gallo to A. Mulcahy, dated Jan. 13, 2004,
FMSE-EC 28982.
(2036) See Minutes of the Meeting of the Compensation Committee of the Board of
Directors of Fannie Mae, dated Jan. 22, 2004, FMSE-IR 276449-72, at
FMSE-IR 276458.
(2037) Performance Measures for the AIP, FMSE-EC 29090-98, at FMSE-EC 29090.
(2038) Semler Brossy Report at FMSE-KD 25885.
(2039) Compensation Committee Update: Review of Current Practices, dated July
2004, FMSE-IR 18154-77, at FMSE-IR 18168. Determination of whether the
risk management and mission goals had been met would be undertaken by
the Compensation Committee with the assistance of two other Board of
Directors' committees: the Assets and Liabilities Policy Committee and
the Housing & Community Development Committee, respectively. Id.
536
change; however, because the Company has been unable to issue financial
statements, this change has not been implemented.( 2040)
The Company's decision to change from a sole-EPS measure to a
weighted combination of measures does not reflect a conclusion by Fannie Mae or
its regularly engaged consultants that EPS is an inappropriate measure for
determining compensation. To the contrary, Brossy and Johnson also agree that
the use of EPS as a compensation performance measure is neither inherently
problematic nor more problematic than other numerical indicators (even if, as
discussed previously, EPS should not be the sole measure).(2041) Brossy and
Johnson also agree, based on their experience and references to other
institutions, that it is logical and sensible for financial services companies
to employ numerical financial targets to trigger compensation elements.(2042)
That Fannie Mae used and continues to use EPS as part of a measure to determine
whether business financial goals are met for purposes of triggering compensation
is not improper. Implementation of Semler Brossy's recommendations to include an
EPS target as one of several factors considered in bonus situations will be an
improvement over the Company's past practice.
C. Performance Share Plan
The other executive compensation program that depended on EPS as a
compensation trigger was the PSP. Fannie Mae granted performance shares only to
officers at the SVP level and above.(2043) The reason for this limitation was
Fannie Mae's belief that "SVPs and above are considered to have the greatest
direct impact on the long-term objectives of the program."(2044)
The PSP ran on a staggered three-year cycle; that is, whether goals
were met and the award paid depended on a review of the Company's performance
over the
- ----------
(2040) Annual Incentive Plan, FMSE-IR 18090-91, at FMSE-IR 18091. Semler
Brossy's recent recommendations for changing the AIP employ similar
measures. Semler Brossy Report at 111, FMSE-KD 25930.
(2041) Semler Brossy Report at 66, FMSE-KD 25885; see also Johnson Associates,
Inc., Fannie Mae Performance Metrics study, dated Oct. 9, 2003, FMSE-IR
293968-77 (analyzing various financial performance measures).
(2042) See Semler Brossy Report at 66, FMSE-KD 25885; Johnson Associates, Inc.,
Fannie Mae Performance Metrics study, dated Oct. 9, 2003, FMSE-IR
293968-77.
(2043) The PSP did not formally limit grants to this set of officers, but it
was Fannie Mae's practice not to award performance shares to officers
below the SVP level. Performance Shares, in SEPT. 2003 EXECUTIVE
COMPENSATION PROGRAMS at FMSE-IR 283205.
(2044) Id.
537
previous three years. For example, the first three-year PSP cycle ran from
1988-1990; the second PSP cycle ran from 1989-1991; the third PSP cycle ran from
1990-1992; and so forth.(2045)
At the beginning of each PSP cycle, the Board of Directors would
establish the term of the cycle and set the goals for senior management to
achieve.(2046) At the end of each cycle, the Compensation Committee determined
whether the goals set by the Board had been achieved. Unlike the AIP, the PSP
was paid in stock: fifty percent of the earned shares were granted in the year
of the award, and fifty percent were granted the following year.(2047) This
staggered award was intended to support the purpose of the PSP, which was to
"motivate[] executives to focus on the areas we consider critical to our
long-term success from both a quantitative and a qualitative perspective."(2048)
Since the PSP's inception, the PSP criteria have been (1)
achievement of a quantitative measure and (2) achievement of a qualitative
measure. Each component was weighted fifty percent in the calculation of shares
awarded.
1. Quantitative (EPS) Component
For the relevant time period, the quantitative aspect of the PSP was
an EPS measure. Prior to 2002, this measure was the average annual percentage
increase in EPS over the three years of the plan. Beginning with the 2002-2004
PSP cycle, the goal was changed to annualized compound EPS growth over the
three-year period.(2049)
As with AIP, the Compensation Committee recommended and the Board
set three EPS goals for the PSP: a minimum (or "threshold") level that paid
forty percent of the target pool of shares; a target level, which paid 100
percent of the pool; and a
- ----------
(2045) Performance Share Program, in JAN. 2000 AGENDA at FMSE-IR 16362. Fannie
Mae initiated the PSP in 1982; between 1982 and 1987, each PSP cycle was
four years in duration. Id.
(2046) Performance Shares, in SEPT. 2003 EXECUTIVE COMPENSATION PROGRAMS at
FMSE-IR 283207; Semler Brossy Report at FMSE-KD 25857.
(2047) Performance Shares, in SEPT. 2003 EXECUTIVE COMPENSATION PROGRAMS at
FMSE-IR 283206. For PSP 15 (1999-2001) and earlier, fifty percent of the
total award was paid at the end of the three-year cycle, and the balance
paid in equal installments at the beginning of the following two years
(i.e., twenty-five percent and twenty-five percent). Id.
(2048) Fannie Mae Performance Share Program - Summary, in NOV. 2003 AGENDA at
FMSE-IR 17603.
(2049) January 15, 2002 Compensation Committee Meeting, FMSE-IR 17487-89, at
FMSE-IR 17488. No one we interviewed recalled why this was changed.
538
maximum (or "high") level, which paid 150 percent of the pool. As an example,
for the 2000-2002 PSP cycle (PSP 16), the quantitative goals were expressed as
the average annual growth in EPS:(2050)
Achievement Level EPS% Change PSP Vesting
- ----------------- ----------- -----------
High (Maximum) 14.9% 150%
Target 13.6% 100%
Low (Threshold) 10.0% 40%
Also as with AIP, Fannie Mae correlated its maximum PSP targets to
the Company's goal of doubling EPS within five years.(2051) The effect of
reaching a particular EPS target on the PSP award, however, was tempered by two
facts. First, because PSP payouts were determined by three years of financial
results, a single year's EPS results would have a relatively smaller impact on
the eventual PSP payout than it would have on the AIP pool. Second, the fifty
percent weighting of qualitative performance measures in the PSP calculation
further diminished the PSP impact of reaching annual EPS targets. Accordingly,
EPS results played a significant role in PSP awards as the sole financial
measure therein, but the impact of EPS on the PSP was significantly less
prominent than its impact on the AIP.
2. Qualitative (Subjective) Component
The qualitative or subjective component of the PSP depended on
Fannie Mae achieving certain business performance goals.(2052) At the beginning
of each PSP three-year cycle, the Board of Directors reviewed the "Corporate
Goals and Objectives" prepared by management.(2053) In the Corporate Goals and
Objectives, Company management set forth broad corporate goals and tailored
business objectives for the forthcoming year. For example, the 2004 Corporate
Goals and Objectives set forth six missions:
- ----------
(2050) Performance Share Program, in AGENDA - COMPENSATION COMMITTEE OF THE
BOARD OF DIRECTORS - FANNIE MAE, dated Jan. 16, 2001, FMSE-IR 16699-748,
at FMSE-IR 16743 (hereinafter "JAN. 2001 AGENDA").
(2051) See supra note 2025 and accompanying text (discussing Company's target
of annual 14.9% increase in EPS).
(2052) Johnson considers the corporate performance measure for the PSP to have
been a leading practice at the time it was implemented and to be a best
practice today.
(2053) See, e.g., 2004 Corporate Goals and Objectives, FMSE-E 2161591-620.
539
LONG-TERM CORPORATE GOALS
Goal 1: Acknowledged Leadership in Increasing Access to
Affordable Housing
Goal 2: Leading Presence in the Secondary Market and Partner of Choice
Goal 3: Optimal Risk Management
Goal 4: Record Financial Performance
Goal 5: Corporate Culture to Enhance Strategy Execution
Goal 6: E-Commerce Company Infrastructure to Increase
Capabilities and Lower Costs(2054)
Within each goal was a list of objectives. For example, "Goal 1: Acknowledged
Leadership in . . . Affordable Housing," had eight separate objectives: (1)
American Dream Commitment; (2) HUD goals; (3) minority lending; (4) first time
home buyers; (5) community development; (6) affordable rental housing; (7)
addressing homelessness; and (8) outreach.(2055) These Corporate Goals and
Objectives usually then were translated by the Board of Directors into Corporate
Performance PSP measures.(2056) These measures were detailed but subject to the
Compensation Committee's qualitative review.(2057)
Twice a year (mid-year and after year-end), management would provide
the Board with "Corporate Performance Assessments" (often referred to as "CPAs"
or "Report Cards"). For the seven PSP cycles ending between 1998 and 2004,
Fannie Mae produced only three three-year assessments.(2058) In other years,
only a single year's
- ----------
(2054) See id. at FMSE-E 2161592.
(2055) Id. at FMSE-E 2161593-97.
(2056) See, e.g., Fannie Mae Performance Share Program - Summary, in OCT. 2004
AGENDA at FMSE-IR 18098.
(2057) In each of the PSP cycles during the period under review, the Committee
determined that management had merited the maximum, or 150%, award for
the non-numerical portion of the PSP. Feb. 2004 Executive Compensation
Programs at FMSE-EC 76. The only exception was the 2000-2002 cycle, for
which the Committee awarded 140%. Id.
(2058) Breaking Records!: Corporate Performance Assessment for 1996-1998, FMSE
1162-95; Corporate Performance Assessment 1999-2001: Our Best Year Yet!,
FMSE-EC 20945-64; Corporate Performance Assessment 2000-2002, FMSE
10542-60.
540
performance was assessed.(2059) Even the three-year reports focused almost
entirely on the last year of the PSP cycle.(2060) Roger Brossy commented that a
single-year review (rather than a three-year review) did not ensure a realistic
analysis of the performance over the full three-year period, but instead only
gave the most recent information to be assessed. Brossy questioned whether this
approach ensured compliance with the multi-year plan.
The CPAs often were exceedingly positive, primarily reporting on the
Company's achievements. For example, the 1996-1998 Corporate Performance
Assessment given to the Board had a baseball theme and was entitled "Breaking
Records!"(2061) The assessment began with a heading, "Record Shattering Results,
Outstanding Performance," and had subheadings such as "Record Volumes," "Record
Total Business Outstanding," "Record Earnings and Stock Performance," "Record
Credit Performance," and "Record Accomplishments in the Information Technology
Arena."(2062) Under each goal, management extolled the Company's virtues and
achievements. The report was written in a highly positive manner, using phrases
such as "we significantly enhanced," "[o]ur efforts have contributed
significantly," and "[w]e are determined to do more and build upon our
record."(2063) Our review of the entire report revealed few, if any
self-critical statements. Indeed, the report concluded with a "highlights"
section that repeated Fannie Mae's "records" for the three-year period.(2064)
Similarly, the 2003 CPA began: "For our mission, business and
disciplined growth strategy, 2003 was one of Fannie Mae's most successful years
ever."(2065) The executive summary then proceeded to tell the Board of Directors
of highlights of Fannie Mae's "Mission," Business," "Disciplined Growth
Strategy," and
- -------------------------
(2059) See e.g., Year-End Corporate Performance Assessment 1999: A Record Year
Ends a Record Decade, FMSE 3313-32; Corporate Performance Assessment
2003, FMSE-EC 6040-57.
(2060) See Corporate Performance Assessment 1999-2001: Our Best Year Yet!,
FMSE-EC 20945-64, at FMSE-EC 20947 ("2001 truly was a watershed year for
our company . . . ."); Corporate Performance Assessment 2000-2002, FMSE
10542-60, at FMSE 10543 ("2002 was an extraordinary year for our service
to families and communities, and for our business and financial results
overall.").
(2061) Breaking Records!: Corporate Performance Assessment for 1996-1998, FMSE
1162-95, at FMSE 1162.
(2062) Id. at FMSE 1163-64.
(2063) Id. at FMSE 1167-68.
(2064) Id. at FMSE 1181.
(2065) Corporate Performance Assessment 2003, FMSE-EC 6040-57 at FMSE-EC 6041.
541
Policy Challenges."(2066) With respect to its analysis of Goal 1: "Increasing
access to Affordable Housing," the CPA began: "In the face of extraordinary
market conditions and significant legislative and regulatory issues, Fannie Mae
once again met our key mission goals and helped increase homeownership
opportunities for millions of American families."(2067) Fannie Mae also listed
what it perceived as future "challenges." Most significantly, Fannie Mae
identified its biggest challenge as what to do in future years, "[h]aving
reached [certain of its] most prominent goals" already.(2068) Fannie Mae
repeated this formula in its discussion of each of the remaining areas.
Although Fannie Mae did recognize that it faced a single policy
challenge in 2003, that challenge was laid squarely at the feet of Freddie Mac
and the revelations of its management and accounting problems.(2069) Otherwise,
the only self-critical statement in the presentation was that the Company's
administrative expenses ran "slightly higher than expected . . . due primarily
to higher than planned development and testing costs for the Core Infrastructure
technology project."(2070) In tone and presentation, this CPA (like others)
reads more like a marketing piece than an internal document intended to provide
members of the Board of Directors with a realistic insight into Fannie Mae's
performance in the previous calendar year.(2071)
When Brossy saw a CPA for the first time, he expressed to Mulcahy
his concern about the positive cast of the document.(2072) Brossy recalls that
Mulcahy agreed. However, she indicated to us that she believed it would be very
difficult to have a meaningful, reflective discourse on corporate performance
with management.(2073) Both
- ----------------
(2066) Id. at FMSE-EC 6041-42.
(2067) Id. at FMSE-EC 6044.
(2068) Id. at FMSE-EC 6045.
(2069) Id. at FMSE-EC 6051.
(2070) Id. at FMSE-EC 6052.
(2071) The "marketing" feel of the document may have resulted in part from the
Communications team's editorial review, which we understand was a step in
the drafting process. See E-mail from Robert J. Levin to Michael Quinn,
dated Dec. 6, 2004, at FMSE-E_EC 54175-76.
(2072) Brossy was provided a copy only shortly before the meeting at which it
was discussed; he was not given an opportunity to comment on it. In
addition to Brossy, Thomas A. Lawler and Mudd individually expressed the
view that the CPAs were overly positive. E-mail from J. Morgan Whitacre
to T. Lawler, dated Dec. 26, 2002, FMSE-E_EC 36647-48 (noting Lawler's
response to draft CPA).
(2073) This tone may have been intentional: In at least one instance in
connection with PSP performance, management sought to limit the
information provided to the
542
Brossy and Mulcahy suggested that the positive light of the CPAs was immaterial
because there were "not a lot of weaknesses" at the Company at that time. So,
although the CPAs emphasized the positive rather than providing a more balanced
(or even negative) view of the Company, the perception of the Compensation
Committee and others, even without the CPAs, was that the Company was doing
well.
Although there is no doubt that Fannie Mae appeared to be performing
well, the tone of the document raised questions regarding its reliability. A
more balanced approach, which included real business challenges and how Fannie
Mae overcame them, as well as issues that the Company confronted or would
confront in the future, would have lent a greater tone of seriousness to this
process for determining a potentially significant portion of a senior
executive's compensation.
One other criticism surrounding the CPAs was that they, in fact,
offered too much information. Johnson recalled that, in presenting the CPAs to
the Compensation Committee, the presenter overwhelmed the members of the
Compensation Committee with unnecessary details. Johnson suggested that the
Compensation Committee thus became mired in minutiae. Mulcahy also indicated
that she believed that the Compensation Committee was given too much information
generally. Similarly, Rudin recounted that she had heard that sentiment
expressed by Compensation Committee members prior to 2000, although she did not
recall by whom.
In concept, Johnson found Fannie Mae's PSP "to be well-designed and
considered it a `best practice' among financial service companies,"(2074) and we
have not concluded otherwise except to note these areas of potential weakness.
To establish more rigor in the goal setting and achievement analyses,
particularly as presented through the CPA, Semler Brossy has recommended that
Fannie Mae retain the internally set corporate performance goals but put
pressure on the Board to ensure that the goals in fact are met before awards are
made.(2075) To do so, Semler Brossy recommends the use of an
- -----------
Compensation Committee. For the 2003 PSP17 payout, when asked by a
co-worker if management needed to give the Compensation Committee the
details of how the payout "would look" with a "CPA grade of less than
100%," Rudin responded that she did "not think it would be `positively
viewed' if I added an alternative below 100%, as in `why would you even
want to put that possibility into the committee's head.'" E-mail from K.
Gallo to L. Rudin, dated Jan. 14, 2004, FMSE-E_EC 152286-87. When asked
who would not "positively view[]" the edit, Rudin identified "senior
management," including Howard, Raines, and Leanne Spencer. Rudin
indicated that she normally gave the Compensation Committee choices only
above 100 percent.
(2074) Performance Share Program, in AGENDA - COMPENSATION COMMITTEE OF THE
BOARD OF DIRECTORS - FANNIE MAE, dated Jan. 20, 2003, FMSE-IR 17752-89,
at FMSE-IR 17781.
(2075) Semler Brossy Report, FMSE-KD 25886-88.
543
outside firm to make objective assessments of the corporate goals.(2076) These
steps will improve the effectiveness of the qualitative assessment and ensure
that the Compensation Committee is receiving relevant and understandable
information from management.
IV. LEGAL DEPARTMENT INVOLVEMENT IN COMPENSATION DECISIONS
In anonymous letters received by OFHEO during the course of Paul,
Weiss's investigation, individual(s) accused Fannie Mae's Legal Department of
improperly reviewing all compensation decisions for purposes of cloaking the
decisions in the attorney-client privilege. We found no evidence to support
these allegations.
To investigate this concern, we requested and reviewed thousands of
documents from Fannie Mae's Legal Department related to executive compensation,
including documents involving (1) negotiation of employment contracts for
Raines, Daniel H. Mudd, and Howard;(2077) (2) general ERISA/benefits issues; (3)
disparate impact analyses undertaken to insure against invidious discrimination;
and (4) the Company's position with respect to OFHEO proposed regulations on
compensation. We also interviewed Donald M. Remy, Judith Dunn, and Anthony Marra
from the Legal Department and asked others involved in compensation issues about
the role of the Legal Department. We found nothing to support an allegation that
the Legal Department was making inappropriate changes to compensation decisions
or otherwise reviewing materials for the purpose of cloaking compensation
decisions with the attorney-client privilege.
The Legal Department's primary involvement in compensation decisions
involved a review for any indication of unlawful discrimination. As noted above,
certain bonus payments under the AIP program were determined by department
heads, who allocated amounts to their subordinates from a pool. The Legal
Department reviewed the allocations for indications of discrimination or other
impropriety.
We found only one instance in which the Legal Department was
involved in issues relating to compensation at Fannie Mae in other than what
might be considered the ordinary course. In March 2004, Dunn and others in the
Legal Department conferred with Professor David Yermack, a professor at New York
University, regarding the use of EPS as a measure of financial performance for
compensation purposes. According to e-mail correspondence between attorneys in
the department, the Legal Department contacted Yermack for purposes of assessing
Fannie Mae's position on proposed OFHEO regulations that would have restricted
or eliminated the use of EPS in calculating
- ----------
(2076) Id. at FMSE-KD 25888.
(2077) Only Raines, Howard, and Mudd had negotiated employment contracts with
the Company.
544
incentive compensation.(2078) This also followed OFHEO's report regarding
Freddie Mac, and our interviews suggested that OFHEO's criticism of Freddie
Mac's compensation practices at least partially motivated Fannie Mae's 2004
inquiries.
Although Fannie Mae clearly was seeking support for its position
that EPS was a suitable measure, Yermack was critical of using EPS as a target
for compensation purposes. Yermack warned the Legal Department that "it is
relatively easy to smooth earnings in a way most convenient to managers."(2079)
Yermack also noted, as Brossy and Johnson had, that exceeding goals year after
year suggested that targets were set too low, that managers knew the targets,
and that managers performed accordingly. Yermack noted, in particular, that the
PSP goals were "much too achievable."(2080) Although Fannie Mae did not, in the
end, oppose OFHEO's proposal that compensation should not focus solely on
earnings performance, except to note that the language proposed by OFHEO was not
consistent with Fannie Mae's Charter, resulting in some ambiguity as to the
regulation's effect.(2081)
In conclusion, we found no evidence to corroborate the anonymous
allegations that the Legal Department was wrongly involved in executive
compensation decisions. The most likely genesis of the concern was the
Department's proper review of compensation practices and decisions to guard
against discrimination. We saw no evidence that the Legal Department's
involvement resulted in the improper assertion, or contemplated assertion, of
privilege or confidentiality for decisions regarding compensation matters.
- ----------
(2078) E-mail from Saadia Mahmud to R. Senhauser, et al., dated Feb. 6, 2004,
FMSE-IR 293943-44.
(2079) E-mail from J. Dunn to T. Donilon, et al., dated Mar. 5, 2004, FMSE-E_EC
162705-06.
(2080) Id.
(2081) Letter from Ann M. Kappler to Alfred M. Pollard, dated June 14, 2004, at
11, available at http://www.ofheo.gov/media/PDF/CorpGovAmendFNM.pdf
(responding to Proposed Corporate Governance Regulation, RIN 2550-AA24).
545
CHAPTER IX: FANNIE MAE'S INVESTIGATION OF ROGER BARNES'S
ALLEGATIONS
I. INTRODUCTION
In August 2003, Roger Barnes, then a Manager in the Controller's
Office, raised allegations of accounting impropriety at Fannie Mae, including
potential noncompliance with FAS 91. Barnes also alleged that Controller's
Office management was not receptive to employee concerns regarding Fannie Mae's
accounting, and, shortly thereafter, he alleged that he had been discriminated
against on the basis of race and gender. In the subsequent three months: (1) The
Company's Office of Audit ("Internal Audit") and its Legal Department conducted
three investigations into Barnes's allegations; (2) Barnes threatened to bring a
lawsuit against Fannie Mae; and (3) Barnes and Fannie Mae executed a settlement
agreement. In the agreement, Barnes relinquished all legal claims against Fannie
Mae in exchange for monetary consideration. The agreement also required Barnes
to cooperate with investigations into matters relating to his allegations.
Barnes subsequently submitted written testimony to Congress, and he
participated in an interview by OFHEO. His testimony and interview raised
additional accounting issues and included other allegations against Fannie Mae.
In light of these events, the SRC asked Paul, Weiss to determine:
(1) whether the Company's investigations into Barnes's accounting allegations
were conducted appropriately, and (2) whether the Company entered into the
settlement agreement with Barnes to prevent him from pressing his allegations of
accounting impropriety. Because the substance of Barnes's initial accounting
questions concerned premium/discount adjustments to the Company's mortgage
portfolio, we also inquired into the substance of his allegations.
As to the issues raised by the events surrounding Barnes's
allegations and departure from Fannie Mae, we draw the following conclusions:
- Controller's Office management communicated with Barnes
poorly, and, in some instances, inappropriately, regarding
both accounting and personnel matters. The remedial measures
Fannie Mae directed for Controller's Office management
following the investigations into Barnes's allegations were
not effective in improving the reporting environment within
the Controller's Office.
- Fannie Mae's investigations into Barnes's allegations were
flawed in several respects, including conflicts-of-interest,
inappropriate pressure to complete the investigations in an
unreasonable time frame, and assigning assessment of proper
GAAP accounting to Internal Audit, a department that was
neither equipped nor authorized to render such determinations.
546
- Management's explanation of the issues Barnes raised relating
to the existence of "anomalous" amortization factors above 100
percent or below zero percent was reasonable.
- Although there was an inappropriate lack of documentation
regarding the $6.5 million factor change Barnes identified,
management's assertion that the amount involved was immaterial
was not unreasonable.
- Management's practice of editing certain conditional
prepayment rates ("CPRs") was inappropriate considering, among
other things, that management could not identify a consistent
rationale for changing the CPRs, the Controller's Office made
the changes without consulting the economists who developed
the CPRs, and only the Controller's Office used the changes
for calculating catch-up -- the changes were not applied
consistently to all areas of Fannie Mae.
- Barnes has raised additional allegations regarding Fannie Mae.
The Company did not have the opportunity to investigate these
allegations while he was with Fannie Mae.
- The Company's decision to reach a settlement of threatened
litigation by Barnes was based on an appropriate analysis of
the Company's litigation risk. It was not intended to conceal
misconduct by Fannie Mae or its employees or officers.
II. BACKGROUND
A. Barnes's Work History
Barnes began his employment at Fannie Mae in October 1992 as
Assistant Manager of MBS Accounting. Between 1992 and 2003, Barnes generally
received top performance ratings and was promoted several times, eventually
rising to the position of Manager of Premium/Discount Amortization. In this
position, he supervised three analysts and reported to Mary Lewers, then
Director -- Financial Accounting.(2082) Barnes's responsibilities primarily
included premium/discount amortization accounting via the PDI/iPDI systems and
separate cash reconciliation functions. In this role, Barnes regularly worked
with Jeffrey Juliane, then Manager of New Products, who reported directly to
Janet L. Pennewell. Juliane oversaw the AIMS system that transmitted to PDI/iPDI
data used to calculate premium/discount amortization.
- ----------
(2082) Lewers reported to Pennewell, Vice President -- Financial Reporting and
Planning, and, during the period relevant to our investigation,
Pennewell reported to Spencer, who became Senior Vice President and
Controller.
547
B. Barnes's Allegations and the Company's Investigations
Beginning as early as 1997, Barnes began to draft memoranda and
e-mails documenting his concerns regarding both Fannie Mae's accounting
practices and the difficulties he experienced in seeking a promotion to a
Director-level position within the Controller's Office.(2083) Barnes sent
numerous e-mails to Stephen Spivey, a Senior Developer in the systems area with
whom Barnes had worked on PDI. Spivey stated that he paid little attention to
Barnes's accounting allegations, rarely responded to them, and was unsure why
Barnes sent them to him. Barnes also wrote memoranda to himself and to "file";
these memoranda contained allegations similar to those outlined in his e-mails
to Spivey.
Barnes's e-mails and memoranda outline a broad range of allegations
regarding, among other things, perceived mistreatment and racial discrimination
by his supervisors. These allegations include the following:
- In 1994, Barnes was twice denied promotion to Manager
positions in the Controller's Office in favor of white
employees.(2084)
- In 1998, another employee was moved to a fixed-wall office,
despite Barnes's allegation that several minority managers
held seniority over her.(2085)
- In 1999, Controller Leanne G. Spencer asked an
African-American employee to hold her water bottle during a
presentation to Controller's Office personnel.(2086)
- In 1999, another manager and her subordinates received an
internal award that Barnes felt he and his subordinates should
have received. Barnes alleged that this employee received the
award because Controller's Office management wanted to
"showcase" her.(2087)
- ----------
(2083) See, e.g., E-mail from R. Barnes to R. Barnes, dated Mar. 20, 1997, FMSE
22104 (regarding being passed over for promotion in favor of white
employees); E-mail from R. Barnes to S. Spivey, dated Mar. 4, 2002,
FMSE-IR 4248-49 (regarding 2001 performance evaluation); E-mail from R.
Barnes to S. Spivey, dated Oct. 5, 2002, FMSE 22885 (listing ten
accounting-related concerns).
(2084) E-mail from R. Barnes to R. Barnes, dated Mar. 27, 1997, FMSE 22104.
(2085) E-mail from R. Barnes to R. Barnes, dated Nov. 9, 1998, FMSE 22105.
(2086) E-mail from R. Barnes to R. Barnes, dated Feb. 24, 1999, FMSE 22108.
(2087) E-mail from R. Barnes to R. Barnes, dated May 19, 1999, FMSE 22633-34.
548
- In 2000, Juliane began attending biweekly meetings with
Pennewell, which Barnes viewed as a sign that Pennewell
planned to promote Juliane to Director.(2088)
- In 2000, Juliane and Martin Waugh were moved to fixed-wall
offices.(2089)
- In 2000, Spencer held in her hand, but did not refer to, notes
that Barnes had prepared for her use during a meeting.(2090)
- In 2001, Juliane was invited to participate in a leadership
training program that Barnes perceived as a stepping-stone to
a Director-level promotion. Barnes wrote that "[m]anagement
was even instructed to deny the existence of the program . . .
if employees asked."(2091)
- During a 2001 meeting, Juliane made a "caustic comment" about
Barnes being "verbose," and, rather than rebuke Juliane,
Pennewell laughed. Barnes wrote, "This is as bad as Leanne
rubbing my tummy, or resting her hand on my leg at the picnic
or always excessively hugging."(2092)
- In 2001, Barnes alleged that "senior management" was using
on-top adjustments to reduce Fannie Mae's income tax
liability.(2093)
- In 2001, Barnes was offered a transfer to the Core
Infrastructure Project, a transfer that management suggested
would offer significant advancement potential. Barnes declined
the transfer because his supervisors would not guarantee him a
promotion to Director along with or after the transfer. In
2002, Barnes learned that the individual who accepted
leadership of the Core project was promoted to Director when
he was transferred.(2094)
- ----------
(2088) E-mail from R. Barnes to R. Barnes, dated July 20, 2000, FMSE 22138.
(2089) E-mail from R. Barnes to R. Barnes, dated Aug. 23, 2000, FMSE 22139.
(2090) E-mail from R. Barnes to S. Spivey and R. Barnes, dated Oct. 17, 2000,
FMSE 22147.
(2091) E-mail from R. Barnes to S. Spivey, dated Feb. 15, 2001, FMSE 22183-84.
(2092) E-mail from R. Barnes to C. DeFlorimonte, dated July 19, 2001, FMSE
22196.
(2093) E-mail from R. Barnes to S. Spivey, dated Aug. 8, 2001, FMSE 22607.
(2094) E-mail from R. Barnes to S. Spivey, dated Mar. 6, 2002, FMSE-IR 4250.
549
- In March 2002, Barnes claimed that the Controller's Office
terminated seven employees, one of whom was a Director. All of
the employees, according to Barnes, were religious or ethnic
minorities.(2095)
- In May 2002, Barnes wrote that Fannie Mae was "consciously
using the REMICs to reduce short term income." He alleged that
Raines and Howard had decided to move income from 2002 via
REMIC amortization because the Company had enough income in
2002 to meet that year's "goals."(2096) Later that year,
Barnes compiled a list of Fannie Mae's accounting practices
that he found troubling, including, among other things,
premium/discount amortization using "negative factors" and
"intentionally not designing audit trails" for the AIMS
system.(2097)
- In May 2002, Spencer held a "grief session" for Controller's
Office personnel after the suicide of a former Fannie Mae
employee. Barnes wrote that this was hypocrisy and
"ridiculous" because Spencer had not even informed
Controller's Office personnel of the employee's
resignation.(2098)
- In May 2002, Barnes reported that he mistakenly had believed
that eight minority Directors had been terminated earlier in
May. Barnes wrote that one of the fired Directors was white
and that another white director was offered a package to
resign "purely to make it look like race had no impact."(2099)
- In 2003, Barnes wrote that, unlike other managers, he had not
been informed of Fannie Mae's new guidelines regarding snow
and inclement weather.(2100)
- ----------
(2095) E-mail from R. Barnes to S. Spivey, dated Mar. 7, 2002, FMSE-IR 4245.
(2096) E-mail from R. Barnes to S. Spivey, dated May 7, 2002, FMSE-IR 4241.
(2097) E-mail from R. Barnes to S. Spivey, dated Oct. 5, 2002, FMSE 22885.
(2098) E-mail from R. Barnes to S. Spivey, dated May 21, 2002, FMSE-IR 4252-56,
at FMSE-IR 4252.
(2099) E-mail from R. Barnes to S. Spivey, dated May 30, 2002, FMSE-IR 4251. In
his e-mail, Barnes refers to an earlier e-mail he says he sent about
directors being terminated; we did not locate that e-mail.
(2100) E-mail from R. Barnes to R. Barnes, dated Feb. 11, 2003, FMSE 22229.
550
- In October 2003, Donald M. Remy sent an e-mail to a broad
group of Controller's Office and Internal Audit managers
regarding preparation for the OFHEO Special Examination.
Barnes did not receive this e-mail directly but instead was
informed of it by a colleague. Barnes claimed that management
intentionally excluded him from the team preparing for the
OFHEO review.(2101)
During the summer of 2003, in addition to continuing to document the
perceived discrimination issues listed above, Barnes also began to compile data
relating to the Company's FAS 91 systems. As part of this data compilation, it
appears that he asked one of his subordinates, Patricia Wells, to create a CD of
amortization documents that he added to his file. Barnes told Wells that this CD
had been requested by Lewers, but, in reality, Barnes used it to perform
analyses of perceived FAS 91 noncompliance.
On July 18, 2003, during a regularly scheduled monthly meeting with
Lewers, Barnes included as a topic of discussion items regarding Fannie Mae's
FAS 91 accounting.(2102) Barnes stated that he told Lewers that there appeared
to be a problem with unamortized balances increasing and exceeding historical
costs. According to Barnes, because Controller's Office management was not
receptive to criticism, he raised these concerns in the form of questions,
rather than through direct confrontation.(2103) Barnes and Lewers had a brief
(one-minute) conversation regarding the perceived FAS 91 problems, but because
Barnes framed his questions as relating to data analysis, rather than to GAAP
noncompliance, Lewers was not particularly concerned by these questions.
During a meeting on the afternoon of July 29, 2003, Pennewell
informed Barnes that Fannie Mae had promoted Juliane to Director.(2104) As a
result of this promotion, Juliane became Barnes's immediate supervisor.(2105)
Approximately one hour after this announcement, Barnes sent an e-mail to Sam
Rajappa, Senior Vice President -- Operations Risk (with responsibility for
Internal Audit), requesting a confidential meeting "regarding analysis and
research [Barnes had] been conducting for a number of weeks."(2106) Rajappa
responded by asking Barnes to meet with him and Ann Eilers, Vice
- ----------
(2101) Handwritten notes on e-mail from Debbie D. Milton to L. Spencer, et al.,
dated Oct. 13, 2003, FMSE 22716-18, at FMSE 22716.
(2102) See One on One Meeting July 18, 2003, dated July 18, 2003, FMSE-IR
132789 (listing meeting agenda item of "detailed analysis of reports,
factors and balances").
(2103) Barnes stated that Lewers often did not respond to his questions in any
way, instead sitting in silence until Barnes moved on to another topic.
(2104) Mem. from R. Barnes to File, dated July 29, 2003, FMSE 22265.
(2105) See id.
(2106) E-mail from R. Barnes to S. Rajappa, dated July 29, 2003, FMSE 22259.
551
President -- Internal Audit, on Monday, August 4.(2107) Barnes did not detail
his accounting concerns in the e-mail to Rajappa; as a result, Rajappa did not
know beforehand what issues Barnes intended to raise when they met.
After receiving Barnes's e-mail, but before the meeting, Rajappa
contacted Ann M. Kappler, General Counsel, and informed her that an employee had
requested a confidential meeting to discuss accounting issues. Rajappa told
Kappler he would follow up with her after the meeting with the employee. It does
not appear that Rajappa identified Barnes as the employee in question at that
time.
III. FINDINGS REGARDING THE INVESTIGATION INTO BARNES'S ACCOUNTING ALLEGATIONS
A. August 4, 2003
At the August 4 meeting, Barnes shared with Rajappa and Eilers a
binder of material he had prepared containing his analysis of certain
"anomalies" within Fannie Mae's premium/discount amortization accounting system.
Barnes highlighted concerns relating to: (1) deferred items amortized in excess
of 100 percent; (2) deferred items amortized in reverse (also referred to as
"negative amortization"); and (3) unusually rapid amortization.(2108) Barnes
informed Rajappa and Eilers that he had not raised these concerns to his
supervisors because he did not feel comfortable doing so. Barnes explained to
Rajappa that Spencer and Pennewell repeatedly had told him that he had "no need
to know" about the amortization factors, and that he did not understand them.
Furthermore, according to Barnes, Pennewell, Lewers, and Spencer had excluded
him from meetings on the topic, and he stated that employees who raised
questions about accounting were viewed by management as not being "part of the
team."
Rajappa encouraged Barnes to inform his management chain of the
accounting concerns because Rajappa would be required to do so to investigate
Barnes's concerns properly in any event. Rajappa also told Barnes that he would
not be mistreated for raising these issues with management.
After meeting with Barnes, Rajappa and Eilers immediately met with
Kappler. Kappler and Rajappa together decided that Internal Audit would
investigate Barnes's accounting allegations and that the Legal Department would
investigate Barnes's concerns about the reporting environment in the
Controller's Office. They also agreed that Rajappa would inform KPMG and Thomas
P. Gerrity, Chair of the Audit Committee, about the allegations.
- ----------
(2107) E-mail from S. Rajappa to R. Barnes, dated July 29, 2003, FMSE 22797.
(2108) Barnes later raised concerns regarding manual adjustments made to the
FAS 91 amortization modeling factors.
552
B. August 5, 2003
During the morning of August 5, Barnes sent an e-mail to Spencer,
Pennewell, Lewers, Stawarz, and Juliane listing his concerns that Fannie Mae's
FAS 91 accounting was not in compliance with GAAP.(2109) This was the first time
he had contended to his supervisors that any Fannie Mae accounting practice
relating to amortization of premiums and discounts did not comply with GAAP. He
also provided each with a copy of the binder that he had provided to
Rajappa.(2110)
Given the seriousness of the allegations, the recipients of this
e-mail engaged in immediate verbal and written communication regarding Barnes's
assertions. Within several hours, Pennewell decided to task Juliane with
determining whether Barnes's concerns were justified.(2111) Juliane reacted
negatively to Barnes's e-mail, forwarding it to his subordinate, Rene LeRouzes,
with a note stating: "look at the [expletive] that I'm dealing with. we need to
jump on this. Need to look at the [factors] that are hosed Let's discuss."(2112)
Juliane explained to us that his frustration stemmed from the fact that he had
explained these factor issues to Barnes previously, and Barnes never had
indicated disagreement or asked any follow-up questions before sending his
e-mail to the entire management group of the Controller's Office.
On August 5, 2003, Rajappa called a meeting with Paul Jackson, an
Internal Audit Director, and Joyce Philip, an Internal Audit Manager, to begin
the investigation into Barnes's concerns.(2113) Rajappa selected Jackson and
Philip because, in July 2003, they had completed an audit of Fannie Mae's
amortization system ("July audit"). In the July audit, Internal Audit had found
control problems within the system, as well as the need for a $155 million
accounting adjustment to correct for MBS incorrectly identified by the wrong FAS
91 type.(2114)
- ----------
(2109) E-mail from R. Barnes to M. Lewers, et al., dated Aug. 5, 2003, FMSE-IR
496799.
(2110) See id. ("The supporting documentation is too expansive to cover in
email. Please see the hard copy provided in your inbox.").
(2111) E-mail from J. Pennewell to J. Juliane, et al., dated Aug. 5, 2003, FMSE
23266 ("Roger and Jeff - I'd like to request that you guys get together
to discuss Roger's analysis, and [report] back to Dick, Leanne, and me
I'd like this to be a high priority.").
(2112) E-mail from J. Juliane to R. LeRouzes, dated Aug. 5, 2003, FMSE-E
117364.
(2113) The Internal Audit team later enlisted the assistance of Gunes
Kulaligil, an Internal Audit staff member specializing in data analysis
and validation.
(2114) Audit Report: Office of Auditing, Amortization Audit, dated July 9,
2003, FMSE-IR 176943-50.
553
During our interview with Jackson, he noted his surprise that Barnes
had not raised any concerns about amortization accounting during the July audit.
Jackson particularly was surprised because Barnes generally had been critical of
the Controller's Office procedures during the audit. Jackson believed Barnes was
given ample opportunity during the July audit to raise these issues, but he had
not done so.
Barnes explained to us that he did not raise his concerns about the
Controller's Office or accounting to Internal Audit during the July audit
because he had hoped that Internal Audit would find the problems without his
help. He said that he did not complete his analysis of the anomalies until after
Internal Audit issued the July audit results.
During our interviews, no one in Internal Audit expressed any
concerns about using the same auditors who recently had examined the
amortization area. Rajappa indicated that he did not believe the auditors had a
conflict-of-interest because there was no connection between the previous audit
and Barnes's allegations. Philip, however, stated that Internal Audit had become
aware during the July audit of at least one of the issues Barnes later raised.
Philip also explained that she believed that she and Jackson were the
appropriate individuals to conduct the investigation because they were the most
familiar of all Internal Audit staff with the issues to be investigated.
However, both Kappler and Deborah House of the Legal Department's Office of
Corporate Compliance ("OCC") subsequently concluded (in hindsight) that Internal
Audit should not have been involved.
Although we have no evidence that either the assignment of Internal
Audit to this investigation or the conduct of the investigation itself was
undertaken to conceal misconduct, Internal Audit had a conflict-of-interest in
performing this work because of its previous audit of the same area.
Specifically, to substantiate Barnes's allegations, the auditors would have had
to find that their own conclusions during the July audit were incorrect. Both
Kappler and Rajappa should have recognized this conflict, and, instead of
assigning Internal Audit to the investigation, they should have assigned the
investigation into Barnes's accounting allegations to someone else.
From the time he learned of Barnes's allegations, Rajappa was
concerned that any problems with the catch-up calculations implicated by
Barnes's complaints might prevent the CEO and CFO from certifying the previous
quarter's financial results. The preliminary CEO/CFO certification meeting for
that quarter had taken place on August 1, and the overall FAS 91 catch-up
process had been discussed at that meeting; final certification tentatively had
been scheduled for either August 13 or 14. Thus, Rajappa believed Barnes's
subsequent allegations could impede certification. Despite acknowledging this
concern, Rajappa maintained that he did not give Jackson and Philip any
deadlines to complete their work or urge them to finish their portion of the
investigation to allow for certification by the deadline.
After meeting with Jackson and Philip, Rajappa separately briefed
Howard, Gerrity, and Raines, as well as Mark Serock and Harry Argires of KPMG on
Barnes's allegations and Fannie Mae's plan to investigate those allegations. No
one
554
whom Rajappa briefed disagreed with Internal Audit's workplan, and each person
asked to be kept informed of developments in the investigation.(2115) It is
unclear whether the CEO/CFO certification was explicitly mentioned, but all of
the relevant parties whom we interviewed noted that they were aware of the
approaching certification date and that Barnes's allegations might affect
Raines's and Howard's ability to sign their certifications.
Kappler assigned the investigation into Barnes's complaints
regarding the Controller's Office culture to House. Rajappa and House first met
to discuss the investigation on August 5. During that meeting, Rajappa described
to House the division of the investigation between Internal Audit and the Legal
Department and provided her with general information about Barnes's cultural
allegations as well as Barnes's complaints about specific individuals within his
reporting chain. Rajappa asked House to keep him apprised of developments in
OCC's investigation.
Also on August 5, Spencer called a meeting of Controller's Office
personnel to discuss Barnes's allegations. It is undisputed that Pennewell
became agitated towards Barnes during this meeting. Pennewell explained to us
that she reacted angrily because she felt that Barnes was calling her integrity
into question by going over her head to Spencer with his concerns. Barnes felt
that Pennewell's behavior constituted retaliation for his having approached
Internal Audit, and, shortly thereafter, he informed House of the meeting and
that he had been confronted by Pennewell, Spencer, and Juliane regarding
bringing his concerns to Internal Audit. House telephoned Spencer and told her
that the confrontation should not have occurred, particularly in the context of
an investigation. Spencer, who felt that Pennewell was demoralized already by
the allegations, did not inform Pennewell of the call from House.(2116) It seems
that Spencer, Pennewell, and Lewers subsequently determined that the appropriate
way to avoid any appearance of retaliation was to have as little contact with
Barnes as possible.(2117)
C. August 6-7, 2003
On August 6 and 7, the Internal Audit team met with Controller's
Office personnel (including Barnes, Juliane, Lewers, Wells, and LeRouzes) and
began analyzing
- ----------
(2115) Rajappa told Paul, Weiss that KPMG affirmatively agreed with Internal
Audit's workplan and did not offer any suggestions of it own.
Separately, Rajappa stated that Howard expressed some anger over the
fact that Rajappa had briefed Raines before briefing Howard.
(2116) House later called Pennewell directly to counsel her against holding
meetings with Barnes to discuss his allegations.
(2117) Barnes stated that his supervisors ostracized him after he raised his
allegations. Barnes interpreted Spencer's, Pennewell's, and Lewers's
tactical avoidance as retaliation, whereas Spencer, Pennewell, and
Lewers believed avoiding contact would prevent any claims of
retaliation.
555
data in relation to Barnes's allegations.(2118) Juliane, in particular, assisted
Internal Audit in gathering and analyzing the relevant data.(2119) Jackson
characterized Juliane's demeanor during their conversations as "defensive and
devastated," primarily because Juliane felt his integrity was being questioned.
In fact, Juliane later stated to Jackson that he had not slept for days after
the allegations were made. Jackson also kept Barnes informed of the status of
the investigation, informing him during this period that Internal Audit had not
yet substantiated Barnes's allegations.
Witnesses provided inconsistent descriptions of the results of
Internal Audit's interviews. Philip indicated that Internal Audit had uncovered
at least some of the issues Barnes raised during the July audit and that the
Controller's Office viewed these as problems to be corrected. Controller's
Office personnel, however, indicated that these issues were not problematic at
all; instead they suggested Barnes simply misunderstood the data he had
compiled.(2120)
D. August 8, 2003
On the morning of August 8, 2003, Rajappa, Eilers, Jackson, Philip,
and Gunes Kulaligil of Internal Audit; Spencer, Pennewell, Lewers, Jonathan
Boyles, and Juliane of the Controller's Office; Serock and Michael Tascher of
KPMG; and House of the Legal Department all met with Barnes to discuss Internal
Audit's investigation into Barnes's accounting allegations.(2121) Witnesses have
differing recollections as to the purpose of the meeting: Most viewed it as
Internal Audit's presentation of its conclusions, while the Internal Audit
attendees considered it a meeting to update everyone on the status of Internal
Audit's investigation.
- ----------
(2118) Internal Audit's workplan had three stages: (1) Verify the mathematical
accuracy of Barnes's calculations; (2) determine whether the factor
anomalies were isolated occurrences or pervasive throughout Fannie Mae's
portfolio; and (3) determine whether the anomalies impacted the analysis
of Fannie Mae's catch-up position that was part of the CEO/CFO
certification process for the second quarter of 2003. Cf. Fannie Mae
Office of Auditing: Amortization Investigation, dated Aug. 2003, FMSE
23295-96.
(2119) See Analysis on Factors, dated August 5, 2003, FMSE 23267 ("Analysis
performed by Jeff Juliane to explain apparent discrepancies in
factors.").
(2120) See infra Subsection IV ("Findings Regarding Roger Barnes's FAS
91-Related Allegations").
(2121) Summarized Minutes of the Meeting (8/8/03): Unamortized Balances and
Factor Analysis, dated Aug. 8, 2003, FMSE 24411-19, at FMSE 24417-19
(hereinafter "August 8 Minutes"). Rajappa scheduled this meeting as
early as August 6 - just two days after meeting with Barnes for the
first time.
556
At the meeting, Juliane explained the source of the anomalies Barnes
had identified.(2122) No one disagreed that Barnes had identified the anomalies
correctly; instead, the only concern was whether the existence of the anomalies
meant that Fannie Mae's accounting did not comply with GAAP.(2123) Serock
expressed KPMG's initial view that these anomalies did not indicate GAAP
noncompliance.(2124) It is undisputed that Barnes said little, if anything,
during the meeting.
Jackson drafted minutes of the meeting, and Rajappa circulated the
draft to all attendees.(2125) The final minutes indicate that Internal Audit,
KPMG, and Boyles, then head of Financial Standards, all agreed that Fannie Mae's
accounting was in compliance with GAAP (to the extent Barnes had challenged it
was not).(2126)
Internal Audit inappropriately led the Company to believe that it
was investigating the accuracy of Barnes's allegations regarding GAAP
noncompliance, despite Internal Audit's having neither the capability nor the
intention of investigating GAAP issues. This course of action began when Rajappa
and Kappler asked Internal Audit to oversee the accounting investigation, which,
on the face of Barnes's allegations, raised issues concerning GAAP compliance.
And, it continued when Rajappa made statements during the August 8 meeting that
all attendees interpreted as confirming GAAP compliance.(2127)
Despite the indications in the August 8 minutes, Rajappa now denies
that he opined on GAAP issues.(2128) In his interview with Paul, Weiss, Rajappa
stated that Internal Audit's conclusion was that the FAS 91 system was in
compliance with the
- ----------
(2122) August 8 Minutes at FMSE 24417.
(2123) Id. ("Juliane stated that he had reviewed Roger's amortization analysis
and this analysis was correct.").
(2124) Id. at FMSE 24418.
(2125) E-mail from S. Rajappa to L. Spencer, et al., dated Aug. 25, 2004, FMSE
22734 (attaching draft meeting minutes for review and comments). Barnes
was an addressee of this e-mail, but he did not receive the draft
minutes because he was on leave at the time of their circulation.
(2126) August 8 Minutes at FMSE 24418.
(2127) Serock stated that he understood the reference in the minutes to being
in compliance with GAAP was not to suggest that the Company's review
actually tested GAAP compliance, but instead that the process itself was
compliant with GAAP and that the allegations were incorrect.
(2128) No one else within Internal Audit (Philip, Jackson, and Eilers)
identified any inaccuracies in the minutes.
557
internal standards established by Financial Standards rather than in compliance
with GAAP. Additionally, he maintained that the conclusion that the factors
identified by Barnes were accounted for properly was based upon representations
by Juliane and Pennewell. Rajappa had multiple opportunities to revise both the
meeting minutes and OCC report, discussed below, that referred to Internal
Audit's GAAP determinations, but he did not do so. Indeed, he did not express
any disagreement with these documents until his interview with us. Since every
party that opined on whether Fannie Mae's amortization practices raised by
Barnes were in compliance with GAAP relied on Internal Audit's findings, the
reliability of those opinions could be called into question.
E. August 9-12, 2003
Following the August 8 meeting, Rajappa individually briefed Raines,
Howard, and Gerrity on Internal Audit's conclusions. Rajappa gave these
briefings in anticipation of a previously scheduled August 12 Audit Committee
meeting set to discuss certification of the previous quarter's financial
results. In each of his briefings, Rajappa apparently stated that Internal
Audit's testing was complete, that Internal Audit's initial conclusion was that
Barnes's allegations had no impact on the second quarter financial statements,
and that Rajappa felt comfortable signing his sub-certification. Yet, at the
same time, Jackson and Philip still were performing testing of Barnes's
allegations regarding manual amortization factor changes, and they continued to
do so until approximately the end of September.
Rajappa and Kappler also told Gerrity and the Audit Committee that
Barnes was satisfied with Internal Audit's investigation.(2129) Barnes, however,
never made such a statement; instead, Barnes had told House that he was glad the
Company had looked into his concerns. House either mistransmitted this statement
to Rajappa or Rajappa misunderstood House's characterization. Regardless,
Gerrity reported that he was left with the understanding that Barnes's concerns
had been addressed, and that Barnes would not be pressing the issues further.
On August 12, 2003, the Audit Committee held a telephonic
meeting.(2130) During this meeting, Gerrity, by prior arrangement with Rajappa
and Kappler, raised the Barnes matter to the Audit Committee and Kappler
provided a report on the Legal
- ----------
(2129) E-mail from S. Rajappa to A. Kappler, dated Aug. 11, 2003, FMSE-SP 3400
(stating, in planning for Audit Committee meeting, "I will note that
Roger has indicated that he is satisfied"); Audit Committee Meeting:
Quarterly Certification, dated August 12, 2003, FMSE 15573-76, at FMSE
15576 ("[T]he employee has expressed satisfaction that his concerns have
been addressed.").
(2130) The Company certified its quarterly financial results on August 14,
2003. Fannie Mae Form 10-Q, dated Aug. 14, 2003, FMSE-E_EC 113092-309,
FMSE-E_EC at 113307, 113309.
558
Department's investigations.(2131) Rajappa then informed the Audit Committee
that Internal Audit had investigated the accounting issues and that both the
Company and KPMG had found that these issues presented no problems related to
the certification.(2132) Rajappa later stated that he did not know what
independent analysis, if any, KPMG performed to reach this conclusion.
There is no doubt that Internal Audit felt pressured to produce the
results of its investigation in an unreasonably short period of time due to the
upcoming CEO/CFO certification, and it appears that Rajappa himself was the
source for that pressure. Our conclusion is based primarily on the fact that
Rajappa provided "conclusions" from the investigation to Raines and Gerrity
after only three days of what eventually became a two-month process. It was
inappropriate for Rajappa to inform Raines and the Audit Committee that the
investigation was complete when, in fact, a substantial amount of test work
remained to be performed.
IV. FINDINGS REGARDING ROGER BARNES'S FAS 91-RELATED ALLEGATIONS
In addition to reviewing the Company's investigation into Barnes's
FAS 91 accounting allegations, we also independently and substantively reviewed
certain of these allegations themselves.(2133) For example, Barnes alleged that:
(1) Management improperly used amortization factors that were less than zero or
greater than 100 percent to calculate premium and discount amortization, and (2)
improperly "develop[ed] factors to meet desired objectives."(2134) We discuss
these two issues below.
A. Factor Anomalies
To calculate amortization, Fannie Mae applies percentages, known as
amortization factors or simply "factors," to original premium and discount
amounts. Fannie Mae uses cumulative factors to calculate accumulated, or
"inception to date," amortization. In theory, since the premium or discount on
any given loan cannot be amortized more than 100 percent or less than zero
percent, cumulative factors should always be between zero and 100 percent.
However, documents indicate and Fannie Mae personnel have stated that, on
occasion, management used cumulative factors that were
- ----------
(2131) Minutes of the Meeting of the Audit Committee of the Board of Directors
of Fannie Mae, dated Aug. 12, 2003, FMSE 15573-76, at FMSE 15576.
(2132) Audit Committee Meeting: Quarterly Certification, dated Aug. 12, 2003,
FMSE 23184-85, at FMSE 23185.
(2133) Other allegations made by Barnes, including allegations regarding
realignments and Fannie Mae's use of Account 1622, are discussed in other
chapters of this Report.
(2134) See Mem. from Finance Division Manager to Office of Chairman, F. Raines
and T. Howard, dated Sept. 23, 2002, FMSE 22882-84, at FMSE 22882.
559
negative or greater than 100 percent to calculate premium and discount
amortization. Barnes alleged that because of these "anomalous" factors, the
Company's financial statements were not in compliance with GAAP.(2135)
Management, specifically Juliane and Lewers, explained that these
factor anomalies sometimes occur when premiums and discounts are combined into
the same FAS 91 "bucket" in Fannie Mae's amortization systems.(2136) In the case
of the amortization of REMIC securities, which were modeled at the Committee on
Uniform Securities Identification Procedures ("CUSIP") level, multiple REMIC
CUSIPs are combined into a single FAS 91 bucket for financial reporting
purposes. When a FAS 91 bucket includes CUSIPs with both premiums and discounts
there is a potential to have anomalous factors. Below is a hypothetical example
of this situation:
ORIGINAL AMORTIZATION ACCUMULATED
Premium/(Discount) Factor Amortization
Premium $ 11,000,000 70% $ 7,700,000
Discount ($ 10,000,000) 50% ($ 5,000,000)
Net $ 1,000,000 270% $ 2,700,000
In this example, a FAS 91 bucket for REMICs contains two CUSIPs, one
with a $11 million premium and the other with a $10 million discount. Combined,
the two REMICs net to a premium of $1 million. If the cumulative amortization
factor for the premium CUSIP were seventy percent, Fannie Mae would have
amortized $7.7 million of the premium. If the cumulative amortization factor for
the discount CUSIP were fifty percent, Fannie Mae would have amortized $5
million of the discount. When combined, it appears as though Fannie Mae
amortized $2.7 million of net premium even though only $1 million of premium was
available to be amortized. The cumulative amortization factor in this case would
be 270 percent. However, the seemingly anomalous factor would be appropriate
since the amortization factors for the individual CUSIPs were between zero and
100 percent, and the anomalous factor resulted only when these CUSIPs were
combined for financial reporting purposes.
This explanation and real examples were presented to and accepted by
Internal Audit, the OCC, and KPMG.(2137) Although we did not investigate every
instance
- ----------
(2135) Mem. from R. Barnes to File, dated Aug. 5, 2003, FMSE 22899-90, at FMSE
22899.
(2136) See Tr. of June 8, 2004 OFHEO Dep. of J. Juliane at 65:6-67:4,
125:10-126:9 (hereinafter "Juliane OFHEO Testimony"); Tr. of July 13,
2004 OFHEO Dep. of M.Lewers at 251:3-258:17.
(2137) See Office of Corporate Compliance: Decision # 2003-1 (Part A,
Amortization and Documentation Issues), dated Sept. 29, 2003, FMSE
24411-19.
560
in which anomalous factors may have occurred at Fannie Mae, we conclude that
management's explanation as to why cumulative factors are sometimes above 100
percent or below zero is reasonable. We also found that anomalous factors
existed consistently at least as far back as October 1998.(2138) We conclude
that this supports management's contention that anomalous factors were a
by-product of the Company's modeling process.
B. Manual Factor Changes
We understand that Barnes's concern that management manually
adjusted amortization factors to manage earnings related to an incident in July
2003, when management manually changed a factor generated by AIMS to elicit a
$6.5 million impact on the amortization calculated by iPDI. Juliane explained
that this manual factor change was made to correct the amortization performed by
iPDI. Juliane said that this occurred as part of a reconciliation process, in
which the results produced by iPDI were compared to the predicted values
generated by AIMS. In this instance, the amount of amortization expense
calculated by AIMS was $6.5 million higher than the amount that was booked by
iPDI.(2139) Juliane explained that he discussed this discrepancy with Pennewell,
and they concluded that AIMS contained more accurate data than iPDI. Therefore,
management made a manual factor change to increase amortization expense in iPDI
by $6.5 million.(2140)
This explanation was presented to Internal Audit, the OCC, and KPMG.
Each of these groups concluded that there was an inappropriate lack of
documentation surrounding the $6.5 million factor change. However, each also
accepted management's assessment that the amount involved in the factor change
was immaterial.(2141) Given the size of the adjustment, its timing (it did not
occur at quarter- or year-end),(2142) and the lack of evidence that the
adjustment had an improper purpose (such as managing earnings), that conclusion
does not seem unreasonable.
- ----------
(2138) Purchase Discount Amortization Management System, Catch-up Adjustments,
Reporting Period 10/1998, dated Dec. 3, 1998, FMSE-IR 22442-57.
(2139) See Juliane OFHEO Testimony at 118:2-119:11.
(2140) See id.
(2141) See Office of Corporate Compliance: Decision # 2003-1 (Part A,
Amortization and Documentation Issues), dated Sept. 29, 2003, FMSE
24411-19 (hereinafter "OCC Part A").
(2142) Had the adjustment occurred at quarter or year-end, it might have raised
a more significant issue.
561
C. CPR Edits
Although Barnes did not raise this issue with Internal Audit, Barnes
separately alleged that Fannie Mae personnel were "[m]anaging income by
developing factors to meet desired objectives."(2143) We investigated this issue
and learned that management, from time to time, would manually change CPRs
produced by Valuation Net ("VN")(2144) before they were inputted to AIMS. These
CPR edits had the potential to allow Fannie Mae to manage earnings because CPRs
directly affect estimates of future cash flows, indirectly affect amortization
factors, and ultimately affect earnings.
Pennewell explained that CPR edits were necessary when the CPRs
produced by VN varied significantly from Fannie Mae's current outlook of
prepayment rates. Juliane explained that he would propose CPR changes from time
to time based on market analysis. We understand that Fannie Mae would use
prepayment estimates published by Bloomberg to create a CPR range representing
high and low market estimates based on that data.(2145) Fannie Mae would then
compare the VN produced CPRs to this market range and make adjustments to the
CPRs when management deemed the adjustment to be appropriate. Juliane indicated
that, based on an analysis of the prepayment data from the Bloomberg website, he
would suggest CPR edits to Thomas A. Lawler, who would sign-off on the
adjustment.(2146) Although Lawler admitted that he signed off on these CPR
edits, he stated that his function was to check the adjustments only to see if
they seemed "reasonable," not to determine whether the adjustments were
appropriate. Lawler also stated that these CPR edits were made for the use of
the Controller's Office only, and not applied globally.
When we asked Leonard Mills, the Fannie Mae employee responsible for
the modeling in VN that produced CPRs, about these CPR edits, he said that he
was unaware that anyone in Financial Reporting, within the Controller's Office,
ever had altered the CPR outputs of VN manually. Mills did say that Pennewell
had approached him at some point to ask his opinion of the Bloomberg prepayment
rate ranges, but he rejected the idea of Fannie Mae using these ranges for a
number of reasons, including: (1) The prepayment range was likely very large;
(2) the range obtained from Bloomberg was not based on the same assumptions as
Fannie Mae's data; (3) the ranges may have been based on projections that were
up to a month old; and (4) the results were not analogous to the results of the
modeling performed by Fannie Mae.
- ----------
(2143) See Mem. from Finance Division Manager to Office of the Chairman, F.
Raines and T. Howard, dated Sept. 23, 2002, FMSE 22882-84.
(2144) VN is a modeling application, which for FAS 91 amortization purposes,
applies an interest rate path to its library of prepayment models to
estimate CPRs.
(2145) CPR Analysis, dated Mar. 15, 2003, FMSE-SP 2936; CPR Analysis, dated Dec.
15, 2001, FMSE 217689.
(2146) See Juliane OFHEO Testimony at 45:20-46:10.
562
For several reasons, we find that it was improper for Juliane, as a
Director in Financial Reporting within the Controller's Office, to propose and
process CPR edits. First, CPRs are generated by VN through sophisticated models
monitored by eight economists and headed by Mills, who considered Fannie Mae's
CPR modeling capabilities to be "state of the art." Pennewell admitted that,
although she does believe the CPR edits were justified, in hindsight, it would
have been preferable from an internal controls perspective to rely solely on the
CPRs generated by Portfolio Analytics. Second, the CPR edits were made without
consulting Mills, whose input should have been considered critical to any
decision regarding the accuracy of the VN outputs. Third, any warranted changes
in CPRs should have been applied consistently to all areas of Fannie Mae, not
just the premium and discount amortization calculated by the Controller's
Office. Fourth, there does not appear to have been any consistent rationale for
the CPRs that management chose to alter or for the magnitude to which they were
adjusted.(2147)
v. FINDINGS REGARDING THE INVESTIGATION INTO BARNES'S CULTURAL COMPLAINTS
During early August, as Internal Audit was completing its
investigation, OCC began its investigation into Barnes's additional allegations
about the Controller's Office culture.(2148) OCC attorneys House, Karl Chen, and
Patricia O'Connor interviewed a substantial number of Controller's Office
personnel and management over several weeks.(2149) OCC found that some employees
in the Pennewell-Lewers reporting chain shared Barnes's concerns about the
atmosphere and management's attitude towards employees who raised questions, but
most employees in other groups indicated they felt comfortable raising issues to
their supervisors.(2150) Based on Barnes's complaints and the
- ----------
(2147) Some CPRs that originally fell outside of the market range were adjusted
to the approximate edge of the range while others were adjusted to the
approximate middle of the range. Still others were adjusted to an amount
that was within the range but neither at the edge nor the middle of the
range. Fannie Mae even adjusted some CPRs that fell within the market
range. In many cases, rather than adjusting the CPRs to be more
consistent with the middle of the range, the adjustments forced CPRs
closer to an edge of the range.
(2148) The OCC investigation commenced on August 5, 2003, but the majority of
OCC's interviews occurred after the August 8 meeting. This does not cause
concern because the August 8 meeting focused on accounting issues, rather
than the cultural issues Barnes had raised.
(2149) O'Connor was and is employed by the Office of Corporate Justice; she was
tasked to OCC's Barnes investigation because OCC did not have significant
investigatory experience at the time.
(2150) Office of Corporate Compliance: Decision #2003-1 (Part B, Reporting
Environment), dated Oct. 6, 2003, FMSE 24562-66, at FMSE 24563
(hereinafter "OCC Part B") ("Staff in the Controller's office who are not
in the same reporting chain as Barnes . . . indicated that they feel very
comfortable raising issues.").
563
employee statements made in the interviews, OCC concluded that Spencer,
Pennewell, and Lewers were not fostering an open environment in which employees
felt comfortable raising concerns.(2151)
Our interviews confirmed that the Controller's Office suffered from
managerial deficiencies, particularly as to communications regarding personnel
decisions and accounting policies. Lewers, for example, inappropriately failed
to address Barnes's personnel concerns and his accounting complaints. Both
Lewers and Pennewell, by refusing to address accounting matters with him, acted
in such a way that Barnes reasonably believed he would receive negative
treatment if he directly raised any accounting-related concerns. Proper
managerial action in this regard might have allayed Barnes's concerns before he
raised them formally.
VI. FINDINGS REGARDING THE INVESTIGATION INTO BARNES'S DISCRIMINATION
ALLEGATIONS
Early in the OCC investigation (on or about August 8), Barnes told
O'Connor and House that Controller's Office management repeatedly had
discriminated against him on the basis of race and gender. House referred this
complaint to Alan Tanenbaum of the Office of Corporate Justice ("OCJ").(2152)
Tanenbaum and his staff commenced an investigation into Barnes's discrimination
allegations, including document review and interviews. This investigation
continued after Barnes left Fannie Mae, and OCJ ultimately concluded that there
was no discrimination, but that there were environmental problems within the
Controller's Office.(2153)
VII. FINDINGS REGARDING THE RESULTS OF THE OCC INVESTIGATIONS
A. OCC Decision Part A: Internal Audit's Analysis
The OCC issued its Decision 2003-1, Part A, on September 29, 2003;
this decision focused on the accounting issues Barnes had raised.(2154) House
and Rajappa co-signed the Decision, which incorporated Internal Audit's
analysis.(2155) The Decision
- ----------------
(2151) OCC Part B at FMSE 24564. During the OCC interviews, many individuals
complained about Spencer, Pennewell, and Lewers. One individual said that
she even heard Spencer referred to as "the blonde ambition tour." Undated
Summary of Interview with a Fannie Mae Employee, PW-PR 283521-23, at
PW-PR 283522.
(2152) Fannie Mae has tasked OCJ with investigating discrimination complaints.
(2153) Mem. from A. Tanenbaum to L. Spencer, dated Jan. 12, 2004, FMSE-IR
508828-40 (hereinafter "OCJ Report").
(2154) See generally OCC Part A.
(2155) Id. This decision also incorporated the August 8 Minutes.
564
concluded, in relevant part, that "Internal Audit is satisfied that the
amortization issues raised by Barnes can be reasonably explained, [and] are in
compliance with GAAP . . . ."(2156)
On October 2, 2003, Jackson and Philip met with Barnes to provide
him with the results of their investigation.(2157) It appears that none of the
participants in the meeting were aware that Internal Audit's formal findings
already had been issued. Philip and Jackson each noted that Barnes did not
question or complain about the adequacy of Internal Audit's review of his
allegations. After the meeting, however, Barnes sent Jackson an e-mail stating
that Barnes neither agreed nor disagreed with Internal Audit's
conclusions.(2158)
B. OCC Decision Part B: Controller's Office Culture
On October 6, 2003, OCC issued Decision 2003-1, Part B, which
addressed the environmental issues in the Controller's Office.(2159) OCC
attorney Chen prepared the first draft of the report, concluding that the
Controller's Office culture was not conducive to open discussions regarding
accounting issues.(2160) House revised the draft and sent it to Remy for
review.(2161) Remy alerted House that he had concerns about the report because
it was "not crisp and clear."(2162) After discussion between House and Remy,
House drafted and sent to Remy and Kappler a "kinder gentler" version of the
report, which, according to House, was "much less harsh and more sympathetic
than earlier versions" in its criticism of Controller's Office management.(2163)
- ----------
(2156) Id. at FMSE 24413.
(2157) See E-mail from R. Barnes to P. Jackson, dated Oct. 2, 2003, FMSE 22719
(thanking Jackson for meeting to discuss Internal Audit's findings).
(2158) Id.
(2159) See generally OCC Part B.
(2160) Untitled draft, dated Sept. 2, 2003, FMSE-IR 463838-49, at FMSE-IR
463847-48.
(2161) Remy oversees both OCC and Fannie Mae's litigation group.
(2162) Chen had been with OCC only two weeks when the Barnes investigation
began; we understand that this was the first draft report of this type to
come out of OCC and thus potentially could have been subject to more
scrutiny than might otherwise be expected.
(2163) E-mail from D. House to A. Kappler, dated Oct. 2, 2003, FMSE-E 2170320
(attaching revised draft and noting that Remy had approved it).
565
The Decision directed certain remedial actions to improve the
Controller's Office reporting environment.(2164) Most notably, OCC required that
Pennewell, Lewers, and Juliane receive "coaching" to assist them in
communicating with their subordinates.(2165) Pennewell, however, informed Lewers
that Lewers was being assigned a coach to aid her professional development,
rather than noting the relationship of this assignment to the Barnes matter. As
a result, we conclude that Lewers had no reason to believe that her behavior
towards Barnes had been criticized by OCC; this thwarted any potential
beneficial effect of the allegedly remedial measure.
Other OCC-directed actions included the conduct of regular
employee-management meetings within the Controller's Office. Although all of the
meetings were held, employees did not report any improvement in the Controller's
Office culture following the OCC Report and Barnes's departure. The OCC also
mandated that Spencer attend a workplace-environment seminar.(2166) Spencer did
not attend this seminar prior to her departure from Fannie Mae, apparently due
to scheduling issues.
The Decision concluded that "[t]he Reporting Environment in the
Controller's Office is unacceptable."(2167) According to Thomas E. Donilon, this
conclusion caused several executives to whom the report was distributed,
including Donilon, Howard, and possibly Spencer, to complain that the Decision
failed to provide sufficient information to allow the reader to understand the
basis for OCC's conclusions. Howard, in particular, voiced concern that the
Decision was too vague for him to know how to remedy the problems it described.
These concerns were conveyed to Remy and House. House construed the concerns as
management's request for a supplemental or amended decision, but she determined
that amending a report that already had been signed and issued would set a poor
precedent, and she declined to do so. No one made any further requests, and the
subject was dropped.
VIII. FINDINGS REGARDING THE RESULTS OF THE OCJ INVESTIGATION
On January 12, 2004, after a four-month investigation, OCJ issued
its report relating to Barnes's allegations of discrimination.(2168) This report
concluded that,
- ----------
(2164) OCC Part B at FMSE 24566.
(2165) Id.
(2166) Id. at 24566.
(2167) Id. at 24565.
(2168) See generally OCJ Report. Although Barnes left Fannie Mae in the middle
of the investigation, as discussed below, OCJ decided that its
investigation into his discrimination complaints should continue to
determine whether there were any institutional problems within the
Controller's Office that needed to be addressed. This is why the final
decision post-dates Barnes's departure from Fannie Mae.
566
although there was no evidence of race or gender discrimination, Controller's
Office management had communicated its personnel decisions to Barnes poorly (or,
at times, not at all), leading him to misunderstand the basis for those
decisions.(2169) As a result of its investigation, OCJ directed, inter alia,
that Spencer limit the ability of those in Pennewell's line of authority to hire
their own subordinates and that Pennewell direct Juliane to improve his
communication skills.(2170)
IX. FINDINGS REGARDING BARNES'S RESIGNATION AND SETTLEMENT OF THREATENED
LITIGATION
On October 16, 2003, shortly after the OCC issued Part B of its
decision but before OCJ had completed its investigation, Barnes's attorney(2171)
sent to Fannie Mae (care of Raines) a litigation demand letter, claiming that
Fannie Mae had discriminated against Barnes based on age and race and that the
Company had retaliated against Barnes as a whistleblower in violation of federal
law.(2172) Barnes threatened to file a lawsuit unless Fannie Mae responded by
October 27, 2003.(2173)
Among his allegations, Barnes claimed that Fannie Mae had: (1)
Discriminated against him by denying him a series of promotions for which he had
applied or had indicated an interest; and (2) retaliated against him for sending
an anonymous interoffice memorandum to Raines and Howard.(2174) The demand
letter attached a copy of an anonymous memorandum that Barnes said he had sent
to Raines and Howard in September 2002 and that detailed alleged accounting
problems within the Controller's Office.(2175) Barnes's counsel further charged
that Fannie Mae management
- ----------
(2169) OCJ Report at FMSE-IR 508833-40. Portions of the report relating to
Barnes's allegations of inappropriate physical contact by Spencer were
redacted from versions delivered to Pennewell and Lewers. Id. at FMSE-IR
508831; see also Handwritten notes from A. Tanenbaum to E. Bailey, dated
Dec. 15, 2004, FMSE-IR 359602-14 (attaching unredacted version of
report).
(2170) OCJ Report at FMSE-IR 508828-29.
(2171) Barnes stated that he had been seeking to retain counsel since the spring
of 2003. From his comments during his interview, we surmise that Barnes
must have hired counsel during the summer of 2003, although Barnes would
not confirm that information.
(2172) Letter from Elaine D. Kaplan to F. Raines, dated Oct. 16, 2003, FMSE
24667-84.
(2173) Id. at FMSE 24683.
(2174) Id. at FMSE 24667-84.
(2175) Id.; Mem. from Finance Division Manager to Office of the Chairman, F.
Raines, and T. Howard, dated Sept. 23, 2002, FMSE 22882-84.
567
had treated Barnes in a hostile manner since that time (and thus that Fannie Mae
must have known that Barnes had sent the memorandum).(2176)
Because the anonymous memorandum appended to the demand letter did
not appear on correspondence logs maintained in the Office of the Chairman,
Fannie Mae's litigation group, under the direction of Remy, launched an
investigation into whether Raines or Howard actually had received this anonymous
letter. Remy initially stated that Fannie Mae had located forensic computer
evidence indicating that the letter had been drafted well after its alleged
date, evidencing that it was not created and sent as Barnes claimed. Remy later
withdrew from this position, acknowledging that there was no specific evidence
of Barnes creating the letter after the date listed. Tom Foster, the head of
Fannie Mae's Information Security Management ("ISM") team that conducted the
forensic search, confirmed that the letter was not found on Barnes's work
computer.(2177) Nonetheless, Fannie Mae attorneys and executives believed that
Barnes did not send the letter as he claimed because it was not found in the
correspondence logs of the Office of the Chairman.(2178)
Fannie Mae hired outside counsel to investigate and report on the
substantive allegations contained in the demand letter. Outside counsel
conducted numerous interviews and advised Fannie Mae on the risks and prospects
of litigation with Barnes. Based on all the information gathered relating to the
allegations contained in the demand letter, Fannie Mae concluded that it was in
the Company's interest to settle Barnes's threatened litigation.(2179)
During the course of our investigation, we had access to and
reviewed privileged material and attorney work-product related to Fannie Mae's
decision to settle the threatened litigation. We also interviewed the attorneys
who participated in making this decision. Based on all of the information
available, we found no evidence that the Company settled the anticipated
litigation to prevent Barnes from pressing his allegations of accounting
impropriety. Indeed, because the settlement specifically required Barnes to
cooperate with any internal, OFHEO, or other regulatory investigation into
Fannie Mae,
- ----------
(2176) Letter from E. Kaplan to F. Raines, dated Oct. 16, 2003, at FMSE 24675.
(2177) At our request, Huron conducted its own forensic analysis of Barnes's
hard drive and confirmed ISM's conclusion.
(2178) Blickstein, Vice President and Assistant to the Chairman and CEO, stated
that such a letter would have been considered "nuclear" and that Fannie
Mae's Office of the Chairman would have responded to it immediately.
(2179) The parties executed a settlement agreement on November 3, 2003.
Settlement Agreement, dated Nov. 3, 2003, FMSE-IR 8207-15.
568
he was (and continues to be) contractually obligated to discuss his concerns
with all relevant investigators.(2180)
X. FINDINGS REGARDING KPMG'S REVIEW AND FINAL REPORT
In January 2004, Argires of KPMG informed Rajappa that Fannie Mae needed
to perform additional work to investigate Barnes's environmental allegations; we
were told that KPMG asked for this work so it could sign-off on Fannie Mae's
year-end financial statements. Argires stated that, because Barnes had alleged
that it was difficult for employees to raise issues within the Controller's
Office, KPMG's forensic group recommended that the Company perform additional
procedures, including examining employees' e-mails to determine if other
employees in that group had raised issues internally that had not been addressed
properly.
In connection with this request, Rajappa and Eilers examined approximately
3,500 e-mails identified by keyword searches on the computers of sixty
individuals.(2181) Internal Audit, with assistance from Pamela Verick-Stone of
KPMG, crafted the search terms. Rajappa stated that he kept KPMG informed of the
process and provided KPMG with a CD containing all of the reviewed
e-mails.(2182)
After reviewing the e-mails, Rajappa and Eilers concluded that there had
been no stifling of discussion within the Controller's Office. In fact, they
found that the accounting issues that had been raised had been fully
disseminated and discussed. KPMG also determined that Internal Audit and OCJ
were "adequately independent" and, therefore, KPMG could rely on their
investigation. KPMG did not make any follow-up requests after the e-mail review
was complete.
As part of the same KPMG-requested review, Fannie Mae imaged certain
employees' computer hard drives.(2183) House and Tanenbaum then reviewed the
files on these hard drives. Like Rajappa and Eilers, House and Tanenbaum found
no evidence of complaints having been raised but not answered. Rajappa then
conveyed the results of both reviews to KPMG. Based on this information, KPMG
concluded that Barnes's
- ----------
(2180) Id. at FMSE-IR 8207-08 ("The Employee agrees that he will fully cooperate
with any investigation conducted by Fannie Mae or by any federal, state,
or local government authority relating to Fannie Mae."); see id. at
FMSE-IR 8212.
(2181) Barnes's computer was not examined at this time because it had been
searched previously in connection with the decision to settle his
discrimination charges.
(2182) Rajappa does not know what KPMG did with this CD.
(2183) These employees were Spencer, Pennewell, Lewers, Juliane, and Barnes.
569
allegations would not prevent it from signing off on Fannie Mae's 2003 financial
statements.(2184)
XI. FINDINGS REGARDING BARNES'S TESTIMONY TO OFHEO AND CONGRESS
On September 1, 2004, Barnes testified before OFHEO, and, on October 6,
2004, he provided sworn written testimony to the House Subcommittee on Capital
Markets, Insurance, and Government Sponsored Enterprises.(2185) In both sets of
testimony, Barnes asserted that Fannie Mae's senior management (up to and
including Raines) had engaged in inappropriate earnings management and
intentional accounting impropriety.(2186) He also alleged that he had mentioned
these concerns repeatedly to Controller's Office management and had been
punished as a result.(2187) He further claimed that other Fannie Mae personnel
who had raised concerns internally had been demoted, reassigned, or fired.(2188)
Barnes did not make these allegations during the investigations conducted
while he was at Fannie Mae. Therefore, Fannie Mae did not have the opportunity
to investigate these claims earlier.
- ----------
(2184) Mem. to Administration File from M. Serock, Steve Galotta, and R.
Forster, dated Jan. 21, 2004.
(2185) Written Testimony of Roger Barnes, Former Manager of Financial
Accounting, Deferred Assets in Fannie Mae's Controller Division, dated
Oct. 6, 2004 (hereinafter Barnes Congressional Testimony), available at
http://financialservices.house.gov/media/pdf/100604rb.pdf; Tr. of Sept.
1, 2004 OFHEO Interview with R. Barnes (hereinafter "Barnes OFHEO
Testimony").
(2186) See, e.g., Barnes Congressional Testimony at 11-12; Barnes OFHEO
Testimony at 81:21-83:7.
(2187) See, e.g., id. at 2, 8-9, 13; Barnes OFHEO Testimony 184:8-12 ("The
top-rated manager can't get promoted, but he is the only one asking
questions. Something is wrong.").
(2188) Id. at 2.
570
CHAPTER X: MANAGEMENT'S CONDUCT DURING OFHEO'S SPECIAL EXAMINATION
I. INTRODUCTION
This Chapter reviews Fannie Mae's conduct in the OFHEO examination that
commenced in late 2003, up through the issuance of the OFHEO Report in September
2004. In particular, we focused on the adequacy of the Company's production of
documents in response to OFHEO requests, and on the conduct of the Legal
Department and its advisors during the examination, including the accuracy of
the information they provided to the Board.
II. BACKGROUND
A. FREDDIE MAC'S ANNOUNCEMENT
On January 22, 2003, Freddie Mac announced that its outside auditor would
delay certification of Freddie Mac's year-end 2002 financial statements and that
it expected to restate its financial statements for 2001, 2002, and possibly
2000.(2189) Freddie Mac announced the results of its restatement on November 21,
2003.(2190)
In December 2003, OFHEO released its "Report of the Special Examination of
Freddie Mac" (the "Freddie Report").(2191) The Freddie Report found, among other
things, that Freddie Mac "cast aside accounting rules, internal controls,
disclosure standards, and the public trust in the pursuit of steady earnings
growth."(2192)
B. OFHEO's Announcement to Examine Fannie Mae
In July 2003, OFHEO announced that it would conduct a special examination
of Fannie Mae's accounting policies, internal controls, and financial reporting
(the "Special Examination").
On July 17, 2003, Armando Falcon, Jr., then Director of OFHEO, testified
before the United States Senate Committee on Banking, Housing, and Urban
Affairs. Although the Director's testimony focused on the Freddie Mac
restatement process, he added that OFHEO intended to conduct a review of Fannie
Mae to "independently
- ----------
(2189) Freddie Mac press release, dated Jan. 22, 2003, available at
http://www.freddiemac.com/news/archives/investors/2003/4q02.html.
(2190) Freddie Mac press release, dated Nov. 21, 2003, available at
http://www.freddiemac.com/news/archives/investors/2003/restatement_
112103.html.
(2191) OFHEO Report of the Special Examination of Freddie Mac, dated Dec. 2003,
available at http://www.ofheo.gov/media/pdf/specialreport122003.pdf.
(2192) Id. at i.
571
evaluate the accounting policies at Fannie and examine whether their
implementation is resulting in a high level of conformance to GAAP."(2193)
The next day, on July 18, 2003, OFHEO General Counsel Alfred M. Pollard
sent a letter to Thomas E. Donilon, then Executive Vice President -- Law and
Policy at Fannie Mae, stating that "the Director has indicated that he will
undertake a review of Fannie Mae's accounting policies . . . in light of
concerns surrounding accounting interpretations over the past few years relating
to FAS 133, FAS 125, FIN 45 and other FASB releases and with accounting control
functions."(2194) The letter directed the Company to "assure that document
retention policies maintain the integrity of written, electronic and other
information media in the accounting area and related internal control
functions."(2195) As described below, OFHEO issued its first document request to
Fannie Mae on November 21, 2003.(2196)
III. FANNIE MAE'S RESPONSE TO OFHEO REQUESTS
A. Document Preservation Efforts
In response to OFHEO's July 2003 letter to Donilon, Fannie Mae's Legal
Department compiled a list of fifty employees whom it believed were most likely
to have information relevant to OFHEO's inquiry. The list included employees
from the Office of the Chairman, Office of the Controller ("Controller's
Office"), Office of Auditing ("Internal Audit"), Mortgage Portfolio, and the
Legal Department. On July 22, 2003, Ann M. Kappler, Executive Vice President and
General Counsel, sent a memorandum to these fifty individuals, asking them to
"ensure the retention of all documents and material, including electronic files,
e-mail and other media dating back to 1999 and going forward that concern Fannie
Mae's accounting policies and related internal accounting control functions,
including, specifically, documents or information involving interpretations
relating to FAS 133, FAS 125, FIN 45 and any other FASB releases."(2197)
- ----------
(2193) Oversight of Freddie Mac Accounting Practices: Hearing Before the S.
Comm. on Banking, Housing, and Urban Affairs, 108th Cong. (2003)
(statement of Honorable Armando Falcon, Jr., Director, OFHEO), available
at http://www.ofheo.gov/News.asp?FormMode=Release&ID=84.
(2194) Letter from Alfred M. Pollard to Thomas E. Donilon, dated July 18, 2003.
(2195) Id.
(2196) See infra text accompanying note 2204.
(2197) Mem. from Ann M. Kappler to Distribution, dated July 22, 2003, FMSE-IR
376116-17, at FMSE-IR 376116.
572
As the Company identified other employees as potential custodians of documents
in these areas, those employees were provided a copy of the retention
memo.(2198)
On August 19, 2003, the Company began archiving all incoming and outgoing
e-mails for fifty-one employees to ensure the retention of any relevant e-mails.
As company counsel at Wilmer explained in a memorandum submitted to Paul, Weiss
on November 17, 2005 ("Document Collection Memorandum"),(2199) the Legal
Department implemented the following protocol: "employees with operational and
management responsibility in the areas identified by OFHEO were added to an
`e-mail archive' that automatically captured and stored e-mails received by each
employee at the time of receipt, and, on a nightly basis, copied e-mails sent by
each employee."(2200) The Legal Department then reminded these employees, via an
August 18, 2003 e-mail, that "[t]he process will not preserve electronic
documents other than e-mail" and, therefore, they "should not delete any
electronic documents or information stored on [their] m-drive, a shared drive,
or any other location (including information on [their] calendar)."(2201) The
Company added additional names to the list of relevant employees over the course
of the Special Examination, ultimately archiving the e-mails of 121
employees.(2202)
On October 13 and 14, 2003, after obtaining and reviewing a copy of
OFHEO's Request for Proposals ("RFP") from accounting firms to assist OFHEO in
conducting its Special Examination, the Legal Department sent e-mails to the
original fifty employees to highlight other potential issues raised in the RFP.
In addition to the areas specified in Kappler's July 22, 2003 memorandum, the
October 14, 2003 e-mail identified for employees several other areas of
potential interest to OFHEO, including: (1) policies and transactions relating
to the timing of income recognition; (2) policies and transactions relating to
derivative financial instruments and securitization; (3) "transactions that do
not appear to have a valid business risk management purpose" and/or "that have
been executed without proper authorization"; (4) management's process
- ----------
(2198) Mem. from Jody A. Kris to Senator Warren B. Rudman, dated Nov. 17, 2005,
at 3 (hereinafter "Document Collection Mem.").
(2199) Id. This and other examples of documents relevant to the discussion in
Chapter X can be found in the accompanying Appendix, at Tab G.
(2200) Id. at 3. On account of a new e-mail system at the Company, as of late
2003/early 2004, all e-mails sent by employees were captured
instantaneously by the e-mail archive. Id. n.2.
(2201) E-mail from Donald M. Remy to A. Kappler, et al., dated Aug. 18, 2003,
PW-PR 853405-06, at PW-PR 853405.
(2202) Document Collection Mem. at 3.
573
for formulating sensitive accounting estimates; and (5) how estimates and
judgments are estimated and monitored.(2203)
On November 21, 2003, OFHEO issued its first request to Fannie Mae for
hardcopy and electronic documents, including e-mails. The request applied to all
Fannie Mae employees and covered materials from January 1999 to the date of the
letter, including: (1) copies of all communications to or from Fannie Mae
employees, Board members, or agents concerning communications with the SEC; and
(2) copies of all documents prepared by Fannie Mae employees, consultants,
contractors, or Board members related to FAS 133.(2204) In response, on November
26, 2003, Fannie Mae's Legal Department sent an e-mail to the employees it had
identified in July 2003, attaching OFHEO's request and explaining that someone
from the Legal Department would contact them to collect all potentially
responsive documents. The e-mail stated that employees should continue to retain
all documents relevant to Kappler's July 22, 2003 memorandum.(2205) That same
day, the Legal Department sent an e-mail to all Fannie Mae officers to inform
them of OFHEO's request and direct them to review their files for any responsive
documents.(2206) The Legal Department continued to send out additional reminder
e-mails periodically.(2207)
As part of its document preservation efforts, the Company restored certain
employees' e-mails. With respect to those individuals identified by the Company
as most likely to have relevant, accounting-related information, the Legal
Department instructed
- ----------
(2203) E-mail from A. Kappler to Franklin D. Raines and Timothy Howard, et al.,
dated Oct. 14, 2003, FMSE-IR 376118-19, at FMSE-IR 376118; see also
Letter from A. Kappler to A. Pollard, dated Nov. 7, 2003, at 2; E-mail
from Debbie D. Milton to Leanne G. Spencer, et al., dated Oct. 13, 2003,
FMSE 490446-48.
(2204) Letter from A. Falcon, Jr. to F. Raines, dated Nov. 21, 2003, FMSE-IR
376129-32, at FMSE-IR 376130-32.
(2205) Id. at FMSE-IR 376129.
(2206) E-mail from Jonathan Griffith to #OFHEO 5, dated Nov. 26, 2003, FMSE-IR
376125-28, at FMSE-IR 376125.
(2207) See, e.g., E-mail from A. Kappler to all Senior Vice Presidents and Vice
Presidents, dated Feb. 18, 2004, FMSE-IR 376135-47 at FMSE-IR 376135.
On September 27, 2004, following the release of the OFHEO Report, the
Legal Department sent a records retention memorandum to all employees in
the Controller's Office, Internal Audit, Portfolio Management, Portfolio
Strategy, Treasurer's Office, and others. FMSE-IR 376155-77, at FMSE-IR
376156-57.
574
the Company's information technology personnel to restore such individuals'
e-mails directly from backup tapes in order to recreate their mailboxes as of
July 19, 2003.(2208)
Regarding electronic documents other than e-mail, however, the Company did
not initially suspend its ordinary practice of recycling its system-wide
disaster recovery backup tapes. We found no evidence that anyone made an
affirmative decision not to suspend the disaster recovery backup tapes, and the
Company's outside lawyers view this failure to secure the backup tapes as
understandable, because attempting to recover responsive electronic documents in
this manner would have been extremely costly and inefficient. Indeed, according
to the Document Collection Memorandum, "[t]he disaster recovery tapes store
information in a format not conducive to easy restoration or searches to
identify the tiny fraction of data contained on them that would pertain to
Fannie Mae's accounting systems and controls. Moreover, that fraction of data
was replicated on Fannie's servers, and Fannie Mae had clearly instructed
relevant personnel not to destroy such information."(2209) For a short time
period in September 2004, and in response to civil law suits that were filed at
the time, the Company did retain daily and weekly backup tapes for the disaster
recovery systems.(2210) This practice, however, was discontinued after a few
months due to practical constraints outlined above.
In responding to OFHEO's initial requests for employee e-mails, Fannie
Mae's Legal Department drew upon three additional sources to the restored
e-mails previously mentioned.(2211) The first was the archived e-mails from
select employees. The second source was a series of annual backup "snapshots"
taken of the Company's entire computer system. These snapshots, which were made
near the end of the years 2000 through 2003, included all of the e-mails
residing on the system on the day that the backup was made. Due to the Company's
pre-existing e-mail retention policy, however, these snapshots generally
recorded only e-mails from the approximately four to six weeks prior to the date
of the snapshot. The third source of recovered e-mail was the e-mail that
individual users of the Fannie Mae system had archived independently by saving
messages to storage folders on their local hard drives or on their network
space.
B. E-mail Review
The Company had extensive communication with OFHEO about e-mail
restoration, review, and production throughout the course of the Special
Examination. Most of the communication focused on Fannie Mae's ability to
respond in a timely fashion to what it considered to be OFHEO's extremely broad
e-mail requests. For example, we understand that in early January 2004, in-house
and Wilmer lawyers
- ----------
(2208) Document Collection Mem. at 5.
(2209) Id. at 5.
(2210) Id.
(2211) See supra text accompanying note 2208.
575
requested a meeting with OFHEO, at which they expressed the view that
substantial time and resources would be required for the Company to respond
adequately to OFHEO's November 2003 document request, particularly for
conducting the responsiveness and privilege review of all recovered e-mails sent
by relevant employees. The lawyers thus suggested utilizing search terms to
narrow the pool of potentially responsive e-mails, but did not receive
permission to do so.
Over the next several months, OFHEO issued additional document requests to
Fannie Mae, which included requests for e-mails. On June 28, 2004, OFHEO issued
a subpoena duces tecum to Fannie Mae, seeking the production of e-mails from
thirty-six employees or former employees.(2212) The subpoena directed that
production begin on July 6, 2004 and be completed by July 26, 2004.(2213) At
Fannie Mae's request, the Company's lawyers met with OFHEO representatives on
July 7, 2004 to discuss the scope of the subpoena. At that meeting, the lawyers
expressed the view that OFHEO's timeline for the production of all e-mails was
not realistic on account of the volume of material that needed to be reviewed.
At this meeting, OFHEO representatives told Fannie Mae that it would not allow
the use of search terms in reviewing e-mails.
In August 2004, Fannie Mae organized an "all hands" review of e-mail
messages, in which attorneys from the Company's divisions throughout the country
were brought in to review e-mails, along with dozens of attorneys from Wilmer.
E&Y, the accounting firm retained by Wilmer, also assisted with the review under
Wilmer's direction. In all, Fannie Mae enlisted over 100 individuals who were
provided with certain guidelines for identifying responsive e-mails.
In total, during the period from January 2004 up to the issuance of the
OFHEO Report,(2214) the Company produced 965,565 pages of e-mail in response to
OFHEO's initial requests. Following the release of the OFHEO Report, the Company
produced an additional 1,146,565 pages of e-mail through November 2005.(2215)
- ----------
(2212) Letter from Charlotte A. Reid to Jodie Kelley, with attached subpoena,
dated June 28, 2004. The subpoena required production of each e-mail from
the thirty-six individuals "relating to, referring to, reflecting,
pertaining to, describing, evidencing, constituting, or commenting on, in
whole or in part, with respect to Fannie Mae's accounting policies,
procedures and practices, securities valuation, financial reporting,
internal audit, internal controls, or related matters." Id. at 3.
(2213) Id. at 4.
(2214) See OFHEO Report.
(2215) Mem. from J. Kris to Senator W. Rudman, dated Dec. 16, 2005, at 2
(hereinafter "Supplemental Document Collection Mem.").
576
C. Hardcopy Documents
The Fannie Mae Legal Department maintained responsibility for hardcopy
document collection in response to OFHEO's document requests.(2216) Within
Fannie Mae's Legal Department, Jodie Kelley, Vice President and Deputy General
Counsel, was primarily responsible for the Company's document collection
efforts. Kelley reported to Donald M. Remy, Senior Vice President and Deputy
General Counsel, who in turn reported to Kappler. Kelley stated that she
delegated the document collection tasks to a team of junior attorneys who
reported to her.
Kelley (and later Remy, as well) met with the team responsible for
collecting documents on a regular basis. According to the Document Collection
Memorandum, the discussions at these meetings focused on the scope of OFHEO's
requests, potential interviewees, document collection efforts to date, and
transmission of collected documents to outside counsel for review. As additional
requests were received by the Company in the summer of 2004, Wilmer attorneys
began participating in these team meetings to help coordinate the Company's
response.
After Fannie Mae received OFHEO's first document request in November 2003,
the junior attorneys, initially accompanied by attorneys from Wilmer, met with
the employees identified by the Company as likely to have responsive documents.
The attorneys showed the employees a copy of OFHEO's request and asked them to
produce all responsive documents from the relevant time period, which was
January 1, 1999 to the date of the request. Although the attorneys explained the
type of documents that were covered by the request, the responsibility for
collecting and identifying responsive materials was left to the employees. This
approach applied to hardcopy and electronic documents other than e-mail. By
contrast, all of the documents, network spaces, and hard drives of employees who
received individual subpoenas were collected and reviewed by attorneys in the
Legal Department.
In its Document Collection Memorandum, Wilmer challenged the notion that
employees were left with discretion to produce responsive documents, stating
that "[e]mployees were not left to interpret the requests as they saw fit - they
were provided with substantial, detailed guidance by the Legal Department
members as to what OFHEO sought and strict instructions to comply fully with
those demands."(2217) As detailed more fully in Section E below, notwithstanding
the Legal Department's "detailed guidance," numerous documents that were
responsive to OFHEO's requests were not produced until after the issuance of the
OFHEO Report.
- ----------
(2216) Wilmer was not responsible for collecting documents and was involved
primarily with reviewing documents for responsiveness and privilege, and
for the physical production. Wilmer apparently became more involved in
the collection process when subpoenas were directed by OFHEO to
individual employees.
(2217) Document Collection Mem. at 11.
577
When employees provided documents to lawyers in the Legal Department,
Fannie Mae sent those documents to Wilmer for responsiveness and initial
privilege review. Fannie Mae's Legal Department then conducted a second-level
privilege review and made the final decisions on whether to withhold documents.
As for electronic documents, Fannie Mae created a server that allowed employees
to download the electronic documents to a shared drive, such that Fannie Mae
could eventually download the documents and send them to Wilmer for review and
production.
D. Interviews
From November 2003 to September 2004, OFHEO requested interviews with
fifty-seven current or former employees of Fannie Mae. And, after withdrawing
certain requests, OFHEO ultimately met with forty-eight employees, some on
multiple occasions.(2218) Those interviewed included Timothy Howard, Leanne G.
Spencer, Janet L. Pennewell, Jonathan Boyles, Thomas A. Lawler, Jeffrey Juliane,
Sam Rajappa, Rene LeRouzes, Roger Barnes, and Mary Lewers.
Individuals from Wilmer and the Legal Department typically attended the
interviews, as did the interviewee's personal counsel, if counsel had been
retained. Also present were individuals from Deloitte & Touche ("Deloitte"),
which OFHEO had selected in February 2004 to provide accounting advice in
connection with the Special Examination. OFHEO continued to conduct interviews
of Fannie Mae employees following the release of its Report.
E. Findings Regarding the Company's Response to OFHEO Requests
From the period November 2003 through the issuance of the OFHEO Report in
September 2004, OFHEO issued to Fannie Mae 340 individual requests on
twenty-four occasions. In response, the Company produced to OFHEO approximately
412,670 pages of hardcopy and electronic documents exclusive of e-mail. In
contrast, after OFHEO issued its report in September, from October 2004 to
November 2005, OFHEO issued 151 individual requests on thirty-eight occasions,
and the Company produced in response an additional 744,081 pages of hardcopy and
electronic documents exclusive of e-mail.(2219) We have reviewed the pages
produced after October 2004, and have determined that a significant number of
documents were, in fact, responsive to OFHEO's earlier requests. The failure to
produce these documents before October 2004 resulted from a number of factors,
including the Company's initial failure to approach the task of collecting
documents in a sufficiently comprehensive and methodical manner and the
Company's attorneys' unduly narrow construction of a number of the document
request.
- ----------
(2218) Id. at 1-2.
(2219) Supplemental Document Collection Mem. at 2. Wilmer provided these page
numbers, which, for purposes of this Report, we have assumed to be
accurate. Paul, Weiss did not independently verify through a re-count.
578
Company employees and lawyers were not given clear or standardized
instructions to help them identify relevant documents. For example, certain
employees recalled being told that they were not required to look for documents
in their files if they did not create the document, but merely were copied on
the document. The junior attorneys involved in the document collection also did
not recall receiving any specific instructions on how to collect responsive
documents; and Kelley, who was in charge of the overall production, did not
regularly attend document collection interviews. The closest to a routine
process that we discovered was a template created by a junior lawyer. The
template provided a checklist of items to cover in the interviews, including the
interviewees' supervisor and direct reports, OFHEO's individual document
requests, other employees who may have relevant knowledge of documents, and
whether the interviewee stored any documents outside of the office, including at
home.(2220) This junior lawyer initially prepared the template for his own use,
so that he could have a list of relevant questions for the document collection
interviews he was conducting, and he later shared the template with other
attorneys. However, neither this lawyer nor anyone else from the Legal
Department conducting the document collection interviews could be certain that
they used the template for many of the interviews. Moreover, even after
reviewing the templates that have been produced to us, we still do not have a
clear record of the instructions that Company employees received, the places
that were searched, or the documents that were deemed non-responsive. In short,
we are unable to form a view that the Legal Department conducted the document
collection and review in a methodical and professional manner.(2221)
In the Document Collection Memorandum, Wilmer, on behalf of the Company,
notes that almost all of the relevant employees received the template:
Fannie Mae . . . identified 93 employees as potential custodians of
responsive documents for the November 21, 2003 request Of those 93, four
were no longer employed by the company when the interviews took place. Of
the remaining 89, there are only 11 employees for whom a template (or
associated handwritten notes) has not been located - 3 of whom were
lawyers involved in responding to the Special Examination The failure to
retain (or even to complete) a template for 8 of the 93 eligible employees
does not create a reasonable basis for inferring that the Legal Department
failed to instruct those 8 employees to direct the lawyers to potentially
responsive documents wherever they might be stored, in light of the
- ----------
(2220) See Undated Template, FMSE-IR 365233-37.
(2221) See, e.g., Undated Template for Brian Graham, FMSE-IR 430239-42; Undated
Template for Thomas A. Lawler, FMSE-IR 430104-08.
579
otherwise consistent approach and shared understanding . . . .
Likewise, the fact that some of the templates were not dated and did not
have all fields populated with notations does not create a reasonable
basis for inferring that the Legal Department somehow failed to search for
documents in certain locations within the employee's possession [E]ach of
the lawyers has affirmed the shared understanding that the lawyers were
tasked with guiding the employees to identify all responsive documents in
their custody, wherever located.(2222)
Simply noting the existence of templates, however, does not demonstrate that the
Legal Department did, in fact, undertake a comprehensive review for documents in
response to OFHEO requests. The fact remains that many of the documents that
were responsive to OFHEO's requests did not turn up until 2005, when the Company
abandoned its initial approach of allowing employees to search their own files
and adopted a new approach of having attorneys review documents in employees'
offices for responsiveness.
Finally, it appears that Wilmer, which was charged with the task of
conducting responsiveness and privilege reviews of the documents collected by
the Legal Department, construed OFHEO's requests very narrowly. For instance, it
is our view that the presentation notes of Timothy Howard for the meeting of the
Board of Directors in January 1999,(2223) where the 1998 catch-up was discussed,
were responsive to OFHEO's Request 9, which asked for "notes, transcripts,
minutes and draft minutes . . . recordings and/or summaries of all Board and
Board Committee meetings from January 1999 to date taken or compiled by Fannie
Mae employees."(2224) However, the Company did not produce this document until
after the issuance of the OFHEO Report.
Wilmer stated that it did not deem this document to be responsive to
OFHEO's request because:
[The document] does not purport to memorialize what was said at the
meeting. Therefore, the determination that the
- ----------
(2222) Document Collection Mem. at 9-10.
(2223) Notes for Jan. 19, 1999 Meeting of the Board of Directors of Fannie Mae,
FMSE-IR 182240-64.
(2224) Letter from A. Falcon, Jr. to F. Raines, dated Nov. 21, 2003, FMSE-IR
376129-32, at FMSE-IR 376130-32.
580
document was not responsive to Request 9 was reasonable.(2225)
Similarly, the Company did not produce a draft Quarterly Business Review
("QBR") summary, which reflected Howard's comments to the effect that the
Company was trying to push income out of 2001 into 2003 and 2004.(2226) It is
our view that this document was responsive to OFHEO Request 12, which called for
"complete unedited agendas, minutes, presentations, reports or recordings . . .
prepared with regard to or made in conjunction with the Quarterly Business
Reviews from January 1999 to date."(2227) Wilmer offered the following rationale
for the decision to designate the draft summary as non-responsive:
Fannie Mae . . . understood Request 12 to seek production of a complete
set of final documentation from the Quarterly Business Reviews over the
five year period in question Lawyers at WCPHD and the Fannie Mae Legal
Department reasonably determined that the document was not final, was not
a "complete unedited report," and was therefore non-responsive.(2228)
To be sure, lawyers often disagree in good faith regarding how to conduct
document reviews and respond to document requests. We discuss the examples noted
above to highlight what we consider to be unduly narrow constructions of OFHEO
document requests and to note that this may have been one reason why certain
relevant documents were not initially produced in response to OFHEO's requests.
It is important to emphasize, however, that we view Wilmer's decision as those
made by a zealous advocate in good faith. It is not our view, and we do not
find, that Wilmer intended to hinder or obstruct OFHEO's examination.
In the final analysis, the Company would have been better served by a less
restrictive approach by its lawyers in handling OFHEO document requests. First
and foremost, such an approach would have provided the attorneys with documents
that would have enabled them to have a more complete understanding of the facts
and be in a better position to recognize the potential flaws in the Company's
accounting practices. This would have helped the lawyers to avoid taking
factually unsupportable positions in defense of the Special Examination. Second,
a fuller document production may have
- ----------
(2225) Supplemental Document Collection Mem. at 5.
(2226) QBR Summaries, dated May 2002, FMSE-IR 565521-27.
(2227) Letter from A. Falcon, Jr. to F. Raines, dated Nov. 21, 2003, FMSE-IR
376129-32, at FMSE-IR 376132.
(2228) Supplemental Document Collection Mem. at 5-6.
581
staunched the increasingly adversarial and hostile relationship between the
Company and its principal regulator, OFHEO, during the Special Examination.
IV. CONDUCT OF THE LEGAL DEPARTMENT AND ITS ADVISORS DURING THE SPECIAL
EXAMINATION
Our investigative scope also included a review of the information
and advice that had been given to the Board during the Special Examination by
third parties, including by Wilmer and E&Y. This scope was added after OFHEO
raised questions about whether the Company's lawyers shielded certain documents
from OFHEO through an overly aggressive use of privilege during the course of
the Special Examination, and whether anyone in the Legal Department "lied to" or
"misled" the Board in connection with the Special Examination.
A. There is No Evidence That Privilege Assertions Were Made in Bad
Faith to "Cloak" Relevant Documents from OFHEO
With respect to the Company's assertion of privilege during the
Special Examination, while instances where documents that had been deemed
privileged were, on subsequent review, deemed not legitimately privileged, we
did not find any evidence that lawyers did, or were instructed by anyone to,
make aggressive privilege calls in order to shield relevant information from
OFHEO. We found that lawyers - both in-house and outside - sought to make good
faith determinations of privilege in the fast-moving examination, and found no
instance where critical documents were placed on privilege logs without any
basis for a claim of privilege simply to prevent their production to OFHEO.
It is true that documents withheld from OFHEO during the Special
Examination and placed on the privilege log prepared by outside counsel were
subsequently produced by the Company to OFHEO in 2005. However, the decision to
do so was made only after a lengthy discussion between the Board of Directors,
Paul, Weiss, and OFHEO, which culminated in the implementation of a Memorandum
of Understanding between the Board of Directors and OFHEO ("MOU"), which sought
to balance OFHEO's need for access to all information at Fannie Mae to conduct
its safety and soundness review, against Fannie Mae's legitimate interest in
protecting confidential privileged information against disclosure to any third
parties. Accordingly, we do not consider the fact that privileged documents were
produced post-MOU to be evidence that the withholding of such information
pre-MOU was in bad faith.
B. The Board Was Advised By Wilmer and E&Y That the Company's
Accounting Was Reasonable and Defensible
As for the allegation that anyone in the Legal Department "lied to"
or "misled" OFHEO, we again did not find any evidence that any lawyer - in-house
or outside - knowingly provided false information to the Board during the course
of the Special Examination.
582
Our interviews of Board members revealed that they did have the
mistaken belief that E&Y was engaged in a "Substantive Review" of the Company's
accounting, and that it would opine on the GAAP compliance of the Company's
accounting practices. As it turned out, E&Y never completed the Substantive
Review and never opined on the Company's accounting as in accordance with GAAP.
While we did not find any evidence that anyone intentionally provided
misinformation about the role of E&Y to the Board or to senior management, in
our view, the failure to clarify E&Y's limited role from the outset - as well as
during a joint meeting of the Audit and the Special Review Committees of the
Board on July 19, 2004 ("July 2004 meeting") - created confusion for the Board,
and led the Board to take significant but unwarranted comfort in the belief that
the Company's accounting practices were supported by E&Y as in accordance with
GAAP.
There is no dispute that E&Y had been retained by outside counsel to
the Company.(2229) However, the retainer agreement that specified E&Y's role was
never provided to the Board. Further, based on information provided to the
Board, E&Y was mistakenly perceived by several members of the Board and senior
management to be performing a "validation" of the Company's accounting
practices, rather than providing mere "litigation support" services to
Wilmer.(2230)
For example, in February 2004, the Audit Committee was informed that
E&Y would conduct tests and procedures to validate the GAAP-compliance of the
Company's critical accounting practices - including FAS 91 and FAS 133 - and
also to determine whether such accounting practices were "best practices."(2231)
While this "Substantive Review Plan" was described by E&Y in hindsight as a mere
"issue-spotting" exercise consistent with its litigation support function,(2232)
we conclude that the information about the Substantive Review Plan further
assured the Board that management and its counsel had engaged a second "Big
Four" firm to opine on the GAAP-compliance of the Company's accounting practices
that were under scrutiny.
E&Y emphatically disputed the suggestion that its role was to
provide such a "second opinion" on the Company's accounting practices, stating
that:
Our role was to identify accounting issues and assist the lawyers in
evaluating the risks associated with them. In
- ----------
(2229) See Letter from Russell J. Bruemmer to Dale Kitchens, with attachments,
dated Jan. 26, 2004, FMSE-IR 694352-60.
(2230) Letter from Kevin M. Downey to Senator W. Rudman, with attachments, dated
Oct. 20, 2005, at 25.
(2231) See Substantive Review Plan, dated Feb. 4, 2004, FMSE-IR 694361-63.
(2232) See Letter from J. Andrew Heaton to Robert P. Parker, dated Dec. 30,
2005, at 3 (hereinafter "December 2005 E&Y Letter").
583
this role, we informed our client about the accounting issues we
identified. However, we were not engaged to, and did not, conduct an
independent review of the Company's accounting or determine whether
Fannie Mae's accounting complied with GAAP - nor did we perform the
work that would have been necessary for us to reach such a
conclusion.(2233)
Unfortunately, we saw no evidence that E&Y or Wilmer clearly explained this
limitation on E&Y's work to the Board at any time in 2004. Thus, it appears
entirely reasonable for certain Board members and senior management to have
understood E&Y's comments about the Company's accounting practices as a "second
opinion" that the accounting was consistent with GAAP.(2234)
As noted above, it is E&Y's view that it never conducted procedures
to validate the GAAP-compliance of the Company's accounting policies.(2235)
However, in the July 2004 meeting, E&Y and Wilmer representatives both made
statements concerning the work they had performed under the Substantive Review
Plan that gave further comfort to the Board that the Company had a reasonable
basis for its accounting decisions and policies, and that there was no reason to
believe that a restatement would be required.(2236) Again, we saw no evidence
that either E&Y or Wilmer ever explained to the Board members at this meeting
that E&Y was not in a position to opine on the GAAP compliance of the Company's
accounting practices.
At the July 2004 meeting, Wilmer, E&Y and Boyles briefed the Board
on the key accounting issues under review, FAS 91 and FAS 133.(2237) We
carefully examined the information and advice that the Board received at the
July 2004 meeting because it was the only time, prior to September 2004, when
the Board was given a substantive presentation on the Company's accounting
practices at issue in the Special
- ----------
(2233) Id. at 2 (emphasis added).
(2234) Indeed, notwithstanding E&Y's position, as late as December 23, 2005,
Wilmer stated that "E&Y was expected to formulate and present its expert
views about Fannie Mae's accounting and whether Fannie Mae's policies did
not comply with GAAP in the areas subject to examination, and it did
exactly that." Letter from William R. McLucas and Charles E. Davidow to
Senator W. Rudman, dated Dec. 23, 2005, at 14 (hereinafter "December 23,
2005 Wilmer Letter").
(2235) December 2005 E&Y Letter at 2.
(2236) See Minutes of the Audit Committee of the Board of Directors of Fannie
Mae, dated July 19, 2004, FMSE 504860-69, at FMSE 504866-68 (hereinafter
"July 2004 Audit Committee Minutes"); see also December 23, 2005 Wilmer
Letter at 2-3.
(2237) July 2004 Audit Committee Minutes at FMSE 504866-68.
584
Examination. The recollections of witnesses who were interviewed about the
discussion at this meeting differed substantially. On balance, we conclude that
the tone and the content of the briefing by Wilmer and E&Y were such that the
briefing provided substantial comfort to the Board that the Company's accounting
was reasonable and defensible, and that a restatement would not be
necessary.(2238)
E&Y contends that it did not advise the Board at this July 2004
meeting that in its view, the "[C]ompany's positions and rationales for its
decisions and policies in the areas reviewed were justifiable and
reasonable,"(2239) and that, in fact, the discussion at the meeting included the
caution that OFHEO may "seek to cause a restatement."(2240) In support, E&Y
points to the draft minutes of the July 2004 meeting, which reflected both of
the above points,(2241) although neither point was included in the final version
of the minutes.(2242) In our view, the most significant point the Board members
heard at the July 2004 meeting from Wilmer and E&Y - which is unchallenged by
E&Y - was that "neither [Wilmer] nor E&Y had reached a conclusion that a
restatement in any period under review was required."(2243)
- ----------
(2238) See id.; see also December 23, 2005 Wilmer Letter at 2-3 (summarizing
Wilmer's presentation at the July 2004 meeting as containing the point
that "Fannie Mae's FAS 91 and FAS 133 accounting was based on defensible
business judgments, and neither E&Y nor WilmerHale had concluded that a
restatement was necessary based on the work done so far"); December 2005
E&Y Letter at 4 ("It is certainly fair to say that the reports made at
the July meeting were not wholly negative. For instance, it would not be
surprising if Board members viewed as positive the fact that management
had articulated practical reasons and business rationales for its
policies").
(2239) July 2004 Audit Committee Minutes at FMSE 504866.
(2240) December 2005 E&Y Letter at 3-4.
(2241) See Draft excerpts of the Minutes of the Audit Committee of the Board of
Directors of Fannie Mae, dated July 19, 2004, FMSE-IR 296116-17, at
FMSE-IR 296116.
(2242) December 2005 E&Y Letter at 4; see also July 2004 Audit Committee Minutes
at FMSE 504866.
(2243) July 2004 Audit Committee Minutes at FMSE 504866. We also note that the
minutes of the July 2004 meeting were high-level summaries of the
discussion that actually took place, and do not capture the tone and the
detail of the discussions. Moreover, it is undisputed that E&Y reviewed
and signed-off on the talking points that were to be used by Bruemmer at
the July 2004 meeting, which contained the conclusion that the Company
had put forward justifiable and reasonable reasons for its accounting
decisions and its policies. See Executive Summary, dated July 13, 2004,
FMSE-IR 694454-60, at FMSE-IR 694454; see also December 23, 2005
585
In addition to the minutes of the meeting, there are two documents
that reflect portions of the relevant discussions that occurred at the meeting:
the handwritten notes that were prepared by Dale Kitchens of E&Y in advance of
the meeting, which Kitchens stated that he followed during the meeting;(2244)
and the handwritten notes of David C. Britt, the engagement partner from KPMG
who attended the meeting.(2245) Both of these documents reflect that the salient
issues and questions raised by OFHEO with respect to both FAS 91 and FAS 133
were explained to the Board. For example, with respect to FAS 91, an E&Y
accountant noted that OFHEO may allege that the one to two percent policy was
"not GAAP" and was "[d]esigned to manage earnings," and that the 1998 audit
difference was "material."(2246) However, the presentation by Wilmer and E&Y at
the July 2004 meeting described any risks faced by the Company as mere "OFHEO
arguments" or "disagreements," without any explanation of the facts that may
form the basis for such OFHEO views.
Many attendees of the meeting also recalled E&Y's Michael S. Joseph
stating at the meeting, in substance, that had E&Y been Fannie Mae's auditor,
they would have signed-off on the financial statements. While such a categorical
statement was not supported in any document memorializing the meeting, the Britt
notes do reflect the comment from E&Y's Joseph that "E&Y would not have objected
to the [FAS 91] policy if they were the auditor;"(2247) and the Britt notes also
reflect the comment attributed to Wilmer that there was "[n]o evidence of
earnings management."(2248) Thus, notwithstanding the description of the
anticipated OFHEO and Deloitte views, the tone of the E&Y and Wilmer
presentation was such that Britt himself took substantial comfort and advised
the Audit Committee after the presentation in an executive session that the FAS
91 policy was GAAP-compliant if objectively and consistently applied.
It does not appear from these notes that E&Y's comments at the July
2004 meeting about the Company's accounting were accompanied by the
clarification that E&Y was not undertaking a GAAP-review of the Company's
accounting. Also, the
- ----------
Wilmer Letter at 6. Accordingly, we do not place much significance on the
edits that were made to the final minutes of the July 2004 meeting.
(2244) See Undated handwritten notes of D. Kitchens, FMSE-IR 296111-13.
(2245) See Undated handwritten notes of David C. Britt.
(2246) Id.
(2247) Id. Joseph has acknowledged that he did not fully comprehend the
Company's FAS 91 policy. Joseph said that he had misunderstood how the
Company's FAS 91 policy worked in practice when he spoke at the July 2004
meeting, and that he would not have agreed with the policy had he
understood how the policy actually worked.
(2248) Id.
586
Board apparently was not advised that E&Y was not performing the tasks reflected
in the Substantive Review Plan. According to the final minutes of the July 2004
meeting, at the conclusion of the presentations by Wilmer and E&Y, the Board
directed management to continue with the Substantive Review Plan, reflecting the
Board members' belief that the Substantive Review Plan was on-going.(2249) Based
upon this record, in our view, it was reasonable for the Board to believe that
E&Y, in fact, was providing a "second opinion" that the Company's accounting was
in accordance with GAAP.(2250)
We also note that in July 2004, the Company possessed many documents
that reflected management's intent to manage earnings. Nevertheless, the
presentation at the July 2004 meeting did not inform the Board of any of these
facts, and instead, provided comfort from the Company's outside lawyers and a
Big Four accounting firm that the Company's accounting was reasonable and
defensible against OFHEO arguments.
We have not seen any evidence that would call into question the good
faith of the Company's lawyers, or their experts, who were undoubtedly taking
directions directly from management about the overall strategy to take with
respect to OFHEO and how to defend the Company in the Special Examination. We
conclude, however, that the lawyers neglected to provide the Board with
sufficient information to allow the Board to weigh the risks and make an
informed decision about the best course for the Company. While management may
have been updated regularly by the lawyers on the relevant facts about the
Company's accounting, the Board did not have regular access to such information.
At the one meeting where the Board was given a substantive presentation, they
were merely told of possible "OFHEO arguments" or "disagreements" accompanied by
ready assurance that such practices were reasonable and defensible, and not
provided any factual information that showed that OFHEO's "arguments" may be
well founded.
Finally, there plainly was an unhealthy relationship between Fannie
Mae management and its primary regulator that had built up over the years, and
by 2004, management's approach to OFHEO was extremely adversarial. Management
and its counsel focused unduly on OFHEO's motives in conducting the Special
Examination, which led them to dismiss the accounting issues as merely "OFHEO's
arguments" and "disagreements." It turned out, of course, that management and
the lawyers were wrong about the accounting issues raised by OFHEO. We conclude
that the Company would have been better served if management and its lawyers had
objectively informed the Board of all of the facts and the risks arising from
those facts, and we recommend that the Company's lawyers make a concerted effort
to do so going forward.(2251)
- ----------
(2249) See July 2004 Audit Committee Minutes at FMSE 504868.
(2250) See supra text accompanying note 2234.
(2251) Wilmer's position is that the Board, at the July 2004 meeting, was
adequately advised of all of the risks that faced the Company, and that
the SEC's decision on FAS 133 was simply an event unforeseen by any of
the Company's accountants.
587
- ----------
See December 23, 2005 Wilmer Letter at 17. While that may be, our view
remains that going forward, the Board should be fully apprised of all
facts relevant to significant regulatory risks in an objective manner.
588
CHAPTER XI: OTHER ALLEGATIONS
PART A: ISSUES RAISED BY CURRENT OR FORMER FANNIE MAE EMPLOYEES
I. INTRODUCTION
On November 29, 2004, Ann M. Korologos, then the Presiding Director
on Fannie Mae's Board of Directors, sent a "broadcast" message to all Fannie Mae
employees asking them to contact us with any information or knowledge they might
have about "any unusual or atypical transactions in the past five years."(2252)
Korologos's message defined "unusual or atypical transactions" to include:
- Transactions that appear to (or did) significantly accelerate
or defer the pattern of income recognition.
- Transactions that appear to (or do) enable Fannie Mae to
change the character or classification of an asset or
liability.
- Transactions that do not appear to have been (or were not)
executed at prevailing market prices.
- Transactions that do not appear to (or did not) have a valid
business or risk management purpose or that lack economic
substance.
- Transactions that appear to have been (or were) executed
without appropriate authorization.
- Transactions that do not appear to have been (or were not)
accurately recorded in our financial statements.
- Transactions that appear to (or did) violate generally
accepted accounting principles or any Fannie Mae rule or
practice.
- Transactions that appear to have been (or were) executed so
that bonus targets are achieved.(2253)
In the course of our investigation, we received several responses to
Korologos's message. In addition, we received an unsolicited communication from
a mortgage lender regarding his experience with Fannie Mae.
- ----------
(2252) E-mail from Ann M. Kappler to all Fannie Mae employees, Nov. 29, 2004
(attaching message from Ann M. Korologos, Presiding Director, Fannie Mae
Board of Directors).
(2253) Id. The e-mail was prepared in consultation with OFHEO and the SEC.
589
We developed the following process for addressing the issues raised
in those responses:
1. When we received a response to the message, we asked the
individual to provide any documentation he or she had relating to
the issue raised.
2. Whether or not documentation was immediately forthcoming, Paul,
Weiss and Huron jointly decided whether the issue raised presented a
significant legal and/or accounting issue that was or should be
included in the scope of our investigation. Our presumption was that
we would treat such contacts as though they did raise a significant
issue unless and until we had satisfied ourselves otherwise. If the
contact raised an issue that was clearly outside the scope of our
review, our practice was to call the employee to discuss his or her
response, document the conversation, and close the matter.
3. If the issue warranted further inquiry, we arranged for a phone
call or meeting with the respondent. At a minimum, we would contact
the respondent by phone in order to: (i) understand that person's
job and involvement with the issue raised; (ii) obtain more details
on the issue, if possible; (iii) understand why the employee
believed that the issue was problematic; and (iv) obtain the names
of the individuals at Fannie Mae who are responsible for the matter,
as well as other individuals at any level who might have more
information. We would then decide whether to proceed with the matter
further and, if so, what steps to take.
In response to the broadcast message, ten Fannie Mae employees
contacted us.(2254) Seven of these contacts took place within the first month
following Korologos's message, while the remaining three contacts were made over
the course of the following year. Of the ten contacts, one matter was closed
with no further action; one matter was closed after interviewing the respondent;
two contacts were invited, but so far have failed, to provide additional
information concerning their allegations; one matter was the subject of
significant, stand-alone review; and the remaining five were folded into other
areas of our review.
- ----------
(2254) Two employees contacted us to discuss the same issue.
590
A. HTM/AFS Redesignation
On November 28, 2004, we were contacted by an employee with a
question about Fannie Mae's decision to move a large amount of securities from
Fannie Mae's held-to-maturity ("HTM") portfolio to its available-for-sale
("AFS") portfolio. This employee expressed no particular concerns about this
transaction, but said that he was coming forward out of an abundance of caution.
We interviewed the employee and discussed the issues he had raised.
He confirmed that the events he had brought to our attention involved the
redesignation of the securities from HTM to AFS in connection with OFHEO's
promulgation of new minimum capital requirements. We concluded that this
redesignation was appropriate. We took no further action on this matter.(2255)
B. Non-Specific Anonymous Call
On December 10, 2004, we received a call from a self-described
Fannie Mae employee who declined to identify herself to us. The caller claimed
to have serious allegations, but said that she would discuss them with us only
on the condition that not doing so would result in legal liability for her. The
caller asked for advice from us as to whether she had a legal obligation to come
forward. We declined to offer legal advice on this question, particularly in the
absence of any information regarding the nature of her allegations, but we
encouraged the caller to provide the information to us anonymously and/or to
discuss the matter with another attorney. The caller said that she would
consider doing so, but to the best of our knowledge we have had no further
contact with her.
C. Home Solutions (Minority Lending Initiative)
On December 10, 2004, we received a call from a Fannie Mae employee
who raised concerns about a Fannie Mae loan program called Home Solutions. The
respondent stated that Home Solutions was a loan program targeted at borrowers
living in zip codes with a high percentage of minority residents. The respondent
was troubled by the aggressive underwriting on the program and indicated that
the mortgage product had been created to meet internal targets - including
possibly bonus targets - rather than as an economically viable business line.
The respondent provided us with documentation about the Home
Solutions program, and we also submitted document requests to the Company about
the program (also called the Minority Lending Initiative or "MLI"). That
information, as well as information we derived independently, confirmed that the
program was targeted
- ----------
(2255) This specific allegation was separate from our consideration of the
Company's redesignation of securities from HTM to AFS as part of a
regular, intra-month process, which we discuss in Chapter VI, Part D.
591
to minority borrowers and that it was implemented as an effort to meet Fannie
Mae's internal business goals for reaching minority homeowners.
After reviewing the initial documentation, we identified certain
potential accounting and related issues in connection with the MLI program.
Accordingly, we added the program to the scope of our review of other minority
lending programs. A discussion of our review of this program can be found in
Chapter VI, Part N of this report.
D. Contract and Procurement Systems ("CAPS")
On December 14, 2004, we received a communication from a Fannie Mae
employee that raised concerns about Fannie Mae's CAPS group - then in the
Controller's Office - which oversees the Company's contract management. The
letter questioned the Company's controls surrounding its contract management
procedures, as well as the relationship between the CAPS group and the Legal
Department.
We interviewed several Fannie Mae employees on this issue. Although
some of these employees denied any serious problems in the CAPS group, the
majority of employees that we spoke with expressed the view that the CAPS group
did have significant management and controls issues. In particular, they alleged
that the CAPS group negotiated significant contracts without any legal
supervision or guidance, the CAPS group did not have a means of tracking
contracts, significant contracts (communications contracts, systems development
contracts, etc.) were allowed to expire, and some contracts were negotiated with
such poor terms that they placed Fannie Mae at risk. We also were told that
there had been no internal audit of the CAPS group as of the time that our
CAPS-related interviews took place. The documentation that we reviewed appeared
to confirm that observation.
These issues were outside of the scope of our review; in addition,
we were aware that the organizational structure of the Controller's Office,
including the CAPS group, was under review as part of the work conducted by
Mercer Oliver Wyman. Under the circumstances, we brought this matter to the
attention of Fannie Mae's Special Review Committee for further action by the
Company. The Company engaged The Hackett Group to conduct an evaluation. The
Hackett Group issued a report in August 2005 that substantially confirms certain
of the issues brought to our attention and makes specific recommendations for
improvement in the CAPS group organization.(2256)
- ----------
(2256) The Hackett Group, Procurement Diagnostic Assessment & Strategic
Transformation Plan: Final Report & Transformation Roadmap, with
appendixes, dated Aug. 10, 2005, FMSE-IR 703065-214. We also received
information that there were potential problems concerning Fannie Mae's
accounting for certain equipment. The individual who made that allegation
referred us to a former Company employee. We contacted the former
employee, who said that his comment had been based on a misunderstanding.
592
E. Anticipatory Hedge Transaction
On December 16, 2004, we received an e-mail contact from a Fannie
Mae employee who raised concerns regarding an anticipatory hedge transaction in
1998, which the contact believed did not qualify for hedge accounting. According
to the respondent, a substantial loss on the transaction was nonetheless
deferred.
We addressed anticipatory hedging transactions in several FAS
133-related interviews, and we identified the transaction that concerned the
contact. Essentially, a sharp movement of interest rates in the days before the
Company closed out the hedge of an anticipated debt issuance resulted in the
loss on the derivative exceeding the gain on the hedged debt issuance by $24.7
million. Management made the decision to defer the entire loss, even though the
applicable authoritative accounting literature required the excess to be
expensed. KPMG identified the issue and included the expense of $24.7 million in
their schedule of passed adjustments for the 1998 year-end.(2257) Given the date
of the transaction and our conclusions regarding the Company's accounting for
anticipatory hedge transactions, discussed in Chapter V, we did not deem it
necessary to pursue a separate inquiry into this incident.
F. Human Resources
We were contacted by an employee who raised concerns about cultural
issues in Fannie Mae's Human Resources department. We met with this respondent
and discussed primarily the "tone at the top" of Fannie Mae's management, both
in the Human Resources department and among the Company's top executives. We
incorporate the issues that this respondent raised into our broader review of
executive compensation issues. Our findings on this issue are described in
Chapter VIII of this Report.
G. Radian Credit Enhancement Product
We were contacted about a credit enhancement arrangement from 2002
with Radian in the form of a pool mortgage insurance policy on loans Fannie Mae
acquired in connection with a program entitled Expanded Approval with Timely
Payments Reward Product ("EA/TPR"). The respondent questioned Fannie Mae's
decision to pay $34.7 million for $38.6 million of insurance coverage when the
Company had already purchased other credit enhancement for that product. The
respondent also stated that there was a suggestion that the policy was
undertaken to defer income from current periods to future periods.
Upon reviewing documentation provided by the employee on the Radian
arrangement, we added this topic to the scope of our review. A full description
of our review of this topic can be found in Chapter VI, Part J.
- ----------
(2257) KPMG workpapers.
593
H. Partnership Office
We were contacted regarding one of Fannie Mae's Community Business
Centers, formerly known as a Partnership Office. The respondent's concerns
related primarily to another Company employee, who was associated with a
prominent politician. According to the manager, before giving the employee a
fairly severe evaluation, the manager received a call from a senior official in
Human Resources who said that the Company keeps track of the ratings of the
twenty to twenty-five employees "who can do political harm to the company." The
Manager was not instructed to change his evaluation, but soon after he gave the
employee his review, he received a call from the office of Thomas E. Donilon
(although not from Donilon himself), asking about the review. The respondent
also expressed concerns regarding the Company's management of his office.
We did not believe that a particular incident involving an
employee's evaluation was within the scope of our review, particularly given
that there was no change in the employee's evaluation. We also did not believe
that the Company's management of an individual Community Business Center fell
within our scope.
We did ask several interviewees whether they were familiar with a
list of "politically sensitive" employees that the Company tracked, but none had
heard of such a list. Likewise, we did not see any documentation that referred
to such a list.
I. Fannie Mae Loan Servicing Litigation
We received a letter, dated November 8, 2005, that described a
six-year-long litigation between Fannie Mae and a mortgage servicing company.
The dispute, which dated back to 1991, involved a breach of claim that the
mortgage servicing company brought against Fannie Mae alleging that the Company
had breached its mortgage servicing contract. According to information provided
with the letter, Fannie Mae prevailed in that lawsuit.
The author of the letter stated that "[r]ecent revelations" about
Fannie Mae were "a very interesting reminder of several issues raised in my
dispute with and litigation against" the Company. He also stated that "much of
what we were arguing at the time has now proven to be the very cause and/or
effect of some of [Fannie Mae's] problems and abuses today." He suggested that
he could "provide some valuable insight into [our] investigation."
Although we believed that the issues raised in a fifteen-year-old
lawsuit are beyond the scope of our investigation, we contacted the author of
the letter and invited him to provide us with a written submission setting out
any relevant information that he could share about Fannie Mae. We also invited
him to send us any additional documentation that he had to support his claim
that Fannie Mae's current problems were in some way related to the issues raised
in the prior litigation. On February 15, 2006, the respondent sent us a
supplemental letter, including a copy of a letter he had sent to the
594
Company's CEO the week before. Given the timing of the submission, and the fact
that the matter has been brought to the Company's attention, we took no further
action.
PART B: FANNIE MAE'S EQUITY INVESTMENTS IN GULF BANK
In January 2005, Stephen B. Ashley, acting Chairman of the Fannie
Mae Board of Directors, and Armando Falcon, Jr., then Director of OFHEO,
received an anonymous letter, dated January 4, 2005, from a self-described
"Former Fannie Mae Employee."(2258) The letter concerned Fannie Mae's $800,000
equity investment in Miami-based Gulf Bank as part of Fannie Mae's Community
Development Financial Institution ("CDFI") Initiative. According to the letter,
Fannie Mae made the investment at a time that Gulf Bank was under a Cease and
Desist Order issued by the Federal Reserve Bank, and that Fannie Mae wrote off
the investment "days after it was made."(2259) The letter also asserted that the
investment was prompted by a personal relationship between Robert J. Levin, at
the time Fannie Mae's Executive Vice President--Housing and Community
Development, who maintained ultimate responsibility for CDFI investments, and
Salvador Bonilla-Mathe, the Chairman of Gulf Bank and a former Fannie Mae Board
member by presidential appointment. Finally, the letter claimed that Levin
received inappropriate gifts and other consideration (such as vacations) from
Bonilla.(2260)
I. INTRODUCTION
The charge that Levin accepted inappropriate gifts or other
consideration from Bonilla is groundless. The evidence we compiled showed that
Levin developed an acquaintance with Bonilla during the Gulf Bank transaction,
not before it. In the course of their association, Bonilla and Levin met and, on
occasion, socialized in an appropriate fashion. Documents showed, and Levin
acknowledged, that he received three gifts from Bonilla. Two of the gifts were
tokens of minimal value, including a bag of coffee and a book about a charity
with which Bonilla was associated. As to the third gift - a chess set - Levin
sought the advice of the Company's General Counsel. Following her advice,
- ----------
(2258) Letter from "A Former Fannie Mae Employee" to Stephen B. Ashley, dated
Jan. 4, 2005, FM SRC 34840. Falcon was copied on the letter, as were
Daniel H. Mudd, CEO of Fannie Mae, and Congressman Richard H. Baker.
(2259) Id.
(2260) Id. The letter also alleged a hostile work environment and made
statements about compensation matters that were unrelated to the Gulf
Bank transaction. Id. The latter were unrelated to the executive
compensation issues within the scope of our investigation (see Chapter
VIII) and we do not address those statements further. By the time we
received the letter, the work environment matter had been investigated
by the Company's Office of Corporate Justice ("OCJ"); to the extent that
issue was within the scope of our review, we found no evidence in the
course of our work that would support it.
595
Levin returned the chess set to Bonilla. There is no evidence that Levin
accepted anything else of value from Bonilla.
Similarly, we have found no evidence to suggest that Levin's actions
in connection with the Gulf Bank matter were influenced either by a personal
relationship with Bonilla or that Levin brought undue pressure on Fannie Mae
employees, either individually or as part of the CDFI Investment Committee, to
approve and consummate the Gulf Bank transaction. As a preliminary matter,
Bonilla did not approach Levin initially; Bonilla approached Levin's then boss,
Lawrence M. Small, who asked Levin to pursue the transaction. In addition, (1)
at least some of the communication that referred to Levin's interest in this
transaction came from others in the Company who also supported the transaction,
and (2) Levin's immediate subordinates - including Senior Vice
President--Housing and Community Development Barry Zigas - felt free to express
reservations about the investment, but nonetheless gave it their support. Levin
maintained that, apart from a few shared meals, his relationship with Bonilla
was always strictly professional. Although Levin's level of involvement and
interest in the transaction seems out of proportion to the size of the
investment, Levin's personal interest in a CDFI transaction of this type was not
unprecedented. His explanation - that he respected Bonilla and was keenly
interested in helping to improve mortgage lending in the underserved Hispanic
neighborhoods in Miami - is credible.
Fannie Mae's equity investment in Gulf Bank does not appear to have
been extraordinary in the context of Fannie Mae's CDFI program. The transaction
was consistent with the purpose of the CDFI program, which was to support
potential housing partners in underserved communities and also to generate other
"franchise value" for Fannie Mae. With the possible exception of the final two
weeks of 2000 when the transaction was presented to the CDFI Investment
Committee, there is little evidence that the transaction was given preferential
treatment. The CDFI Investment Committee's consideration of the transaction at
that time does appear to have been rushed, and the circumstances do suggest that
the CDFI staff and Committee were under some pressure to act. That pressure, at
least in part, was the result of Bonilla's unrealistic and unrealized request
that the transaction close by the end of 2000. And, notwithstanding that
request, the transaction did not close for another nine months.
Gulf Bank's disclosure to Fannie Mae in 2001 that the Federal
Reserve found compliance violations at the bank was addressed by Levin to the
Fannie Mae Legal Department and outside law firms. Levin also sought information
on Gulf Bank and Bonilla from a private investigation firm. The available
evidence is that no one inside or outside Fannie Mae raised concerns about the
transaction moving forward.
The Company's write-off of the Gulf Bank investment occurred about
eighteen months after the investment closed and was part of a larger,
portfolio-wide review of CDFI investments. We found nothing unusual about this
practice, and the timing of the write-off was dictated by other factors.
596
II. BACKGROUND ON THE CDFI PROGRAM
A. The CDFI Program
The CDFI Initiative was established in 1994 as part of a broader
effort, dubbed the National Partners Project, to provide support to institutions
involved in community-based investments. Another goal of the program, at least
at the outset, was to generate financial returns on the investments made in the
CDFI institutions ("CDFIs").(2261)
Fannie Mae's technical staff sometimes would help the institutions
that received CDFI investments to establish mortgage lending operations.
Although the recipients did not always offer mortgages prior to Fannie Mae's
investment, encouraging the CDFIs to enter the mortgage business was one of the
program's goals.
Fannie Mae's CDFI investments usually took the form of certificates
of deposits ("CDs") (generally $100,000, although sometimes larger amounts) or
equity investments. The shares purchased in these institutions usually paid no
dividends and, given the nature of the institutions involved, were often highly
illiquid. Fannie Mae generally did not make equity investments in larger
institutions that had ready access to other sources of capital.
B. The "Typical" CDFI Transaction Life Cycle
According to Susan Weintraub, the CDFI analyst who worked on the
Gulf Bank transaction, the investment was "normal" compared to other potential
investments she worked on while with the CDFI Initiative. She characterized the
Gulf Bank transaction as an "average, typical transaction."
Weintraub described a typical CDFI project as having several stages.
At the outset, CDFI investment candidates often were identified by Fannie Mae's
regional and partnership offices, which would forward these suggestions to the
CDFI staff at Fannie Mae's headquarters; the CDFI staff would then undertake the
necessary due diligence.
As part of this due diligence process, information about the CDFI
candidate would be distributed to other groups within Fannie Mae, such as Credit
Policy, to evaluate the potential investment. Corporate Finance would assist by
valuing the equity that Fannie Mae might acquire in the deal.
The CDFI staff also would create an investment package for review by
Fannie Mae's CDFI Investment Committee to use in determining whether to approve
a candidate for investment. This Committee, whose members were appointed by
Levin,
- ----------
(2261) Letter from Susan M. Golden to Salvador Bonilla-Mathe, with attachments,
dated Dec. 7, 1999, FMSE 481158-65, at FMSE 481158.
597
generally included Fannie Mae officers at the Senior Vice President level and
above. According to Levin, he had overall oversight of the program, but at the
time of the Gulf Bank transaction, Roger L. Williams was in charge of the
program on a day-to-day basis. Levin stated that Williams, a Vice President,
reported to Zigas.
If the CDFI Investment Committee approved the proposed investment,
then CDFI staff would prepare the relevant documents and assist in the closing
process. One interviewee suggested that the rejection rate was approximately ten
percent, the majority of which were rejected on the basis of curable defects.
Ultimately, most (if not all) CDFI projects were approved.
C. The Gulf Bank Transaction
1. Genesis of Fannie Mae's Relationship with Gulf Bank
On May 20, 1999, Bonilla wrote to Small, then President and Chief
Operating Officer at Fannie Mae. Bonilla told Small that he (Bonilla) had met
the day before with Nitin J. Dave and Cecilia LaVilla-Travieso at Fannie Mae's
partnership office in Miami to discuss the "Minority and Women Owned Lenders
Initiative."(2262) Bonilla indicated that, due to its rapid growth, Gulf Bank
soon would require "additional capital infusions," and he expressed interest in
an investment from Fannie Mae. Bonilla also expressed a desire to become part of
Fannie Mae's "deposit program," and he asked for Small's help in "securing the
maximum available [deposit] as soon as possible."(2263)
On May 25, 1999, Small replied to Bonilla, stating that he would
alert his colleagues to Bonilla's "interest in a relationship."(2264) Small then
forwarded both his letter and Bonilla's letter to Levin with a handwritten note
stating that Bonilla "wants to get into our deposit program for minority
banks."(2265) He asked Levin to follow-up on the request and reminded Levin that
Bonilla was a former Board member. Levin apparently forwarded this message to a
member of the CDFI staff, along with a handwritten note stating: "Here's the
item I mentioned yesterday. Pls [sic] give me frequent status reports."(2266)
During our interview with Levin, he recalled that Fannie Mae's
partnership office was already working on the Gulf Bank transaction before he
became
- ----------
(2262) Letter from S. Bonilla to Lawrence M. Small, dated May 20, 1999, FMSE
482947.
(2263) Id.
(2264) Letter from L. Small to S. Bonilla, dated May 25, 1999, FMSE 482946.
(2265) Handwritten mem. from L. Small to Robert J. Levin, with attachments,
dated May 25, 1999, FMSE 482945-47, at FMSE 482945.
(2266) Id.
598
involved; he did not remember that Bonilla had approached Small directly.(2267)
Levin did not recall either receiving Small's note about Bonilla's letter or
sending the note on to someone else, although the handwritten note did appear to
be in his handwriting. Levin speculated that his request for "frequent" updates
was probably because of Small's involvement.
Within a few weeks of this exchange, Fannie Mae acquired a Gulf Bank
CD in the amount of $100,000.(2268) There is no indication that the request for
a "capital infusion" was discussed at this time.
2. The Request for an Equity Investment
In late October 1999, Bonilla visited with Glenn Austin and Dave at
Fannie Mae's Southeast Regional Office ("SERO") to discuss a possible equity
infusion from Fannie Mae via the CDFI program and Bonilla's goal of expanding
Gulf Bank's mortgage lending business, possibly through "acquisition of a
Hispanic mortgage banking firm to give him a jump start."(2269) According to
Dave's e-mail recounting the meeting, Bonilla later communicated with Small on
this subject.(2270) Dave indicated that Small then wrote to Levin, "requesting
him to stay in the loop on it," and that Dave had been asked to "spearhead"
Bonilla's request. Dave asked Weintraub to send Bonilla a "CDFI letter."(2271)
In an e-mail from around the same time, Dave noted that it would "behoove us to
leverage our CDFI initiative to increase our business with the MWOLs, CDFIs, and
HFAs, regionally and nationwide, and still extract the fundamental [f]ranchise
value from such prudent investments."(2272)
- ----------
(2267) Levin's recollection that the partnership office - the Southeast
Regional Office - was the source of Bonilla's first contact with Fannie
Mae is consistent with Weintraub's recollection that the Gulf Bank
opportunity came from that office through the usual channels.
(2268) E-mail (within chain) from Susan Weintraub to Nitin J. Dave, final
e-mail within chain dated Nov. 22, 1999, FMSE 482900-03, at FMSE 482900
(reminding Dave that Fannie Mae had "purchased a one-year $100,000 CD at
Gulf Bank on June 24, 1999").
(2269) Id. (e-mail within chain from N. Dave to S. Weintraub).
(2270) Id. Specifically, Bonilla spoke to Small, and then followed up with a
letter. Id. We have not seen a copy of the letter.
(2271) Id.
(2272) E-mail from N. Dave to Glenn Austin, et al., dated July 31, 1999, FMSE
482898-99, at FMSE 482899.
599
Levin wrote to Small on November 22, 1999, forwarding an e-mail from
Austin to Dave, which Levin thought would provide Small with "a description of
the follow up that's occurred so far as a result of Salvadore's [sic] letter to
you."(2273) Levin stated that "Glenn and his team, and the CDFI team are on
it."(2274) The forwarded e-mail from Austin stated that Austin had "spoken with
Rob about giving Gulf Bank special attention when the equity investment
application is complete."(2275)
Although Fannie Mae sent a request to Gulf Bank for supporting
documents in early December 1999,(2276) the bank's response was slow in coming.
Over the course of the next twelve months, members of Fannie Mae's CDFI team
exchanged several e-mails soliciting documentation from Gulf Bank needed to
proceed with the transaction.(2277) Part of the delay is attributable to Gulf
Bank's consideration of an acquisition target to expand into mortgage
banking.(2278) We have not determined the cause of the remaining delay, but it
appears to have been caused by Gulf Bank, rather than Fannie Mae.(2279)
3. The CDFI Investment Committee
Despite the year-long delay in providing the requested information,
by the middle of December 2000, Bonilla asked Fannie Mae to approve and close
the transaction by the end of Gulf Bank's fiscal year on December 31. During the
second
- ----------
(2273) E-mail from R. Levin to L. Small, dated Nov. 22, 1999, FMSE 482902-03,
at FMSE 482902. Several other Fannie Mae employees were copied on the
e-mail.
(2274) Id.
(2275) E-mail from G. Austin to N. Dave, et al., dated Nov. 22, 1999, FMSE
482902-03, at FMSE 482902.
(2276) See Letter from S. Golden to S. Bonilla, with attachments, dated Dec. 7,
1999, FMSE 481158-65.
(2277) See, e.g., E-mail from S. Weintraub to N. Dave and S. Golden, dated Apr.
17, 2000, FMSE 486630; E-mail from N. Dave to G. Austin, et al., dated
June 25, 2000, FMSE 486631; E-mail chain between Roger L. Williams, N.
Dave, and S. Weintraub, dated Sept. 14, 2000, FMSE 486634; and E-mail
chain between R. Williams, S. Weintraub, and David Elam, dated Dec. 5,
2000, FMSE 482586.
(2278) E-mail from N. Dave to G. Austin, et al., dated June 25, 2000, FMSE
486631. We asked our interviewees whether Gulf Bank had ever actually
purchased a mortgage lending institution with the funds it received from
Fannie Mae. Dave replied that he and Bonilla went before Gulf Bank's
Board of Directors to argue in favor of such a purchase, but the Board
declined.
(2279) See infra text accompanying note 2283.
600
week of December 2000, Dave sent an e-mail conveying Bonilla's request to
Williams, Weintraub, and Tanya P. McInnis. Dave asked that the Gulf Bank
transaction be considered at the next CDFI Investment Committee meeting.(2280)
Williams replied that the next meeting would not take place until late January
2001. Williams also told Dave that, even with approval in December, the
transaction probably would not close until after the first of the new
year.(2281)
Nonetheless, Williams did set the wheels in motion to obtain CDFI
Investment Committee approval before the end of 2000. Around that same time,
Dave provided some insight into Gulf Bank's urgency. Dave indicated that the
bank's assets had "grown substantially this year (>25%)," and that, if the
transaction did not close, the bank would "have to shrink its balance sheet
(which Mr. Bonilla prefers not to do if at all possible) in order to stay at a
well capitalized levels [sic] at the current [a]sset size."(2282)
Handwritten notes from a teleconference that occurred on December
18, 2000, reflected a conversation among various Fannie Mae employees involved
in the Gulf Bank transaction.(2283) The notes indicated that Jonathan Roman (who
would be involved in valuing the shares that Fannie Mae was to acquire in the
transaction) was in New York and would be on vacation for the rest of the year.
They also noted that Levin "wants to get [the] deal done - whatever it takes."
The notes listed the remaining documentation required to proceed with the
planned funding as well as the names of the legal documentation contacts, which
included Daniel F. Danello at Fannie Mae and Fannie Mae's outside attorney on
the transaction. The notes also stated that Gulf Bank needed the equity
investment for "capital reasons."(2284)
A package of Gulf Bank-related materials was distributed to the CDFI
Investment Committee on December 19, 2000. Williams noted in the cover
memorandum:
Rob Levin and SERO have asked us to accommodate the timeframe of a
potentially strong affordable housing partner, and as such, we
request from you an expedited
- ----------
(2280) E-mail (within chain) from N. Dave to R. Williams, S. Weintraub, and
Tanya P. McInnis, final e-mail within chain dated Dec. 11, 2000, FMSE
482586-89, at FMSE 482587.
(2281) E-mail from R. Williams to N. Dave and T. McInnis, dated Dec. 11, 2000,
FMSE 482586-89, at FMSE 482587.
(2282) E-mail from N. Dave to R. Williams, dated Dec. 12, 2000, FMSE 486654.
(2283) Handwritten teleconference notes, dated Dec. 18, 2000, FMSE 483243. The
author of these notes is unknown.
(2284) Id.
601
review of this transaction by this Thursday, December 21, 2000. We
apologize for rushing this transaction and asking you to act on this
transaction prior to our next scheduled Committee meeting at the end
of January 2001.(2285)
The contents of the package generated some concerns about the
transaction, which were discussed during a December 21 teleconference. One
participant, identified as "BZ" (probably Barry Zigas), expressed concern about
an "apparent lack of care/urgency by GB" (probably Gulf Bank).(2286) Zigas also
asked about Fannie Mae's "exit strategy" in the event that Gulf Bank did not
carry out its plan of acquiring a mortgage company. Another participant,
identified as "DE" (probably David Elam), stated that the investment "should
stay for franchise reasons."(2287)
Notwithstanding these concerns, the CDFI Investment Committee voted
unanimously to approve the transaction.(2288)
Levin apparently agreed that the transaction should go forward. He
told Dave and Williams that he had spoken with Bonilla and told him that "we're
giving his situation #1 priority."(2289) A few weeks later, Levin invited
Bonilla to contact him if Bonilla sensed "that anything is slipping off
course."(2290) During our interview, Levin stated that he viewed these messages
as simply talking to a customer to keep him happy. Nonetheless, Levin said that
he did view the deal as a priority.
- ----------
(2285) Cover mem. from R. Williams to CDFI Investment Committee, dated Dec. 19,
2000, FMSE 481515-53, at FMSE 481515 (emphasis omitted). During our
interview, Wilson pointed out that the cover memorandum also stated: "As
we agreed at the last Committee meeting, if you have questions or
comments on this transaction we will have a phone meeting at 10:00am on
Thursday, December 21st." Wilson interpreted this to mean that the
Committee had discussed Gulf Bank at a prior meeting, and this
memorandum reflected the need to make a final decision on the investment
after a two-day expedited review. Nonetheless, Wilson stated that it
would be very unusual for the Committee to make a decision regarding an
investment within such a short period of time.
(2286) Handwritten teleconference notes, dated Dec. 21, 2000, FMSE 483242. The
author of these notes is unknown.
(2287) Id.
(2288) See Signed vote pages, dated Dec. 19, 2000 through Dec. 21, 2000, FMSE
481507-14.
(2289) E-mail from R. Levin to N. Dave and R. Williams, dated Dec. 21, 2000,
FMSE 482675.
(2290) Letter from R. Levin to S. Bonilla, dated Jan. 3, 2001, FMSE-IR 211440.
602
4. The Transaction Loses Momentum
Although the Committee approved the transaction in December 2000,
efforts to close the deal appear to have been hampered by two factors: a concern
over the price that Fannie Mae would pay for Gulf Bank shares and an earthquake
in El Salvador that affected Bonilla's family there. With respect to pricing,
Dave told Williams and Weintraub that Fannie Mae would have to discuss with
Bonilla the share price that had been approved by the Committee, which Dave said
was "significantly less than . . . the valuation documentation furnished to us
by Gulf Bank."(2291)
Then on January 19, 2001, Levin wrote to Bonilla to thank him for
Bonilla's gift of a book about Mercy Hospital and of a package of coffee.(2292)
A handwritten postscript conveyed Levin's "sympathy to [Bonilla] over the
earthquake" and Levin's concern for Bonilla's family.(2293) This reference
appears to relate to a major earthquake in El Salvador on January 13, 2001.
Later messages indicate that Bonilla's family sustained substantial economic
losses as a result of the earthquake, and Bonilla made several trips to El
Salvador during the first half of the year to assist there.(2294)
Around this time, the first sign of Gulf Bank's later regulatory
troubles appeared. Bonilla sent responses to a questionnaire concerning Gulf
Bank's use of Fannie Mae's CDFI investment to Joan Wilson, a new Director in the
CDFI program.(2295) In response to a particular question regarding the bank's
regulatory standing, Bonilla wrote:
As a result of a routine examination of the Bank by the Federal
Reserve Bank ("FRB") subsequent to December 31, 2000, it was
determined that the Bank may have failed to comply with certain
rules and regulations relating to the filing of Currency Transaction
Reports. The FRB has the ability to impose fines or sanctions
against the Bank for this failure. Management believes the Bank has
- ----------
(2291) E-mail from N. Dave to R. Williams and S. Weintraub, dated Jan. 2, 2001,
FMSE 486664.
(2292) Bonilla is listed as a member of the Mercy Foundation, which is
associated with Mercy Hospital in Miami. See
http://www.mercyfoundationmiami.org/members.html (last visited Feb. 17,
2006).
(2293) Letter from R. Levin to S. Bonilla, dated Jan. 19, 2001, FMSE-IR 211442.
(2294) See, e.g., E-mail from R. Williams to R. Levin and Barry Zigas, dated
Mar. 1, 2001, FMSE 482671.
(2295) See Letter from S. Bonilla to Joan Wilson, with attachment, dated Jan.
3, 2001, FMSE 483319-25.
603
taken necessary measures to correct this failure and to assure
compliance with these rules and regulations.(2296)
We have seen no indication that this initial disclosure of the regulatory
examination of Gulf Bank raised concerns at Fannie Mae that the transaction
should not proceed.
On January 17, 2001, Williams told Levin that Gulf Bank had not yet
filed with the State of Florida certain documents required to complete the
transaction and that the "transaction appears to have moved from a fast track to
a slow track."(2297) Williams stated that there had apparently been a
"disconnect" between Bonilla and Gulf Bank's Chief Financial Officer about the
urgency of the transaction.(2298)
Williams also noted that the valuation of Gulf Bank's shares
performed by a member of Roman's group at Fannie Mae suggested a lower price per
share ($25-$30) than the independent valuation submitted by Gulf Bank ($37-$45).
Williams said that he and Dave would speak to Roman to see how much
"flexibility, if any, he may have in his appraisal."(2299) Handwritten notes
from that day appear to reflect a discussion concerning the valuation of Gulf
Bank's shares and indicate that, according to Roman, "20% discount immediately
must be offset by franchise values."(2300)
On January 19, 2001, Roman forwarded to Williams his valuation of
the transaction.(2301) Roman noted in the cover e-mail that Fannie Mae's
decision should be "based on the value of the relationship and other intangible
attributes."(2302) Roman noted that Fannie Mae "would have a nega[t]ive
mark-to-market were it booked today but still with a reasonable chance of a
positive valuation in the future if they can deliver somewhere in line with
their projections." He said that he found Gulf Bank's "price expensive but not
unreasonably so even before factoring in intangibles."(2303)
- ----------
(2296) Id. at 483323.
(2297) E-mail from R. Williams to R. Levin, dated Jan. 17, 2001, FMSE 488157.
(2298) Id.
(2299) Id.
(2300) Handwritten notes, dated Jan. 17, 2001, FMSE 488707. The author of these
notes is unknown.
(2301) See E-mail from J. Roman to R. Williams, with attached memorandum, dated
Jan. 19, 2001, FMSE 482633-35.
(2302) Id. at FMSE 482633.
(2303) Id. Apparently, the previous valuation had been prepared by one of
Roman's subordinates, who was reluctant to release the valuation until
Roman had approved it.
604
According to Roman's valuation memorandum, "buying Gulf Bank stock
at $37 or even $40 is not irresponsible; it is in the realm of a reasonable
difference of opinion."(2304) But the memorandum pointed out that "were it
marked-to-market today by methods consistent with [those used by Gulf Bank's
valuation firm], a $750,000 investment could result in a markdown of around
$150,000 on Fannie Mae's books." Roman concluded that "we need to make a
comprehensive business call rather than a stock portfolio call. Is the value of
the relationship we gain with Gulf Bank and its constituents worth the
incremental value?"(2305)
On March 1, 2001, Williams wrote to Levin and informed him that
Bonilla wanted to close the transaction by the end of March, and that Williams
did not think that would present a problem. Bonilla also had indicated that he
wanted to "have an event with Governor Jeb Bush to announce the
investment."(2306)
After further delays caused by misunderstandings over the way that
the transaction would be structured, Williams met with Bonilla, and the two of
them discussed the possibility of increasing Fannie Mae's investment from
$750,000 to $800,000. The bank's capital had grown sufficiently to allow Fannie
Mae to "make this larger investment and still remain below the 10%
threshold."(2307) On May 4, 2001, Williams sent a request to the members of the
CDFI Investment Committee requesting approval of the increase based on the
bank's growth as reflected in its unaudited financial statement; the Committee
subsequently approved the requested increase.(2308)
5. Gulf Bank's Disclosure Regarding the FRB Examination
On July 26, 2001, Williams wrote to Levin to inform him that Gulf
Bank had received the required approvals for the transaction from the State of
Florida. Williams also relayed Bonilla's hope that Bonilla could meet with Levin
for a purpose unknown to Williams.(2309)
- ----------
(2304) Id. at FMSE 482635.
(2305) Id.
(2306) E-mail from R. Williams to R. Levin and B. Zigas, dated Mar. 1, 2001,
FMSE 482671.
(2307) E-mail (within chain) from J. Wilson to R. Levin, final e-mail within
chain dated Apr. 25, 2001, FMSE 487705.
(2308) See Signed May 4, 2001 vote pages, dated May 18, 2001 through May 30,
2001, FMSE 481494-501.
(2309) E-mail from R. Williams to R. Levin, et al., dated July 26, 2001, FMSE
488540.
605
On July 31, 2001, Levin met with Bonilla in Miami to discuss
regulatory issues arising out of a recent examination by the FRB of Atlanta, and
the potential effect of these issues on the transaction. It is unclear exactly
how much information was disclosed to Levin at this meeting. Levin recalled at
our interview that someone else at Fannie Mae - whose identity he could not
remember - had told him that Gulf Bank's regulatory problems stemmed from its
failure to fill out certain forms. Levin also recalled that Bonilla told him
that the bank had hired a consultant to help deal with the problem and that the
bank was working to resolve the situation. The day after Levin's meeting with
Bonilla, Williams wrote to Wilson and others involved in the transaction to
inform them that Levin had placed the transaction "on hold until further
notice," and that they should direct further inquiries to Levin.(2310)
6. Fannie Mae's Evaluation of the Gulf Bank Disclosure
Upon his return from Miami, Levin set the wheels in motion for
Fannie Mae to evaluate the potential effect of Gulf Bank's regulatory problems.
On August 1, 2001, Levin wrote to Bonilla and informed him that Levin had
"spoken to our senior attorney here about the situation and told her that you
will send me material for us to review."(2311)
On August 6, 2001, Bonilla wrote a letter to Levin describing the
FRB's investigation into whether Gulf Bank had failed to comply with the Bank
Secrecy Act.(2312) According to the letter, the FRB had "discovered that our
compliance officer failed to file currency transaction reports (CTRs) as
required by the Bank Secrecy Act (BSA) and Federal regulations." The letter also
noted that the bank had engaged BSA experts and that this team was "conducting a
BSA due diligence investigation, rectifying any BSA deficiencies in the Bank and
enhancing the Bank's BSA compliance system."(2313)
The letter went on to state that, "[t]o date, neither state nor
Federal regulators nor other government agencies have imposed any enforcement
sanctions or penalties on the Bank," and that "[n]either the Bank nor any of its
employees have been charged with any violations of state of federal laws or
regulations."(2314) But, the letter advised, "generally the regulators
eventually require banks to enter into agreements to ensure future compliance
with the applicable rules and regulations," and that "under
- ----------
(2310) E-mail from R. Williams to J. Wilson, et al., dated Aug. 1, 2001, FMSE
488561.
(2311) E-mail from R. Levin to S. Bonilla, dated Aug. 1, 2001, FMSE 482926.
(2312) See Letter from S. Bonilla to R. Levin, dated Aug. 6, 2001, FMSE
483776-91.
(2313) Id. at 483777.
(2314) Id.
606
applicable state and Federal laws and regulations the Bank may be subject to
monetary fines and other sanctions."(2315)
There is a handwritten note on the front cover of the letter,
addressed to "Ann" (probably Fannie Mae's then General Counsel Ann M. Kappler)
stating that "[t]his is the item about which Rob spoke to you last week."(2316)
At Levin's request, Fannie Mae's outside counsel were consulted regarding the
Gulf Bank situation. The Company asked one of its outside attorneys to look into
whether there were any "outstanding regulatory enforcements [sic] actions
against Gulf Bank."(2317) Donald M. Remy, a Deputy General Counsel at Fannie
Mae, asked another outside attorney for her views on Fannie Mae's moving forward
with the transaction in light of the FRB's investigation.(2318)
Levin also engaged a private investigation firm, Decision
Strategies, to conduct a background check on Bonilla and Charles H. Morley, one
of the BSA experts that Gulf Bank had retained to assist it.(2319) The report on
Bonilla did not reveal any significant information, and the research on Morley
was called off after his professional background was confirmed.
There is little documentation regarding the legal advice the Company
received from outside counsel. During our interview, Levin could not recall the
precise advice that he had received, but he did recall that the tenor of the
advice was sufficiently comforting that he decided to move forward with the
transaction.(2320) Levin said that he convened a meeting with Zigas, Dana Moore
(Levin's Chief Risk Officer for the division, who has since resigned from Fannie
Mae), Williams, and possibly others, to discuss the results and decide on a
course of action. Levin said that they decided to proceed with the transaction,
but that he does not clearly remember this meeting.
Wilson recalled that Fannie Mae asked Gulf Bank to certify, prior to
closing, that there had been no material change in the bank's position since the
signing of
- ----------
(2315) Id. at 483778.
(2316) Id. at 483776.
(2317) E-mail from Outside Counsel to R. Williams, S. Weintraub, and Daniel F.
Danello, dated Aug. 8, 2001, FMSE 488568-69, at FMSE 488568.
(2318) Letter from Donald M. Remy to Outside Counsel, dated Aug. 15, 2001, FMSE
489320.
(2319) See Letter from Michael Dorrler to Gary Owens, dated Aug. 8, 2001, FMSE
489336-37.
(2320) Levin's characterization of the tenor of the advice is consistent with
information that we obtained in other interviews.
607
the stock purchase agreement. The bank's officers signed the certifications,
which Wilson forwarded to Weintraub and Danello, among others. Levin then called
Wilson and informed her that he did not see any reason why the equity investment
should not proceed; she recalled his statement being something to the effect of
"go ahead and do it."
We asked several interviewees whether it was unusual for Fannie Mae
to close on an investment in a bank that was currently being investigated by the
FRB. Only one - Weintraub - stated that it was not unusual. She said that,
during her years with the CDFI program, several banks had informed Fannie Mae
that they were under investigation, but because they were not subject to any
regulatory action, Fannie Mae had made the investment. She could not recall the
banks involved in those transactions.
7. The Closing
On August 22, 2001, Wilson wrote to Williams and others involved in
the transaction to inform them that Levin had "asked that we move forward on
funding the $800,000 equity investment in Gulf Bank." Wilson said that she would
work with the team to finalize the investment.(2321) During our interview,
Wilson did not recall the CDFI Investment Committee's being reconvened to
address the change in circumstances of the transaction. She stated that the
normal procedure would have been to call or e-mail the committee members with an
update, rather than to reconvene them. Wilson noted that, in hindsight, it
perhaps was strange that the Committee did not meet by phone at this time, but
she could not recall any telephonic committee meetings regarding specific
investments during her tenure at the CDFI program.
We asked Levin and Wilson about two e-mails exchanged between them
at the end of August 2001 concerning a transaction update to be sent to the CDFI
Investment Committee members about the Gulf Bank transaction. Levin's message to
Wilson instructs her to "[t]ake out the reference to the long term business
relationship and the business and franchise value."(2322) Wilson's subsequent
e-mail to the Committee contains no reference to these items, but does note
that, after "consultations with our legal staff, Rob approved going ahead with
the total investment."(2323) Levin said that the blurb in Wilson's e-mail was
for purposes of the committee minutes, but that he could not recall the purpose
of his own message to Wilson. He said that he had determined already that there
was not as much franchise value associated with the transaction as he had first
expected. Wilson indicated that these e-mails probably were related to the
update she sent to the CDFI Investment Committee members after receiving Levin's
feedback. We asked if this update e-mail indicated that the Committee was not
consulted regarding Gulf
- ----------
(2321) E-mail from J. Wilson to R. Williams, et al., dated Aug. 22, 2001, FMSE
488570.
(2322) E-mail from R. Levin to J. Wilson, dated Aug. 28, 2001, FMSE 482927.
(2323) E-mail (within chain) from J. Wilson, final e-mail within chain dated
Aug. 28, 2001, FMSE 482928.
608
Bank's regulatory problems; Wilson confirmed that the Committee was informed of,
but not consulted on, Levin's decision to proceed with the investment.
The closing took place on August 29, 2001.(2324) The next day, Levin
wrote to congratulate Bonilla on the closing of the transaction.(2325)
8. The Cease and Desist Order
A little more than two months after the transaction closed, the FRB
and the Florida Banking Department issued a Cease and Desist Order directed to
Gulf Bank.(2326) Although the order dealt primarily with the BSA issues that
Bonilla had identified to Levin prior to the closing, the order also dealt with
a number of other issues that do not appear to have been covered by Bonilla's
briefing or written correspondence.(2327)
On December 3, 2001, Fannie Mae's outside counsel sent a memorandum
to Williams, Wilson, and Danello outlining the order, its implications for
Fannie Mae's transaction with Gulf Bank, and Fannie Mae's possible claims for
breach of the representations and warranties in the stock purchase
agreement.(2328) The memorandum noted that the order referred to a report of
examination dated June 7, 2001, and stated that such a report should have
provided Gulf Bank with a sufficiently detailed warning that Gulf Bank could
have provided Fannie Mae with a fuller disclosure of the pending regulatory
issues.(2329) Despite this initial inquiry into Fannie Mae's options in
connection with the order, it does not appear that Fannie Mae pursued any
possible remedies.
Shortly after the first of the new year, Levin wrote to Bonilla,
thanking him for the gift of a chess set, but informing Bonilla that he would be
returning the set. Levin sent a blind copy of this letter to Kappler.(2330)
Levin confirmed that he returned the set.
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(2324) See Community Based Lending CDFIs Disbursement Form, dated Aug. 29, 2001,
FMSE 481127-28.
(2325) E-mail from R. Levin to S. Bonilla, dated Aug. 30, 2001, FMSE 482930.
(2326) Order to Cease and Desist Issued Upon Consent, dated Nov. 28, 2001, FMSE
483380-99.
(2327) See id. at FMSE 488840-42.
(2328) See id. at FMSE 488839-46. (2329) Id. at FMSE 488843.
(2329) id. at FMSE 488843.
(2330) Letter from R. Levin to S. Bonilla, dated Jan. 3, 2002, FMSE-IR 211444.
609
9. Renewal of the CD and the Write-Off
At the end of 2002, Fannie Mae's CD deposit at Gulf Bank came up for
renewal.(2331) In the e-mail that accompanied formal investment renewal
documentation that Dave and LaVilla-Travieso prepared, they stated that "the
Chairman of the bank, Mr. Bonilla, is very well known to Frank and Rob."(2332)
The formal investment renewal documentation also noted that Bonilla's "strong
ties with Senator Graham, the House Members for Dade and Broward and Governor
Bush will be invaluable in our needs for support at the Hill in DC." The summary
concludes: "We strongly believe that Mr. Bonilla and Gulf Bank provide us
substantial franchise value."(2333)
During our interview, Levin stated that he believed this assessment
of Bonilla's importance was overstated, but he said that he did not know the
politicians in South Florida and could not assess Bonilla's importance in the
community. We asked whether Levin thought this type of analysis was appropriate
when considering Fannie Mae's investment decisions. Levin said that it was part
of their business to know their partners and what kind of influence they had,
but that such information did not make or break a given deal.
Sometime in early 2003, Fannie Mae wrote off the entire Gulf Bank
investment.(2334) This write-off was the result of a portfolio-wide review of
CDFI investments carried out by a third party vendor, Sheshunoff. During our
interview, Roman stated that CDFI Initiative staff began to mark its equity
portfolio to market annually beginning in 1999. Roman noted that a mark-down
might occur soon after an equity investment if that happened to be the time
period when the Sheshunoff analysis
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(2331) See E-mail chain between N. Dave and Cecilia LaVilla-Travieso, et al.,
dated Dec. 9, 2002, FMSE 484118; see also Letter from S. Bonilla to C.
LaVilla-Travieso, dated Dec. 31, 2002 (stating a $100,000 CD would mature
on February 8, 2003).
(2332) E-mail from N. Dave to D. Elam, et al., dated Jan. 6, 2003, with attached
documentation, FMSE 482642-48, at FMSE 482642. By this time, Franklin D.
Raines had named Bonilla to a Fannie Mae advisory committee. According to
Raines, he made those selections based on recommendations from other
Company officers.
(2333) Undated Recommendation Summary for CDFI Deposit Investment: Gulf Bank,
FMSE 482643-45, at FMSE 482643 (part of documentation attached to Jan. 6,
2003 e-mail from Dave cited in note 2331). In January 2004, during a later
renewal of the Gulf Bank CD, CDFI Initiative staffer Mark W. Lacey stated
that Bonilla had "a strong history with Fannie Mae . . . and a personal
relationship with Rob Levin." E-mail from M. Lacey to Frank Quesada, Greg
Awad, et al., dated Jan. 5, 2004, FMSE 482663-64.
(2334) See Equity Customer Evaluation Grid: Specific Customer Write Down, dated
Spring 2003, FMSE 485757.
610
was conducted.(2335) Wilson confirmed that the Gulf Bank write-off occurred in
the context of the Sheshunoff portfolio evaluation and that she did not remember
any write-downs in 2003 happening outside of the regular process.(2336)
10. Subsequent Events
In the Summer of 2003, Levin wrote to Bonilla to thank him for an
enjoyable dinner among Levin, Bonilla, and their wives.(2337) The language of
the letter implies that Levin's wife had not met Bonilla before that evening.
There is no indication that the Levins and Bonillas otherwise socialized
together.
As Gulf Bank's financial condition deteriorated in the wake of the
Cease and Desist Order, its Board of Directors began looking for a buyer for the
bank. On February 17, 2004, Gulf Bank entered into a sale agreement with
PanAmerican Bank.(2338)
III. FINDINGS
A. Due Diligence
Neither the CDFI Initiative staff nor the Investment Committee
members "cut corners" with regard to the due diligence portion of the process or
the consideration of the investment. Only Dave suggested that the diligence on
Gulf Bank may have been inadequate, but it was his view that the CDFI Investment
Committee was "a sham" and performed only token reviews generally. We found no
other information to support that allegation.
B. Valuation
We found a difference of opinion concerning Fannie Mae's valuation
of Gulf Bank's stock. Levin stated that he did not know what the reference to
"intangible attributes" in Roman's valuation e-mail meant. Levin said that this
investment supported Fannie Mae's mission to increase Hispanic lending, and Gulf
Bank was seen as important for gaining a potential foothold in that market. We
asked Levin whether it would be unusual for Fannie Mae to have entered into a
transaction knowing in advance that there
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(2335) Roman stated that the valuation of debt investments was adjusted for
changes in market interest rates.
(2336) Dave claimed that such mark-downs were unusual and should not occur if a
transaction undergoes proper due diligence. He stated that many CDFI
investments were not properly scrutinized, as evidenced by the large
number of investments in the CDFI portfolio that had mark-downs.
(2337) Letter from R. Levin to S. Bonilla, dated July 10, 2003, FMSE-IR 211443.
(2338) Letter from S. Bonilla to M. Lacey, dated Mar. 1, 2004, FMSE 483770-71,
at FMSE 483770.
611
would be a $150,000 write down. Levin said that valuing these entities was
difficult, but he agreed that it would be unusual to go forward anticipating a
write down.
Williams and Dave both expressed the view that Roman was instructed
to value the stock higher than he thought it was worth. Roman's description of
the valuation process, however, indicates that Levin did not bring pressure to
bear on him, and we have no reason to doubt his first-hand account. Notably,
Roman's valuation itself made clear that it took account of both commercial and
"franchise" values.(2339)
C. Policy Against Having Both CD and Equity Investment
Of the six individuals that we interviewed, only Williams seemed to
have an inkling that maintaining both a CD and an equity investment in the same
institution violated Fannie Mae's CDFI policies. In an e-mail from early in the
transaction, Williams noted that it was Fannie Mae's "preference" not to have an
equity investment and a deposit in an institution at the same time.(2340)
D. Allegations of Wrongdoing Against Rob Levin
Although our interviewees suggested that Levin was more directly
involved with this transaction than with most CDFI deals, we have found no
evidence that Levin exerted inappropriate pressure on CDFI staff in connection
with this transaction. Roman stated that Levin called him and asked him to have
the valuation analysis performed so that a decision could be made regarding the
investment. But Roman stated that he discussed the valuation with Williams
several times, and that, although Williams expressed reservations about it,
Williams never indicated that Levin was pushing to approve the investment. Roman
did say, however, that Gulf Bank was the only transaction that he discussed with
Levin directly.
Williams described Levin's involvement in the Gulf Bank equity
investment as "significant," in that he often checked in with the CDFI team
regarding the progress of the investment. Williams characterized this level of
involvement by Levin as unusual, and he stated that it created "pressure" to
make the transaction happen.
Dave felt that, after Levin's return from Miami in 2001, the normal
due diligence for CDFI investments was bypassed because of "Rob's clout," which
Levin exercised because he thought that Bonilla had a good reputation and would
be helpful to Fannie Mae. We asked Williams and Dave whether Levin explicitly
pressured people at Fannie Mae to approve the Gulf Bank investment to help
Bonilla; both used the same phrase to describe the form that Levin's pressure
took: "get it done."
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(2339) See supra notes 2301-2305 and accompanying text.
(2340) E-mail from R. Williams to D. Elam and S. Weintraub, dated Dec. 5, 2000,
FMSE 482586.
612
Despite these suggestions of heightened involvement by Levin, we did
not find any instances of inappropriate conduct on his part. Our interviewees
generally disputed that Levin had directed anyone to do "whatever it takes" to
make the transaction happen. Levin noted that it was not uncommon for people at
Fannie Mae to invoke the names of senior officers in a bid to raise the priority
level of an issue, and he thought it possible that this had happened in Gulf
Bank's case. It appears, in fact, that Dave, in particular, invoked Levin's name
on several occasions. On the whole, however, we have found no evidence that
anyone at Fannie Mae, either at the direction of Levin or on their own
initiative, knowingly entered into a transaction they believed was inappropriate
or violated Fannie Mae's policies and procedures in order to conclude the Gulf
Bank deal.
E. Levin's Relationship with Salvador Bonilla
We found evidence that Levin and Bonilla engaged in a few social
activities together, such as the dinner also attended by both men's wives.(2341)
We have found no credible evidence, however, that would call into question
Levin's assertions that he and Bonilla never had a close personal relationship.
At the outset of the transaction, Bonilla contacted Small, not Levin;(2342)
Levin appears to have reacted to Small's expression of interest in the
matter.(2343) Levin stated that, prior to the Gulf Bank transaction, their
relationship was only in the context of Bonilla's Board membership. Levin said
that he and Bonilla had not kept up their relationship after the transaction
closed. Levin said that they had some meals together, but Levin could not recall
who paid for these meals. Levin said that it could have been Bonilla at times,
but that Levin may have done so too.
With the exception of one message by Mark W. Lacey - which was sent
well after the transaction had closed - all of the documents suggesting a close
personal relationship between Bonilla and Levin (or between Bonilla and any
other senior office at Fannie Mae) are traceable back to Dave. We believe that
Dave may have had an exaggerated sense of the closeness of Levin's and Bonilla's
relationship.
F. Levin's Receipt of Gifts
We found no credible evidence to support the allegation that Levin
received inappropriate gifts from Bonilla that would have influenced Levin's
professional judgment on the Gulf Bank matter. Apart from Levin himself, only
Williams recalled any gifts: he had heard of Levin's receiving a chess set from
Bonilla.
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(2341) See supra note 2337 and accompanying text.
(2342) See supra note 2262 and accompanying text.
(2343) See supra note 2265 and accompanying text.
613
G. Franchise Value and the CDFI Program Generally
1. Franchise Value
There is substantial evidence that the perceived "franchise value"
of the Gulf Bank transaction was probably a significant factor in Fannie Mae's
decision to move forward with the deal. "Franchise value," however, had several
components. Franchise value included support for Fannie Mae's mission of
promoting affordable housing across the country and the goal of achieving
minority participation in the mortgage business. Franchise value also included
any political value that such investments could bring, e.g., in the form of
generating grass-roots support for Fannie Mae or creating ties with influential
individuals. Franchise value considerations were an important characteristic of
the CDFI program generally, and the Gulf Bank transaction does not appear to
have been unique in this regard.
Dave said that the Gulf Bank transaction was viewed as a "franchise
investment," i.e., an accommodation made in expectation of future political
support. Roman agreed that Bonilla's purported political connections entered
into the decision-making process regarding the investment, but he noted that
this was true of many CDFI investments.(2344) He acknowledged that there is a
fair amount of discussion on this topic in the documents, but he said that
Bonilla's political connections were not much of a motivator in the Gulf Bank
case, and that Fannie Mae had never done transactions just for franchise value.
Wilson explained that "franchise value" referred to actions that
would support Fannie Mae's mission goals (such as affordable housing) and/or
benefit the Company from a public- or government-relations standpoint. When
asked whether the term also included political value, Wilson stated that mission
goals and political goals generally were connected, although she did not recall
if any politicians were personally involved in the Gulf Bank matter.
2. Mission Value
We found evidence that Fannie Mae took into account the "mission
value" of the Gulf Bank investment in helping the Company to meet its minority
lending goals. Levin said that Gulf Bank did not have much of a mortgage
origination function, so Gulf Bank was an attractive partner to increase lending
penetration in a heavily Hispanic neighborhood. Levin said that the CDFI program
was the best way to achieve greater penetration in South Florida and that
Bonilla indicated that he wanted to start a real mortgage lending operation.
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(2344) Interviewees were able to identify at least one other CDFI transaction
that could be viewed as "political"; it involved a bank whose president
had been an officer in an important mortgage banking organization.
614
Wilson recalled that Gulf Bank met the CDFI criteria because it was
active in an underserved, low income area; was minority-owned; had established
management; and had plans for how to utilize the CDFI funds in a
mortgage-lending business.(2345) We asked if it was unusual for Fannie Mae to
make an equity investment in a bank that did not already have any kind of
mortgage business, and Wilson replied that the pre-existence of such a business
was not a criterion for equity investments.(2346) Gulf Bank's failure to pursue
such a business actively does not appear to have been a significant concern to
Fannie Mae.
3. Economic Value
Although there is some evidence that Fannie Mae considered the CDFI
program to be, at least in part, a profit-oriented program, the CDFI staff and
Levin freely acknowledged that such investments were inherently risky and
frequently subject to write-offs. Indeed, it appears that many CDFI
transactions, including the Gulf Bank deal, were undertaken with the expectation
that they would be written off, at least in part.
According to Levin, while there was some intent that the Company
achieve minimum investment returns, there were different expectations for the
various kinds of investments made under the CDFI program. Equity investments
were risky by their nature, and expectations were accordingly lower. On debt
investments, Levin said that the goal was to break even at the portfolio level,
even if a particular investment did not perform well.
Roman stated that, when the CDFI program was created, Fannie Mae
intended to receive a return on its CDFI investments. That goal became difficult
to meet, however, when nonprofit entities entered the community development
field, as these entities did not expect any return on their investments. By
1999, Fannie Mae had determined that its best-case scenario would be to break
even on its CDFI program. Accordingly, Roman viewed CDFI investments as budget
items, and he analyzed them in terms of whether the potential benefits for
Fannie Mae's relationships with investment recipients outweighed the budgetary
cost.
Weintraub stated that it would not be unusual for Fannie Mae to have
an immediate negative mark-to-market on a CDFI investment, considering that the
CDFI Initiative dealt with small, community banks with illiquid stock.
In sum, although the Gulf Bank transaction might have been unusual
in certain respects - including Levin's personal involvement - we found no
evidence that
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(2345) Wilson recalled that Dave was tasked to help Gulf Bank develop the
technological capability to implement these plans.
(2346) Wilson stated that nonprofit entities were subject to a different
analysis, which focused on the entity's debt repayment history,
information technology infrastructure, and management.
615
anyone involved in the transaction acted improperly. To the extent that those
involved considered factors other than economic return when approving the
investment, and were not overly concerned that the investment might be subject
to a write-down, both were consistent with the nature of the CDFI program.
616