Fannie Mae Fraud Essay
Fannie Mae’s Fraud 1. Fannie Mae was established in 1938 as a federal charter under President Franklin Roosevelt as a secondary market to expand the flow of mortgage money under any economic condition because millions of Americans could not become homeowners before Fannie Mae.
In 1968 Fannie Mae was rechartered by congress as a shareholder owned company, funded solely with private capital raised from investors. The charter is directed to increase the availability and affordability for homeownership for low, moderate, and middle-income families.Fannie Mae purchases home mortgages from banks, guaranteeing them, and then resells them to investors, which helps the banks to eliminate the credit and interest rate risk. (Fannie Mae Case) Fannie Mae has an advantage over commercial banks, like the US Treasury, Fannie Mae can buy $2. 25 billion of each company’s debt, receive exemption from local and state taxes, and implied government backing gives them the ability to take on large amounts of home loans without increasing their low cost of capital.
Fannie Mae committed a fraud, where it overvalued its assets, overstated profits, underreported credit losses, and exploited tax credits.To cover their losses, Fannie Mae purchased finite insurance policies to smooth out the earnings. The two people involved in the fraud were Franklin Raines, chairman and CEO, and Timothy Howard, CFO, which both resigned from Fannie Mae. The top executives of Fannie Mae today are CEO Daniel Mudd, COO Michael Williams, and CFO Stephen Swad.
The person responsible for the recognition of the fraud is Roger Barnes, who was an accountant for Fannie Mae, and for five years, was complaining that the accounting practices were flawed.The auditing company that was hired by Fannie Mae during the fraud was KPMG and the auditing company that took over was Deloitte and Touche. Deloitte and Touche was hired by the government at first to be the independent auditor. 2.
Fannie Mae did not follow all of the GAAP compliances, which led them to their accounting fraud. The government agency that regulates Fannie Mae’s operation and accounting is the Office of Federal Housing Enterprise Oversight (OFHEO). One of the issues is derivative losses, which both OFHEO and Deloitte believed should have been recorded on the income statement instead of the balance sheet.The OFHEO also stated that Fannie Mae recognized $200 million in expenses when they should have recognized $400 million. Overall Fannie Mae misstated the financials by $10. 6 billion from 1998 through 2004.
There were four main accounting manipulations used in the Fannie Mae fraud. The first was improper accounting for loan fees, premiums, and discounts, which requires companies to recognize loan fees, premiums, and discounts as an adjustment over the life of the applicable loans, to create a constant effective yield, stated under the SFAS No. 1. The SFAS No. 91 also requires that any changes to the amortization of the fees, premiums, and discounts should be recognized as a gain or loss in the income statement, which Fannie Mae referred to as the “catch-up adjustment. ” Fannie Mae had $439 million catch-up adjustments, but they only reported a $240 million catch-up adjustment in the income statement, which was directed by management.
This manipulation affected Fannie’s financials by understating their expenses and overstating income by a pretax amount of $199 million.The second manipulation was improper hedge accounting. “Fannie Mae used derivative instruments to hedge against the effect of fluctuations in interest rates on its debt cost. ”(Fannie Mae Case) SFAS No. 133 requires the value of derivatives to change with the market values.
SFAS No. 133 also requires companies to measure and record the ineffectiveness of hedging a debt with derivative in the income statement, this method is also known as the long-haul method. If a company qualifies then they do not have to use the measure method, which is called the short-cut method.Fannie Mae did not qualify for the short-cut method, but they used this method anyway. This led to misstatements in the financial statements and this manipulation was the main portion of the $11 billion restatement. The third manipulation was accounting for loan loss reserve.
Management had the responsibility to have a quantitative estimate of their losses on their loans and the failure to do this was a violation of GAAP. Instead of making an educated guess Fannie Mae had a high level of loan loss reserves in case for any compensation.This over estimating created an overstatement of $100 million. The final manipulation was the classification of securities held in portfolio.
Fannie Mae would classify securities as held-to-maturity and then at the end of the month classify them as something else. This method violated the SFAS No. 115, which states that the “classification of securities acquired as either held-to-maturity or trading at the time of acquisition. ” 3. The people responsible for the fraud were mainly senior executives.The executives committed this fraud for the bonuses they would receive if there were growth.
The main individuals responsible are Franklin Raines the CEO, Timothy Howard the CFO, and Leanne Spencer the controller. Tim Howard and Leanne Spencer where also responsible for manipulating the financial statements and hiding the fraud. KPMG sued Fannie Mae for “fraudulent deception”, which prevented KPMG from uncovering the fraud. (Bloomberg News 2007) KPMG claims that Fannie Mae withheld information from them, which affected their job of auditing the company efficiently.In return Fannie Mae filed a countersuit on KPMG claiming it was their job to overlook the financials and to research the financials and make sure they were correct. Fannie Mae also stated that KPMG was supposed to be there independent watchdog.
(Bloomberg News 2007) Franklin Raines motivation for this fraud was growth of company, so he could receive compensation of $38 million from 2002 and 2003. Raines greed is what led the motivation for this fraud. Thirty executives and employees will be reviewed for the possible disciplinary action and termination including the present CEO Daniel Mudd.Timothy Howard and Franklin Raines both were forced to resign and that is the only punishment that they have faced. Fannie Mae had to pay a penalty fine of $400 million and the majority of that fine is being returned to investors.
(Fannie Mae manipulated Accounting 2006) Some people blame the Board of Directors for failing to discover “a wide variety of unsafe and unsound practices” because it is their responsibility to watch over management and to go over the financial statements.The Board of Directors failed to be informed and independent of the fraud. (Lockhart 2006) 4. The Fraud Triangle was present in this fraud because there were incentives/pressures, opportunities, and attitudes/rationalizations.
Senior management had the pressure for growth and the incentive to get compensation for those growths. Top management received millions in compensation due to the nonexistent growth they created. An example is Franklin Raines received $90 million in compensation from 1998 to 2003.Of the $90 million, $52 million of that compensation was from achieving EPS targets. (Lockhart 2006) The office of auditing told his staff that the EPS must double from $3.
23 to $6. 46, which was a conflict of interest for the internal auditor. (Lockhart 2006) The opportunity in this fraud was the weak internal controls and risk management, which made the fraud possible. One problem was that management decided to use old systems when the accounting pronouncements and growth called for new systems.
Lockhart 2006) The management also allowed or even created weak internal controls, which allowed the fraud to happen. The Office of Auditing did not do their job by following GAAP and they also did not make sure the financial statements followed accounting principles. The internal auditors failed to do their jobs and they failed to issue reliable financial statements. (Lockhart 2006) The external auditor is one form of internal control for a company, which failed for the Fannie Mae because the auditor missed many accounting manipulations that did not follow GAAP.The only way the auditor became aware of the fraud was from the whistleblower Roger Barnes.
The attitudes that lead to this fraud were greed from upper management. The senior executives were worried about how to achieve their bonuses and compensation, and the only way to do this was to manipulate the financials. A statement that CEO, Franklin Raines, said was “ the future is so bright that I am willing to set as a goal that our EPS will double over the next five years. ( Fannie Mae Case) Raines did accomplish this goal and this goal is what gave him the incentive to commit the fraud and Raines had greed in his mind when saying this statement because he wasn’t doing it to help the company’s growth, only his growth in wealth.
5. I would propose that the government keep a stricter eye on companies they have invested with to help prevent fraud in the future. The OFHEO needs to have stricter guidelines and programs to follow and monitor Fannie Mae closer. The company also needs to implement stricter internal controls where upper management cannot override the controls.