Order Code RS21949
Updated November 16, 2004
CRS Report for Congress
Received through the CRS Web
Accounting Problems at Fannie Mae
Mark Jickling
Specialist in Public Finance
Government and Finance Division
Summary
On September 22, 2004, the Office of Federal Housing Enterprise Supervision
(OFHEO) made public a report that was highly critical of accounting methods at Fannie
Mae, the government-sponsored enterprise that plays a leading role in the secondary
mortgage market. OFHEO charges that Fannie Mae has not followed generally accepted
accounting practices in two critical areas: (1) amortization of discounts, premiums, and
fees involved in the purchase of home mortgages and (2) accounting for financial
derivatives contracts. According to OFHEO, these deviations from standard accounting
rules allowed Fannie Mae to reduce volatility in reported earnings, present investors
with an artificial picture of steadily growing profits, and, in at least one case, to meet
financial performance targets that triggered the payment of bonuses to company
executives. On September 27, Fannie Mae’s board of directors agreed to correct the
accounting deficiencies, augment the firm’s capital surplus, review staff structure and
internal controls related to accounting, and to appoint an independent chief risk officer.
The Securities and Exchange Commission (SEC) and Justice Department are
investigating. On November 15, 2004, Fannie Mae reported that it was unable to file
a third-quarter earnings statement because its auditor, KPMG, refused to sign off on the
accounting results. Fannie also estimated that if its derivatives accounting is found to
be incorrect, it might have to report a third-quarter loss of about $9 billion. This report
will be updated as events warrant.
Background
Fannie Mae and Freddie Mac, the two government-sponsored enterprises (GSEs) that
dominate the secondary mortgage market, are huge and complex financial institutions that
play a key role in the financial system. Most home mortgage loans made each year are
purchased by one or the other of the GSEs and either held in portfolio or repackaged and
sold as mortgage-backed securities (MBS). The two GSEs have about $1.6 trillion in debt
outstanding, and large quantities of GSE bonds are held by insured banks, pension funds,
and investors of all types. While GSE debt is not guaranteed by the government, the
“government sponsored” nature of Fannie and Freddie ( their charters grant them a line
of credit with the U.S. Treasury and exempt them from certain taxes and securities
regulations) leads market participants to put faith in an “implicit” guarantee, a belief that
the Treasury will never allow either GSE to become insolvent.
Congressional Research Service ˜ The Library of Congress

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The savings and loan crisis of the 1980s was a painful demonstration of the risks
inherent in mortgage markets. Over a thousand S&Ls failed because their long-term
revenues (from mortgage loans) fell below their cost of funds (the interest they paid to
savers). When interest rates are volatile, holders of mortgages and MBS face a variety of
financial risks, and these risks are now concentrated in the two GSEs. Although both
institutions manage risk with sophisticated financial techniques far beyond the capacity
of any S&L, the accounting problems at Freddie Mac in 2003,1 and now at Fannie Mae,
raise serious questions. Are accounting irregularities simply a reflection of the
managements’ wish to persuade investors and regulators that, despite the volatile nature
of the mortgage market, the firms’ earnings are insulated from sudden changes? Or, do
they suggest that the firms themselves lack a clear picture of their complex financial
positions, risk management strategies, and risk exposures? In either case, improvements
in accounting transparency and rigor appear to be needed.
The Accounting Issues
The OFHEO report2 identifies three major accounting problems at Fannie Mae. Two
have to do with failure to comply with accounting rules, and the third focuses on
weaknesses in the firm’s accounting processes. These issues are summarized below.
Amortization of Purchase Discounts, Premiums, and Fees (SFAS 91).
When Fannie Mae buys mortgages or MBS, it does not pay the exact amount of unpaid
premium balance outstanding on the loans. If the interest rate (or coupon rate) paid by the
borrower is above current market interest rates, the loan will sell at a premium, above the
unpaid balance. If the coupon rate is below current market rates, the loan is less valuable,
and will sell at a discount. To calculate the effective yield on the loan, Fannie Mae must
take these premiums and discounts into account. (A loan bought at a premium is less
valuable than the coupon rate would imply, and vice versa for loans purchased at a
discount.) Under SFAS 91, a Financial Accounting Standards Board (FASB) rule, the
amount of these premiums and discounts must be amortized, or recognized over the
estimated life of the purchased loans (or MBS). The amounts recognized appear on the
income statement as an adjustment to current interest income.
When Fannie Mae purchases mortgages that are riskier than usual (i.e., where the
borrowers are less creditworthy), it may accept up-front fees from the loan sellers in lieu
of credit guarantees. Conversely, Fannie may pay fees to lenders in exchange for greater
protection against credit risk. These fees also have an impact on the effective yield that
Fannie will receive over the life of the loans, and must also be amortized according to
SFAS 91.
As fees, premiums, and discounts are amortized and recognized for accounting
purposes, Fannie Mae’s quarterly income is increased or lowered. The size of the
adjustment to reported income depends upon the estimated life of the loan: other things
being equal, the longer the loan, the smaller the adjustment required to each quarter’s
1 See CRS Report RS21567, Accounting and Management Problems at Freddie Mac, by Mark
Jickling.
2 Office of Federal Housing Enterprise Oversight, Office of Compliance, Report of Findings to
Date: Special Examination of Fannie Mae, Sept. 17, 2004, 198 p.

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earnings. A complication is that Fannie Mae does not know at the outset how long a
mortgage will last, because borrowers generally have the right to prepay and refinance
their mortgages. Critical to the amortization process, therefore, are the assumptions that
Fannie Mae makes about the prepayment rate in a group of mortgages. SFAS 91 requires
that those assumptions be updated as market conditions change, and that the amounts
amortized into interest income be revised accordingly. This is the point, according to
OFHEO, at which Fannie Mae has failed to follow accepted accounting practices.
In the fall of 1998, as central banks struggled to contain global financial panic,
interest rates fell dramatically. The drop in rates adversely affected Fannie and Freddie
by accelerating the rate of mortgage prepayments. The effect of the speed-up in
prepayments on Fannie Mae’s earnings was a $400 million expense, which according to
SFAS 91 should have been recognized and charged against 1998 earnings. However,
Fannie chose to recognize only $200 million, and to defer recognition of the other half.
The deferred $200 million became known within Fannie Mae as the “catch-up.”
OFHEO claims that Fannie used “inordinate flexibility” in its handling of the catch-up
amount, and used it as an accounting reserve, or “cookie jar,” that gave it wide discretion
to report or defer amortization income in order to obtain the accounting results it wanted.
Fannie adopted polices “specifically intended to manage the catch-up position as a buffer
to sudden changes in interest rates and the resultant volatility of amortization accounts.”3
OFHEO concludes that Fannie Mae’s practice was not to produce a single best
estimate of prepayment rates, but to generate a range of estimates and choose the one that
was most convenient.4 “[M]odeling of the catch-up was performed for both the current
quarter as well as for prospective reporting periods for the purpose of generating results
under varying assumptions in order to achieve a specific desired outcome.”5
OFHEO puts forward two explanations for Fannie Mae’s failure to follow SFAS 91.
A key company goal was to minimize the volatility of quarterly earnings to create the
impression that the company’s operations were stable, predictable, and low-risk. For a
company like Fannie Mae that issues billions of dollars in debt each year, even a slight
increase in the perception of riskiness can be very expensive, as bond investors demand
higher yields. Second, the report analyzes Fannie Mae’s earnings in 1998 and concludes
that if the full $400 million had been charged against earnings, top executives would not
have received bonuses linked to earnings per share target levels.6 The explanations are
not mutually exclusive.
Derivatives Accounting (SFAS 133). Derivatives — including futures
contracts, options, forwards, swaps, and caps — are financial instruments whose value
is linked to changes in some economic variable, most often interest rates. Fannie Mae
uses derivatives extensively to manage risk. For example, if Fannie had a portfolio of
bonds that would decline in value if interest rates rose and wished to protect itself against
3 OFHEO, Report of Findings, p. 13.
4 Ibid., p. ii.
5 Ibid., p. 40.
6 Ibid., pp. 10-12.

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that loss, it might purchase a derivative that would gain value by an equal amount as rates
went up. The OFHEO report finds major problems in Fannie’s accounting for the value
of these financial instruments.
Derivatives accounting is governed by SFAS 133.7 Under SFAS 133, the fair value
of all financial derivatives must be calculated (“marked-to-market”) at the end of each
accounting period. Changes in fair value from the previous accounting period must be
reported as current income, unless the derivatives are used for hedging. If a derivative is
used to hedge an asset (as in the example above), the value of that asset — the hedged
item — will move in the opposite direction to the derivative’s value. Thus, a fall in the
price of the hedged asset will be offset by a gain in the derivative (or vice versa). Under
SFAS 133, the firm can recognize as earnings both the change in the derivative’s value
and the offsetting change in the hedged item’s. If the gains and losses are closely
correlated, the net effect on reported earnings will be very small or zero.
There is another form of hedge accounting under SFAS 133, covering derivatives
held to hedge a future transaction or cash flow. Since the hedged item in this case does
not yet exist, it cannot be marked to market and used to offset gains in the derivative’s fair
value. However, SFAS 133 allows the gain or loss in a derivative used to hedge a future
event to be assigned to comprehensive income, a subcategory of stockholders’ equity.
When the future transaction or cash flow occurs, the derivative is marked to market and
changes in fair value are recognized as current income, but presumably gains or losses in
the derivative will be offset by the hedged item.
Either form of hedge accounting has the effect of reducing the impact of changes in
derivatives’ fair value on current earnings and the bottom line. To qualify for this
accounting treatment, however, FASB requires that there be a close relationship between
changes in the value of the derivative and the hedged item. Derivatives that do not meet
FASB’s hedge test are considered speculative trading instruments, and changes in fair
value from period to period must be recognized and reported as current earnings.
The OFHEO report identifies several problems with Fannie Mae’s compliance with
SFAS 133. The most general problem was also a major issue in Freddie Mac’s 2003
accounting restatement: “many of [Fannie Mae’s] hedging relationships should not qualify
for hedge accounting treatment.”8 Because Fannie Mae does not properly measure the
“effectiveness” of its hedges — the correlation between changes in the value of the
derivative and the hedged item — they do not meet FASB’s hedge test. In many cases,
OFHEO finds that Fannie simply assumes perfect effectiveness (that changes in the
derivative’s fair value and the hedged item’s value will exactly offset each other) and fails
to perform the calculations and maintain the documentation that SFAS 133 requires.
OFHEO analyzes a number of derivatives transactions in detail and finds numerous
specific practices that do not conform with SFAS 133. A common theme is the
inappropriate use of “short-cuts” that produce the desired result of perfectly effective
hedges that will have no impact on the bottom line. OFHEO finds that Fannie Mae’s
7 See CRS Report 98-52, Derivatives: A New Accounting Standard, by Mark Jickling.
8 OFHEO, Report of Findings, p. 113.

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failures to follow SFAS 133 are consistent with the objectives of minimizing earnings
volatility and simplifying operations.9
Structural Problems in Accounting Operations and Review. The OFHEO
report finds significant problems with the way Fannie Mae’s accounting results are
generated and reviewed. Individuals involved in the process are encumbered by a “heavy
workload, weak technical skills, and a weak review environment.”10 Under these
conditions, OFHEO finds that accounting operations rely on a few individuals who
exercise wide discretion. In this environment, the process for developing new accounting
policies is said to be ineffective, and internal controls are called weak or non-existent.
The unfortunate result, in OFHEO’s analysis, is an accounting culture where methods are
chosen to produce the desired results, rather than to produce an objective and transparent
view of the firm’s financial condition, which is the basic aim of GAAP.
The Financial Impact
How different would Fannie Mae’s financial results appear if the deficiencies
identified by OFHEO were corrected? The OFHEO report does not attempt to quantify
the impact on earnings, but does suggest that it might not be trivial. A formal restatement
of earnings may take many months, if the Freddie Mac precedent is any guide.
Fannie Mae’s annual report sets out separately the amounts involved in amortization
of (1) premiums and discounts and (2) deferred guaranty fees. For the years 2001 through
2003, adjustments in net amortization increased or decreased net income by annual
amounts ranging from $71 million to $508 million.11 It is not certain how these figures
would be affected by full compliance with SFAS 91, but OFHEO estimates that
recognition of improperly deferred earnings could have increased quarter-to-quarter
earnings volatility by as much as 16%.12
In derivatives accounting, the OFHEO report notes that Fannie Mae has classified
$12.2 billion in losses relating to cash flow hedges as “accumulated other comprehensive
income” (AOCI), and that $7.2 billion in adjustments to the carrying value of liabilities
on the balance sheet reflect derivatives classified as fair value hedges.13 If Fannie Mae
is required to reclassify many of its derivatives contracts from hedges to speculative
positions (which must be marked-to-market and reported in current earnings), the impact
on past and future earnings could be significant. OFHEO notes that such reclassification
could have “a substantial impact on Fannie Mae’s compliance with its regulatory capital
requirements.”14 On November 15, 2004, Fannie reported that if its derivatives
accounting methods were found to be incorrect, its earnings statement for the third quarter
might show a net loss of about $9 billion.
9 OFHEO, Report of Findings, p. 122.
10 Ibid., p. 168.
11 Fannie Mae 2003 10-K Report, p. 43.
12 OFHEO, Report of Findings, p. 26.
13 Ibid., p. 93. These figures are as of Dec. 31, 2003.
14 Ibid., p. 93.

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As for the financial impact of the general weaknesses in Fannie Mae’s accounting
structures, perhaps the best indicator is the behavior of Fannie Mae’s stock price since the
OFHEO report was released to the public on September 22, 2004. Between the close of
trading on the 21st and the end of the week (September 24), the share price dropped by
$10.14, or 14.4%. This equals a loss of about $11 billion for Fannie Mae shareholders.
The Regulatory Response
On September 27, 2004, Fannie Mae’s board of directors reached an agreement with
OFHEO to take a number of actions to address problems identified in the report. Fannie
Mae will (1) correct its accounting practices related to SFAS 91 and 133, (2) supplement
its capital surplus by an amount equal to 30% of the required minimum capital, (3) review
staff structure, responsibilities, independence, compensation, and incentives, (4) appoint
an independent chief risk officer and separate key business functions now performed
jointly by certain individuals or departments, and (5) put in place new controls and
policies to assure adherence to accounting rules.
The Securities and Exchange Commission (SEC) is reported to be conducting its
own investigation, not limited to the issues raised by OFHEO. Although the SEC’s
jurisdiction over the GSEs is limited, it could require a restatement of past accounting
results or bring civil charges against Fannie Mae or individual employees. On November
15, 2004, Fannie informed the SEC that it could not file a third-quarter earnings report
because its outside auditor, KPMG, had declined to sign off on the financial statements.
On September 30, 2004, press reports stated that the Department of Justice had
opened a criminal investigation.
Congressional Action
The 108th Congress has considered a number of bills that would restructure OFHEO
and strengthen its regulatory authority, but none has reached the floor of either chamber.15
If no bill is passed this year, the issue is likely to be taken up again in the 109th Congress.
The House Financial Services Subcommittee on Capital Markets, Insurance, and
Government Sponsored Enterprises held a hearing on October 6, 2004, where OFHEO’s
director summarized the report’s findings and stressed that serious safety and soundness
issues had been raised. Fannie’s CEO and CFO argued that the applications of SFAS 91
and 133 challenged by OFHEO were within GAAP and had been accepted by KPMG
(Fannie’s outside auditor), that there had been no attempt to manipulate earnings, and that
the financial condition of the company remained sound. The Presiding Director of
Fannie’s board described steps taken to respond to OFHEO’s charges and insisted that
Fannie Mae’s current corporate governance structure was up to the tasks of getting the
facts and taking any necessary remedial actions.
15 See CRS Report RL32069, Improving the Effectiveness of GSE Oversight: Legislative
Proposals, by Loretta Nott and Mark Jickling.

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