Posted on: Thursday, August 11, 2005
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The Potential Crisis at Fannie Mae

   
 
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We have no proprietary information about Fannie Mae, but what is publicly known is scary enough.  As you may recall, last December the SEC required Fannie to restate prior financial statements while the Office of Federal Oversight (OFHEO) accused the company of widespread accounting regularities that resulted in false and misleading statements.  Significantly, the questionable practices included the way Fannie accounted for their huge amount of derivatives.  On Tuesday, a company press release gave some alarming hints on how extensive the problem may be.

 

The press release stated that in order to accomplish the restatements, “we have to obtain and validate market values for a large volume of transactions including all of our derivatives, commitments and securities at multiple points in time over the restatement period.  To illustrate the breadth of this undertaking, we estimate we will need to record over one million lines of journal entries, determine hundreds of thousands of commitment prices and securities values, and verify some 20,000 derivative prices…”

 

“…This year we expect that over 30 percent of our employees will spend over half their time on it, and many more are involved.  In addition we are bringing some 1,500 consultants on board by year’s end to help with the restatement…Altogether, we project devoting six to eight million labor hours to the restatement.  We are also investing over $100 million in technology projects to enhance or create new systems related to accounting and reporting…we do not believe the restatement will be completed until sometime during the second half of 2006…”  

 

It seems to us that anybody reading that press release should be shocked by what appears to be the paucity of knowledge about what is going on at a company of such great size and importance to the U.S. economy.  About 18 months ago Fed Chairman Greenspan stated that problems at both Fannie Mae and Freddie Mac had the potential to bring down the financial system.  He stated at the time that, “…Most of the concerns associated with systemic risks stem from the size of the balance sheets that these GSEs (government-sponsored enterprises) maintain…”.  He added that the immense size of their holdings and the need to keep growing to satisfy their shareholders made them increasingly vulnerable.

 

The White House, too, in its 2003 budget report, expressed their concerns.  They stated that although both GSEs tries to limit their risks through various risk-management methods, these techniques “do not eliminate all the risk associated with funding long-term, mostly fixed-rate assets that have uncertain payment streams… Furthermore, the hedging transactions transform credit or interest rate risk into counterparty risk (the risk that a counterparty of a hedging transaction fails to honor the contract).  Thus the GSEs management of counterparty risk is of increasing importance”.

 

Now it appears that Fannie Mae’s internal controls have been so weak that no one actually knows what the risks are or what the auditors will find—and we won’t know for at least another year.  For a company as important to the U.S. as Fannie Mae, this is a national problem with widespread potential for developing into a dangerous financial crisis.

 

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