Although some residential MBS market professionals said the Office of Federal Housing Enterprise Oversight (OFHEO) came down a bit severely on Fannie Mae last week, they say the agency's disciplinary recommendations will not materially impact the MBS market, or damage the GSE's credit standing among investors.
Last Tuesday, the OFHEO released its long-awaited report on its examination of Fannie Mae's accounting practices, after sifting through eight million pages of documents. In a blistering summary, the OFHEO said the mortgage corporation put up a facade as one of the lowest-risk and best in class institutions in terms of its internal management practices.
"The findings in this report show that risks at Fannie Mae were greatly understated and that the image was false," James Lockhart, acting director of the OFHEO said in a statement released by the oversight agency. "Senior management manipulated accounting, reaped maximum, undeserved bonuses and prevented the rest of the world from knowing. They co-opted their internal auditors. They stonewalled the OFHEO."
As a result, the OFHEO recommended a $400 million civil penalty against the corporation; ordered it to limit its assets growth to that of Dec. 31, 2005 levels, which amounted to $727 million; and said Fannie Mae should maintain a capital surplus of 30% until the director of the OFHEO determines that a change in the surplus amount is warranted.
Harsh punishment
"The OFHEO was a little on the harsh side of what I expected," said Art Frank, head of MBS research at Nomura Securities. "We did not expect a portfolio freeze," he added, referring to growth limitations slapped on the corporation. On the surface, a portfolio freeze diminishes Fannie Mae's status as a backup bid for MBS, should spreads widen more attractively in the months ahead. To the extent that the corporation has to curb its MBS purchases, that could lead to reduced demand for non-agency paper.
Frank noted, however, that Fannie Mae was not likely to grow significantly in the next few months anyway, owing to tight, stagnant spreads. If spreads do widen, the MBS market has a lot of backup bids available - such as Freddie Mac - to step in where Fannie Mae cannot. Furthermore, non-agency issues are declining, he said, leaving very little excess supply that needs to be sopped up.
Fannie Mae's growth cap is subject to the discretion of the OFHEO's acting director. Fannie Mae's CEO Daniel Mudd noted on Tuesday's conference call that the limit was not statutory. Analysts from Barclays Capital believe that Fannie Mae's portfolio will likely be capped for at least the next several months, with no apparent catalyst that would lift the cap anytime soon.
"In this environment, we would expect Fannie Mae to allow its portfolio to run off," read a Barclays report on the Fannie Mae's situation. "It creates some space, allowing Fannie Mae to buy MBS when significantly cheaper, while not losing out on potential relative value opportunities."
The immediate effect on the mortgage basis should be small, said Barclays, because the GSEs have not been huge drivers of the MBS basis. The more significant effect, said the bank, might turn out to be a boost to the Gold/FNMA swap.
Management woes
The OFHEO began its special examination of Fannie Mae in 2003, near the tail end of a period extending from the 1980s into 2004, when the corporation enjoyed extraordinary financial and political success. In 1999, Franklin Raines, who was Fannie Mae's CEO at the time, set out to double the corporation's earnings per share (EPS) within five years, from $3.23 in 1998, to $6.46 in 2003.
According to the OFHEO, the GSE made achieving double-digit EPS growth its driving focus. In so doing, many of its accounting policies and practices violated Generally Accepted Accounting Principles (GAAP). The enterprise also committed serious internal control, financial reporting and corporate governance errors, which resulted in Fannie Mae overstating reported income and capital by about $10.6 billion, according to current estimates by the OFHEO.
These manipulations allowed Fannie Mae to hit its EPS targets and maximize bonuses paid to Raines and other senior management. Raines, the OFHEO said, collected more than $90 million in compensation from 1998 to 2003, and of that, more than $52 million was directly tied to achieving earnings per share targets.
The penalties might not stop at the fine and reigned-in growth. The OFHEO recommended an investigation into the roles that individual executives played in the abuses, and report back as to whom should be terminated, transferred, have benefits altered or be ordered to pay restitution.
Lastly, the OFHEO said it would continue to support legislation that would establish government oversight of the GSEs.
For its part, Fannie Mae executives said it would comply with the consent order, although it says it neither admits nor denies any wrongdoing.
"We are glad to resolve these matters," said Fannie Mae's Mudd. "We have all learned some powerful lessons here about getting things right and about hubris and humility. We are a much different company than before."
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