American Banker reported on Friday that, “The chance of any housing finance reform bill moving in Congress this year — as well as in the foreseeable future — is now seriously in question…”
That is too bad, since something must surely be done about recidivist accounting screw-ups Fannie Mae and Freddie Mac.
Fannie Mae (FNMA) quietly acknowledged several errors in its financial statements that have largely gone unnoticed, even by sophisticated investors who made daring contrarian bets on the turnaround of the controversial mortgage giant.
Fannie Mae reported the errors, which add up to nearly $4 billion, during five consecutive quarters from the fourth quarter of 2011 through the fourth quarter of 2012 and also in the second quarter of 2010.
How could such large errors go unnoticed for so long? (The New York Times’ Floyd Norris asked my favorite question when Bank of America recently admitted to the same kid of thing: Where was Bank of America’s auditor PwC when the bank was putting the wrong number, by billions, in its MD&A disclosures year after year?)
While Fannie Mae did disclose the errors, one reason they did not attract more scrutiny is likely the manner in which they were disclosed — as out-of-period adjustments rather than restatements. In correspondence with the Securities and Exchange Commission, Fannie Mae took the position that the errors were too small to be of much interest to investors.
In an Aug. 30 letter to the Securities and Exchange Commission, explaining $528 million worth of adjustments in the first half of 2012, Fannie Mae CFO Susan McFarland (who left Fannie Mae in 2013) wrote:
We do not plan to include disclosure regarding how these misstatements were discovered in our future filings because we believe the effects of these misstatements, both quantitatively and qualitatively, are not material to prior periods or to our projected annual 2012 income; therefore we do not believe additional information regarding the detection of these items would be meaningful to investors.
The SEC followed up on the issue, we learn from McFarland’s response to the SEC on Dec. 13. Among the SEC’s requests:
Please provide your analysis supporting your conclusion that you do not have a material weakness with respect to the accounting for the allowance for loan losses and reserve for guaranty losses as of December 31, 2011 and discuss any new processes or procedures you have put in place to prevent these types of errors from recurring in the future.
McFarland’s response contended in part that the adjustments did not indicate a “material weakness” because they were relatively small.
These misstatements were less than 2% of our allowance for loan losses as of December 31, 2011 and less than 5% of our net loss for the year ended December 31, 2011. Additionally, we concluded that the misstatements were not material to our projected 2012 consolidated financial statements taken as a whole.
However, they grew larger. The additional $850 million and $172 million discovered in the third and fourth quarters, respectively, were not discussed in this correspondence, even though the $850 million was already disclosed at the time of the second letter.
Dan Freed asked for my comments and added them to the story after it was initially published. You can sum them up with this one:
McKenna says many companies classify mistakes as out-of-period adjustments because restatements are more likely to cause the stock to drop, which can lead to lawsuits.
More important, however, formal restatements require an 8-K filing with the SEC, which gives companies or their regulators the ability to claw back executive compensation under the 2002 Sarbanes Oxley Act. While the 2010 Dodd Frank legislation made it easier in some respects to claw back executive compensation, companies can still use out-of-period adjustments to skate around the issue, McKenna says.
While the SEC could require a restatement, it has not shown a willingness to pursue these cases aggressively and in all possible circumstances, McKenna contends.
I’ve written about the stealth restatement problem, the SEC’s clawback problem, materiality, and the chronic accounting ineptitude that adds up to recklessness at Fannie Mae and Freddie Mac more than once and for a while.
GoingConcern.com does a nice job summing up the problem of allowing the GSE’s to continue to make excuses:
“…this isn’t Fannie Mae’s first rodeo. If accounting errors were felonies in California, Fannie Mae would already be serving life under Three Strikes.
See also, this 2006 SEC complaint, which saw Fannie settling with a $400 million penalty:
In its federal court Complaint, the Commission charged that, between 1998 and 2004, Fannie Mae engaged in a financial fraud involving multiple violations of Generally Accepted Accounting Principles (“GAAP”) in connection with the preparation of its annual and quarterly financial statements. These violations had the effect, among other things, of falsely portraying stable earnings growth and reduced income statement volatility, and – for year-ended 1998 – of maximizing bonuses and achieving forecasted earnings.
So you see, Fannie is a habitual offender. One can only deduce that they are either really, really bad at accounting (possible) or doing this on purpose (also possible). Olga Usvyatsky of Audit Analytics seems to feel maybe it is just an honest mistake but our pal Francine McKenna does not share that opinion.
Olga Usvyatsky, an accountant with a research firm called Audit Analytics, believes the errors may point to “control deficiencies” — a catch-all accounting phrase that encompasses issues such as poorly trained or inadequate staffing, inadequate technological capabilities or ineffective business processes, among other examples.
“From what I see on the surface, it does not look like intentional manipulation,” she said. “It looks more like [the] financial statements in general are not very reliable because they keep finding those errors.”
Leave it to Francine to point out the obvious: when you do the math on numerous immaterial errors, it adds up to one big error. Now where have we seen that before?
“How do you know? That’s the WorldCom situation. Nobody adds it all up until someone says ‘Wait a minute. Over five years we’ve had so many billions of non-material errors it adds up to be material.'”
Fannie Mae’s auditor is Deloitte. You may recall that KPMG used to audit Fannie Mae. In 2010 I wrote at Forbes that Fannie and Freddie must go.
That baggage didn’t bother Deloitte, who jumped at the chance to get close to Fannie when her dance card opened.
Four years later I haven’t changed my mind.