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SEIFFE:  The Rainesy Day Fund

Friday, July 25, 2008 

By Ralf Seiffe

Congress has socialized the costs of Fannie Mae’s faulty lending policies and poor choice of companions by obligating tax payers to bail out the government sponsored enterprise.  The president has signaled he has reversed his threat to veto and will sign the legislation into law.  When he does, it will put at least $300 billion in debt on the national balance sheet, and, for the first time, the government changes from the sponsor of Fannie Mae to an explicit guarantor.  Once that line is crossed, it’s reasonable to believe the bail out will become a precedent rather than a final solution to the present financial crisis.  One under-appreciated reason we’ve gotten into this position are the accounting shenanigans that former managers of Fannie Mae used to trick their investors.

On April 19, 2008, The New York Times reported that Franklin Delano Raines, the former CEO of Fannie Mae agreed to a settlement with the Office of Federal Housing Enterprise Oversight (OFHEO) for accounting irregularities on his watch.  The settlement requires him to disgorge some $26 million in compensation he received while performing what is essentially a government job. 

The reason Raines received such spectacular pay was his uncanny ability to manage Fannie Mae’s earnings.  The former budget director for Bill Clinton so convinced his board of directors of his executive gifts that they rewarded him with hedge fund sized bonus checks. The only problem is that the performance wasn’t real—it was the product of accounting fraud.  It turns out that Raines kept a secret “rainy day” fund to adjust and tune up Fannie Mae’s earning to meet the investment community’s expectations.

Most reports concentrate on the size of the bonuses and personal problems this has caused Mr. Raines.  If the complaining regulator had been the SEC, rather than OFHEO, one wonders if the troubles Mr. Raines was able to settle might have been the subject of more serious charges.

The more lasting effect of the accounting fraud is the damage it’s done in the markets.  Investors define risk as the variability of outcome and that includes the ebb and flow of earnings for entities that report them.  The compensation—the quid pro quo--they demand for assuming more risk is a higher, expected return .  So, when Fannie Mae falsified earnings by “smoothing” them, they camouflaged their variability, thereby hiding the real risk risks of investing in Fannie’s shares or debt.

When a company’s earnings are very predictable—or they appear to be—it needs less “margin for error” than other companies whose earning are more variable.  One way to take advantage of  predictable, low-risk earnings is to take on more debt.  Financing assets with debt magnifies earnings and investors correctly insist that managers use debt prudently to maximize returns.

Financial institutions, like Fannie Mae, are expected to be highly leveraged.  Well-managed banks borrow as much as $19 for ever dollar in equity and that that makes earnings predictability very important.   By reporting low-variability—but false—earnings, Fannie Mae hoodwinked investors into believing that the company could tolerate higher debt levels that more truthful accounting would indicate.   As a consequence, Fannie Mae was able to borrow $65 dollars for every dollar in equity it had.  At that level of leverage, a 1.5% decline in the value of the mortgage portfolio would wipe out all of Fannie Mae’s net worth.  That—or something worse-- is exactly what’s happened.

Should the U.S. taxpayer be responsible for bailing out Fannie Mae?  According to an opinion published in The Washington Post on July 16, Raines thinks it’s a debatable question. But, to the extent that investors relied on the fraudulent accounting issued by a government sponsored entity, one could conclude a tort exists that should be remedied.

Injecting $300 billion in new cash into a $5 trillion portfolio would bring Fannie’s equity to the 6%  range, assuming that its net worth is zero; if it is negative, more capital will be required.  To put that into perspective, bailing out Mr. Raines’ rainy day fund will obligate each of the 55 million households that pay 97% of the nations’ taxes about $5,400 each.  And we will borrow that, too. 

Ralf Seiffe advises business start-ups and product launches from Chicago, Illinois and is a political analyst and columnist for the Illinois Leader and Illinois Review.

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