Fannie Mae scandal rocks US audit

For those outside the United States, it may be difficult to understand the significance of the Fannie Mae financial scandal. But the reality is that its problems really do matter - and not just in the US. Say it slowly to allow it to sink in. Fannie Mae owns or guarantees over $4,000bn of home mortgage debt in the US. And yes, that is billions - it is no misprint. Fannie Mae is the world's biggest financial institution outside of banking. So when Fannie Mae gets pneumonia, a lot of other people expect at least to get a bad dose of the flu.

The Securities and Exchange Commission has determined that Fannie Mae breached FAS 91 and FAS 133 from 2001 until the middle of last year, having used: 'Unique methodology to assess whether hedge accounting was appropriate,' said the SEC. As a result of the decision, Fannie Mae must restate earnings and declare losses of around $9bn, arising from previously undeclared losses on derivatives. In doing so, Fannie Mae also goes into breach of its minimal capital requirement laid down by its regulator, the Office of Federal Housing Enterprise Oversight (Ofheo).

It was Ofheo which initially blew the whistle on Fannie Mae, alerting the SEC to the scale of the disaster. The company was involved in 'cookie jar' accounting, said the regulator, by manipulating reserves and the timing of recognition of earnings. One result by-product of this smoothing was that executives were enabled to earn huge bonuses. Franklin Raines, chief executive of the company until forced out in December, obtained incentive pay of $26m over the last three years on top of his salary for that period of $14m. Finance director Timothy Howard obtained $7m of incentive pay additional to his $4m in pay.

Senators are now demanding that Raines and Howard return their bonuses and there has been discussion as to whether under the Sarbanes-Oxley Act these can be forcibly withdrawn, as laid down by the Act. The general view is that probably only bonuses awarded after the passing of the legislation can be taken back through legal process, even if the SEC finds the directors guilty of misconduct - which they have not been as yet.

But ramifications over the Fannie Mae scandal are more widely felt. Raines is a leading Democrat and was a member of President Clinton's budget team. Both Raines and Fannie Mae were influential players in the Washington theatre. And the structure of mortgage support which generated Fannie Mae - and its smaller sidekick Freddie Mac, itself engulfed in accounting scandal in 2003 - is now being reviewed.

Fannie Mae was established during the Depression to promote home ownership. Rather than issue mortgages itself, it buys loans from banks to free up liquidity in the market and keep down interest rates. It was part of the federal government until 1968, when it became a traded company. But its debts are effectively guaranteed by the state, despite attempts in recent years by Alan Greenspan, as chairman of the Federal Reserve, to withdraw this protection.

We are now set for a period of uncertainty, in terms of both the political and commercial fall-out. The Securities and Exchange Commission is investigating the behaviour of the company and its directors - who are expected to deny wrongdoing. And the Public Company Accounting Oversight Board (PCAOB) is examining the work of the company's auditor KPMG, which is likely to argue that the case arose from differences of interpretation over the application of extremely complex accounting standards.

A spokesman for KPMG said: 'In situations like the Fannie Mae matter, it is to be expected that the PCAOB will become engaged, and we recognise the responsibility of the PCAOB to investigate matters such as these that come to their attention.' Deloitte has now taken over as Fannie Mae's auditor.