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Fannie Mae Death Watch Part I: Overview


Ross M. Miller
Miller Risk Advisors
October 4, 2004

While I was doing the promotional bit for my Enron book, I was often asked what company would be the subject of my next post-mortem. Aware of my past ties to General Electric, many of the questioners hoped I would answer "GE," however, it shared none of Enron's key weaknesses. Unlike the "anything goes" spirit of Enron, GE under Jack Welch had numerous checks and balances in place. Furthermore, GE was financially conservative, with Jack Welch at one point outright banning any use of derivative securities after the Kidder, Peabody mess. I did, however, have an answer to the "what's next" question. It was an answer that no one liked: Fannie Mae.

While the mass media labors under the delusion that the key players at Enron were, to quote the title of a competing Enron book, "the smartest guys in the room," in all the time that I labored in neighboring fields, I ran across Enron only once. That was at a conference in honor of the late Fischer Black hosted by UCLA where a colleague of mine at General Electric, David P. Greene, and I were invited to present a paper on a new framework for risk management. Someone from Enron was on the program as a "discussant," but only because the company had purchased a slot as a corporate sponsor of the conference. (Ironically, the other practitioner who earned his way onto the program was from McKinsey, the consulting firm that took the credit for creating Enron's business model.) There was, however, one firm that was big in the risk business that never came up in any context. It was an intellectually invisible company with an enormous presence in the marketplace called Fannie Mae.

This commentary is the first in what looks to be a long series that examines the growing number of "red flags" sprouting up around Fannie's business. I do not find it mere coincidence that the key red flags have an eerie similarity to the early warning signs at Enron. There is, however, one very important difference between Fannie Mae and Enron. Enron was a business of modest size and even more modest importance that appeared big because of the way that it accounted for its trading businesses. Enron's collapse created a small hole in the U.S. economy that was quickly plugged up.

Fannie Mae is a gigantic enterprise--one of the few that might rate the designation "too big to fail." Not only does Fannie have in excess of a trillion dollars on its balance sheet, more frighteningly, it has more than a trillion dollars off its balance sheet. And all of these trillions of dollars are managed by a CFO, Tim Howard, who may have more chutzpah than Andy Fastow, Enron's legendary CFO. (It should be noted that Mr. Howard along with other execs at Fannie Mae is currently the subject of a criminal probe by the Justice Department. Andy Fastow, on the other hand, will soon be serving a 10-year prison term.)

Whether or not Fannie Mae currently has a hole in it the size of a hundred Enrons, I do believe that it can be "dismantled" in a manner that causes the least possible disruption to the U.S. economy and the housing market in particular. Long-Term Capital Management, whose implosion in 1998 was supposed to bring down the world's economy with it, not only survived being "unwound," but generated sizable profits for those who unwound it and who would be the first in line to unwind Fannie Mae. Fannie Mae, of course, it is biggest proponent of the myth that the world would end without them, and I will examine that myth in my next commentary, which dissects Fannie's latest annual report.

My "death watch" on Fannie Mae has been triggered by three events/revelations that are surprisingly high fidelity echoes of Enron. I do not, however, see Fannie's demise as imminent; they appear to have bought themselves a 270-day reprieve from their formerly hapless regulator, OFHEO, short for the Office of Federal Housing Enterprise Oversight, whatever that means. As for the senior management of Fannie, there are already some in the media who see their departure in coming weeks as a done deal.

The first echo of Enron is the mysterious departure of Anne Mulcahy, CEO of Xerox, from Fannie's board of directors. Two days after writing a letter that rearranged the terms of employment for Fannie's top management (but still left them with giant loopholes to crawl through), Anne found it no longer convenient to make the trip to Washington, D.C. to attend board meetings and swapped her seat on Fannie's board for one on Citigroup's, which is closer to her Stamford, Connecticut office. Citigroup also stands to make billions of dollars on several fronts should Fannie Mae be dismantled or legislated out of existence.

Anne Mulcahy gives us two Enron coincidences for the price of one. At least if one is rather elastic on the notion of a coincidence. Her departure with lame excuse recalls CEO Jeff Skilling's sudden resignation from Enron. Her presence at Xerox during its major accounting scandal reminds us that Andy Fastow was at Continental Illinois when it collapsed. (Both Mulcahy and Fastow went on to greater glory despite being at the scene of a train wreck.)

The second echo is the aforementioned Tim Howard, Fannie's CFO. While I do not yet deem Mr. Howard as worthy of meeting the Fastow Challenge for CFO creativity, he has already performed a deed that mertis a Fastovian tip of the hat. It is standard practice for financial companies to employ either a chief credit officer or chief risk officer to provide an independent monitor of the company's financial health. Even Enron had one, for all the good it did them. Ideally, the chief risk officer reports to the board of directors so that he or she can provide them with an independent source of control and information. Alternatively, the chief risk officer may report directly to the chairman of the board. Under no circumstances, however, should the chief risk officer report to the CFO. Something about foxes and henhouses.

Tim Howard found an insanely clever way of controlling the chief risk officer without having the chief risk officer report to him. He was the chief risk officer. And Fannie's board and its regulator apparently let him get away with this until it surfaced two weeks ago. Of course, Howard's dual role was nowhere to be found in Fannie's various spotty filings with the SEC. And given that Fannie appears to possess no in-house risk management expertise, it should surprise no one that they appeared not to have a chief risk officer. Still, having your CFO be the chief risk officer is far worse than no chief risk officer at all.

The final echo is an accounting firm, KPMG, which has been bought and paid for by the company whose books it audits. Or so it would appear, even if Fannie and KPMG deny it. The meager millions that KPMG makes for doing Fannie's book is supplemented by several times that amount in consulting fees for "rendering opinions" and that sort of thing. Standard and Poor's, which gave Fannie 9 out of 10 points for corporate governance, even singled the relationship with KPMG as the sole negative mark against the company. Enron, which would likely have also scored close to 9 out of 10, showed that all it takes is a friendly accountant and you are off to the races.

Of course, KPMG may have learned something from the plight of Enron's auditor, Arthur Andersen. For one thing, there is no evidence that KPMG signed off on Fannie Mae's glossy public version of its annual report. (The customary signed "Independent Auditors' Report" page is missing. KPMG did, however, sign off on Fannie's 10-K, the official version of the report filed with the SEC. If they are lucky, they will live to regret it.) That annual report is the focus of next week's commentary.

Copyright 2004 by Miller Risk Advisors. Permission granted to forward by electronic means and to excerpt or broadcast 250 words or less provided a citation is made to