Fannie and Freddies Fraud: Misstated Earnings, Exploitation of Stakeholders - Research Paper Example

? Fannie and Freddie’s Fraud: Mis d Earnings, Exploitation of Stakeholders Introduction From public trust to public downfall, twolarge American government-sponsored enterprises (GSEs), Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac), became involved in misstatements and other fraudulent acts, which the Office of Federal Housing Enterprise Oversight (OFHEO) revealed in its 2006 report, Report of the Special Examination of Fannie Mae. The report disclosed the widespread institutional, organizational, and individual factors that allowed these fraudulent activities to occur, which means that similar recommendations must be applied at these levels to prevent future activities and outcomes from occurring. The Fraud This section describes the business activities of Fannie and Freddie before the fraud occurred. Since the 1990s, lenders have been increasingly using automated underwriting systems (AUSs), a technology that changed the mortgage industry (DiVenti, 2009, p.236). These systems executed underwriting criteria and statistical algorithms to foresee the default likelihood of loan applications (DiVenti, 2009, p.236). GSEs became industry leaders in the growth and adoption of these systems, which they used to appraise their loan purchases. Fannie Mae’s system, Desktop Underwriter, and Freddie Mac’s system, Loan Prospector, significantly decreased the expenses and time linked with loan approvals (DiVenti, 2009, p.236). In 2000, Fannie Mae and Freddie Mac broadened their procurements to comprise “Alt-A,” A-minus, and subprime mortgages, aside from private-label mortgage securities (Blackburn & Vermilyea, 2010, p.5). In order to expand their mortgage purchases, Fannie Mae used the Expanded Approval system and Freddie Mac enlarged its Loan Prospector system to contain risk-based pricing (DiVenti, 2009, p.236). Throughout the subprime lending crisis, Fannie and Freddie acted in the secondary market in two different ways: 1) providing guarantees for residential mortgages and giving eligible residential-mortgage-backed securities and 2) buying residential mortgages and residential-mortgage-backed securities for investment purposes (Bonander, 2013, p.843). Generally, Fannie and Freddie bought, packaged, securitized, and re-traded residential mortgages into mortgage-backed securities, with an assurance that the principal and interest payments would be paid to investors, thus, making a profit from the disparity between the sales price of the mortgage-backed securities and their first cost of funding (Bonander, 2013, p.843). Since 2004, Fannie and Freddie abandoned their stern underwriting standards and started to purchase and guarantee subprime mortgages, while also investing in subprime-mortgage-backed securities (Bonander, 2013, p.844). They bought more than $434 billion of subprime mortgages from 2004 to 2006 (Bonander, 2013, p.844). Their greatest purchase occurred from 2004 to 2005, when altogether they bought “$175 billion (44% of the market) and $169 billion (33% of the market) of subprime-mortgage-backed securities, respectively” (Bonander, 2013, p.844). In 2006, lax standards and actions affected Fannie and Freddie, when the housing bubble burst, thereby pushing them to insolvency (Bonander, 2013, p.844). The problems of Fannie and Freddie are not over yet though. In 2003, Freddie revealed that it used unacceptable accounting practices to inflate its earnings. The Office of Federal Housing Enterprise (OFHEO), its regulator during this time, discovered that the company had “misstated earnings by $5 billion between 2000 and 2003” (DiVenti, 2009, p.237). Freddie underreported its earnings, however, which is the “interesting” part of the fraud (DiVenti, 2009, p.237). The OFHEO investigated Fannie Mae too, where it learned in 2004 that Fannie overstated earnings “between 2000 and 2003 by $6.3 billion” (DiVenti, 2009, p.237). OFHEO discovered significant accounting, disclosure, and management concerns that allowed these misstatements to be developed and to be hidden (DiVenti, 2009, p.237). The misstatements resulted in misperceptions of the financial performance and future of Fannie’s and Freddie’s portfolio and exorbitant executive compensation benefits. DiVenti (2009) argued that the misstatement had two effects: first, the incorrect accounting hid the disparities in GSEs’ earnings over time, hiding their volatility and providing enterprises with the manifestation of low-risk environments, and second, for Fannie Mae, senior management maneuvered earnings to take full advantage of their annual bonuses. One of the serious accounting rule violations was the failure of both GSEs to correctly book intricate financial instruments called derivatives, which the companies employed to hedge against changes in interest rates in their mortgage investments (DiVenti, 2009, p.237). Because of this practice, Fannie and Freddie misled investors by projecting false performance outcomes and growth patterns (DiVenti, 2009, p.237). Furthermore, the fraud showed that the senior management failed to create and enforce sufficient internal control systems (DiVenti, 2009, p.237). In May 2006, the OFHEO stated that aside from breaching accounting and corporate governance standards, Fannie and Freddie used unwarranted risk-taking and meager risk management efforts. These actions resulted in amplified holdings of subprime and Alt-A private-label MBS and their employment of derivatives to control the interest-rate risk of their investment portfolios. DiVenti (2009) noted that the misstatements of Fannie and Freddie and their widespread effects indicated the “systemic risk that the GSEs posed to the greater financial system” (p.238). Thus, because of the large role of GSEs in the financial industry, their fraudulent acts affected the entire industry, as well as the national economy. Corporation and Government Response The government responded to Fannie and Freddie’s fraud with a strict regulatory approach. Congress has revamped the regulatory supervision of Fannie Mae, Freddie Mac, and the Federal Home Loan Banks through the Housing and Economic Recovery Act (HR 3221). The Act formed an autonomous and integrated regulator of GSEs, which has extensive powers similar to federal banking regulators, and with freedom to institute sufficient capital standards (Hamilton, 2008, p.2). The Act also produced a clear and trustworthy process authorized by Congress for putting a GSE in receivership. The law also mandates GSEs to follow SEC reporting requirements that are analogous to other large, complex public companies (Hamilton, 2008, p.2). On September 17, 2008, the Federal Housing Finance Agency (FHFA) took the conservatorship of Fannie and Freddie. Fannie and Freddie were forced to enter into a “senior preferred stock purchase agreement with the U.S. Department of the Treasury,” which “allowed [Fannie and Freddie] to borrow up to $200 billion to remain solvent” (Bonander, 2013, p.844). At present, Fannie and Freddie have borrowed almost $150 billion from the Treasury, turning it into the biggest bailout of the 2008 financial crisis. As the conservator of Fannie and Freddie, thr FHFA is permitted a “6-year period beginning on the date on which the claim accrues” (Bonander, 2013, p.844). Because of this provision, the FHFA filed a section 11(a) claim, charging material misstatement or oversight in the mortgage-backed-security registration statement, and a section 12(a)(2) claim, alleging a material misstatement or omission in the mortgage-backed-security prospectus (Bonander, 2013, p.844). The Act added Section 38 to the Securities Exchange Act of 1934 to oblige the registration of securities of GSEs (Hamilton, 2008, p.7). For Fannie Mae and Freddie Mac, the statute means no exemptions and the like: …that no class of their equity securities will be exempt from the registration provisions of the Exchange Act, and also provides that there will be no exemption from the books and records, internal accounting controls, beneficial ownership reporting, proxy, tender offer, insider reporting, and short-swing trading provisions of the 1934 Act (Hamilton, 2008, p.7). To respond to legislative changes, as of July 18, 2008, Freddie Mac and Fannie Mae have willingly registered their common stock and follow the Act’s periodic reporting requirements (Hamilton, 2008, p.7). Changes were also made in executive compensation and other management concerns that led to the accounting fraud of Fannie and Freddie. Core Ethical and Accounting Issues The main issues of the concerned fraud intersect institutional, organizational, and individual factors. At the institutional level, related agencies did not rigorously monitor the actions and outcomes of Freddie and Fannie’s lax underwriting standards. Fannie Mae’s internal audit unit, the Office of Auditing, did not meet OFHEO safety and soundness standards in relation to “1) the reliability and integrity of financial and operational information, (2) the effectiveness and efficiency of operations, and (3) meeting its stated audit report objectives” (OFHEO, 2006, p.6). Furthermore, the Office did not follow standards that came from the Institute of Internal Auditors and the Committee of Sponsoring Organizations, especially those that refer to auditor proficiency and the execution of professional care (OFHEO, 2006, p.6). As a result, the Office also failed to meet responsibilities that Fannie Mae’s Board of Directors assigned to it. In addition, KPMG, Fannie Mae’s former auditor, did not stringently review if Fannie Mae observed GAAP accounting policies (OFHEO, 2006, p.8). KPMG also inappropriately gave “unqualified opinions on financial statements even though they contained significant departures from GAAP” (OFHEO, 2006, p.8). These combined actions did not comply with the standards of the OFHEO. The lack of implementation on KPMG’s part to recognize and to unveil the grave flaws in the policies, procedures, systems, and controls of Fannie Mae’s financial accounting and reporting facilitated the latter’s conduct of fraudulent practices. Aside from poor execution of government controls, Fannie and Freddie had senior managers, who exploited their companies’ inadequate internal controls. The OFHEO (2006) reported that “the extreme predictability of the financial results reported by Fannie Mae from 1998 through 2003, and the ability to hit EPS targets precisely each quarter, were illusions deliberately and systematically created by senior management” (p.6). Senior executives abused the weaknesses of their firms’ accounting and internal control systems. They did not ensure proper observance of GAAP, so that they could misstate yearly earnings (OFHEO, 2006, p.6). Furthermore, senior management employed a diversity of transactions and accounting exploitations that inflated annual earnings (OFHEO, 2006, p.6). The management would not be able to perform these actions, nevertheless, if organizational controls existed. Hence, the management and poor organizational systems reinforced the weakness of these companies in ensuring ethical company conduct. Reaction to Government Responses The government provided proper responses to Fannie and Freddie’s fraudulent actions. However, the punishment for white collar criminals must be extended to include life sentences. These people committed horrific crimes because they did not only steal from their shareholders and clients, but also from their employees and the public, by destroying their morale and trust in GSEs. In addition, because of the lasting socio-economic effects of the 2008 financial crisis, these managers are modern robber barons. They financially benefited from these fraudulent activities, so they must pay for such widespread consequences. They may not be sociopathic killers, but they are similar to serial killers because they deliberately and seriously affected numerous stakeholders (Lucasa & McDonald, 2006). In addition, the bailout is an enormous burden to taxpayers. It is a cost that they paid because the senior management and internal and external auditors failed to do their jobs. These people and companies should pay for their crimes with life sentences, in order for the government to demonstrate political will against purposeful fraudulent acts that has significant financial and social consequences. Recommendations This section focuses first on the implicit guarantee of Fannie and Freddie’s (F&F) loan. It is ideal for the government to remove the implicit guarantee because of the externality it provides to taxpayers (Glaeser & Jaffee, 2006, p.3). Since the guarantee exists already though, the government can consider two approaches to the externality. First, the government could assume quantity control and put a boundary on either the quantity of debt that F&F can issue, or the amount of their retained portfolios (Glaeser & Jaffee, 2006, p.3). Second, the government could compel a Pigouvian tax on F&F, according to the predicted size of the externality (Glaeser & Jaffee, 2006, p.3). To be successful, the tax must be connected to the F&F’s interest rate risk, where the quantity of F&F debt is a good substitute (Glaeser & Jaffee, 2006, p.3). Glaeser and Jaffee (2006) used Weitzman’s standard examination of quantity controls and taxes, which they believed serve as the ideal case for quantity controls (p.3). They noted that it is hard to precisely assess externality, and there is a possibility that the most favorable retained mortgage portfolios for F&F are near to zero (Glaeser & Jaffee, 2006, p.3). The report added: “Any social gains from having this portfolio presumably come from the ability of F&F to act like a hedge fund allocating mortgage risk and funding efficiently” (Glaeser & Jaffee, 2006, p.3). Nevertheless, providing limitations to the quantity of debt that F&F can issue, or taxing them, can compel them to become more rigorous in their accounting behaviors. As for the accounting practices of these companies, the government already instituted controls that must be fully implemented in order to be effective. But these changes will not be enough, if these companies do not undergo genuine cultural change. For the past few years, the management of these companies continues to face misstatement charges. These companies are struggling to be free from their corrupt management practices. Francis (2010) talked about permissive attitudes to fraud in organizations, which allow employees to see it as part of the norm. Moral corruption cannot be fully removed, unless companies change from within, where how they see and respond to fraud is utterly transformed. Cultural auditing must be applied, where all employees are evaluated for their ethical beliefs, practices, and concerns. Afterwards, ethical standards must be determined and monitored closely by third-party and autonomous employees. This way, Fannie and Freddie can transform their culture and become more socially responsible GSEs, for the benefit of numerous stakeholders, who are depending on the former’s credibility and success. References Blackburn, M. L., & Vermilyea, T. (2010). The prevalence and impact of misstated incomes on mortgage loan applications. Retrieved from http://www.frbsf.org/economics/conferences/1007/blackburn_vermilyea.pdf. Bonander, A. (2013). Fannie Mae, Freddie Mac, and Due Diligence failures: Should comparative responsibility be imposed on a government-sponsored entity’s claims brought under Sections 11(a) and 12(a)(2) of the Securities Act of 1933? Iowa Law Review, 98, 835-862. Retrieved from http://www.uiowa.edu/~ilr/issues/ILR_98-2_Bonander.pdf. DiVenti, T. R. (2009). Fannie Mae and Freddie Mac: Past, present, and future. Cityscape: A Journal of Policy Development and Research, 11(3), 231-242. Retrieved from http://www.huduser.org/periodicals/cityscpe/vol11num3/ch11.pdf. Francis, L. (2010). Banking on robbery: The role of fraud in the financial crisis. Casualty Actuarial Society E-Forum, 2. Retrieved from http://www.casualtyactuaries.com/pubs/forum/10fforumpt2/Francis.pdf. Glaeser, E. L., & Jaffee, D.M. (2006). What to do about Fannie and Freddie? Economist’s Voice, 1-5. Retrieved from http://faculty.haas.berkeley.edu/jaffee/Papers/097BEPressFannie.pdf. Hamilton, J. (2008). Congress overhauls regulatory regime for Fannie Mae and Freddie Mac. Retrieved from http://business.cch.com/securitieslaw/news/whitepaperGSEs.pdf. Lucasa, D., & McDonald, R. L. (2006). An options-based approach to evaluating the risk of Fannie Mae and Freddie Mac. Journal of Monetary Economics, 53(1), 155–176. Office of Federal Housing Enterprise Oversight. (2006). Report of the special examination of Fannie Mae. Retrieved from http://www.fhfa.gov/Preview-FHFAWWW/webfiles/747/FNMSPECIALEXAM.pdf. Read More