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Posted 9/27/2004
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Watch out for the hurricane named Fannie
Regulators are starting to take a hard look at the books of Fannie Mae, and they dont like what they see. That could spell trouble for the largest source of mortgage capital.
By Bill Fleckenstein
I think that there is a very important story for everyone to pay attention to, and that is Fannie Mae (FNM, news, msgs). The mortgage giant is now being investigated by both the Office of Federal Housing Enterprise Oversight (OFHEO) and the Securities and Exchange Commission.
In a report released Tuesday, OFHEO, Fannie Maes chief regulator, found that Fannie "employed an improper 'cookie jar' reserve in accounting for amortization of deferred price adjustments under GAAP" and "in at least one instance, deferred expenses apparently to achieve bonus compensation targets."
OFHEO concluded: "The matters detailed in this report are serious and raise doubts concerning the validity of previously reported financial results, the adequacy of regulatory capital, the quality of management supervision, and the overall safety and soundness of the Enterprise."
(Editors note: On Thursday, Sept. 23, the OFHEO asked Fannie Mae to take immediate remedial action to correct pervasive accounting problems, Reuters reported. )
Checkmate for Fannie chicanery?
The probes into Fannie Mae raise two questions:
First, will a proper and thorough investigation of Fannie Mae take place? It looks like we may be headed in that direction. It will also be important to see what sort of consequences befall Fannie, depending on exactly what they have done.
I have been saying for years that management of earnings by corporations has been the biggest open secret on Wall Street. Companies with far-flung interests and many moving parts cannot make the numbers and beat them by a penny with any regularity unless they are managing earnings, which is illegal. I will be most interested to see whether or not any of this finally stops.
Second, will these investigations force Fannie Mae -- the ultimate engine of the housing machine -- to modify its behavior? A major change in how Fannie Mae does business would have huge ramifications for every facet of the economy, given the amount of leveraged speculation that's transpired in the housing market.
Unmasking smoke and mirrors
Of course, one of the reasons Fannie can do what it can do (and likewise, every other financial institution) is because of the accounting treatment that financial institutions enjoy. They get to choose whether an asset (or derivative) is marked to market or not. (For review, please see my March 17, 2003, Contrarian: "I'm with Buffett: Some derivatives are scary.") They can also switch their decision. In any case, it appears that the misapplication of an accounting rule for derivatives (SFAS 133) is one of the things that Fannie Mae has used to manage their earnings.
I expect that if the light of day is truly trained on Fannie Mae and other financial institutions -- and an ounce of common sense is applied -- their rules and behavior will have to change, and it will have enormous consequences. Fannie Mae is an absolutely gargantuan organization with approximately $1 trillion in assets and $1 trillion in notional (or face value) derivatives exposure, yet has only $26 billion of equity. Said differently, its $26 billion of equity is holding up an asset and derivatives book that is about 20% of GDP. That gives you some idea of how big the problems can get if something bad, in fact, happens.
Whether or not something bad is going to happen cannot be forecast at this point, because we just don't know how serious "the authorities" are about discovering what went on. (And at this point, we can't know exactly what went on.) Also, these types of companies that I am mentioning are very politically connected. It may be too much to hope for to actually have everything treated as it should be.
However, I would note that all big accounting scandals start small. (Think back to Enron, WorldCom, etc.) So, I intend to follow this story closely, and everyone else should, too, because as I pointed out, the ramifications and the consequences will be quite large.
Sarbanes-Oxley: The hype turns out to be costly
The Sarbanes-Oxley Act of 2002, which is supposed to improve corporate accounting, is more hype than substance. Its also a perfect example of the law of unintended consequences: Compliance is turning out to be so costly that I think "S-OX," as Sarbanes-Oxley has been called, will throw a real monkey wrench into the technology mix over the next couple of quarters.
Let me explain, with some help from Lawson Software (LWSN, news, msgs), a small company but a significant participant in the enterprise resource planning, or ERP, arena. To quote from their preannouncement of Sept. 15:
"In our first quarter (the one that ended on Aug. 31), Lawson experienced what many other enterprise software companies have recently announced -- lower business activity, longer customer-decision cycles, and contract deferrals. . . . Priorities such as Sarbanes-Oxley impacting customers' capital spending on software adversely impacted software-licensing activity."
Lawson's comments may be a harbinger of what we hear from a lot more software companies, as compliance with Sarbanes-Oxley causes IT-spending plans to be put on hold. It's certainly something that "It's-the-bottom!" bulls haven't counted on.
The burden of compliance
I myself was initially dubious that the law would penalize software companies. Indeed, there has been little written about the potential negative impact of S-OX. That's why it was very helpful to receive three e-mails from subscribers to my daily column who are intimately involved with all this. Here are some worthwhile excerpts:
- 'Orders of magnitude more complex:' "Believe me, I've led the S-OX (Sarbanes-Oxley) effort for the past 18 months for a Fortune 200 company, and this project is orders of magnitude more complex and resource-intensive that anyone ever expected, and will really put a dent in new programs (especially IT-related) in the 4th quarter."
- For a CPA, certifiable pain: "I work as a CPA in a top-10 mutual fund company in our tax compliance group. . . . We were researching enterprise-wide paperless workflow solutions. That stopped dead in its tracks. . . . Cumulatively, 150 hours of research between IT and accounting were flushed down the drain. We are now making due with a previously existing product that does a quarter of what we need it to do in three times the time of the forsaken project software. . . .The time and energy devoted by our IT staff, coupled with the raw costs of compliance in man-hours, leaves little time and no resources to begin a major software push of any kind."
- Earnings hits are coming: "I, too, am working on S-OX issues as a consultant (CPA). . . . I think there will be earnings impact as well (costs/rates go higher as deadlines loom?) -- at least enough for companies to blame their other problems on S-OX. And I think we're in for some true blowups, simply because the process will discover some material reporting problems."
Obviously, many software companies will be vulnerable, as will many hardware companies. I would think that IBM (IBM, news, msgs) could potentially be unusually impacted, given the problems in all their other businesses. IBM never preannounces, of course, because they always seem to find some way to make the number. But I can't imagine that their results are going to look very good for the next couple quarters, at a minimum.
Bill Fleckenstein is president of Fleckenstein Capital, which manages a hedge fund based in Seattle. He also writes a daily Market Rap column on his Fleckensteincapital.com site. His investment positions can change at any time. At the time of publication, Bill Fleckenstein was short IBM and long IBM puts. Under no circumstances does the information in this column represent a recommendation to buy, sell or hold any security. The views and opinions expressed in Bill Fleckenstein's columns are his own and not necessarily those of MSN Money.
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