According to Peter Wallison of the American Enterprise Institute, traders regard Fannie Mae (NYSE-FNM) stock as the best pure punt on the election, sure to benefit if Democrat John Kerry wins. Punters who try this, and are able to use Fannie Mae’s accounting, can then decide post facto Wednesday whether the punt was a speculation or a hedge, and thus whether to record the profit or lose the loss “below the line.”
An AEI seminar Thursday discussed the questionmarks over Fannie Mae’s accounting in 1998-2003, which according to unanimous opinion at the seminar are likely to cause a restatement of $8-15 billion in Fannie Mae’s capital account, putting the company well below its regulated capital requirement and forcing it to shrink by $200 billion or more the $900 billion portfolio of home mortgages held on its balance sheet.
The most important problem relates to Fannie Mae’s selection under Rule 133 of the Financial Accounting Standards Board of “hedge accounting” for many of its huge portfolio of derivative contracts. This accounted for the great bulk of Fannie Mae’s “adjusted other capital items” deficit of $8.5 billion at June 2004, losses not taken through the income statement and not counted in calculating Fannie Mae’s capital. Apparently, Fannie Mae claimed that the contracts had “no ineffectiveness” as hedges against its liabilities, even though many of them had an option component, and were not recorded as hedges for several weeks after the position was taken on. This contravened paragraph 68 of the FASB regulations covering derivatives accounting.
To see why this is serious, go back to my election gamble example. Suppose you are a Wall Street trader, with a steady $500,000 of taxable income. If Kerry wins, he has promised to repeal President George W. Bush’s tax cuts on incomes over $200,000, but not increase taxes in any other way. Hence you have a well defined exposure on a Kerry victory; you would lose approximately 4 percent in additional taxes on $300,000 taxable income over $200,000, or $12,000 per annum, or $48,000 in the four years until the 2008 election gives you a new spin of the political roulette wheel.
Regulatory enforcement against Fannie Mae has been steadily increasing in intensity in the last two years; the company’s accounting is currently subject to a Securities and Exchange Commission investigation. However it is felt by Wall Street that this pressure would largely disappear under a Kerry administration; Fannie Mae chief executive Franklin Raines is close to the Democrat leadership, and the company has great political power within the Democrat congressional delegation. Hence if the Democrats are elected, Wall Street expects Fannie Mae’s stock price to rise, reversing much of its drop over the last few weeks.
As a Wall Street trader you can assess the possible magnitude of this rise, perhaps 10 percent or $7 from the $70 at which the stock was trading Friday. Conversely, if Bush wins, the stock might be expected to drop $3, just under 5 percent. To be perfectly hedged, therefore, you must buy 4,800 shares. If Kerry wins, you will make $7 x 4,800 or $33,600, minus $48,000 in additional Kerry taxes, for a net loss of $14,400. If Bush wins, you will lose $3 x 4,800 or $14,400 on the Fannie Mae stock. You are perfectly hedged.
Now here’s the clever bit. Instead of deciding how to book the position when you take it on, suppose you’re allowed to use Fannie Mae accounting, and only decide how to book the position on Wednesday, when you know the election result (you hope – as we all do!) If Bush has won, you book the position as a “no ineffectiveness” hedge against your now-removed Kerry tax liability (the Fannie Mae shares aren’t truly a perfect hedge against a Kerry election victory, but the “swaptions” (options to enter into swaps) that Fannie Mae buys aren’t a perfect hedge against a non-optional liability, either.) By doing so, you don’t need to record your $14,400 loss now; instead you can amortize it over the next 4 years against the Kerry taxes you don’t have to pay – no loss in 2004, in other words, and $3,600 per annum in losses in each of 2005-08.
If Kerry has won, then Wednesday you claim that of course the position wasn’t a hedge, it was just a successful speculation, based on your shrewd foreknowledge of the Kerry victory. The $33,600 in profit goes into 2004’s net income, boosting it accordingly.
This accounting treatment contravenes the clear standards set in FAS 133, but if your auditors will let you do this, it’s pretty clever, right? Pretty unethical, too, if your bonus depends in some precise way on hitting a 2004 profit target, and the $33,600 just allows you to make it.
According to the Office of Federal Housing Enterprise Oversight report on Fannie Mae, the company has for the last several years followed a policy of choosing whether to book each of their huge portfolio of derivatives trades as a hedge only after a few weeks, when it knows which way interest rates have moved in the interim – thereby as in the example above either recording a profit or deferring a loss.
In 1998, $200 million of derivatives losses diverted out of the profit and loss account by this means increased that year’s Fannie Mae profits just enough to hit the earnings per share target set by the Board of Directors, and move top management’s bonus pool from no bonuses to maximum bonuses. Further investigation will show whether the similar distortions of proper accounting in 1999-2003 had similar effects on those years’ management bonuses. Since bonuses in Fannie Mae are a substantial multiple of base salary, this was not insignificant. I leave it to your own judgment and that of the SEC as to whether it was outright fraud.
Fannie Mae is important because if there is indeed $15 billion of water in its capital base, about a third of its stated capital, the U.S. taxpayer is seriously at risk in a housing downturn. There would seem no good reason why a company whose sole rationale is to place a quasi-Federal guarantee on home mortgages should be part of the private sector at all, certainly not accumulating a $900 billion portfolio of home mortgages in its balance sheet, capitalizing itself three times as aggressively as any commercial bank would be allowed to, and rolling the dice. Entrepreneurship in performing Fannie Mae’s core function is simply encouraging a taxpayer rip-off; the company should be set up not to permit it. CEO Raines, paid $12 million last year, could be replaced with a member of the Government’s Senior Executive Service, whose maximum basic pay in 2004 is $158,100. The saving, as Fannie Mae’s advertising nauseatingly re-iterates, could provide cheaper mortgages for America’s Homeowners.
The Fannie Mae problem is symptomatic of a wider ailment in the U.S. corporate system, the excessive remuneration of top management, and its over-dependence on achieving earnings numbers that can be and are manipulated. Professor Michael Jensen of the Harvard Business School propounded in his seminal 1979 paper “Theory of the Firm: managerial behavior, ownership costs and agency structure” and in a number of other writings during the 1980s the thesis that management remuneration needed to be tied more closely to achievement of earnings goals and increase in shareholder value. Since this thesis promised to lead to more money for top management, it was eagerly accepted by U.S. business, and has led to a spiraling in management remuneration, all of it justified by apparent achievement of shareholder goals. Jensen’s theory was codified into U.S. tax law in 1993, when corporations were prohibited from tax-deducting pay of more than $1 million to any manager, unless it was linked to corporate performance.
The increase in management remuneration has taken two forms. One is an explosion in the use of stock options, which gained rocket fuel in 1995 from the U.S. Senate, led by Senator Joseph Lieberman (D.-Conn), successfully preventing the FASB from bringing their cost onto the income statement, where it should properly be counted. Following the scandals of 2001-2, the FASB is trying again, but the U.S. Senate, lobbied hysterically by the more unpleasant elements of the tech sector, has forced the FASB to postpone implementation of its new rule until June 2005, and once the election is over will presumably stick the knife in it permanently. Clearly, management remuneration you don’t have to account for in the income statement is particularly attractive.
The other remuneration explosion has taken the form of cash bonuses, frequently a large multiple of base salary, awarded on the basis of achieving budgeted earnings targets for the year. Both budgets and earnings results are accordingly manipulated by management, and the result has been a catastrophic decline in the quality of U.S. corporate accounting. Fannie Mae is just one example of this.
Jensen himself has been appalled by the results of the revolution he caused, has spoken out against excessive stock options, and in 2001 issued a research paper “Paying people to lie: The truth about the budgeting process” which claimed that abolition of counterproductive budgeting behavior could increase productivity and shareholder value by as much as 50-100 percent. Sorry, Professor, it may well be too late; you should have thought of this problem the first time, and not placed an excessive reliance on the questionable integrity of U.S. top management.
It is interesting to note, incidentally, that the advent of new temptations to U.S. management, and their almost total failure to resist them coincided closely with a wave of “ethics” courses at U.S. business schools, exemplified by the 1992 establishment at Harvard of the John Shad Professorship of Ethics. Hypocrisy, too, is not unknown among the management class.
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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)
This article originally appeared on United Press International.