Fannie Mae and Income Smoothing

The Office of Federal Housing Enterprise Oversight completed a scathing report on Fannie Mae (FNM.) The report, released this morning, contains some very interesting observations which should make us think about the treadmill of quarterly earnings management. In light of my most recent post, I think the message is pertinent and timely.

A few quotes:

"During the period covered by this report—1998 to mid-2004—Fannie Mae reported extremely smooth profit growth and hit announced targets for earnings per share precisely each quarter. Those achievements were illusions deliberately and systematically created by the Enterprise’s senior management with the aid of inappropriate accounting and improper earnings management."

"By deliberately and intentionally manipulating accounting to hit earnings targets, senior management maximized the bonuses and other executive compensation they received, at the expense of shareholders. Earnings management made a significant contribution to the compensation of Fannie Mae Chairman and CEO Franklin Raines, which totaled over $90 million from 1998 through 2003. Of that total, over $52 million was directly tied to achieving earnings per share targets."

"Management intentionally developed accounting policies and selected and applied accounting methods to inappropriately reduce earnings volatility and to provide themselves inordinate flexibility in determining the amount of income and expense recognized in any accounting period. In that regard, the amortization policies that management developed and the methods they applied created a “cookie jar” reserve."

"Management deliberately developed and adopted accounting policies to spread estimated income or expense that exceeded pre-determined thresholds over multiple reporting periods;
Management established a materiality threshold for estimated income and expense, within which management could avoid making adjustments that would otherwise be required under FAS 91;
Management made discretionary adjustments to the financial statement for the sole purpose of minimizing volatility and achieving desired financial results"

"Under the Fannie Mae executive compensation program, senior management reaped financial rewards when the Enterprise met earnings per share (EPS) growth targets established, measured, and set by senior management itself. The structure of the executive compensation program created the incentive and opportunity for senior executives to benefit at the expense of safety and soundness."

"Fannie Mae tied major portions of executive compensation to EPS, a metric easily manipulated by management." (my emphasis)

"The extreme predictability of the financial results reported by Fannie Mae from 1998 through 2003 was an illusion deliberately and systematically created by management."

The reaping of massive incentives for a management that sets EPS targets, measure EPS, manipulates EPS constitutes theft in my opinion. Shifting EPS routinely to future years when the EPS target has been exceeded smooths earnings, an act which tends to be applauded by Wall Street analysts. Rather than recognizing the deliberate manipulation, many analysts applauded the predictability, and the notion of controlled, disciplined growth.

Disclaimer: Neither I, my family, nor clients have a current position in Fannie Mae.