Fannie Mae: a hand in the cookie jar

Rumours of accounting shenanigans have been swirling around Fannie Mae, America's biggest mortgage finance provider, "like flies around a cow's flank for years", said Dailyreckoning.com. And quite rightly, as it turns out. Last week, after "eight months of peeking under Fannie's skirt", its regulator, the Office of Federal Housing Enterprise Oversight (OFHEO), concluded that she had been up to no good. Directors had deferred expenses in order to meet executive bonus targets, and dipped into reserves to boost reported earnings. Fannie's dodgy accounting for derivatives was also highlighted. The findings, says the OFHEO, raise "serious doubts" about the "overall soundness of the business".

Talk about a "too-smooth operator", said David Henry in BusinessWeek. The point of the fiddles was to "hide the real ups and downs of the business behind a veneer of stable and steady quarterly earnings growth". This was then supposed to bolster the group's low-risk credentials, buoy demand for its bonds, and counter the mounting clamour in Washington for it to be reined in. But there was always good reason for the clamour. Fannie and its sibling Freddie Mac, which was caught smoothing its earnings last year, were created by the government to provide liquidity to the housing market. They do so by buying mortgages from banks, which they then hold as investments or repackage as mortgage-backed securities. They also issue bonds, on which they pay low interest rates, thanks to an implicit government guarantee to fund the lending. Easy credit has fuelled rapid growth: Fannie and Freddie now own, or guarantee, payments on half of America's $8trn of residential mortgages.

They are now so big that - as even Alan Greenspan has noted - if they get into trouble, "they could imperil America's entire financial system", necessitating a bail-out by the Fed, said Albert Crenshaw in The Washington Post. Banks large and small hold much of their capital in Freddie and Fannie securities. Add their "gigantic derivatives positions" to their $1.7trn of debt, and the fallout, "if the two did go splat, would make the Long Term Capital hedge-fund collapse of 1998 look like a Sunday picnic", said Andy Serwer in Fortune.

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With concern growing over the potential ramifications of trouble at Fannie or Freddie amid this accounting scandal, there have been calls for tougher regulation, said Peter Wallison in the FT. But stricter rules will be "useless" if executives decide to keep ignoring them. Only removing the firms' government backing and thus turning them into private entities - "just two more competitors in a competitive mortgage market"- can protect taxpayers and the economy against "serious losses".