The Next Enron?

Fannie Mae, it seemed, turned a roller coaster into a ski lift. No one on Wall Street likes a roller coaster. You shoot up and plunge down again and again until you return to where you started, sick to your stomach, woozy, and, unless you are a kid, vowing never to return. But a ski lift? One solid, beautiful quarter on top of another, ever rising, no looking back, with terrific views and lots of new highs? Nothing like it.

Truly nothing, it turns out, and certainly not Fannie Mae. When I first got in the business, Fannie Mae was a stock no one would own. What was the point of buying shares of a company chartered by the federal government to help the housing market, a quasi-public entity that had to take one for the team, the American homeowner, whenever rates fell or rose dramatically? Backed by a sort of wink-wink guarantee from the Feds, Fannie bought mortgages from banks and got them off the banks’ books, so the banks could make still more loans without worrying about inventory. Fannie then sold those loans in buckets, for a profit, provided it could manage the interest-rate risk so it wouldn’t get stuck holding too many of them.

For years, Fannie’s quarterly earnings would shock you, both high and low, and like the proverbial sickening coaster, they produced a stock that went nowhere. But in the nineties, after Tim Howard took over as chief financial officer, Fannie Mae started reporting smooth, positive earnings—earnings usually reserved for classic growth companies like Coca-Cola or Pfizer, even though, beginning in 1998, interest rates began to rise and fall like waves at a football stadium—a process much too hard for most mortals to game.

For those of us who have managed interest-rate risk, for those who have created, sold, or bought complex derivatives, Fannie’s earnings seemed too good to be true. Who could be that smart? Who could deliver great results no matter how fast the prepayments came in when rates went down, no matter how quickly the mortgage market dried up when rates went up? Who were these geniuses?

“Fannie executives have reacted with the same denial we saw when the Enron scam broke.”

As always, when someone gets it right when everyone else gets it wrong—as WorldCom did versus AT&T, Verizon, and Sprint, as Nortel did versus Lucent, as Enron did versus everyone in the natural-gas merchandising business—you hear jealous carping. “They’re cooking the books,” traders would tell me. “They’re lying to make the number,” bond merchants would whisper. When the whispers grew to a din, I invited Frank Raines, the gentlemanly CEO of Fannie Mae, on Kudlow & Cramer, where he responded to critics by saying that Fannie Mae would never manipulate anything, that it would never jeopardize its mission because homeownership was too important to trifle with. To drive home the point, Fannie bombarded the airwaves with saccharine ads about poor folks getting homes because of the good deeds of this great company. Fannie, well connected in Washington, given the millions it has doled out in lobbying, and worshiped on Wall Street, given the billions it has paid in underwriting fees, became too big and powerful to question. The roller coaster turned ski lift kept climbing.

Until last month. When we found out that Fannie Mae may have hidden losses—perhaps $11 billion worth, by some analysts’ estimates—losses that, had they been revealed at the time, would have shown that Fannie’s earnings resembled something from Coney Island, not Vail. Last month, Fannie’s regulator, an obscure agency called the Office of Federal Housing Enterprise Oversight, issued a 211-page report alleging that Fannie Mae hid the volatility—and losses—to smooth out earnings. It appears that Fannie, far from being a prosperous enterprise that consistently delivers profits, is actually technically insolvent, and in need of billions of dollars in fresh capital to support the massive edifice of derivatives it has put on its books, in part to obscure how bad things really are.

Fannie executives have reacted with the same classic denial and indignation that we saw when the Enron and WorldCom scams broke. Every time anyone questions Fannie’s ethics, Fannie produces its top brass and congressmen (typically Democrats, but often Republicans) to praise the company and to warn us not to touch it, lest the housing market get hurt and people lose their ability to buy homes. But a rare combination of a booming housing market, low interest rates, and a president who is no friend of Fannie Mae’s have made those defenses seem fanciful. Even Barney Frank, a staunch Democratic defender of Fannie, told me recently that he’s interested only in protecting the company, not current management, now that the rickety mechanics of the ski lift have been exposed.

How bad will the fallout be? Freddie Mac, the sister company of Fannie Mae, fired its top executives last year when it was revealed that they hid billions in gains to be applied at a later date to obscure losses and keep earnings consistent. It’s difficult to imagine how executives at a company that may have hid billions in losses will suffer a different fate. In fact, criminal indictments could be coming if Raines and Howard don’t step down. Before the passage of the Sarbanes-Oxley reforms, prosecutors felt they needed to catch executives looting the company red-handed to bring criminal charges. Now, though, the simple act of managing earnings to produce smoothness when there is none has been criminalized. Of course, Fannie Mae the stock, unlike WorldCom and Enron, hasn’t gone to zero (investors seem to believe that Fannie’s supporters will eventually bail it out, and Raines’s sales job has, at least to an extent, been working). But there’s nothing in Sarb-Ox that says a stock has to become worthless before prosecutors can get involved. And because it appears Fannie lied for so long about its books, layering on a new derivative every time it looked like another one was about to go bad, it now must raise billions in fresh capital in order not to violate federal capital requirements. It’s difficult to imagine how the Justice Department would let the same executives who may have caused the capital shortage now raise the funds needed for compliance.

All executives want their companies to be growth companies—even when the companies have no real growth. That way mutual funds will bid up their companies’ share prices, and the insiders can cash out their stock and options for fat gains. It’s just sad that after Enron and WorldCom showed just how disastrous that strategy can be, the one major company still playing by the old bogus rules, apparently, is the one that was meant to make housing affordable for all. For the good of the company, the current team would be wise to step down now and avoid the tarnish of criminal indictments. Otherwise it will only get uglier, if not fatal, for the executives—and the enterprise itself.

James J. Cramer is co-founder of TheStreet.com. He often buys and sells securities that are the subject of his columns and articles, both before and after they are published, and the positions he takes may change at any time.

The Next Enron?