WASHINGTON (AP) – Regulators have found serious accounting problems at mortgage giant Fannie Mae, prompting an inquiry by the Securities and Exchange Commission and calling into question its financial soundness, the company disclosed Wednesday. Its shares dropped nearly 7 percent.

In at least one instance, the regulators said, it appeared that the government-sponsored company put off some accounting for expenses to a future reporting period in order to meet earnings targets that brought bonuses for executives.

The Fannie Mae board has named a special committee of outside directors to respond to the allegations by the Office of Federal Housing Enterprise Oversight. Fannie Mae is the second-largest U.S. financial institution behind Citigroup Inc.

The developments surprised financial experts and Wall Street.

A little more than a year ago, Freddie Mac – Fannie Mae’s sister agency and competitor in the multitrillion-dollar home mortgage market – disclosed that it had understated profits by some $4.5 billion for 2000-2002 in an effort to smooth earnings.

Fannie Mae’s accounting then came under close government scrutiny, though its leaders insisted that it had no problems of that type.

“It is a ‘wow’ situation,” said Arvind Sachdeva, an analyst for Victory Capital Management who follows the company. But, he added, “These are opinions.”

Rep. Richard Baker, R-La., a longtime critic of Fannie Mae and Freddie Mac, called it “a sad and disturbing day for investors, homebuyers and taxpayers alike. … Investors have been fooled, homebuyers have been cheated and taxpayers are at risk.”

On Monday, the regulators at OFHEO – who have been investigating Fannie Mae’s accounting for eight months – submitted a report to its board that found earnings manipulation, lax internal controls and a corporate culture “that emphasized stable earnings at the expense of accurate financial disclosures,” according to a letter from OFHEO to the directors that was made public Wednesday.

The regulators found that Fannie Mae violated generally accepted accounting principles in its reckoning for transactions involving derivatives, financial instruments that it uses to hedge against interest-rate and other risk.

They also found that the company used an improper “cookie jar” reserve in accounting for some items. The SEC maintains that the practice – setting aside artificially large cash reserves to reduce revenues, with the idea of reversing that procedure to bolster revenues in less profitable times – gives investors an inaccurate picture of a company’s financial performance.

OFHEO’s report said its findings “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 Fannie Mae, according to a statement Wednesday by Ann McLaughlin Korologos, the presiding director of the Fannie Mae board.

Korologos also disclosed the preliminary inquiry by the SEC, which she said includes issues raised in OFHEO’s report.

While Fannie Mae shares declined sharply Wednesday, the market for securities fashioned from bundles of home mortgages that Fannie Mae buys from lenders reacted only slightly.

SEC spokesman John Nester declined to comment, as did OFHEO spokeswoman Corinne Russell.

Korologos said the Fannie Mae board has named a committee of independent directors to deal with the accounting matters.

That means a crucial function effectively has been removed from Fannie Mae’s chairman and chief executive, Franklin Raines, and other top managers.

Raines said in a statement Wednesday that company management “strongly supports the leadership” shown by Korologos and the other outside directors in responding to OFHEO’s investigation and the SEC inquiry. “We will assist them in any way we can as they carry out their duties,” Raines said.

Fannie Mae stock fell $4.96 to close at $70.69 a share on the New York Stock Exchange.

Fannie Mae and Freddie Mac were created by Congress to pump money into the home mortgage market. They stand behind $4 trillion of home mortgages, representing more than three-fourths of the single-family mortgages in the country.

On the Net:

Fannie Mae: http://www.fanniemae.com

Securities and Exchange Commission: http://www.sec.gov

Office of Federal Housing Enterprise Oversight: http://www.ofheo.gov

AP-ES-09-22-04 1819EDT

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