How Did Fannie Get on the Wall in the First Place?
Fannie Mae was established to facilitate the perceived social responsibility in the United States of encouraging the growth and affordability of housing, especially for disadvantaged groups. During the period in which Franklin Raines was at the helm, the company could seem to do no wrong, garnering recognition for many socially responsible accolades, being “near the top of everyone’s ‘best’ list” (Jennings, 2010, p. 268). For a company, is social responsibility the only mandate? Perhaps for Fannie Mae who was established by federal charter to meet such a mandate, this might be the case, but Milton Friedman argues that “there is one and only one social responsibility of business . . . increase its profits” (1970, para. 33). This author believes that if a company does not minimally maintain cash flow, or “real” profits, over the long term, it will be unable to meet any contrived social responsibility or survive.
How an organization goes about maintaining or increasing cash flow brings into play the idea of governance, which “comprises the roles, responsibilities, and balance of power among executives, directors, and shareholders” . According to Aguilera and Cuervo-Cazurra (2004) there are two purposes of corporate governance policy; improving quality of governance (or the running of the company), and increasing accountability of the leadership. Fannie Mae’s leadership was fixated on a single indicator of company success, while using its other accolades as a means of inviting investment. Ethics indicates the behavior that all individuals should take in any given situation. In regards to Fannie Mae’s governance, the behaviors engaged in by upper management were contrary to good governance, and ethics.
This author believes that there is no direct connection between social responsibility and ethics – because responsibility is an individual acceptance of behavior and obligation, while ethics deals what is right and what is wrong for all individuals. On the other hand, good governance of a company tends toward the continuation of that company. Continuation, works toward the maintaining of jobs for employees, the receipt of quality goods and services by customers, and a solid investment for shareholders. In this way there is a connection between good governance and ethical behavior.
How Many Kings’ Men Passed Fannie and Took No Notice?
The signals that were “overlooked” in Fannie Mae’s devolution, listed by Jennings (2010), were:
“In 1998, Armando Falcone of the OFHEO issued a warning report that challenged Fannie Mae’s accounting and a stunning lack of internal controls” (p. 272).
In 2002, the Wall Street Journal raised issues about Fannie’s accounting practices.
In 2002, Fannie shifted income by lending $40 million to Radian Insurance, listing said investment as an insurance policy.
In 2003, employees “expressed concerns about the company’s accounting policies” (p. 273).
In November of 2003, Roger Barnes “provided a detailed concern about the company’s accounting policy” (p. 272)
In each case, Fannie Mae’s management took no action to investigate these claims. In part this was due to the way that the company was organized, and contributed to their minimal internal controls. The Ethics and Compliance Office at the time was part of Fannie’s litigation division. The principle responsibility of the individual in charge of this office, however, was to “defend the company against allegations and suits by employees” (Jennings, 2010, p. 272). So, even though Barnes included specific information regarding suspected wrong doing in regards to Fannie’s accounting practices, no steps were taken by either that office or The Office of Auditing. Jennings further states that in interviews “many of the officers at Fannie were aware of . . . Barnes allegation . . . but none followed up on the issue or required an investigation” (p. 273).
Holmes, Langford, Welch, & Welch noted that “unethical charismatic leaders have dependent and compliant followers, who learn to rationalize their immoral behavior. These leaders manage to convince followers that immoral behavior is justified” (2002, p. 87). The implication of Jennings case is that management was on the same page to ensure the attainment of the major goals of the corporation, and did nothing to endanger their paychecks, or their bonuses.
Did Fannie Climb or Was It Helped?
With bonuses up to 100% for the attainment of a single accounting measurement each year, each officer was invested and motivated to meet the targeted goal, this is human nature. Without stringent methods of internal control, and empowered external auditors, however, this was a situation fraught with peril to the ethical nature of everyone involved. No one benefitted from a negative report, all of the benefit was in allowing discrepancies in policy or numbers to not be investigated. According to Howell & Avolio (1992),
“Unethical . . . leaders follow standards if they satisfy their immediate self-interests. They are adept at managing an impression that what they are doing conforms to what others consider “the right thing to do.” By applying their enormous skills of communication, they can manipulate others to support their personal agenda” (p. 49).
It is ironic that Raines, while engaging in non-standard accounting practices to “smooth” the earning profile of his company, publicly stated that the boards of public corporations should “select and oversee competent and ethical management”, and that those managers are responsible to “operate the company in a competent and ethical manner . . . never put[ting] personal interest ahead of or in conflict with the interest of the company” (Jennings, 2010, p. 274). By tying incentives to a single accounting measurement, Raines ensured that each officer’s self-interest was potentially in conflict with the interest of the company.
If policies had been put in place, and the organizations structure organized in such a way that safeguards had been put in place to ensure the quality and accuracy of the numbers without the personal involvement of those who were to benefit, then the conflicts of interest between the personal and professional interest of the officer’s may have been mitigated. The use of earnings per share as Raines single determiner of Fannie’s success, however, is even more questionable. Earnings per share should be a straight-forward calculation since it’s supposed to be the net revenue of the company, less dividends to preferred stockholders, divided by the number of common shares extant. With accounting strategies this simple indicator is not as simple as it would appear, as there are GAAP EPS, and pro forma EPS, and EBITDA EPS. It is possible for two companies to have the same EPS number, with one flush with cash, while the other bleeding cash and accruing large amounts of debt. It is a poor investor, and a terrible management team, that relies on one financial measure without it being used in conjunction with statement analysis and other measures or corporate health.
How Do We Achieve Fannie-“ness”?
By working the books backwards Fannie Mae officers were assured of making their goals, and their bonuses. The only way that this could be done over the long haul is to resort to funny numbers and creative bookkeeping. The problem with this strategy is that reality does not change just because you report it differently. For Fannie they were able to build in this fudge factor by invoking the volatility adjustment. This way the numbers worked out, the executives took home huge paychecks, investors were encouraged, analysts supported and the scheme continued.
The longer any measured system is skewed from reality, however, the larger the divergence and the more obvious the difference becomes to knowledgeable observers. A con cannot go on forever, sooner or later it must collapse because it is not built on a sound, square, or true foundation. The longer the scheme goes, the more likely it is to be discovered. If a pilot heads on a bearing that is one-half of a degree off, it may be some time before the pilots error might become noticeable, but in time it would put the airplane hundreds of miles off course if not corrected. This is why honesty is truly the best policy, for any other policy must ultimately result in failure. In the case of Fannie Mae, the volatility adjustment must have been important in the smoothing of financial statements, because after six years of “smoothing” there was the need of a “$6.3 billion restatement of revenue” (p. 274).
Few Noticed the Potential Fall
When Raines decided the goal for the company, the remaining executives got on board. The Vice President of operations risk (auditing) gave a talk to the auditors in 2000, setting a culture for the attainment of the goal – a form of tunnel vision. It has been shown that where lax management attitudes exist in regards to internal controls of accounting there is also the likelihood of fraud, and that auditors should “be especially vigilant in assessing the ‘tone at the top’ and control weaknesses” (Holmes, et al., 2002, p. 86). If the auditors were more invested in the goals of the company, than they were in ensuring the accuracy of the numbers, as is the case with Fannie, they were not doing their jobs. Holmes, et al.’s study indicated that “a lax attitude by top management encourages unethical activity and discourages the reporting of it” (p. 88), which is also seen in the Fannie Mae story. Graham (1995) compared leadership styles in a study to determine the “moral development and organizational citizenship behaviors” of each styles followers (p. 48), and found that leaders who follow a transactional model emphasize “influencing subordinate behavior by connecting it to specific rewards and/or punishments” which allows for “dependable task accomplishment”, but also “provides no check on the possibility of unethical rules or instructions” (p. 49).
The ethical implications of the Fannie Mae failure are many. Perhaps more than any other lesson this author takes from this scenario is that one should not believe the hubris of one’s own moral superiority. Fannie Mae seemed to be the penultimate poster child of social responsibility and ethics, but this was a specious picture that masked the internal workings of a company that was anything but responsible, or ethical. How much of the corresponding rationalization from their dishonest practices came because the executives “knew” they were doing something worthwhile in the service of the disadvantaged, and the down-trodden, the “huddled masses yearning to breathe free” (Lazarus, 1883)? Just because one is doing good, does not mean that one’s every action IS good. The long-term consequences of actions and inactions need to be carefully considered, and if the direction of those decisions are deviant, one needs to apply an immediate course correction.