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Taxpayers Could Foot Bill For Fannie Mae Fraud Settlement

Originally published at Updated 5/21/2013.

Years after the government accused Fannie Mae of accounting fraud, are taxpayers being forced to pay the price?

Last week, Fannie Mae and its former auditor agreed to pay $153 million to settle a lawsuit in which a group of Ohio pension funds alleged that they were defrauded by Fannie Mae’s long-ago conduct.

But Fannie Mae, the giant housing finance company, was taken over by the government at the height of the financial crisis in 2008 and remains a ward of the state. It has received billions of dollars of taxpayer support.

Is Fannie Mae’s half of the $153 million settlement the latest insult and injury to taxpayers?

The Project On Government Oversight (POGO) asked the company and its regulator, the Federal Housing Finance Agency (FHFA), who bears the cost of the settlement. They would not answer. (A Fannie Mae spokesperson referred POGO to the regulator, which declined to comment.)

But based on an examination of publicly available records, it appears that taxpayers could be left holding the bag, at least temporarily.

The regulator was clearly aware of the risk. In 2011, it published a rule explaining the general pitfalls for taxpayers if Fannie Mae were required to pay litigation claims while it was under what is called federal conservatorship. The rule said, in part, that Fannie Mae’s “payment of securities litigation claims will be held in abeyance during a conservatorship, except as otherwise ordered by the [FHFA] Director.”

In other words, without special dispensation, the rule would have prevented alleged victims of Fannie Mae’s accounting from collecting damages while the company remained a ward of the federal government.

The Ohio pension funds cried foul. They challenged the rule in federal court, arguing it was “designed to single out securities fraud victims and restrict their ability to recover their losses.”

In response, FHFA argued that the rule was necessary to protect taxpayers. “Because Fannie Mae and Freddie Mac currently depend for their very existence on hundreds of billions of dollars of taxpayer funds…Plaintiffs’ position would essentially effect a massive wealth transfer from the taxpayers of the United States to compensate Plaintiffs for investment losses,” FHFA wrote in a 2012 motion.

But that may be precisely what’s happened. It appears the regulator has exercised its legal authority to green light the payment.

Last week’s proposed settlement, filed in federal court, says that Fannie Mae is “paying its portion of the Settlement Fund with the express approval of its conservator, FHFA.”

Fannie Mae and its former auditor, KPMG, did not admit any wrongdoing. The settlement must still be approved be a federal court.

“We are satisfied with the outcome and pleased to put the matter behind us,” a Fannie Mae official said in a statement provided to POGO.

“KPMG determined that it was in the firm’s best interest to put this matter behind us and avoid the significant additional cost, and the distraction and inherent uncertainty, of protracted litigation,” a KPMG spokesperson told Bloomberg for a story reporting the settlement.

The class action litigation began in 2004. The Ohio pension funds—representing more teachers, police officers, and other public service employees—alleged that, from at least 2001 through 2004, Fannie Mae “engaged in one of the largest financial frauds in U.S. corporate history,” according to their complaint. “Over thirty of Fannie Mae’s accounting policies and practices—nearly every major accounting standard applicable to its mortgage-financing business—violated [Generally Accepted Accounting Principles],” resulting in millions of dollars in losses for the pension funds, the plaintiffs alleged.

Fannie Mae has also been in hot water with federal regulators. “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,” Fannie Mae’s regulator at the time said in a 2006 report. Fannie Mae paid $400 million to settle with the regulator and the Securities and Exchange Commission. In late 2006, Fannie Mae disclosed in a regulatory filing that it had overstated earnings by $6.3 billion.

Fannie Mae could have set aside funds to pay for any liability in the class action litigation before it was seized by the government. The company and its regulator would not tell POGO whether Fannie Mae established such a reserve. But even if it did, that wouldn’t spare taxpayers the consequences, according to a former regulator who is now removed from the situation and spoke on condition of anonymity.

As of this year, “every dollar of earnings” generated by Fannie Mae “is used to benefit taxpayers,” according to the Treasury Department. So money that’s used to pay a settlement is money that can’t be taken out of reserve and used to pay back the government.

Neither Fannie Mae nor the regulatory agency would say whether insurance will cover any of Fannie Mae’s tab. If so, that would seem at odds with the agency’s warning that a legal settlement would amount to a “massive wealth transfer” from the taxpayers to the pension funds. (The quote was noted in a January 2012 article by Law360 discussing a legal disagreement between the pension funds and the regulator.)

Fannie Mae has returned to profitability, buoyed by a recovering housing market. Last week, it announced a one-time paper gain of $50.6 billion from writing up the value of tax benefits it had previously written down. This extraordinary development will help it pay a dividend of $59.4 billion to the U.S. Treasury by the end of June, but that doesn’t mean it will be able to repeat the feat in future quarters. (As Washington Post columnist Steven Pearlstein explained: “Remember, we’re talking here about an accounting adjustment, not an actual surge in cash flow.”)

As of March 31, the company had received $116.1 billion from the Treasury, according to its latest quarterly report.

Compared to those numbers, Fannie Mae’s half of the $153 million settlement is just a drop in the bucket. It’s also a fraction of what the Ohio pension funds claimed they were owed. Estimates cited by the plaintiffs said that Fannie Mae’s damages could range from $2.2 billion to $8.6 billion, according to the company’s latest annual report.

Nonetheless, the possibility that taxpayers are being forced to pay for Fannie Mae’s legal troubles, on top of already paying billions of dollars to rescue the company, is emblematic of Fannie Mae’s toxic legacy.

At the very least, Fannie Mae and its regulator should explain how taxpayers will be affected by the settlement. It’s remarkable that a company that owes its survival to a taxpayer bailout—and the regulator responsible for overseeing it—won’t answer basic questions about what’s at stake for taxpayers. We hope the judge calls on the parties to provide more sunlight.