CHAPTER 14

Allegations of Fraud: The Special Examination

IN THE FALL OF 2002, FRANK RAINES AND I RECEIVED IDENTICAL anonymous letters containing allegations of serious accounting, financial reporting, and internal control irregularities at Freddie Mac between 1999 and 2001. We turned them over to our general counsel, Ann Kappler, who faxed a copy of the letter Raines received to Freddie Mac’s chairman and CEO, Leland Brendsel. This seemingly innocuous action began a lengthy and complex chain of events that became entangled in the mortgage wars, intensified the mortgage crisis, and ultimately led to the demise of both Freddie Mac and Fannie Mae as public companies.

Freddie Mac Stumbles

Brendsel informed his board of directors of the letter, and on December 10, 2002, Freddie Mac’s Audit Committee retained the outside law firm of Baker Botts L.L.P to look into its allegations. Baker Botts quickly concluded that the allegations were unfounded, but during their investigation, their team found other issues they said they “believed required further inquiry.” Baker Botts shared the findings of their investigatory work with Freddie Mac’s new auditor, PriceWaterhouse Coopers (PwC). Freddie Mac had hired PwC in March 2002 to replace their former auditor, Arthur Andersen, after questions arose about Andersen’s role in the collapse of Enron in the fall of 2001. In the course of its audit of Freddie Mac’s 2002 financial statements, PwC also had found accounting treatments it questioned and that it suspected might involve more than simple accounting error.

On January 22, 2003, the Freddie Mac board issued a press release saying it would publish unaudited financial statements for 2002 that would be subject to change as PwC completed its audit. It also revealed that “management expects to restate its financial results for 2002, 2001, and possibly 2000.” The board noted that the reaudit involved “accounting policies previously used by management and approved by the company’s prior auditor, Arthur Andersen,” having to do with the “hedge accounting treatment of certain transactions including those occasioned by the implementation of FAS 133.”

The Office of Federal Housing Enterprise Oversight followed the Freddie Mac press release with a statement from Falcon, which given the circumstances was surprisingly mild. Freddie Mac generally stayed in the background on political issues—allowing Fannie Mae to take the lead (and the heat)—so at OFHEO as on Capitol Hill, they were considered the good GSE. Falcon’s statement neutrally described Freddie Mac’s reaudit as “the result of accounting interpretations and the resulting uncertainty associated with the timing of their income recognition” and called it “prudent and appropriate.” It did not mention the earnings restatement at all. Falcon praised Freddie Mac as a “well-capitalized institution with sound internal controls and prudent risk management,” while pledging, “OFHEO will remain fully engaged with Freddie Mac as the reaudit progresses.”

Freddie Mac put out its unaudited 2002 earnings on January 27. That same day, the Freddie Mac board retained Baker Botts to investigate the circumstances surrounding the transactions under review by PwC. PwC continued its reaudit during the winter and spring of 2003, as Baker Botts conducted their investigation of the accounting issues. On June 4, the Baker Botts investigators learned that Freddie Mac’s president and chief operating officer, David Glenn, had altered entries and in one case removed pages from a notebook he kept and had been asked to produce in connection with the investigation. Baker Botts immediately informed the Freddie Mac board of this discovery. The board’s reaction was swift and severe. On Monday, June 9, Freddie Mac announced the retirement of their chairman and CEO, Leland Brendsel; the resignation of their chief financial officer, Vaughn Clarke; and the termination of Glenn. Brendsel’s job was split in two. Outside director Shaun O’Malley was elected nonexecutive chairman of the board, and Greg Parseghian—Freddie Mac’s chief investment officer and the head of its mortgage portfolio business—was made president and CEO.

Falcon was caught flat-footed by these developments. Only a few days earlier, OFHEO had released their 2003 annual report to Congress on Fannie Mae and Freddie Mac. The report included a discussion of the Freddie Mac reaudit that ended with the statement, “We remain satisfied that the Board of Directors and executive management are taking the appropriate action.” The Freddie Mac board informed Falcon of its decision concerning the three executives, and the rationale behind it, on June 6. Scrambling to appear to be on top of the situation, Falcon sent the board a letter on June 7 in which he attempted to front-run the announcement the board told him it would be making on June 9. In that letter, released to the media, Falcon said in part, “I have become increasingly concerned about evidence that has come to light of weakness in controls and personnel expertise in accounting areas and the disclosure of misconduct on the part of Freddie Mac employees.” He added, “The removal of members of the management team only goes a part of the way toward correcting serious problems—concerns surrounding management practices and controls remain.” That same day, Falcon ordered a special OFHEO examination of Freddie Mac, and he put Steve Blumenthal in charge of conducting it.

The Freddie Mac accounting restatement and executive turmoil came at an extremely bad time for Falcon. A strong consensus already existed in Congress that OFHEO was feckless and not up to the task of regulating either Fannie Mae or Freddie Mac. Falcon’s clumsy attempt to play catch-up with the Freddie Mac situation only served to reinforce that view. On June 24, Richard Baker introduced HR 2575, abolishing OFHEO and shifting safety and soundness regulation of Fannie Mae and Freddie Mac to the OTS, inside the Treasury Department. The following month, Congressman Ed Royce of California introduced a bill creating a new regulator for Fannie Mae, Freddie Mac, and the Federal Home Loan Banks, also inside Treasury, and on July 31 and September 25, two more bills abolishing OFHEO were introduced in the Senate.

Facing sharp criticism for having missed the severity of the problems at Freddie Mac—one of only two companies he regulated—and with his agency in danger of being eliminated, Falcon knew he had to respond decisively. On July 14, he announced in a letter to the Senate Banking and Appropriations Committees that he intended to conduct a special examination of Fannie Mae, similar to the one he had announced in early June for Freddie Mac. Then he got tough on the good GSE.

Baker Botts released its “Internal Investigation of Certain Accounting Matters” to Freddie Mac’s board and the general public on July 22. One revelation that attracted attention was that Freddie Mac’s newly appointed president and CEO, Greg Parseghian, had as the company’s chief investment officer approved many of the transactions PwC found to have been accounted for improperly. Shaun O’Malley, Freddie Mac’s new chairman, and James Doty, the Baker Botts partner who led the accounting investigation, each said they were fully aware of Parseghian’s involvement with the transactions at the time the board proposed him as CEO and that they continued to support him. But a number of observers were troubled by Parseghian’s connection to the accounting difficulties, and some were saying the company would have been better served with a different choice for CEO.

Critics’ reaction to the Baker Botts report gave Falcon a second chance to exert his regulatory authority in the Freddie Mac situation, and he did not miss it. He directed the Freddie Mac board to replace Parseghian as president and CEO and to commence a search for his successor. Falcon had no statutory authority to require the Freddie Mac board to dismiss Parseghian (or Freddie Mac’s general counsel, Maud Mater, whom he also wanted replaced), so in an August 22 letter, he made a thinly veiled reference to the potential consequences of the board’s not acceding to his wishes: “The Board understands that OFHEO has continuing supervisory authority with regards to the matters addressed in this letter and that OFHEO is committed to the safe and sound operation of Freddie Mac,” he said. He added, “The actions outlined here should assist in meeting that end. The Board’s compliance signals a commitment to cooperation and to ensuring the continued safe and sound operation of the Corporation.”

Directing the board to oust Parseghian may have made sense for Falcon politically, but it resulted in the near complete replacement of Freddie Mac’s top management in a very short period of time. Parseghian had been at the company since 1996, and with Brendsel gone, he was the most seasoned and experienced risk manager Freddie Mac had. In December 2003, the Freddie Mac board chose Richard Syron as Parseghian’s successor. Syron had been president of the Federal Reserve Bank of Boston between 1989 and 1994, but his most recent positions had been as chairman of the American Stock Exchange and as chairman of the Thermo Electron Corporation, a provider of scientific instruments. Syron lacked the in-depth mortgage experience of either Brendsel or Parseghian. The extensive turnover of Freddie Mac’s top management, coupled with the choice of Syron to replace Parseghian as CEO, came just as mortgage credit standards were being relaxed dramatically and would have profound impacts on the company’s response to the worsening credit environment in the months and years immediately ahead.

Falcon Sets His Sights on Fannie Mae

OFHEO issued their report on the special examination of Freddie Mac in December 2003, the same month Syron became CEO. In the report, OFHEO noted that most of the accounting judgments PwC found to be incorrect were related to the implementation of FAS 133 in 2001. OFHEO said, “It is clear that management went to extraordinary lengths to transact around FAS 133 and push the edge of the GAAP envelope,” adding, “Freddie Mac cast aside accounting rules, internal controls, disclosure standards, and the public trust in the pursuit of steady earnings growth.”

I took careful note of OFHEO’s analysis of the causes of the Freddie Mac accounting errors. If OFHEO were looking for any of the same issues at Fannie Mae, there was a simple reason they would not find them. We and Freddie Mac had approached FAS 133 very differently. Our response had been to work with the FASB to improve the standard, to avoid using derivatives that did not qualify for hedge accounting, and to publish a simple and understandable supplemental non-GAAP earnings measure that eliminated the distorting effects of FAS 133. Freddie Mac’s approach to dealing with the FAS 133 distortions involved trying to offset them with what OFHEO claimed were accounting treatments that were inconsistent with GAAP and transactions OFHEO believed had little or no business purpose. Freddie Mac’s accounting problems stemmed directly from their choice of how to implement FAS 133. We had none of those problems because we had made a different choice.

OFHEO officially launched their special examination of Fannie Mae in November 2003, in a letter to us containing an extensive request for documents. That December OFHEO was granted $7.5 million in additional funding to pay for their special examinations of both Fannie Mae and Freddie Mac, and in February of 2004, OFHEO contracted with Deloitte & Touche to serve as consultants for the Fannie Mae examination. By March the Fannie Mae examination was well under way.

On the business side of Fannie Mae’s parallel worlds, I was confident we would acquit ourselves well in the OFHEO exam. But I also was keenly aware of what was being said on the political side. Led by FM Watch (which by this time had renamed itself FM Policy Focus), the anti–Fannie Mae forces were filling the media with their version of what was about to unfold. The storyline they were pushing was that Fannie Mae would turn out to have even worse accounting problems than had been found at Freddie Mac. Like them we would be forced to restate our earnings—possibly in conjunction with changes in top management as had been the case at Freddie Mac—and in response, Congress finally would agree on long-overdue legislation to toughen the regulation of both companies.

In the Fannie Mae special examination, Falcon had a path to redemption. If he could force an earnings restatement, he would be a hero to Fannie Mae’s critics and also do more than just prevent OFHEO from being replaced as a regulator; he could come away with more power for his agency.

The special examination was barely under way before Falcon trumpeted his objective. One day prior to the March 31 issuance of a routine OFHEO press release announcing our fourth quarter 2003 capital classification, Falcon directed his public relations staff to include the following sentences in the release:

We vehemently protested this addition. We knew of nothing we had done or that OFHEO was reviewing that would warrant their alarming our investors with such an explicit warning in advance of any actual finding. Moreover, it was the second time in barely a month that Falcon had used the media to convey a message about our accounting that was without a basis in fact. On February 24, he had provided the Wall Street Journal with an advance copy of a letter he was about to send to Frank Raines, directing Fannie Mae to submit a “remediation plan” for some 70 manual systems we used in our accounting processes. The Raines letter was sent against the advice of Falcon’s own accounting and examination staffs, who told him they had not even looked at most of the systems he was asserting Fannie Mae needed to fix, let alone concluded they were deficient. Falcon sent the letter anyway and gave a copy to the Journal to ensure that Raines would be questioned about it at a Senate Banking Committee hearing scheduled for the following day.

These blatantly political actions led us to ask Missouri Senator Kit Bond to request an investigation of the circumstances behind both the disclosure of the February 24 letter to the Wall Street Journal and the March 31 news release mentioning a possible restatement. Bond agreed to do so. In an April 20, 2004, letter he asked the HUD inspector general to look into the matters as well as to “assess whether these disclosures reflect any inappropriate or undue political influence in the examination process.”

The HUD inspector general did not make the report of its investigation public until October, after OFHEO had released their preliminary findings in the Fannie Mae examination. The inspector general’s report was replete with testimony from named and unnamed witnesses alleging that Falcon and Blumenthal harbored animus toward Fannie Mae and that they undertook the special examination to promote their public image and do harm to the company. It cited testimony from a confidential witness who said that after the March 31 press release, Blumenthal was “watching the movement in the stock, in the equity price, to see what kind of damage had been done to the Enterprise,” and that he “was almost gleeful that it was going down.” It also quoted a Blumenthal e-mail that “after discussing the drafting of what would become the Raines letter of February 24, 2003, concludes, ‘THE PRODUCT OF OUR COMPANY IS REGULATION, government is the institutionalized use of force. Make them do something.’ [original caps].” OFHEO’s chief accountant told the inspector general that she believed the goal of the examination was “to force a financial restatement.”

The summary of the report concluded:

The HUD inspector general made a criminal referral of Falcon to the Department of Justice, but the U.S. attorney for the District of Columbia declined prosecution in favor of administrative remedies. HUD Secretary Alphonso Jackson—an enthusiastic participant in Operation Noriega—took no action in response to the report’s findings. We were, and would continue to be, on our own.

In late April, OFHEO told us they believed our accounting for impairments on the private-label manufactured housing securities we owned was incorrect. I was not surprised that they would challenge us on this issue; it echoed the claim of a persistent critic of Fannie Mae named Peter Eavis. Through the end of 2003, we had taken $155 million in write-downs on our then $8 billion in manufactured housing securities (which at one point totaled $10 billion). Eavis frequently cited the $183 million write-down by the Federal Home Loan Bank of New York on a much smaller portfolio of manufactured housing securities as support for his contention that we should have written off more than $1 billion on our holdings and that our failure to do so was improper. OFHEO had decided to take essentially that same position.

They picked the wrong issue. Manufactured housing was our “canary in the coal mine” on the risks of private-label securities. When the manufactured housing market collapsed, we realized how little we actually knew about that business. In late 2002, I led a multidisciplinary team to assess our loss exposure on our investments in manufactured housing securities and to determine what actions we could take to minimize it. We quickly concluded that the key to controlling our ultimate losses was the servicing on the delinquent loans backing our securities. To further our interests, we went as far as to make a bid to purchase the servicing rights of a large company in bankruptcy, Conseco Finance, which had issued many of the securities we owned. While we lost the bid, our involvement in the process gave us leverage to negotiate more favorable servicing terms from the entity that won it.

Over the course of our work with the Conseco servicing portfolio, we became highly knowledgeable about the factors that influenced the delinquencies, defaults, and loss severities of manufactured housing loans. Using this knowledge, we built loss models for each of the manufactured housing securities we owned. Virtually all of our holdings were AAA-rated senior tranches, so in order for us to take credit losses on these securities, the tranches junior to them had to be wiped out first. When we did our detailed models, we found that even using conservative assumptions (that is, ones not very favorable to us), our projection was that we would not experience losses on most of the tranches we owned if we held them to maturity.

GAAP permits a company with the ability and intent to hold a security to maturity to use a “loss-based,” rather than a price-based, methodology in determining whether the security in question is impaired and must be written down. That is what we did. We believed our loss-based method was more accurate than a price-based method would have been, since the manufactured housing securities market was illiquid and as a consequence, the pricing for most securities did not reflect their economic value. Our outside auditor KPMG concurred with our accounting, but just to be on the safe side as a new registrant, we also consulted with the SEC. The SEC concurred with our accounting as well.

OFHEO was unaware we had taken our manufactured housing accounting to the SEC, and when Falcon found out, he was furious. He accused us of attempting to interfere with OFHEO’s examination. And he didn’t change his position—at least not publicly. Privately he backed off his contention that our manufactured housing accounting was not GAAP compliant, since the SEC had opined that it was. Falcon’s public claim became that our accounting was not “best in class.” He directed us to change it to a method that resulted in a higher level of impairments and also pushed for a restatement. We went back to the SEC for guidance. The SEC did not require a change in our accounting, nor did they require a restatement, but they did counsel us that getting into a battle over accounting methods with our regulator would not be our wisest course of action. We agreed to adopt the OFHEO impairment accounting, only to have our auditor, KPMG, tell us that it was not GAAP compliant. A flurry of work by all parties over a weekend finally produced a method everyone could live with. This method generated an additional $265 million in impairments, which we committed to record prospectively with our second quarter results.

OFHEO and Fannie Mae’s critics were upset and frustrated that the manufactured housing accounting episode did not force the earnings restatement they were seeking. We had won the first round, or at least not lost it. We heard nothing more from OFHEO about the special examination for four months. As late as mid-August, in response to a due diligence inquiry from KPMG related to the filing of our second quarter 2004 financial results with the SEC, OFHEO informed us they did not know of “any material errors or misstatements” in our financials.

If that were true, they discovered quite a bit very quickly. On Friday, September 17, Falcon requested a meeting with the independent members of Fannie Mae’s board of directors the following Monday, to present what OFHEO called its “findings to date” in the Fannie Mae special examination. We had no idea what to expect. On Monday morning, we read in the Wall Street Journal that “OFHEO found evidence of a pattern of decisions by [Fannie Mae] executives aimed at manipulating earnings,” and that Richard Baker and the SEC already had been briefed on OFHEO’s findings. But no one at Fannie Mae knew anything else about the OFHEO report until OFHEO officials provided us with copies just prior to meeting with our independent directors in the company’s boardroom that day.

The 211-page report was withering. It claimed not just that we had gotten the accounting wrong but that we had done so intentionally and fraudulently. The report alleged deliberate violations of GAAP in two areas: accounting for derivatives (FAS 133) and accounting for the amortization of mortgage purchase premium and discount (FAS 91). It also asserted that in 1998, we had fraudulently deferred $200 million in amortization expenses in order to reach an earnings level that met analysts’ expectations and triggered maximum executive bonuses. In a stinging transmittal letter to the Fannie Mae board accompanying the report, Falcon wrote, “These findings cannot be explained as mere differences in interpretation of accounting principles, but clear instances in which management sought to misapply and ignore accounting principles for the purposes of meeting investor analyst expectations [and] reducing volatility in reported earnings.” He went on to say, “We must consider the accountability of management and whether we have sufficient confidence in management” to remedy the problems OFHEO claimed to have found. Falcon’s letter made clear that he, at least, did not have such confidence.

When the interim OFHEO report was released to the public on Wednesday, September 22, it had the effect OFHEO and Fannie Mae’s critics intended. OFHEO’s allegations were almost universally accepted as matters of fact, and they elicited uniform and harsh condemnation. Long-time Fannie Mae critics attempted to outdo one another in their expressions of outrage, with most adding some version of “I told you so.” In an editorial, the Wall Street Journal went directly to its end game: “This news gives new urgency to the need to reform, and ultimately to privatize, these two ‘government sponsored enterprises.’” Baker issued a scathing press release calling the claims in the OFHEO report “inexcusable” and a “disgusting revelation,” and he announced his intention to hold a hearing on the report in early October.

Baker set his hearing for October 6. Raines and I were invited to testify, as were Falcon and Fannie Mae’s presiding director, Ann Korologos. Because of pending litigation, I had been advised by my personal counsel to assert my Fifth Amendment rights at the hearing, but along with Raines I chose to testify under oath.

The two most serious allegations in the OFHEO report were that we had improperly deferred 1998 amortization expenses and that we had knowingly accounted for our derivatives incorrectly. Raines and I flatly denied OFHEO’s claims about the 1998 expenses. We had asked Fannie Mae’s outside counsel to investigate the allegations, and they found nothing to support them. Questioned about the OFHEO accusation, Raines responded unequivocally: “There were no facts in the OFHEO report—none. We looked into the facts of what happened six years ago—we found no facts that would support the allegations in the report.”

We defended our derivatives accounting as well. Raines and I both noted that FAS 133 was an extraordinarily complex standard, with experts differing widely on many of its implementation issues. We testified that we believed we had applied FAS 133 in a GAAP-compliant manner, and we stressed that our outside auditor, KPMG, concurred with our accounting and had not withdrawn its opinion of our financial statements. Raines said he found it highly unusual that OFHEO had not raised any accounting concerns with either Fannie Mae’s management or KPMG before going to our board and the public with their allegations of impropriety, adding, “I don’t believe there has been an adequate explanation of why they have followed this path.” Raines told the committee that the SEC “ultimately has the final authority over GAAP” and said we would be submitting our FAS 133 accounting (and our FAS 91 accounting) to them for their review and final determination.

OFHEO’s supporters on the committee were caught off guard by the vigorous defense Raines and I mounted. Committee members’ reactions to it split along party lines, with Republicans supporting Falcon and challenging Raines and Democrats doing the opposite. The hearing ended in a standoff, which was viewed as a victory for Fannie Mae. (The company’s stock rose 4.5 percent over the ensuing two days.) Everyone understood that it now would come down to the SEC, who either would agree with OFHEO or with us on the accounting issues.

The Chief Accountant’s Surprise

OFHEO had challenged us on nine specific FAS 133 applications. On October 18, we made a 47-page written submission to the SEC, formally requesting guidance from their Office of the Chief Accountant on each one of them. For each application, we gave the rationale for the approach we took and discussed why we believed it was correct. KPMG concurred with the entirety of our submission, and on November 5, our accounting policy staff met with SEC staff to discuss it. Bill McLucas—a senior lawyer with our outside counsel, Wilmer, Cutler & Pickering, and a former head of the SEC’s enforcement division—was present at the meeting. He later described it to Raines and me as a cordial and professional discussion in which both sides made reasonable arguments over complex technical aspects of the standard. McLucas told us that he left the meeting thinking it was very unlikely the SEC would take a harsh stand against our FAS 133 implementation. His experience, he said, was that the SEC reserved its most severe penalties for companies that either did not know an accounting rule they should have known or knew it but chose not to follow it. It seemed obvious to McLucas that Fannie Mae fell into neither category.

On the afternoon of December 15, Raines received a request to come to the office of the SEC’s chief accountant, Don Nicoliasen, at 6 p.m. that evening. I was not asked to accompany him, nor were any of Fannie Mae’s accountants. Falcon already was in Nicoliasen’s conference room when Raines arrived. Also present at the meeting were officials from the Justice Department, lawyers from Wilmer, Cutler & Pickering, accountants from KPMG and Deloitte & Touche, and three outside Fannie Mae directors—Steve Ashley, Joe Pickett, and Tom Gerrity.

As described in a press release issued later that evening, Nicoliasen informed Raines that “Fannie Mae’s accounting practices did not comply in material respects with the accounting requirements in Statement Nos. 91 and 133.” Regarding FAS 133, he said:

Nicoliasen directed us to restate our financials for FAS 133 to eliminate the use of hedge accounting and to restate for FAS 91 if the correction proved to be material.

I learned of Nicoliasen’s ruling shortly after the meeting concluded. I was stunned by it and even more astonished when I read the SEC press release the next day. Nicoliasen had not ruled on a single one of the nine issues we addressed in our FAS 133 submission. His statement was extraordinarily vague. He did not say where or how we had gotten FAS 133 wrong, just that we had. KPMG was equally shocked by the ruling and was as perplexed as we were by its lack of specificity. KPMG had a larger share of major financial institutions as clients than any of the other top accounting firms. If it had gotten FAS 133 wrong for Fannie Mae—its largest and most prominent financial institution client—might not it have done the same thing for all its other clients? KPMG repeatedly sought clarification from Nicoliasen on the rationale for his Fannie Mae ruling but never was able to obtain any.

The disallowance of hedge accounting forced Fannie Mae to immediately recognize approximately $9 billion in derivatives losses we otherwise would have recorded over the lives of the hedges in question. This $9 billion was not an economic loss, nor was it unknown to our investors. We fully disclosed our deferred hedge losses on our balance sheet. Taking them right away would increase our income in the future by almost exactly the same amount. Where the problem arose was that, unless we could somehow offset it, a $9 billion book loss would push our regulatory capital below our statutory minimum. Any minimum capital shortfall allowed OFHEO to classify Fannie Mae as “significantly undercapitalized” and under the terms of the 1992 statute gain greatly enhanced powers over us. This, of course, was precisely the outcome OFHEO, our critics, and our opponents were seeking.

A Trip to Omaha to See Mr. Buffett

Raines made a final attempt to salvage the situation. On Friday, December 17, he came into my office and said, “We’re going to Omaha.” I knew exactly what he had in mind. Warren Buffett was rumored to have been sitting on over $20 billion in Treasury securities. If we could convince him to do a private placement of capital in Fannie Mae, there still would be time for him to sell some of those Treasuries and settle a capital transaction with us before the end of the year.

We flew to Omaha on Saturday morning and after landing at Eppley Airfield went to a small room in the private services terminal where Buffett wanted to meet. He came alone (which surprised me), and he had done his homework. He told us he was prepared to do a private placement of preferred stock in Fannie Mae in whatever amount we needed, provided we met his terms, which he said were not negotiable. They included an interest rate and a minimum non-call period he specified. In addition, he said, the preferred stock had to be cumulative (meaning any missed or suspended dividends would accumulate and be paid later), and OFHEO would have to declare us adequately capitalized as of September 30, 2004, which they had not yet done. Finally, he told us that if word of the transaction got out before it was settled, the deal would be off. We told Buffett that we would agree to his terms but that it would be up to OFHEO to agree to his conditions.

Buffett walked us out to the plane we were taking back to Washington, a Falcon 2000 from Net Jets, a company he owned. As I settled into my seat, that day’s New York Times was on the table beside it. My picture was on the front page of the business section under the caption, “Fannie Mae Board to Meet.” Inside was another picture with a caption that said, “J. Timothy Howard of Fannie Mae helped certify financial statements that violated accounting rules,” along with an article speculating on the fates of Raines and me. The gist of it was that I was almost certainly going to be forced out, but there was a chance Raines would be able to convince the board to keep him on. With the possibility of getting a capital deal done before year-end, I still held out hope that both of us might be able to stay.

Our plane was just approaching its cruising altitude when its left engine began to make a loud revving noise, rising and falling in amplitude, and the plane shook violently sideways. Raines and I looked at each other and had the same thought: “No one is going to believe this.” After the moment of immediate danger had passed—and after what seemed like several minutes but probably was less than one—the pilot opened his door and said, “I’m sure you’ve noticed we’re having some engine trouble. I’ve shut down our left engine, and we’re diverting to an alternate airport.” Air traffic control had given him the choice of Springfield or Peoria, Illinois, and he picked Peoria.

The runway at the Peoria airport was lined with emergency vehicles, all with their lights flashing. There was a strong crosswind, so the pilot had to bring the plane in with its nose up unusually steeply, but he got us down safely. After we deplaned—and thanked our pilot—Raines called his office to arrange for a new plane to take us to Washington. While we waited for that plane to arrive, I had ample time to reflect that as bad as it was to have your name and reputation trashed in the media and possibly lose your job, worse things could happen.

We had survived the Falcon in the air, but there still was a Falcon on the ground. We did not fare as well with that one. He did not accept the terms Buffett required in order to do a capital placement with us. This had never been about capital or safety and soundness; it was about institutional power and control. Whether we could cover our capital shortfall by year-end was irrelevant to Falcon; OFHEO had not yet completed their official classification of Fannie Mae’s capital adequacy for the previous quarter. We had submitted our September 30 capital data—showing a surplus of $6 billion compared with our minimum requirement (and more than a $20 billion surplus compared with our risk-based requirement)—to OFHEO in November, but they had not yet acted upon it. By applying Nicoliasen’s ruling disallowing our hedge accounting retroactively, Falcon could create a $3 billion minimum capital shortfall as of September 30 and declare us significantly undercapitalized whether we covered the shortfall by year-end or not. And that is exactly what he intended to do.

The September 30 capital shortfall gave Falcon the leverage he needed with the Fannie Mae board to force out Raines and me. I was the first to go. On Sunday evening, December 19, I received a call at home from Korologos informing me that the board had determined it would be in the company’s best interest if I were to step down. I agreed to do so. I expected my resignation to be announced on Monday, but a complication arose with my employment contract that we were unable to resolve that day. While I was attempting to iron out my contract issue, the board was meeting to discuss Raines’s fate.

Falcon was insistent that Raines leave. As had been the case with Freddie Mac’s Parseghian, Falcon lacked the statutory authority to dismiss him. But Fannie Mae’s new condition of being significantly undercapitalized gave Falcon additional powers he could use against the company. In the end, Raines’s many supporters on the board concluded that the cost of a protracted fight with OFHEO would be too great, and reluctantly they agreed to ask Raines to leave. His and my departures were made public simultaneously. On December 21, 2004, Frank Raines announced his retirement from Fannie Mae, and I announced my resignation.