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Report critical of Fannie Mae executives

Fannie Mae senior managers manipulated accounting in 1998 to trigger millions of dollars in bonuses, part of a pattern that for years misled investors by masking the volatile nature of the mortgage finance company's business, an inquiry led by former Sen. Warren Rudman has concluded.

A report on the inquiry describes how a company at the heart of the U.S. housing market was managed with a tone of "arrogance" at the top and played by its own rules in accounting for the hundreds of billions of dollars in transactions that course through its system.

The review found pervasive violations of accounting standards, weak controls and a system that had placed unqualified employees in key positions.

Top management - notably former chief executive officer Franklin Raines and former chief financial officer Timothy Howard - set a tone that focused on achieving profit goals while keeping a tight rein on the flow of information and at times misleading the company's board of directors about what was going on, the report says.

On several occasions, Raines, Howard and other senior managers "intentionally or negligently misled the board," Rudman said.

Howard and Raines left the company in December 2004 after disclosure of its accounting troubles.

Among the document's most significant conclusions was that Howard and former controller Leanne Spencer hatched a plan to delay recording $200-million in 1998 expenses and, at a January 1999 meeting, persuaded then-chief executive Raines to sign off on the idea.

The delay in recording the expenses boosted earnings, in turn releasing millions of dollars in bonuses for top executives, including Howard and Raines.

The action "was motivated by management's desire to meet 1998 EPS and AIP targets," the report says, referring to the company's earnings per share goals and its annual incentive plan bonuses. It was unclear, however, whether Raines was aware of the effect the delay would have on the bonuses.

Steve Salky, Howard's attorney, said he and his client "reject the report's mischaracterization of Mr. Howard's motives and conduct." Howard "consistently acted in accordance with the highest standards of integrity and in the best interest of shareholders," he said.

An attorney for Spencer did not return messages.

Raines' attorney, Robert Barnett, said Raines "strongly believes that, as the leader of Fannie Mae, he should be accountable for what happened within the organization, regardless of his personal involvement or fault."

But Barnett said he was "disappointed" with the report's conclusion that Raines fostered a culture at Fannie Mae focused on earnings targets.

"Throughout his tenure, Mr. Raines sought to create a leadership culture that focused on openness and good governance," the attorney said.

Fannie Mae's board hired Rudman and his law firm in September 2004 to review allegations of accounting failures leveled by the company's chief regulator, the Office of Federal Housing Enterprise Oversight. Rudman's findings, released Thursday, were based on more than 240 interviews with current and former Fannie Mae employees, including Raines, and on more than 4-million documents. His report will be turned over to federal prosecutors and regulators who are investigating the company. Rudman's law firm is Paul, Weiss, Rifkind, Wharton & Garrison LLP.

The House Financial Services Committee plans to hold a hearing on Rudman's report March 14. Rudman, 75, a former Republican senator from New Hampshire, has agreed to testify.

Howard and Spencer were "primarily responsible" for the accounting problems that have forced the company to erase $10.8-billion in profit, the report says.

Rudman did not find evidence that Raines knew Fannie Mae strayed from accepted accounting standards "in significant ways."

But the report concludes he "contributed to a culture that improperly stressed stable earnings growth."

"Although management paid lip service to a culture of openness, intellectual honesty and transparency, the actual corporate culture suffered from an attitude of arrogance (both internally and externally) and an absence of cross-enterprise teamwork (with a "siloing' of information), and discouraged dissenting views, criticism and bad news," the report says.

Citing a desire to pay top executives competitively, Raines and the board of directors created an incentive structure that encouraged a single-minded focus on meeting earnings per share targets. Instead of using bonuses to reward performance, Raines and the board set earnings targets low to make it easier for managers to get bonuses so their compensation would be on par with that of other large financial institutions, the report concludes.

Besides signing off on a flawed compensation strategy, the nonexecutive board members largely escaped criticism in the report, having been misled at times by senior managers about the company's accounting methods. The full board didn't learn of the decision to postpone recording of $200-million in 1998 expenses for an entire year.

Fannie Mae's accounting problems were obscured by weak internal controls. As the company grew rapidly during the '90s, management didn't add enough staff in its in-house accounting and auditing divisions. Critical accounting, financial reporting and audit positions were filled with people who were "unqualified" and "did not understand their roles, or failed to carry out their roles properly," the report says.