NEWS ANALYSIS

By Amey Stone

A To-Do List for Fannie Mae

The mortgage giant has been cleaning up its accounting problems, but here are five steps
it should take to put its recovery in high gear
No, Fannie Mae (FNM ) is not about to implode. Despite late September news stories alleging
extensive new accounting violations and a drop from $77 to $41 in the stock price in the past
year, the nation's largest mortgage-finance company is well-capitalized enough to handle any
downturn in the housing market and is probably still profitable, say analysts.

Only probably still profitable? That's merely most analysts' best guess, since Fannie doesn't have
any recent earnings statements for them to review. In December, 2004, regulators required
Fannie to admit that it had broken accounting rules and to promise to restate past results. It has
yet to reissue clean statements for 2004 -- or file any new ones since last December.

Fannie's investor relations Web site includes this startling disclaimer: "Investors and others
should no longer rely on Fannie Mae's previously issued annual and quarterly financial
statements."

GOOD GOALS. It's high time Fannie Mae, a valuable U.S. institution, got its house in order. It has
a viable business model of creating a secondary market for mortgages so that banks, knowing
they can offload that debt, will keep making new loans to home buyers.

Fannie is trying to execute a turnaround by completing its earnings restatement, filling out its
senior management team, meeting tougher new capital requirements set by regulators, and
improving relationships with Congress, customers, and investors. "We're focused on the task at
hand," says Fannie Mae spokesman Chuck Greener.

Those are the right goals, but Fannie isn't getting the job done fast enough. The following is a
five-step plan for how it can jump-start its turnaround before its stock falls much further:

1. Speed up the timetable for restating 2004 financial statements.

On Aug. 9, Daniel Mudd, Fannie's chief executive, estimated it wouldn't complete the complex
restatement process until the second half of 2006. That's not soon enough. "We're basically
running blind," says Jason Seo, equity analyst with Standard & Poor's. "From my perspective,
they should get it done faster."

Sure, it's a tremendous task. Mudd estimated it would take 6 million to 8 million hours of labor to
complete the restatement. This year alone, 30% of employees will spend more than half their time
on it, and Fannie is bringing in 1,500 consultants and spending $100 million on technology, he
says.

That's a lot of people and money, but Fannie needs to throw more even more resources at the
problem. Given the share-price decline and pessimism of many analysts -- Bank of America rates
the stock a sell mainly because of the risk that new regulation will diminish Fannie's once-
formidable earning power -- investors are clearly running out of patience.

2. Get Congress on its side.

The biggest risk Fannie faces isn't that it will go bankrupt but that Congress will rewrite its charter.
There's a chance Congress will force Fannie to divest of much -- if not all -- of its mortgage
holdings, from which the bulk of its earnings are derived. Pressure in that direction seems to be
growing, says Edwin Groshans, an analyst with Fox-Pitt Kelton in New York.
Reform of Fannie, which would include Freddie Mac (FRE ) and other so-called government
sponsored entities, or GSEs, would still leave Fannie Mae with a viable business buying,
securitizing, and reselling mortgages.

But it wouldn't have anything close to the earning power it once claimed. "If they are going to
survive in any semblance of their current form, they need to satisfy Congress first," says Peter
Cohan, an author and investment strategist in Marlborough, Mass.

Meantime, Fannie has cut its lobbying staff by a third (or about six staffers). This move has
generated some political good will -- Fannie was viewed as too much of a lobbying juggernaut in
the past -- but it comes at a time when working with legislators should be a top priority.

"They have a duty to make sure they are on top of the legislation and protecting shareholders'
interests," says Phil Livingston, vice-chairman of compliance software firm Approva and a past
president of Financial Executives International, the trade group for chief financial officers.

3. Shrink its portfolio of retained mortgages faster than regulators now require.
One reason Congress is so worried about Fannie is because it owns so much mortgage debt --
$768 billion at last count. That massive stake leaves it vulnerable if a housing bubble bursts and
homeowners start defaulting on their loans.

Fannie has spent the last year reducing the size of its mortgage portfolio to meet stiffer minimum
capital requirements set by regulators. Shrinking it even faster might head off legislators at the
pass -- stopping them from demanding draconian cuts.

"I don't think that alone would be sufficient to convince Republicans that there should not be
serious restrictions on Fannie Mae's portfolio holdings," says Jaret Seibert, a financial services
policy analyst at the Stanford Washington Research Group. "But it would lessen the immediacy of
the need for the legislation. And the longer the delay, the less likely they will get a severely
restrictive law."

Stock investors would cry foul at such a move, since downsizing Fannie's portfolio even more
would slash its earnings. A Sept. 28 Banc of America Securities report noted that shrinkage
accelerated in August, lowering profitability. But the analyst acknowledged that further reduction
"may lead to sooner generation of excess capital than we projected."

Bondholders would see that as a good thing for Fannie Mae. "From our perspective it would be a
positive," says Brian Smith, senior bond analyst at USAA Funds. None other than Alan
Greenspan, who commented on Fannie in a recent speech, thinks it is a good idea, too.

4. Give investors more information in the meantime.

Even if Fannie can't spit out full financials in a matter of weeks, it can do more to create that all-
important buzzword that investors crave: Visibility. "They should put out whatever information they
can in the interim," says Approva's Livingston. "They have to overdo it for a while in order to
regain confidence."

Morningstar equity analyst Ryan Batchelor says he would like more information on Fannie's use
of derivatives. And even if it can't complete the restatement sooner, it should at least give a more
detailed timetable for getting it done. "I think they could try to be a little more open with investors,"
he says.

5. Do a better job at PR.

Fannie Mae started the year with a new chief executive, Daniel Mudd (formerly Fannie's chief
operating officer), who is doing a lot of the right things to turn around the company, including
building a stronger board. But the public sees few signs of progress.
"It appears someone else told their story instead of them telling it," says Tom Vogel, practice
leader for capital markets at Sitrick & Co., a communications firm that specializes in crisis
management. Vogel was referring to the Dow Jones report that first alleged the additional
accounting problems.

"They have a good story to tell," he says, pointing to a report from its regulator on Sept. 28 that
said Fannie was adequately capitalized. "But instead of good news, the news that people heard
about was something else."

"Be transparent and communicate frequently," recommends Jeffrey Cohn, managing partner of
succession-planning firm Bench Strength Advisors in New York, in an e-mail interview.
"Communicating to the world that the CEO and the board are in this together is vital."

Mudd and his new team have to get Fannie Mae back in shape. But in addition, they have to let
Congress, investors, and customers see more progress along the way.