Fannie Mae and Freddie Mac Earnings Misstatements Research Paper

Fannie Mae and Freddie Mac Earnings Misstatements - Research Paper Example The Fraud This section describes the business activities of Fannie and Freddie before the fraud occurred. Since the 1990s, lenders have been increasingly using automated underwriting systems (AUSs), a technology that changed the mortgage industry (DiVenti, 2009, p.236). These systems executed underwriting criteria and statistical algorithms to foresee the default likelihood of loan applications (DiVenti, 2009, p.236). GSEs became industry leaders in the growth and adoption of these systems, which they used to appraise their loan purchases. Fannie Mae’s system, Desktop Underwriter, and Freddie Mac’s system, Loan Prospector, significantly decreased the expenses and time linked with loan approvals (DiVenti, 2009, p.236). In 2000, Fannie Mae and Freddie Mac broadened their procurements to comprise â€Å"Alt-A,† A-minus, and subprime mortgages, aside from private-label mortgage securities (Blackburn & Vermilyea, 2010, p.5). In order to expand their mortgage purchases, Fannie Mae used the Expanded Approval system and Freddie Mac enlarged its Loan Prospector system to contain risk-based pricing (DiVenti, 2009, p.236). ... ly, Fannie and Freddie bought, packaged, securitized, and re-traded residential mortgages into mortgage-backed securities, with an assurance that the principal and interest payments would be paid to investors, thus, making a profit from the disparity between the sales price of the mortgage-backed securities and their first cost of funding (Bonander, 2013, p.843). Since 2004, Fannie and Freddie abandoned their stern underwriting standards and started to purchase and guarantee subprime mortgages, while also investing in subprime-mortgage-backed securities (Bonander, 2013, p.844). They bought more than $434 billion of subprime mortgages from 2004 to 2006 (Bonander, 2013, p.844). Their greatest purchase occurred from 2004 to 2005, when altogether they bought â€Å"$175 billion (44% of the market) and $169 billion (33% of the market) of subprime-mortgage-backed securities, respectively† (Bonander, 2013, p.844). In 2006, lax standards and actions affected Fannie and Freddie, when th e housing bubble burst, thereby pushing them to insolvency (Bonander, 2013, p.844). The problems of Fannie and Freddie are not over yet though. In 2003, Freddie revealed that it used unacceptable accounting practices to inflate its earnings. The Office of Federal Housing Enterprise (OFHEO), its regulator during this time, discovered that the company had â€Å"misstated earnings by $5 billion between 2000 and 2003† (DiVenti, 2009, p.237). Freddie underreported its earnings, however, which is the â€Å"interesting† part of the fraud (DiVenti, 2009, p.237). The OFHEO investigated Fannie Mae too, where it learned in 2004 that Fannie overstated earnings â€Å"between 2000 and 2003 by $6.3 billion† (DiVenti, 2009, p.237). OFHEO discovered significant accounting, disclosure, and management concerns that