updated 9/24/2004 1:54:39 PM ET 2004-09-24T17:54:39

Federal regulators, who are ordering Fannie Mae to take prompt action to remedy what they say are serious accounting problems, also have raised the possibility of removing top managers of the giant mortgage finance company.

An eight-month-old investigation by the Office of Federal Housing Enterprise Oversight found pervasive earnings manipulation designed to meet Wall Street’s expectations and smooth volatility in profits from quarter to quarter. The findings warrant “immediate remedial action,” the agency’s director said in a letter to the Fannie Mae board members that was released Thursday.

In addition, “we must consider the accountability of management and whether we have sufficient confidence in management to fully implement these corrective measures,” Armando Falcon wrote in the letter dated Monday.

The Securities and Exchange Commission also is investigating the accounting of government-sponsored Fannie Mae, the second-largest U.S. financial institution behind Citigroup Inc.

Fannie Mae disclosed Thursday that it had revised its employment contracts with the three top executives — Chairman and Chief Executive Franklin Raines, Chief Operating Officer Daniel Mudd and Chief Financial Officer Timothy Howard — to ensure that if they were fired, they wouldn’t get huge severance packages. The changes were made in response to previous comments by OFHEO, the Washington-based company said.

Management at Fannie Mae “deliberately developed and adopted” inappropriate accounting policies, supported widespread violations of generally accepted accounting principles, tolerated lax internal controls and failed to properly investigate an employee’s concerns about accounting, OFHEO’s report said.

The report, made public Wednesday, also cited an instance in 1998 in which accounting for $200 million in expenses was put off to a future reporting period so executives could receive full bonuses.

OFHEO’s investigation continues, and agency officials said Thursday they didn’t know whether Fannie Mae will have to restate its earnings for any period, or whether its earnings overall might have been overstated or understated.

Freddie Mac, Fannie Mae’s smaller competitor in the multitrillion-dollar home mortgage market, disclosed in June 2003 that it had understated profits by some $4.5 billion for 2000-2002 in an effort to smooth earnings.

On Friday, Freddie Mac said it now has had to reduce its reported 2003 earnings by $75 million to reflect a reserve for legal costs stemming from the massive restatement of its results last year.

OFHEO officials indicated that the problems they had found in a key area of accounting at Fannie Mae were more serious, far more complex and wider in scope than those at Freddie Mac — which was fined a record $125 million in a settlement with OFHEO. The area involves accounting for expenses over time related to the home mortgages that Fannie Mae buys from banks and other lenders.

A half-dozen officials of OFHEO, including some senior executives, spoke to a group of reporters on condition they not be identified.

The regulators are negotiating an agreement with the Fannie Mae board, which has named a special committee of outside directors to respond to OFHEO’s allegations and the preliminary inquiry by the SEC.

Details of OFHEO’s proposed agreement were not disclosed. But Falcon’s letter to the board said it includes remedial actions related to accounting policies and practices, adequacy of capital and internal controls.

“The board and OFHEO are working to resolve any issues raised in the examination,” Fannie Mae spokeswoman Janice Daue said Thursday. She declined further comment.

Fannie Mae is the second-biggest seller of securities behind the U.S. Treasury. It uses funds from those sales to buy trillions of dollars in home mortgages from banks and other lenders, which it says provides more liquidity and lower mortgage rates to home buyers.

Fannie Mae could be ordered to decrease its financial leverage by raising fresh capital or buying fewer mortgages — potentially making it harder for some home buyers to obtain financing.

Shares in Fannie Mae dropped 5 percent Thursday, adding to a 7 percent loss on Wednesday. The shares closed at $67.20 Thursday, down $3.49 on the New York Stock Exchange.

Also Thursday, a class-action lawsuit was filed on behalf of Fannie Mae shareholders in federal court in Washington naming Raines, Howard and Controller Leanne Spencer.

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