in re: fannie mae securities litigation 04-cv-01639...

UNITED STATES DISTRICT COURT DISTRICT OF COLUMBIA

In re Federal National Mortgage Association Securities, Derivative, and “ERISA” Litigation

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MDL No. 1688

In re Fannie Mae Securities Litigation

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Consolidated Civil Action No. 1:04-cv-1639 (RLJ)

AMENDED CONSOLIDATED CLASS ACTION COMPLAINT FOR VIOLATIONS OF FEDERAL SECURITIES LAWS

JURY TRIAL DEMANDED

Case 1:04-cv-01639-RJL Document 135 Filed 04/17/2006 of 262

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TABLE OF CONTENTS

I. NATURE OF THE ACTION .......................................................................................... 1

II. JURISDICTION AND VENUE ...................................................................................... 8

III. PARTIES........................................................................................................................... 9

IV. GENERAL BACKGROUND OF FANNIE MAE....................................................... 19

V. OFHEO’S UNCOVERING OF THE FRAUD AND THE SEC FINDINGS............ 24

VI. DEFENDANTS’ KNOWING OR RECKLESS DISREGARD OF GAAP............... 41

A. General GAAP Violations ................................................................................. 42

B. Defendants’ Violations of SFAS 91 .................................................................. 46

C. Defendants’ Violations of SFAS 133 ................................................................ 51

D. Defendants’ Violations of Other Accounting Rules ........................................ 59

VII. ADDITIONAL SCIENTER ALLEGATIONS ............................................................ 60

A. Admissions and Congressional Testimony Concerning Defendants’

Fraudulent Accounting...................................................................................... 60

B. Inadequate Controls and Accounting Oversight Support a Strong Inference

of Scienter ........................................................................................................... 67

C. Defendants’ Compensation Was Tied to Defendants’ Ability to Manage

Fannie Mae’s Earnings...................................................................................... 72

D. Individual Defendants’ Insider Trading.......................................................... 77

VIII. FALSE AND MISLEADING STATEMENTS DURING CLASS PERIOD ............ 93

A. Statements Concerning Fiscal Year 2001 ........................................................ 93

B. Statements Concerning Fiscal Year 2002 ...................................................... 121

C. Statements Concerning Fiscal Year 2003 ...................................................... 170

D. Statements Concerning First Two Quarters of 2004 .................................... 230


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IX. CLASS ACTION ALLEGATIONS............................................................................ 249

X. NO SAFE-HARBOR.................................................................................................... 251

XI. CAUSES OF ACTION................................................................................................. 252

XII. PRAYER FOR RELIEF .............................................................................................. 256


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I. NATURE OF THE ACTION

1. This is a shareholder class action on behalf of the purchasers of the publicly

traded common stock and call options, and the sellers of publicly traded put options, of Fannie

Mae a/k/a Federal National Mortgage Association (“Fannie Mae” or the “Company”) during the

period from April 17, 2001 through September 27, 2005 (the "Class Period").

2. Throughout the Class Period, Defendant Fannie Mae and Defendants Franklin

Raines, the former Chairman of the Board and Chief Executive Officer, Timothy Howard, the

former Vice Chairman of the Board and Chief Financial Officer, and Leanne Spencer, the former

Controller, issued materially false and misleading public financial reports and other statements

that artificially inflated the price of Fannie Mae’s common stock, in violation of Sections 10(b)

and 20(a) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”) and SEC

Rule 10b-5 promulgated thereunder,

3. On September 22, 2004, Fannie Mae publicly revealed that its regulator, the

Office of Federal Housing Enterprise Oversight (“OFHEO”), after concluding its preliminary

investigation into Fannie Mae’s accounting practices and financial reporting, had found that

Fannie Mae and its management had intentionally misapplied generally accepted accounting

principles (“GAAP”) for the purpose of causing Fannie Mae to distort its financial results to

show “smooth” earnings growth quarter over quarter. Fannie Mae’s common stock price fell

from $75.65 per share on September 21, 2004, to $70.69 per share on September 22, 2004.

4. After the close of the stock market on September 22, 2004, OFHEO released its

letter to the Fannie Mae Board of Directors, in which OFHEO said its extensive investigation

had uncovered “clear instances in which management sought to misapply and ignore accounting

principles for the purpose of meeting investment analyst expectations; reducing volatility in


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reporting earnings; and enabling fragmented process and systems, and an ineffective controls

environment to exist.”

5. OFHEO also publicly released its 198-page Report of Findings to Date, Special

Investigation of Fannie Mae dated September 17, 2004 (the “OFHEO Report”) in which it

detailed many of the accounting irregularities undertaken by Defendants. In particular, OFHEO

determined that Defendants had deliberately misapplied and violated Statement of Financial

Accounting Standards (“SFAS”) 91 and 133. The OFHEO Report provided:

We have determined that Fannie Mae, in developing policies and practices in these critical areas, has misapplied Generally Accepted Accounting Principles ("GAAP"), specifically Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases ("FAS 91") and Accounting for Derivative Instruments and Hedging Activities ("FAS 133"). The misapplications of GAAP are not limited occurrences, but are pervasive and are reinforced by management. (Emphasis added.) The matters detailed in this report are serious and raise concerns regarding the validity of previously reported financial results, the adequacy of regulatory capital, the quality of management supervision, and the overall safety and soundness of the Enterprise. (Emphasis in original.)

Fannie Mae’s stock price further declined to close at $65.51 per share on September 24, 2004,

after the market digested this news.

6. On September 30, 2004, the Wall Street Journal reported that the United States

Department of Justice had begun a criminal investigation into Fannie Mae’s accounting practices

and that the Securities and Exchange Commission (“SEC”) had commenced a formal

investigation into whether Defendants had violated the federal securities laws. Fannie Mae’s

stock price closed at $63.40 on September 30, 2004.

7. Fannie Mae, in particular Defendant Raines, publicly disputed OFHEO’s findings

and stridently defended Fannie Mae’s accounting practices. In testimony before Congress on

October 6, 2004, Raines said that Fannie Mae made “no accounting errors.” Although Fannie


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Mae agreed to take a number of remedial actions in response to the OFHEO Report, including an

increase in its capital base and changing how it defers expenses and calculates for hedging

transactions, Raines said that “people have mistakenly concluded that the company’s agreement

with OFHEO constituted an admission by the company to the findings and conclusions of the

report. Let me clarify that is not the case. This is a serious allegation, and we strongly disagree

with it.”

8. Fannie Mae requested that the SEC, the final arbiter of whether a public company

has properly applied GAAP, review Defendants’ accounting to determine if they had misapplied

GAAP, as charged by OFHEO. About two months later, after review of the materials submitted

to it by Defendants, SEC Chief Accountant Donald Nicolaisen issued a statement on behalf of

the SEC stating that the SEC had concluded that, “from 2001 to mid-2004, Fannie Mae’s

accounting practices did not comply in material respects with the accounting requirements in

[SFAS] 91 and 133.” With regard to SFAS 133, the SEC stated that, “Fannie Mae internally

developed its own unique methodology to assess whether hedge accounting was appropriate.

Fannie Mae’s methodology, however, did not qualify for hedge accounting because of

deficiencies in hits applicable of [SFAS] 133.” As a result, the SEC ordered Fannie Mae to

restate its financial statements from 2001 through mid-2004.

9. During testimony before a Congressional committee on February 9, 2005, in

response to the question from a U.S. Representative as to whether Defendants’ incorrect

accounting was a “matter of interpretive judgment” or “clearly outside professional accounting

standards,” SEC Chief Accountant Donald Nicolaisen responded: “In my view, it was outside

professional accounting standards.” Mr. Nicolaisen further testified that, “other companies are


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complying with Statements 91 and 133,” that the standards are “workable and are being

followed,” and that the rules are “not overly complex” but “are clear.”

10. Fannie Mae has agreed to restate its 2001 through mid-2004 financial statements

as directed by the SEC. In a November 15, 2004 Form 8-K, Fannie Mae reported that if it were

required to restate its financial results, it would eliminate an estimated $9 billion of its earnings

during 2001 through mid-2004 - almost 40% of its previously reported earnings for that period.

In addition, the Wall Street Journal reported on March 3, 2005, that Fannie Mae could have to

eliminate up to an additional $2.76 billion in just one year of its previously reported earnings

based upon OFHEO’s recent further finding that Defendants violated SFAS 149. All totaled,

Fannie Mae will have to restate and eliminate approximately $12 billion of earnings. By sheer

numbers, this is the one of the largest financial statement restatements is U.S. corporate history,

second only to the massive restatement by WorldCom. Fannie Mae’s stock price declined $1.10

per share on March 3, 2005.

11. After the SEC agreed that Fannie Mae’s accounting policies and practices

violated GAAP, Raines “retired,” Howard “resigned,” and Spencer “stepped down” from their

respective positions with Fannie Mae. In addition, the Fannie Mae Audit Committee discharged

Fannie Mae’s public accountants, KPMG LLP, who had reviewed and commented and/or

reported on the Company’s various financial statements issued from 2001 through mid-2004.

12. The massive financial fraud at Fannie Mae was brought to the attention of

Defendants Raines, Howard and Spencer during the Class Period, but they ignored the warnings

of an internal whistleblower because they were the perpetrators of the fraud. Roger Barnes, a

former Manager of Financial Accounting, Deferred Assets in Fannie Mae’s Controller Division,

submitted written testimony to an October 2004 Congressional hearing, detailing his efforts to


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alert management, including Raines, Howard and Spencer, to the accounting fraud at Fannie

Mae. Barnes directly questioned Spencer about a number of accounting transactions and

specifically told Spencer that he believed Fannie Mae’s actions violated GAAP. On August 5,

2003, Barnes gave Spencer a detailed memorandum outlining the ways in which Fannie Mae was

violating GAAP and provided her with 60 examples of such misconduct. Spencer simply

ignored Barnes and his warnings.

13. In September 2002, Mr. Barnes sent a written memorandum directly to

Defendants Raines and Howard, detailing the accounting fraud that was occurring at Fannie

Mae. After describing the accounting fraud in detail, Barnes concluded in the memorandum to

Raines and Howard that “the possible impact reaches hundreds of millions of dollars and

possibly affects the integrity of the current financial statements and those we will issue after

beginning compliance with SEC reporting in 2003.” Raines and Howard took no action to

investigate Barnes’ warnings or to stop the intentional manipulation of earnings because, in fact,

they were integral participants in, and personally substantially profited from, the fraud.

14. Indeed, the compensation of Raines, Howard and Spencer, among other top

Fannie Mae executives, was directly tied to Fannie Mae hitting certain earnings’ targets so they

each had a strong motive to inflate Fannie Mae’s earnings and disregard Barnes’ warnings. Even

before the start of the Class Period, Defendants manipulated Fannie Mae’s financial results so

they could achieve additional earnings. OFHEO found that in 1998, Howard deliberately caused

Fannie Mae to defer $200 million of amortization expense that permitted Fannie Mae’s earnings

to reach its target, so an additional $27 million in bonus payments to executives would be paid.

From 2001 to 2003, Raines received more than $35 million as a result of Fannie Mae

“achieving” its targeted earnings and Howard received an almost additional $10 million. In


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addition, Raines sold almost $7 million worth of Fannie Mae stock during the Class Period and

Howard sold $13.7 million worth of stock. If fact, Howard sold a large number of shares and

locked in a $400,000 profit just days before the release of the OFHEO Report.

15. The full effects of Defendants’ accounting fraud continued to be reflected in

Fannie Mae’s stock price. On December 23, 2004, OFHEO announced that it was reviewing

Raines’ and Howard’s termination packages to determine whether “they were unjustly enriched,”

and would seek to recover their severance compensation if that was found to be the case. That

same day Fannie Mae announced that its financial statements from 2001 to the present, including

the third quarter 2004, “should no longer be relied upon” as they did not comply with Generally

Accepted Accounting Principles. In response to the announcements by OFHEO and Fannie

Mae, the Company’s stock price decreased $7.12 to close at $69.62 per share on December 23,

2004.

16. As a result of the accounting irregularities found at Fannie Mae, OFHEO has

required that Fannie Mae maintain a 30% capital surplus. On January 18, 2005, after the close of

the stock markets, Fannie Mae’s Board announced that it was cutting the Company’s common

stock dividend in half in order to “expeditiously increase its capital,” to meet this capital surplus

requirement. Fannie Mae’s stock price declined in reaction to this news, falling from its closing

price of $69.70 per share on January 18, 2005 to $64.85 per share on January 21, 2005, three

trading days later.

17. On February 23, 2005, before the opening of the stock market, Fannie Mae

announced that its deadline to meet its 30% surplus capital requirement was extended by

OFHEO and Fannie Mae reported that it would achieve the increase in surplus capital through

reducing the size of its mortgage portfolio and through an increase in retained earnings. In


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addition, Fannie Mae reported that OFHEO identified additional accounting irregularities that

were engaged in by Fannie Mae - citing GAAP violations in virtually every major accounting

rule that applies to mortgage finance. Fannie Mae’s stock price declined on the news from its

close of $57.80 per share on February 22, 2005 to $56.95 per share on February 24, 2005.

18. On March 17, 2005, OFHEO disclosed that during its investigation it identified

instances of Fannie Mae employees falsifying signatures on accounting ledgers and making

changes in database records related to earnings without authorization. That same day Fannie

Mae disclosed that it would not be filing its Form 10-K for the fiscal year ended December 31,

2004. Reacting to this news, Fannie Mae’s stock declined $2.45 per share to close at $54.40 per

share on March 17, 2005.

19. On April 4, 2005, The Wall Street Journal reported that OFHEO was

investigating whether Fannie Mae improperly accounted for trusts it set up to issue mortgage-

backed securities. In response to this news, shares of Fannie Mae common stock fell $1.78 from

$53.24 per share on April 1, 2005, to close at $51.46 per share on April 4, 2005.

20. After the close of trading on April 9, 2005, Fannie Mae’s current Present and

Chief Executive Officer, Daniel H. Mudd, disclosed that the Company’s restatement was taking

longer than predicted and that it would not be completed until the second half of 2006. The

Company also disclosed that it was in violation of New York Stock Exchange rules requiring the

filing of an annual financial report with the SEC, and thus was facing the possibility of delisting.

Investors reacted negatively to this news, causing Fannie Mae shares to decline $2.19 per share

from $54.83 per share on August 9, 2005, to close at $52.64 per share on August 10, 2005.

21. Investors were again stunned on September 28, 2005 when additional accounting

violations at Fannie Mae were reported. According to Dow Jones, investigators uncovered “new


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and pervasive accounting violations.” In particular, Fannie Mae may have purchased so-called

finite insurance policies to hide earnings losses after they were incurred, and embellished

earnings by overvaluing assets, underreporting credit losses and misusing tax credits. In

response to this news, shares of Fannie Mae plummeted $4.99 per share, or 11%, from $46.70 on

September 27, 2005 to close at $41.71 per share on September 28, 2005.

22. As a result of Defendants’ false and/or misleading statements and violations of

federal securities laws, Lead Plaintiffs and the other members of the class have been damaged by

purchasing Fannie Mae common stock at artificially inflated prices during the Class Period.

II. JURISDICTION AND VENUE

23. The claims asserted herein arise under Sections 10(b) and 20(a) of the Exchange

Act (15 U.S.C. §§78j(b) and 78t(a)) and SEC Rule 10b-5 promulgated under Section 10(b) (17

C.F.R. 240.10b-5).

24. This Court has jurisdiction over this action pursuant to Section 27 of the

Exchange Act (15 U.S.C. §78aa) and 28 U.S.C. §1331.

25. Venue is proper in this Judicial District pursuant to Section 27 of the Exchange

Act (15 U.S.C. §78aa) and 28 U.S.C. §1391(b). Many of the acts in furtherance of the alleged

fraud and/or the effects of the fraud occurred within this District and Defendant Fannie Mae’s

principal place of business is located in this District.

26. In connection with the acts, conduct and other wrongs alleged in this complaint,

Defendants, directly or indirectly, used the means and instrumentalities of interstate commerce,

including, but not limited to, the United States mails, interstate telephone communications, and

the facilities of a national securities exchange.


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III. PARTIES

27. Plaintiff Ohio Public Employees Retirement System (“OPERS”), formed in 1935,

provides retirement, disability and survivor benefit programs for thousands of public employees

throughout the State of Ohio who are not covered by another state or local retirement system.

OPERS serves more than 620,000 members and over 130,000 retirees and surviving

beneficiaries, and had assets exceeding $54 billion under management as of December 31, 2003.

As set forth in the certification previously filed with the Court in this case [Doc. # 4],

incorporated by reference herein, OPERS purchased shares of Fannie Mae common stock during

the Class Period at artificially inflated prices and has thereby been damaged by the wrongful acts

of Defendants alleged herein.

28. Plaintiff State Teachers Retirement System of Ohio (“STRS”) is one of the

nation’s premier retirement systems, serving more than 400,000 active, inactive and retired Ohio

public educators. With assets of approximately $54 billion, STRS is one of the largest public

pension funds in the country. As set forth in the certification previously filed with the Court in

this case [Doc. # 31], incorporated by reference herein, STRS purchased shares of Fannie Mae

common stock during the Class Period at artificially inflated prices and has thereby been

damaged by the wrongful acts of Defendants alleged herein.

29. Defendant Fannie Mae was established as a U.S. government entity in 1938, and

became a federally chartered, shareholder-owned corporation in 1968. Its principal place of

business is located at 3900 Wisconsin Avenue, NW, Washington, DC. Fannie Mae’s common

stock is traded on the NYSE. Fannie Mae is subject to regulation by OFHEO, which was

established as an independent entity within the Department of Housing and Urban Development

by the Federal Housing Enterprises Financial Safety and Soundness Act of 1992 (12 U.S.C.


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§§4501 et. seq.). OFHEO’s primary mission is ensuring the capital adequacy and financial

safety and soundness of Fannie Mae and its smaller rival, Freddie Mac.

30. Defendant Franklin D. Raines ("Raines") was both the Chairman of the Board and

Chief Executive Officer of Fannie Mae from January 1999 until December 2004, and was

Chairman of the Board and Chief Executive Officer—Designate of Fannie Mae from May 1998

to December 1998. Raines was a Fannie Mae Director from September 1991 through September

1996, and from December 1998 through December 2004. Prior to becoming Chairman and CEO

of Fannie Mae, Raines was the Director of the U.S. Office of Management and Budget (“OMB”)

from 1996 to 1998 under President Clinton, was the Associate Director of the OMB under

President Carter from 1978 to 1991, and was a Vice President and then a partner at the Wall

Street investment banking firm Lazard Freres & Co., L.L.C. As detailed herein, Raines made

frequent false and/or misleading public statements about the Company, including its earnings,

operations, financial statements, condition and results, and disclosures and controls, in press

releases, during conference calls with investors and security analysts and in other public financial

reports and other public statements during the Class Period.

(a) As Chairman of the Board and Chief Executive Officer, Raines’ primary

responsibilities included overseeing the overall success or failure of the Company; providing

leadership for the formulation and achievement of the Company’s vision, mission, strategy,

financial objectives and goals; ensuring that effective and qualified management were retained

by the Company; ensuring that the Company established and maintained appropriate internal and

disclosure controls, policies and procedures that were adequate to protect corporate assets; and

directing the conduct and affairs of the Company in furtherance of its safe and sound operation.


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(b) Raines, along with Defendants Timothy Howard and Leanne G. Spencer,

was responsible for ensuring the accuracy of Fannie Mae’s public financial reports and other

public statements throughout the Class Period. Raines commented on the Company’s financial

performance in each of its quarterly and annual earnings press releases issued during the Class

Period. Raines also signed letters to shareholders commenting upon the Company’s performance

and disclosure policies in Fannie Mae’s Annual Reports issued during the Class Period and

signed the Company’s Forms 10-K for the fiscal years ending December 31, 2002 and 2003.

(c) Raines also personally attested to and certified the accuracy of Fannie

Mae’s reported financial results on numerous occasions throughout the Class Period. Raines

signed certifications filed with Fannie Mae’s Forms 10-K for the fiscal years ended December

31, 2002 and 2003, and the Forms 10-Q filed in 2003 and 2004. In these Certifications, he

personally certified, among other things, that:

(i) the reports did not contain any untrue statement of a material fact or

omit to state a material fact necessary to make the statements made, in

light of the circumstances under which such statements were made, not

misleading,

(ii) the financial statements and other financial information included in the

reports fairly presented in all material respects the financial condition,

results of operation and cash flow of the Company as of and for the

periods presented, and

(iii) that he and Defendant Timothy Howard were responsible for

establishing and maintaining disclosure controls and procedures as

defined in the Exchange Act and that they (1) had designed such


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disclosure controls and procedures, or caused such disclosure controls

and procedures to be designed under their supervision, to ensure that

material information relating to the Company was made known to them

by others within the entity, particularly during the period in which the

report was being prepared; and (2) having evaluated the effectiveness

of the Company’s disclosure controls and procedures, both concluded

that the disclosure controls and procedures were effective as of the

applicable period.

As set forth herein, these Certifications were false and/or misleading.

(d) Raines, along with the other Defendants, was also principally responsible

for the Company’s communications with investors and securities analysts during the Class

Period. As described herein, Raines communicated directly with investors and investment

analysts concerning the Company’s financial results and operations in numerous conferences

calls and securities conferences held during the Class Period.

(e) During the Class Period, Raines received substantial compensation based

in whole or in part on the Company’s financial condition and performance, including its earnings

per share. The compensation included the following:

Securities Value of Underlying Performance Salary Bonus Stock Options Shares

2003 $992,250 $4,180,365 135,020 $11,621,280 2002 992,250 3,300,000 311,731 7,233,679 2001 992,250 3,125,000 277,335 6,803,068

(f) On December 21, 2004, after the SEC ordered Fannie Mae to restate its

2001-2004 financial reports, Fannie Mae announced that Raines had “retired” from his positions


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as Chairman of the Board and Chief Executive Officer of Fannie Mae and that his service on the

Board of Directors had terminated effective immediately. In a public statement, Raines said, “I

previously stated that I would hold myself accountable if the SEC determined that significant

mistakes were made in the Company’s accounting. . . . By my early retirement, I have held

myself accountable.” Raines has not, however, returned any of the substantial compensation that

he received, but was paid to him based upon Fannie Mae’s overstated earnings.

(g) Raines claims that he is due a pension from Fannie Mae of more than

$1.3 million a year for life under his employment agreement with the Company. This benefit is

payable to Raines’ spouse upon his death. OFHEO is investigating whether the Company acted

appropriately by letting Raines retire instead of firing him for cause.

31. Defendant Timothy Howard ("Howard") became a member of the Office of the

Chairman in November 2000 and was the Vice Chairman of the Board of Directors of Fannie

Mae from May 2003 until December 2004. He was also Executive Vice President and Chief

Financial Officer of Fannie Mae from February 1990 until December 2004. Howard initially

joined Fannie Mae in 1982. As detailed herein, Howard made frequent false and/or misleading

public statements about the Company, including its earnings, operations, financial statements,

condition and results, disclosures and controls, in press releases, during conference calls with

investors and security analysts and in other public financial reports and statements during the

Class Period.

(a) As Chief Financial Officer, Howard was responsible for the preparation and

accuracy of the Company’s financial statements and reports. Howard has also admitted to

OFHEO that he controlled nearly all of the financial operations, accounting and reporting

activities and risk management of Fannie Mae throughout the Class Period. For example, he told


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OFHEO that, (i) he served informally as Fannie Mae’s chief risk officer, (ii) his responsibilities

at Fannie Mae included risk management, the retained portfolio, the accounting function,

investor relations, treasury and financial reporting; and (iii) Defendant Leanne G. Spencer, who

was responsible for financial reporting, business planning, tax and accounting reporting, reported

directly to him, as did the chief operating officer, the investor relations department and the

corporate financial strategies department.

(b) While stating to the public in each annual “Report of Management” signed by

Howard and Defendant Spencer during the period, that “[o]rganizationally, the internal Office of

Auditing is independent of the activities it reviews,” Howard admitted to OFHEO that, while

the internal auditor supposedly reported directly to the Audit Committee Chairman, for

approximately the last two years of the Class Period the internal auditor had reported on a dotted

line basis to Howard, who is responsible for all financial accounting and financial reporting.

(Emphasis added.)

(c) Howard, along with Defendants Raines and Spencer, was responsible for

ensuring the accuracy of Fannie Mae’s public financial reports and other public statements

throughout the Class Period. Howard commented on the Company’s financial performance in

each of its quarterly and annual earnings press releases issued during the Class Period. Howard

also published statements about Fannie Mae’s performance, growth prospects and safety and

soundness in Fannie Mae’s Annual Reports issued during the Class Period and signed the

Company’s 2002 and 2003 Forms 10-K and the Forms 10-Q filed by Fannie Mae in 2003 and

2004.

(d) Howard also personally attested to and certified the accuracy of Fannie Mae’s

reported financial results on numerous occasions throughout the Class Period. Howard signed


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certifications filed with Fannie Mae’s Forms 10-K for the fiscal years ended December 31, 2002

and 2003 and the Forms 10-Q filed in 2003 and 2004. In these Certifications, he personally

certified, among other things, that:

(i) the reports did not contain any untrue statement of material fact or omit

to state a material fact necessary to make the statements made, in light

of the circumstances under which such statements were made, not

misleading,

(ii) the financial statements and other financial information included in the

reports fairly presented in all material respects the financial condition,

results of operation and cash flows of the Company as of and for the

periods presented, and

(iii) that he and Defendant Raines were responsible for establishing and

maintaining disclosure controls and procedures as defined in the

Exchange Act and that they (1) had designed such disclosure controls

and procedures, or caused such disclosure controls and procedures to be

designed under their supervision, to ensure that material information

relating to the Company was made known to them by others within the

entity, particularly during the period in which the report was being

prepared; and (2) having evaluated the effectiveness of the Company’s

disclosure controls and procedures, they both concluded that the

disclosure controls and procedures were effective as of the applicable

period.

As set forth herein, these Certifications were false and/or misleading.


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(e) Howard, along with the other Defendants, was also principally responsible for the

Company’s communications with securities analysts and investors during the Class Period. As

described herein, Howard communicated directly with investors and investment analysts

concerning the Company’s financial results and operations in numerous conferences calls and

securities conferences held during the Class Period.

(f) According to the OFHEO Report, in July 2003, even as the accounting problems

at Freddie Mac were publicly emerging, Howard “made a presentation to the Board that

emphasized a stable pattern of earnings as a requirement for Fannie Mae if it were to be

perceived as a low-risk enterprise. Mr. Howard included in [that] presentation a graph showing

that the earnings of Fannie Mae were smoother than those of Freddie Mac and almost all other

companies in the S&P 500.” (Emphasis added.)

(g) During the Class Period, Howard received substantial compensation based in

whole or in part on the Company’s financial condition and performance, including the

Company’s earnings per share. The compensation included the following:

Securities Value of Underlying Performance Salary Bonus Stock Options Shares

2003 $645,865 $1,176,145 112,968 $3,470,578 2002 498,614 781,250 81,661 1,947,368 2001 463,315 694,983 75,617 1,987,119

(h) On December 20, 2004, Howard “resigned” from his position as Vice Chairman

of the Board and Chief Financial Officer of Fannie Mae. However, Howard has not returned any

of the substantial compensation that he received, but was paid to him based upon Fannie Mae’s

overstated earnings.


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(i) On December 30, 2004, Howard “resigned” from the Board of Directors of

Fannie Mae.

(j) Howard claims that he is due a pension in the annual amount of $432,852 for life

under his employment agreement with the Company. OFHEO is investigating whether the

Company acted appropriately by letting Howard resign instead of firing him for cause.

32. Defendant Leanne G. Spencer (“Spencer”) was the Vice President and Controller

of Fannie Mae during the Class Period. As detailed herein, Spencer made numerous false and/or

misleading public statements about the Company, including its earnings, operations, financial

statements, condition and results in public financial reports and other statements during the Class

Period.

(a) Spencer, along with Raines and Howard, was responsible for ensuring the

accuracy of Fannie Mae’s public financial reports and other public statements throughout the

Class Period. Spencer reported directly to Defendant Howard. Spencer signed the Company’s

Forms 10-K for the fiscal years ending December 31, 2002 and 2003 and the Forms 10-Q filed

by Fannie Mae in 2003 and 2004.

(b) Spencer, along with the other Defendants, was also principally responsible for the

Company’s communications with investors and security analysts during the Class Period and

communicated directly with these investors and analysts during conference calls held during the

Class Period.

(c) Upon information and belief, Spencer received substantial bonuses, shares of

Fannie Mae common stock and stock options during the Class Period that were based, in whole

or in part, on the Company’s financial condition and performance, including its earnings per

share. The only publicly available compensation information for Spencer is that in 2002, she


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received total compensation of $1,383,714, which included a salary of $260,000, a bonus of

$330,000, stock options for 18,479 shares and long-term incentive payments valued at $396,017.

(d) On January 17, 2005, Spencer “stepped down” from her positions with Fannie

Mae. She continues in a non-officer capacity as a Special Advisor until January 31, 2006 or her

earlier resignation.

33. Defendants Raines, Howard and Spencer (collectively the “Individual

Defendants”) were the Company's senior executive officers during the Class Period and were

responsible for and controlled Fannie Mae and its public financial statements and disclosures and

other public statements, including the content of the Company’s Annual Reports, various SEC

filings, annual and quarterly earnings releases, financial statements, press releases and other

public statements pertaining to the Company during the Class Period. Each of the Individual

Defendants directly participated in the management of the Company, was directly involved in the

day-to-day operations of the Company at the highest levels, was responsible for the preparation

and/or accuracy of the Company’s financial statements and reports and was privy to confidential

information concerning the Company and its earnings, accounting, policies and practices,

reserves, business, operations, investments, growth, financial statements, financial reporting, and

financial condition, and actively engaged in or permitted the misconduct alleged herein. The

Individual Defendants manipulated the Company’s earnings and financial results by intentionally

or recklessly making or approving various accounting policies and practices that did not comply

with GAAP, they made, drafted and/or approved the false and misleading statements and

information alleged herein, were aware or recklessly disregarded that the false and misleading

statements were being issued regarding the Company, and/or approved, certified or ratified these

statements, all in violation of the federal securities laws.


19

34. As senior officers and controlling persons of a publicly held company whose

common stock is traded on the NYSE and governed by certain provisions of the federal

securities laws, the Individual Defendants each had a duty to disseminate promptly accurate and

truthful information with respect to the Company's earnings, financial results, financial

condition, performance, growth, operations, financial statements, business, investments, markets,

management, and compliance with GAAP, and to correct any previously-issued statements that

had become materially misleading or untrue, so that the market price of the Company's publicly-

traded common stock would be based upon truthful and accurate information. The Individual

Defendants' misrepresentations and omissions during the Class Period violated these specific

requirements and obligations.

35. Each of the Defendants is liable, jointly and severally, as a participant in a

fraudulent scheme and course of business that operated as a fraud or deceit on those who

purchased Fannie Mae common stock and call options, or who sold put options, during the Class

Period, by disseminating materially false and misleading statements and/or concealing material

adverse facts. Defendants’ fraudulent scheme deceived the investing public regarding Fannie

Mae’s earnings, financial condition and results, business, operations, and the intrinsic value of

the Company's common stock and options, and caused Lead Plaintiffs and other members of the

Class to purchase Fannie Mae common stock and call options, or sell put options, at artificially

inflated prices during the Class Period.

IV. GENERAL BACKGROUND OF FANNIE MAE

36. Fannie Mae is the nation’s largest source of financing for home mortgages. The

U.S. Congress chartered Fannie Mae in 1968 for the purpose of providing liquidity in the

secondary mortgage market in order to increase the availability and affordability of


20

homeownership for low-, moderate-, and middle-income Americans. Although created by

Congress, the U.S. government does not guarantee, directly or indirectly, Fannie Mae’s securities

or other obligations. Fannie Mae is a private, shareholder-owned company and its common

stock is publicly traded on the New York Stock Exchange (“NYSE”) under the symbol “FNM.”

37. The central idea behind creating Fannie Mae and Freddie Mac was that they

would encourage home-ownership by buying mortgages from banks – freeing up banks’ limited

capital and therefore allowing the banks to make more loans. The purchase also relieved the

banks of both the credit risk (the risk the holder of the loan might default) and the interest rate

risk (the risk that the interest rates might rise during the life of a loan). Fannie Mae and Freddie

Mac have several advantages over other banks, including that they are exempt from state and

local taxes, they have less stringent capital requirements than banks, and the U.S. Treasury is

permitted to buy $2.25 billion of each company’s debt. Also, their cost of capital is kept low by

the market’s belief that the U.S. government would never let them default, even though the U.S.

government does not formally guarantee their debt.

38. Fannie Mae operates exclusively in the secondary mortgage market and does not

loan money directly to consumers. Fannie Mae makes its money in two major ways. The first

and more conservative way is its credit guaranty business. In this part of its business, Fannie

Mae gets a fee for guaranteeing the payments on the mortgages its buys, which it then re-sells to

investors usually in the form of mortgaged-backed securities (“MBS”), i.e., beneficial interests in

pools of mortgage loans or in other mortgage-related securities issued by Fannie Mae. Fannie

receives fees for its guaranty of timely payment of principal and interest payments due to

certificate holders on the MBS it issues. Fannie Mae typically shares the credit risk on the


21

underlying mortgages with third parties such as the lenders that originated the mortgages and

private mortgage insurance companies.

39. The second and more aggressive way that Fannie Mae makes money is its

portfolio investment business. In this part of its business, Fannie Mae holds the mortgage loans

and mortgage-related securities and other investments that it purchases from commercial banks,

savings and loan associations, mortgage companies, securities dealers and other investors and it

also purchases short-term, non-mortgage assets for liquidity and investment purposes. Fannie

Mae funds these portfolio purchases by issuing short and long term debt and by selling debt

securities to domestic and international capital markets investors. Fannie Mae profits to the

extent that the yield on the mortgage assets and other investments in its portfolio exceed its low

cost of capital (the cost of the debt securities it issued to fund those portfolio investments). Since

1995, Fannie Mae’s portfolio has grown an average of 20% a year.

40. Fannie Mae’s business is subject to several areas of risk, including prepayment

risk, interest rate risk, credit risk and operations risk. Most borrowers in the United States can

prepay their mortgage at any time without penalty. Thus, when interest rates decline sharply,

which happened during the Class Period, borrowers rush to refinance their mortgage at lower

rates, causing the mortgages to have a shorter life than originally projected. As a consequence,

when interest rates drop, the investment yield on Fannie Mae’s mortgage-related investments is

reduced. When this occurs, Fannie Mae receives large amounts of cash as the older, higher-rate

mortgages are paid off, but faces the risk that it will not be able to reinvest this cash at rates that

are above the rates that it is required to pay on its outstanding debt securities. This form of risk

is called “prepayment risk.”


22

41. Another risk is linked to the short-term and long-term debt Fannie Mae issues to

fund its mortgage purchases. When interest rates decline, Fannie Mae’s cost of issuing new

short-term debt also declines, but it is required to pay the original and higher interest rate on its

longer-term debt until that previously issued debt matures or can be called. This is called the

“interest rate risk.”

42. Interest rate fluctuations and prepayment risks exposed Fannie Mae to radical

earnings volatility from quarter to quarter. To offset or “hedge” against these risks, Fannie Mae

typically engaged in a variety of derivatives transactions and related hedges. Indeed, Fannie Mae

was noted by the SEC’s Chief Accountant as “one of the largest users of derivatives in the

world.” These risk-mitigating transactions included issuing callable debt, interest rate swaps,

options to enter into interest rate swaps (called “swaptions”), interest rate caps and floors, foreign

currency swaps, forward starting swaps, asset swaps, and other derivatives.

43. In May 1999, five months after becoming Chairman of the Board and Chief

Executive Officer of the Company, Defendant Franklin Raines publicly announced that “[t]he

future is so bright that I am willing to set as a goal that our EPS [earnings per share] will double

over the next five years.” During his tenure, this promise and the Individual Defendants’

personal greed were the motivating force behind everything the Defendants did. Indeed, a

substantial portion of the Individual Defendants’ compensation, averaging from 80-90% during

the Class Period, was tied to Fannie Mae meeting earnings per share growth goals. And,

although Fannie Mae ultimately met the earnings per share target – announcing profits of $7.3

billion in 2003 – it has now been revealed that Defendants were only able to achieve Fannie

Mae’s earnings growth by knowingly, or recklessly, disregarding the proper application of

GAAP.


23

44. As detailed herein, throughout the Class Period, Defendants issued numerous

false and/or misleading public financial reports and other statements to mislead investors into

believing, among other things, that Fannie Mae (i) presented its financial statements in

accordance with GAAP, (ii) was a conservative, stable investment with little or no earnings

volatility, (iii) had a properly computed capital structure that was adequate to meet regulatory

requirements and its business needs, (iv) had steady quarter-over-quarter earnings growth even in

times of market and interest rate volatility through the use of properly reported, tested and

documented financial transactions, and (v) had “effective” internal controls and “transparent”

disclosure policies and procedures that were the “vanguard” of financial institutions. Defendants

publicly said on numerous occasions throughout the Class Period that by their safe and sound

business practices and exceptional risk management policies, Fannie Mae was largely immune to

the financial impact of interest rate fluctuations and other factors that, in comparable institutions,

resulted in earnings volatility and capital impairment. At all times during the Class Period,

however, Defendants knew, or were reckless in not knowing, that Fannie Mae’s reported

operating and financial results, including its earnings, earnings per share and core capital, were

false and/or misleading and that Defendants had engaged in accounting schemes and violations

of GAAP and tolerated weak or non-existent internal controls in order to achieve the purported

“record earnings growth” and steady “increased earnings per share.” As a direct result of their

issuance of the materially false and/or misleading statements set forth herein, Fannie Mae’s

common stock traded at artificially inflated prices during the Class Period and the price declined

upon the revelation of Defendants’ improper accounting and other practices and the resulting

impact on Fannie Mae and its business operations, causing a substantial loss to Lead Plaintiffs

and the other members of the Class.


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45. A recent Fortune article perfectly sums up what brought about this case, stating as

follows:

The Fannie story is not like other accounting scandals . . . Yes, the company broke the rules to produce a smooth stream of earnings, just as Enron, Tyco, WorldCom, and all the others did. But that’s only one of a half-dozen other story lines. The Fannie Mae saga is also about a company that lost sight of its original mission. It’s about power politics run amok, and the combustible blend of politics and business. It’s about a company whose huge debt terrified top government officials, and whose very existence drew ideological opposition. It’s about an orchestrated, behind-the-scenes campaign to rein in a financial powerhouse. It’s about a regulator who learned to fight back against a much more formidable foe. It’s about all of these things and one more. Fannie Mae thought itself so different, so special, and so powerful that it should never have to answer to anybody. And in this, it turned out to be very wrong. 46. As detailed herein, throughout the Class Period, the Defendants issued numerous

false and misleading statements to give the deceptive and inaccurate appearance that Fannie

Mae’s earnings were largely immune to interest rate fluctuations, and to represent to the public

that the Company’s senior management had engaged in highly effective risk management

strategies, including effective internal controls. As has now been revealed, however, the

Company’s reported financial results were false and manipulated by unlawful accounting

gimmickry that violated GAAP and the risk-management and internal control policies of the

Company were weak or non-existent.

V. OFHEO’S UNCOVERING OF THE FRAUD AND THE SEC FINDINGS

47. After an accounting scandal emerged at Fannie Mae’s small rival, Freddie Mac, in

2003, OFHEO undertook an investigation into Fannie Mae’s accounting practices and

disclosures and hired Deloitte & Touche to assist with its investigation. OFHEO’s investigation

involved the review and analysis of 600,000 pages of documents, 1.5 million emails and 29 days

of interviews with Fannie Mae employees. On September 22, 2004, Fannie Mae issued a press


25

release containing a statement from Ann McLaughlin Korologos, the Presiding Director of the

Board of Directors of Fannie Mae. In the statement, Ms. Korologos reported that Fannie Mae’s

Board of Directors had received, on September 20, 2004, the OFHEO Report of its special

examination and that the report had indicated, among other things, that:

Fannie Mae (1) applied accounting methods and practices that do not comply with GAAP in accounting for the enterprise’s derivatives transactions and hedging activities, (2) employed an improper “cookie jar” reserve in accounting for amortization of deferred price adjustments under GAAP, (3) tolerated related internal control deficiencies, (4) in at least one instance deferred expenses apparently to achieve bonus compensation targets, and (5) maintained a corporate culture that emphasized stable earnings at the expense of accurate financial disclosures. OFHEO’s report to the Board states that “the matters detailed in this report are serious and raise doubts concerning the validity of previously reported financial results, the adequacy of regulatory capital, the quality of management supervision, and the overall safety and soundness of the Enterprise.

Ms. Korologos also reported in her statement that the SEC had been conducting an informal

inquiry that included issues raised in the OFHEO Report.

48. On this news, Fannie Mae common stock, which had opened at $74.18 on the

NYSE that day, fell $4.18 to $70.00, and closed out the day at $70.69, on trading volume of over

17.7 million shares. This represented a one-day market capitalization loss of approximately $3.9

billion. During the next weeks, Fannie Mae’s stock price fell to a low of $63.40 per share, with a

resulting market capitalization loss exceeding $9.6 billion.

49. After the close of the market on September 22, 2004, OFHEO publicly released

its letter to the Fannie Mae Board of Directors enclosing its report and the full 198-page OFHEO

Report. In the OFHEO letter to the Board, OFHEO told the Board that its:

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 investment analyst expectations; reducing volatility in reported earnings; and enabling fragmented processes and systems, and an ineffective controls environment to exist. (Emphasis added.)


26

Also in the letter, OFHEO stated that the “findings warrant immediate remedial action,” and

OFHEO submitted an agreement that included the minimum steps that need to be taken to

address the safety and soundness problems identified in the OFEHO Report. OFHEO further

stated:

In addition, we must consider the accountability of management and whether we have sufficient confidence in management to fully implement these corrective measures and bring about broad cultural and operational changes in the areas of concern. The analysis and findings of this report make it difficult to assert such confidence.

A copy of the letter to the Fannie Mae Board and the complete OFHEO Report are attached as

Exhibit A to the Consolidated Class Action Complaint filed on March 4, 2005 and are

incorporated herein by reference.

50. OFHEO also said that Fannie Mae’s accounting problems were more serious,

complex and larger than the problems found last year at its smaller rival, Freddie Mac, which had

to restate its financial statements for 2000, 2001 and 2002.

51. The OFHEO Report further provided:

We have determined that Fannie Mae, in developing policies and practices in these critical areas, has misapplied Generally Accepted Accounting Principles ("GAAP"), specifically Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases ("FAS 91") and Accounting for Derivative Instruments and Hedging Activities ("FAS 133"). The misapplications of GAAP are not limited occurrences, but are pervasive and are reinforced by management. (Emphasis added.) The matters detailed in this report are serious and raise concerns regarding the validity of previously reported financial results, the adequacy of regulatory capital, the quality of management supervision, and the overall safety and soundness of the Enterprise. (Emphasis in original.)

The problems relating to these accounting areas differ in their specifics, but they have emerged from a culture and environment that made these problems possible. Characteristics of this culture include:


27

• management's desire to portray Fannie Mae as a consistent generator of stable and growing earnings;

• a dysfunctional and ineffective process for developing accounting policies; • an operating environment that tolerated weak or non-existent internal

controls; • key person dependencies and poor segregation of duties; • incomplete and ineffective reviews by the Office of Auditing; • an inordinate concentration of responsibility vested with the Chief Financial

Officer; and • an executive compensation structure that rewarded management for

meeting goals tied to earnings-per-share, a metric subject to manipulation by management. (Emphasis added.)

The tenor of earnings management is deeply ingrained at Fannie Mae and has given rise to accounting policies and practices that emphasize effects on earnings volatility, rather than faithfulness to GAAP. A key message by Fannie Mae to the investor community is management's ability to generate stable and growing earnings. This is evidenced by Fannie Mae's annual financial reports, with their recurring graphs of steadily increasing earnings against a backdrop of volatile interest rates. Less well known, but detailed in this report, is the fact that the desire by management to minimize earnings volatility was a central organizing principle in the development of key accounting policies. (Emphasis added.) Management also emphasized the stable earnings imperative in its communications to the Fannie Mae Board of Directors. In July 2003, even as the accounting problems of Freddie Mac were publicly emerging, Fannie Mae's Chief Financial Officer, Tim Howard, made a presentation to the Board that emphasized a "stable pattern of earnings" as a requirement for Fannie Mae if it were to be perceived as a low-risk Enterprise. Mr. Howard included in this presentation a graph showing that the earnings of Fannie Mae were smoother than those of Freddie Mac and almost all other companies in the S&P 500. Sound risk management practices can reduce the economic effects of volatile cash flows. However, management should not reduce earnings volatility through accounting policies and practices that do not comport with GAAP. (Emphasis added.) 52. The GAAP violations by Defendants identified in the OFHEO Report primarily

involve Statement of Financial Accounting Standards 91, Accounting for Nonrefundable Fees

and Costs Associated With Originating or Acquiring Loans and Initial Direct Costs of Leases


28

(“SFAS 91”) and SFAS 133, Accounting for Derivative Instruments and Hedging Activities

(“SFAS 133”).

53. With respect to SFAS 91, the OFHEO Report found that:

OFHEO has concluded that the accounting used by Fannie Mae for amortizing purchase premiums and discounts on securities and loans as well as amortizing other deferred charges is not in accordance with GAAP. This is particularly significant, in that management, in the MD&A section of their Form 10-K, details their underlying application of amortization as it relates to SFAS 91, and also explains that the accounting estimates associated with deferred price adjustments are “critical accounting estimates.” (Emphasis in original.) However, despite the importance of premium and discount amortization to the financial statements of Fannie Mae, and despite the requirement of SFAS 91 to formulate best estimates in good faith, management intentionally developed accounting policies and selected and applied accounting methods to inappropriately reduce earnings volatility and to provide themselves with inordinate flexibility in determining the amount of income and expense recognized in any accounting period. In this regard, the amortization policies that management developed and the methods they applied created a “cookie jar” reserve. In addition, OFHEO found that management:

i. deliberately developed and adopted accounting policies to

spread estimated income or expense that exceeded predetermined thresholds over multiple reporting periods;

ii. established a materiality threshold for estimated income and expense, within which management could avoid making adjustments that would otherwise be required under SFAS 91;

iii. made discretionary adjustments to the financial statements, for the sole purpose of minimizing volatility and achieving desired financial results;

iv. forecasted and managed the future unrecognized income associated with misapplied GAAP;

v. capitalized reconciliation differences as ‘phantom’ assets or liabilities and amortized them at the same speeds as 30-year fixed-rate mortgages;

vi. developed estimation methods that were inconsistently applied to retrospective and prospective amortization required by SFAS 91 for current and future periods;

vii. developed and implemented processes to generate multiple estimates of amortization with varying assumptions in order to select estimates that provided optimal accounting results;

viii. failed to properly investigate an employee’s concerns regarding illogical or anomalous amortization results, along with that


29

employee’s further allegation of an intent to misstate reported income;

ix. tolerated significant weaknesses in internal controls surrounding the amortization process; and

x. inappropriately deferred $200 million of estimated amortization expense in 1998, which had significant effects on executive compensation. (Emphasis added.)

* * * In various memoranda, management openly expressed as an objective of its amortization policies and practices a desire to minimize earnings volatility. For example, a March 1999 memorandum from an employee in the Controller’s Department described the benefits of a particular brand of software for modeling amortization, noting that the software allowed a user to “manipulate factors to produce an array of recognition streams”, which “strengthens the earnings management that is necessary when dealing with a volatile book of business.”

* * *

The consequences of the misapplications of GAAP and control breakdowns surrounding accounting for amortization are potentially large. The management of Fannie Mae, by recording incorrect and incomplete amounts of premium and discount amortization, has misstated interest income over many reporting periods, as well as balance sheet accounts for unamortized premiums and discounts. Also, because amortization estimates ultimately flow to individual securities, gains or losses recorded on the sale or transfer of securities in previous periods are also questionable. Fannie Mae will need to devote considerable resources to determine the full magnitude of these errors. (Emphasis in original.)

54. With respect to Fannie Mae’s violations of SFAS 133, the OFHEO Report stated

inter alia that “Fannie Mae implemented SFAS 133 in a manner that placed minimizing

earnings volatility and maintaining simplicity of operations above compliance with GAAP,”

and “OFHEO has found that in many cases Fannie Mae does not assess and record hedge

ineffectiveness as required by SFAS 133, and applies hedge accounting to hedging

relationships that do not qualify.” The OFHEO Report further stated that Fannie Mae had

failed to properly document hedging activity and that “[t]his lack of documentation and the

ability to create such documentation retroactively is not only a SFAS 133 violation, but is

evidence of a poor control framework and is a significant safety and soundness problem.”


30

(Emphasis in original.) The OFHEO Report also noted this complete lack of documentation was

in contrast to prior statements by Raines that, “The hedge accounting treatment for each

individual transaction is determined -- and documented in writing -- before we enter into the

transaction and it cannot subsequently be changed.”1

55. With respect to Defendant Howard, the OFHEO Report stated:

[T]he Chief Financial Officer, Tim Howard, failed to provide adequate oversight to key control and reporting functions within Fannie Mae. (Emphasis in original.) Mr. Howard oversees the Controller’s Department, which does not possess the skills required to ensure that Fannie Mae has appropriate accounting policies, the resources to appropriately implement such policies, nor an effective system of internal controls. In addition, the Chief Financial Officer significantly influences the evaluation of the head of the Office of Auditing, and makes compensation recommendations for him. This decreases the independence and effectiveness of the internal audit function and is inappropriate. (Emphasis added.) With respect to key person dependencies, we found that the Chief Financial Officer also serves as the Chief Risk Officer of Fannie Mae, and is directly responsible for overseeing the Enterprise’s Treasury and Portfolio Management functions, in addition to the Controller’s Department. The combination of these responsibilities does not provide the independence necessary for an effective Chief Risk Officer function. (Emphasis in original.) We further found that Mr. Howard was instrumental in setting financial targets as Vice Chairman, and had the authority to meet these targets as Chief Financial Officer. (Emphasis added.) 56. After release of the OFHEO letter to the Board and the full OFHEO Report,

Fannie Mae shares fell to a low of $66.50, closing at $67.15 on September 23, 2004.

57. On September 23, 2004, Fannie Mae announced that it had amended its

employment agreements with Defendants Raines and Howard to expand the definition of “cause”

for termination of employment to include when the employee has “materially harmed Fannie

Mae by, in connection with his service under his employment agreement, engaging in dishonest

or fraudulent actions or willful misconduct, or performing his duties in a grossly negligent

1 From Fannie Mae’s website Answers from the CEO, cited in the OFHEO Report at 136.


31

manner.” The employment agreements were also modified to allow more compensation payable

to Defendants Raines and Howard if they were terminated for cause.

58. On September 27, 2004, OFHEO announced that it had entered into an agreement

with the Fannie Mae Board of Directors requiring immediate action to address the improper

accounting and inadequate controls detailed in OFHEO’s findings to date of its special

examination. The agreement requires Fannie Mae to take a series of steps with respect to its

internal controls, organization and staffing, governance, accounting and capital. Fannie Mae, by

signing the Agreement, admitted that it had engaged in improper accounting and had inadequate

internal controls, as the agreement requires Fannie Mae to, among other things:

• Implement correct accounting treatments that will bring the Enterprise into compliance with SFAS 91 and SFAS 133 accounting standards.

• To address SFAS 91, recalculate amortization for each quarterly period

from 1998 to 2004 using parameters provided by OFHEO and report and assess differences from previously reported financial statements.

• Beginning with the first quarter of 2005, cease hedge accounting for any

derivatives, including terminated hedges, that do not or did not qualify under SFAS 133 for such treatment.

• Protect the existing capital surplus and move to a targeted capital surplus

equal to 30% of their required minimum capital; develop capital plan to protect existing capital and achieve surplus requirements.

• Undertake a top-to-bottom review of staff structure, responsibilities,

independence of functions, compensation and incentives.

• Appoint an independent chief risk officer and separate other key business functions currently performed jointly by certain individuals or departments.

• Separate the function of business planning and forecasting from the

controller’s (Defendant Spencer’s) function.

• Separate modeling and accounting functions.

• Take steps to assure the independence of the internal auditor, including the ability of the auditor to report directly to the Audit Committee or Board.


32

• Put in place policies to assure adherence to accounting rules and new

internal controls.

• Board must review accounting policies and other corporate policies to ensure they reflect Board’s objections in complying with law and regulation and in overseeing operations of Fannie Mae.

• Board must hire within 45 days independent counsel and an independent

accounting firm, reporting directly to the Board or Board committee, to conduct certain reviews and called for by the Agreement.

59. On October 12, 2004, Fannie Mae publicly disclosed that the U.S. Attorney’s

Office for the District of Columbia was conducting a criminal investigation and requested that

Fannie Mae preserve certain documents, including documents relating to the matters discussed in

the OFHEO report.

60. Seven days later, on October 19, 2004, Fannie Mae publicly disclosed that the

SEC had initiated a formal investigation of Fannie Mae.

61. On November 15, 2004, Fannie Mae publicly announced in a Form NT 10-Q

filing with the SEC, which was signed by Defendant Howard, that:

(a) It was unable to file its quarterly financial results for the third quarter of 2004 on Form 10-Q because its auditors could not complete their review of the Company’s financial statements until the SEC determined whether or not the Company had previously complied with GAAP.

(b) It had submitted its views to the SEC’s Office of the Chief Accountant and would modify its accounting, if necessary, to comply with the SEC’s views.

(c) It estimated that it would have to record in earnings a net

cumulative after-tax loss on its derivative transactions of approximately $9 billion as of September 30, 2004, if the SEC determined that it has been accounting improperly for derivatives under SFAS 133. There would be a corresponding decrease to retained earnings and, accordingly, regulatory capital. The cumulative after-tax loss would consist of losses of approximately $13.5 billion on cash flow hedge relationships that had been deferred and were currently recorded in equity as a component of accumulated other comprehensive income (AOCI) and gains of approximately $4.5


33

billion on fair value hedges that were currently recorded on Fannie Mae’s balance sheet as an adjustment to the hedged item.

(d) It estimated that it would be required to record in earnings a net

cumulative after-tax loss of approximately $26 million as of September 30, 2004, if the SEC determined that its current accounting under SFAS 91 was not in compliance with GAAP.

(e) It admitted that its methodology for performing calculations to

measure the catch-up adjustment required by SFAS 91 for balance sheet dates in the periods 2001 through 2002 was not consistent with GAAP and that the Company would make adjustments to prior periods “if and to the extent material.” Fannie Mae admitted that to be compliant with SFAS 91, it should have been calculating its catch-up adjustment during those periods with reference to its quarter-end position rather than its projected year-end position and recording amounts solely on the basis of those quarterly calculations. The Company said it was assessing the impact and estimated that the effect would be an increase in 2001 and 2002 earnings and a decrease in 2003 earnings.

62. Fannie Mae, particularly Defendant Raines, stridently defended Fannie Mae’s

accounting practices and polices and publicly disagreed with OFHEO. Fannie Mae then

requested the SEC to review its accounting under SFAS 91 and SFAS 133 and determine

whether Fannie Mae was in proper compliance with GAAP.

63. On December 15, 2004, the SEC issued its conclusion that Defendants had not

materially complied with GAAP and it ordered Fannie Mae to restate its financial statements

from 2001 through mid-2004. The Office of the Chief Accountant (“OCA”) of the SEC found

that “Fannie Mae’s accounting practices did not comply in material respects with the accounting

requirements in Statement Nos. 91 and 133.” Among other things, the SEC determined that:

• Regarding SFAS 91, Fannie Mae had failed to record timely adjustments to the recorded amount of its loans based on changes in the estimated speed with which those loans would be prepaid.

• Contrary to SFAS 91, Fannie Mae recognized adjustments to the carrying

amount of its loans only if they exceeded a self-defined materiality limit, referred to as a “precision threshold”.


34

• “Fannie Mae internally developed its own unique methodology to assess whether hedge accounting was appropriate. Fannie Mae’s methodology, however, did not qualify for hedge accounting because of deficiencies in its application of [SFAS] 133. Among other things, Fannie Mae’s methodology of assessing, measuring, and documenting hedge ineffectiveness was inadequate and not supported by [SFAS 133].”

64. The SEC advised Fannie Mae that, to be consistent with SFAS 91 and SFAS 133,

it had to:

• Restate its financial statements filed with the SEC to eliminate the use of hedge accounting.

• Evaluate its accounting under SFAS 91 and restate its financial statements

filed with the SEC if the amounts required for correction are material.

• Re-evaluate the information purportedly prepared under GAAP and non-GAAP information Fannie Mae previously provided to investors, particularly in view of the decision that hedge accounting was not appropriate.

65. On December 15, 2004, the SEC announced its findings to Defendant Raines,

outside directors Stephen B. Ashley, Joe K. Pickett and Thomas P. Gerrity, OFHEO Director

Armando Falcon, Jr., KPMG (Fannie Mae’s auditor) and criminal prosecutors from the Justice

Department. Reportedly at the meeting, when Defendant Raines asked what they did wrong,

Nicolaisen held up a sheet of paper and responded that if the paper represented the four corners

of SFAS 133 and the center was perfect compliance, “you weren’t even on the page.” When

Raines tried the defense that hedge accounting under SFAS 133 was just too complex,

Nicolaisen responded that hedge accounting was voluntarily and that, “[m]any companies out

there get it right.” Nicolaisen also reportedly said, “Sir, hedge accounting is a privilege, not a

right,” and “[i]t applies under strict circumstances, and you did not comply.”

66. In his testimony to Congress on February 9, 2005, Mr. Nicolaisen made clear that,

while long in text, is not very difficult for companies to comply with SFAS 133. In response to a

question from Congressman Baker, Mr. Nicolaisen testified that Fannie Mae’s failure to comply


35

with SFAS 133 was “outside professional accounting standards” and was not “just a matter of

interpretive judgment where two people could’ve come to varying conclusions.” Mr. Nicolaisen

also testified that he “believes that other companies are complying with Statements 91 and 133.

I have reason to believe that the standards are workable and are being followed.”

67. Mr. Nicolaisen further stated, in response to a question from Congressman

Kanjorski, concerning FAS 133, that, “[t]hose rules are not overly complex. I think those rules

are clear. They’re laid out. They’re laid about because the FASB thought it was important to

maintain the financial integrity of reporting by – when exceptions to basic rules are followed,

that you had to comply with these essential elements. And they exist, and I do believe that those

large financial institutions who engage in derivative transactions are familiar with those rules.”

68. On December 21, 2004, following the determination by the SEC, Fannie Mae

announced that Defendant Raines had “retired” and Defendant Howard had “resigned” from their

positions with Fannie Mae.

69. Also on December 21, 2004, OFHEO classified Fannie Mae as “significantly

undercapitalized” as of September 30, 2004, finding that Fannie Mae had a $3 billion capital

shortfall in its minimum capital for the quarter. OFHEO ordered Fannie Mae to submit a capital

restoration plan to OFHEO for its review and approval. The “significantly undercapitalized”

classification means that Fannie Mae has to obtain OFHEO’s approval before the payment of any

dividend on Fannie Mae’s common stock. Fannie Mae has been forced to take prompt and

extreme measures to attempt to restore its capital shortfall, including private offerings of $5

billion in preferred stock to select investors and cutting the dividend on its common stock by

50%. OFHEO has also required that Fannie Mae maintain a 30% capital surplus.


36

70. On December 22, 2004, Fannie Mae filed a Form 8-K with the SEC in which it

reported that it would fully comply with the SEC’s determination and restate its financial

statements from 2001 to mid-2004. Fannie Mae reiterated that in its November 15, 2004 filing

with the SEC, it had reported that a loss of hedge accounting under SFAS 133 for all derivatives

could result in its recording into earnings a net cumulative loss on derivative transactions of

approximately $9.0 billion, with a corresponding decrease to retained earnings and, accordingly,

regulatory capital. Fannie Mae further stated:

Fannie Mae is working to determine the effect of the restatement, including the effect on each prior reporting period. The company expects that the impact will be material to Fannie Mae’s reported GAAP and core business results for many, if not all, periods and will vary substantially from period to period based on the amount and types of derivatives held and fluctuations in interests rates and volatility. Fannie Mae’s restated financial statements will also reflect corrections as a result of its misapplication of FAS 91 for each prior reporting period described above. Fannie Mae also will consider the impact, if any, of the OCA’s decision on FAS 91 for periods prior to those described above. Accordingly, on December 17, 2004, the Audit Committee of the Board of Directors of Fannie Mae concluded that Fannie Mae’s previously filed interim and audited financial statements and the independent auditors’ reports thereon for the periods from January 2001 through the second quarter of 2004 should no longer be relied upon because such financial statements were prepared applying accounting practices that did not comply with generally accepted accounting principles, or GAAP. (Emphasis added.) 71. On December 23, 2004, OFHEO announced that it was reviewing Raines’ and

Howard’s termination packages to determine whether “they were unjustly enriched.” That same

day Fannie Mae announced that its financial statements from 2001 to the present, including the

third quarter 2004, “should no longer be relied upon” as they did not comply with Generally

Accepted Accounting Principles. In response to the announcements by OFHEO and Fannie

Mae, the Company’s stock price decreased $7.12 per share to close at $69.62 per share on

December 23, 2004.


37

72. On December 28, 2004, Fannie Mae filed a Form 8-K with the SEC in which it

announced that the Audit Committee of the Fannie Mae Board had discharged its public

accountants, KPMG LLP, on December 21, 2004.

73. Fannie Mae also disclosed in this filing that, notwithstanding the prior public

statements of the Defendants that the Company’s controls were effective, KPMG had notified the

Company that there existed strong indicators of material weaknesses in internal control over

financial reporting, which included OFHEO’s determination of weaknesses in such controls,

OCA’s determination that Fannie Mae’s application of SFAS 91 and SFAS 133 did not comply

in material respects with the accounting requirements of those standards, and observed

deficiencies in Fannie Mae’s process of closing its accounting records for the quarter ended

September 30, 2004 that resulted in post-closing entries to the interim financial information.

74. On December 29, 2004, Fannie Mae announced that to address its capital

inadequacy, it was forced to raise $5 billion in preferred stock sales to select institutional

investors – the largest capital placement ever undertaken by Fannie Mae – to offset a $3 billion

capital shortfall for its third quarter ended September 30, 2004. The amount received by Fannie

Mae was far below what it should have received - a direct result of Fannie Mae not being able to

conduct a public stock offering because it did not have current financial statements on file with

the SEC. Some analysts characterized the placement as a “panic-button fire sale.” The

placement may further damage members of the Class by significantly diluting their ownership of

the Company.

75. On January 18, 2005, Fannie Mae announced that it would cut its first quarter

common stock dividend in half because of its lack of capital – another consequence of the


38

accounting fraud. Its stock price fell from a close of $69.70 per share on January 18, 2005, to a

close of $67.43 per share on January 19, 2005, after the market digested this news.

76. On January 21, 2005, Fannie Mae filed a Form 8-K with the SEC in which it

reported that the Compensation Committee of the Fannie Mae Board had determined (i) that for

2004 no cash bonuses would be paid to the company’s executive officers or senior vice

presidents under the Company’s Annual Incentive Plan or otherwise, and (ii) to deter certain

actions under the Company’s performance share program until the Company had reliable

financial data for prior fiscal years.

77. In the same 8-K, Fannie Mae also reported that, on January 17, 2005, Defendant

Spencer had “stepped down” from her positions with Fannie Mae, but would continue her

employment for a certain period in the non-officer capacity as Special Advisor. The Company

also announced that the Board had amended Fannie Mae’s By-Laws on January 19, 2005, to

eliminate the requirement that its Chairman of the Board also be its Chief Executive Officer and

to modify the Chairman’s duties.

78. On January 24, 2005, the Company announced that three additional senior

officers who had responsibilities relating to accounting were also stepping down from their

positions. These officers were Jonathan Boyles, Senior Vice President for Accounting and Tax

Policy, Janet Pennewell, Senior Vice President for Financial Reporting, and Sam Rajappa, Senior

Vice President for Operations Risk.

79. On February 23, 2005, Fannie Mae announced that, during its on-going

investigation, OFHEO had found evidence of additional violations of GAAP by Defendants as

well as internal control deficiencies that it believes raise safety and soundness concerns.


39

Among others, the new accounting problems identified by OFHEO involved SFAS 115, 140, 65

and 149. Specifically:

• With respect to SFAS 115, Accounting for Certain Investments in Debt and Equity Securities, OFHEO has questioned the Company’s compliance with the requirements of SFAS 115 for designating when mortgage-backed securities purchased for Fannie Mae’s investment portfolio are designated as “held-to-maturity” or “available-for-sale.” Specifically, OFHEO raised concerns about the timing of the Company’s designation and about whether certain designations or redesignations subsequent to the acquisition should be accounted for as transfers of securities from one such class to another.

• With respect to SFAS 140, Accounting for Transfers and Servicing of Financial

Assets and Extinguishments of Liabilities, OFHEO raised questions about, among other things, (i) Fannie Mae’s policies and procedures for determining whether securities qualify as “substantially similar” to those sold under FAS 140, (ii) Fannie Mae’s monitoring of these transactions for compliance with the requirements of SFAS 140, (iii) Fannie Mae’s policies and procedures regarding when it must be determined that a dollar-roll repurchase transaction has failed to occur as anticipated, and therefore has failed to qualify under FAS 140 for treatment as secured financing instead of as a sale, (iv) whether Fannie Mae adequately monitors the collateral in these transactions, (v) Fannie Mae’s compliance with its policies with regard to ensuring the return of substantially similar securities, and (vi) Fannie Mae’s practice for recognizing failed deliveries under the contracts.

• With regard to SFAS 65, Accounting for Certain Mortgage Banking Activities,

OFHEO identified issues relating to Fannie Mae’s classification of loans purchased for its portfolio as either held-for-investment or held-for-sale. Specifically, a systems upgrade in 2004 identified a long-standing practice of improperly designating all loans intended to be securitized as held-for-investment. OFHEO has directed Fannie Mae to identify and properly record these loans, and has questioned whether Fannie Mae may treat loans acquired in the future as held-for-investment given the past systems errors.

• OFHEO has questioned whether Fannie Mae’s policies and certain transfers with

respect to the Qualified Special Purpose Entities it uses to issue mortgage-backed securities complies with Financial Interpretation No. 46 (Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin 51) and whether certain transfers have a valid business purpose.

• OFHEO has raised questions about Fannie Mae’s practice of recognizing interest

expense on short-term debt instruments and interest income on certain liquid investments in a monthly ratable manner rather than pursuant to the contractual accrual convention, which had the effect of smoothing certain income and


40

expense amounts. In addition, OFHEO questioned whether Fannie Mae appropriately deferred recognizing the financial impact of implementing new systems or correcting estimation methodologies.

• OFHEO has raised a number of questions about Fannie Mae’s internal controls

and systems, including questions relating to Fannie Mae’s procedures for preparing, reviewing, validating, authorizing and recording journal entries relating to amortization adjustments; reliance on software applications and systems relating to portfolio accounting that may be ill-suited or ill-equipped for their intended purposes; and controls surrounding database modifications.

80. On March 3, 2005, The Wall Street Journal reported that Fannie Mae’s violation

of SFAS 149 alone, for just one year, could cause Fannie Mae to decrease its earnings by nearly

$2.76 billion as a result of the losses incurred in mortgage commitments in that period. As a

result, Fannie Mae’s regulatory capital would be similarly decreased.

81. More accounting violations were identified by OFHEO. First, on March 17,

2005, OFHEO disclosed it uncovered instances of Fannie Mae employees falsifying signatures

on accounting ledgers and making changes in database records related to earnings without

authorization. In response, Fannie Mae’s stock declined $2.45 per share to close at $54.40 per

share on March 17, 2005. Then, on April 4, 2005, The Wall Street Journal reported that OFHEO

was investigating whether Fannie Mae improperly accounted for trusts it set up to issue

mortgage-backed securities. In response to this news, shares of Fannie Mae common stock fell

$1.78 per share from $53.24 per share on April 1, 2005, to close at $51.46 per share on April 4,

2005.

82. After the close of trading on April 9, 2005, Fannie Mae disclosed that the

Company’s restatement was taking longer than predicted and that it would not be completed until

the second half of 2006. The Company also disclosed that it was in violation of New York Stock

Exchange rules requiring the filing of an annual financial report with the SEC, and thus was


41

facing the possibility of delisting. Reacting to this news, Fannie Mae shares declined $2.19 per

share from $54.83 per share on August 9, 2005, to close at $52.64 per share on August 10, 2005.

83. “New and pervasive accounting violations” at Fannie Mae were reported on

September 28, 2005. According to Dow Jones, Fannie Mae used so-called finite insurance

policies to hide earnings losses after they were incurred, and embellished earnings by

overvaluing assets, underreporting credit losses and misusing tax credits. In response to this

news, shares of Fannie Mae plummeted $4.99 per share, or 11%, from $46.70 per share on

September 27, 2005 to close at $41.71 per share on September 28, 2005. This one day drop

wiped out approximately $4.82 billion in market value and constituted Fannie Mae’s lowest per

share price since July 1997. Analysts, including JPMorgan Securities and Morgan Stanley,

stated that these additional accounting violations may cause a “small” change in the amount of

Fannie Mae’s restatement and capital requirements.

VI. DEFENDANTS’ KNOWING OR RECKLESS DISREGARD OF GAAP

84. As has now been revealed, Defendants were only able to satisfy Wall Street

expectations and make it appear as if the Company’s earnings were characterized by steady

growth and low volatility by engaging in the earnings manipulations and numerous accounting

improprieties that violated fundamental GAAP precepts complained of herein. When these

earnings manipulations and GAAP violations were finally exposed, billions of dollars of

shareholder value was wiped out. Now, the Company has admitted that its previously issued

2001 through the second quarter of 2004 financial statements are unreliable because they were

not prepared in accordance with GAAP, and it has ousted the Individual Defendants and its

public accountants.


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A. General GAAP Violations

85. As set forth in SEC Rule 4-01(a) of Regulation S-X, “[f]inancial statements filed

with the Commission which are not prepared in accordance with generally accepted accounting

principles will be presumed to be misleading or inaccurate.” 17 C.F.R. § 210.4-01(a)(1).

Management is responsible for preparing financial statements that conform to GAAP, as set forth

in § AU110.03 of the American Institute of Certified Public Accountants (“AICPA”)

Professional Standards:

The financial statements are management’s responsibility . . . Management is responsible for adopting sound accounting policies and for establishing and maintaining internal control that will, among other things, record, process, summarize, and report transactions (as well as events and conditions) consistent with management’s assertions embodied in the financial statements. The entity’s transactions and the related assets, liabilities, and equity are within the direct knowledge and control of management . . . Thus, the fair presentation of financial statements in conformity with [GAAP] is an implicit and integral part of management’s responsibility…. 86. The Individual Defendants, as senior management, were also responsible for

implementing and maintaining sound accounting policies and appropriate internal controls and

assuring that staffing levels and experience in financial accounting were sufficient to ensure that

significant errors were prevented or detected at an early stage. AICPA, Statement on Auditing

Standards No. 1, Section 110.02 provides as follows:

Management has the responsibility for adopting sound accounting policies, for maintaining an adequate and effective system of accounts, for the safeguarding of assets, and for devising a system of internal control that will, among other things, help assure the production of proper financial statements. The transactions which should be reflected in the accounts and in the financial statements are matters within the direct knowledge and control of management. The auditor’s knowledge of such transactions is limited to that acquired through his examination. Accordingly, the fairness of the representations made through financial statements is an implicit and integral part of management’s responsibility. The independent auditor may make suggestions as to the form or content of financial statements or he may draft them in whole or in part, based on management’s accounts and records. However, his responsibility for the


43

statements he has examined is confined to the expression of his opinion on them. The financial statements remain the representations of management. 87. Defendants were well aware of these responsibilities. In fact, Fannie Mae’s

Annual Report for 2001 and Forms 10-K for fiscal years ended December 31, 2002 and 2003,

contained the following acknowledgement and assurance in a “Report of Management” signed

by Defendants Howard and Spencer:

The management of Fannie Mae is responsible for the preparation, integrity and fair presentation of the accompanying financial statements and other information appearing elsewhere in this report. In our opinion, the financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America as appropriate in the circumstances, and the other financial information in this report is consistent with such statements. In preparing the financial statements and in developing the other financial information, it has been necessary to make informed judgments and estimates of the effects of business events and transactions. We believe that these judgments and estimates are reasonable, that the financial information contained in this report reflects in all material respects the substance of all business events and transactions to which the corporation was a party, and that all material uncertainties have been appropriately accounted for or disclosed. The management of Fannie Mae is also responsible for maintaining internal control over financial reporting that provides reasonable assurance that transactions are executed in accordance with appropriate authorization, permits preparation of financial statements in conformity with accounting principles generally accepted in the United States of America, and establishes accountability for the assets of the corporation. Internal control over financial reporting includes controls for the execution, documentation, and recording of transactions, and an organizational structure that provides an effective segregation of duties and responsibilities. Fannie Mae has an internal Office of Auditing whose responsibilities include monitoring compliance with established controls and evaluating the corporation’s internal controls over financial reporting. Organizationally, the internal Office of Auditing is independent of the activities it reviews.

* * * Management recognizes that there are inherent limitations in the effectiveness of any internal control environment. However, management believes that, as of December 31, [applicable year], Fannie Mae’s internal control environment, as described herein, provided reasonable assurance as to the integrity and reliability of the financial statements and related financial information.


44

88. In footnote 1 to the Notes to Financial Statements in Fannie Mae’s 2001 Annual

Report, Fannie Mae represented that “[t]he accounting and reporting policies of Fannie Mae

conform with accounting principles generally accepted in the United States of America.”

89. Likewise, Defendants Raines and Howard signed certifications attached to the

Forms 10-K for the fiscal years ended December 31, 2002 and 2003 and the Forms 10-Q filed in

2003 and 2004, in which they certified that (i) the reports did not contain any untrue statement of

a material fact or omit to state a material fact necessary to make the statements made, in light of

the circumstances under which such statements were made, not misleading, (ii) the financial

statements and other financial information included in the reports fairly presented in all material

respects the financial condition, results of operation and cash flow of the Company as of and for

the periods presented, and (iii) that Raines and Howard were responsible for establishing and

maintaining disclosure controls and procedures as defined in the Exchange Act and that they (a)

had designed such disclosure controls and procedures, or caused such disclosure controls and

procedures to be designed under their supervision, to ensure that material information relating to

the Company was made known to them by others within the entity, particularly during the period

in which the report was being prepared; and (b) having evaluated the effectiveness of the

Company’s disclosure controls and procedures, both concluded that the disclosure controls and

procedures were effective as of the applicable period.

90. Additionally, in preparing financial statements, senior management was required

to take into consideration the fundamental objectives and concepts upon which GAAP are based,

which include:

(a) The principle that financial reporting should provide information that is useful to

present and potential investors and creditors in making rational investment decisions and


45

that information should be comprehensible to those who have a reasonable understanding

of business and economic activities. (FASB Statement of Concepts No. 1 ¶34);

(b) The principle of materiality, which provides that the omission or misstatement of

an item in a financial report is material if, in light of the surrounding circumstances, the

magnitude of the item is such that it is probable that the judgment of a reasonable person

relying upon the report would have been changed or influenced by the inclusion or

correction of the item. (FASB Statement of Concepts No. 2, ¶132);

(c) The principle that financial reporting should provide information about how

management of an enterprise has discharged its stewardship responsibility to owners

(stockholders) for the use of enterprise resources entrusted to it. To the extent that

management offers securities of the enterprise to the public, it voluntarily accepts wider

responsibilities for accountability to prospective investors and to the public in general.

(FASB Statement of Concepts No. 1, ¶50);

(d) The principle that financial reporting should provide information about an

enterprise’s financial performance during a period. Investors and creditors often use

information about the past to help in assessing the prospects of an enterprise. Thus,

although investment and credit decisions reflect investors’ expectations about future

enterprise performance, those expectations are commonly based at least partly on

evaluations of past enterprise performance. (FASB Statement of Concepts No. 1, ¶42);

(e) The principle that financial reporting should be reliable in that it represents what

it purports to represent. The notion that information should be reliable as well as relevant

is central to accounting. (FASB Statement of Concepts No. 2, ¶¶58-59);


46

(f) The principle of completeness, which means that nothing is left out of the

information that may be necessary to ensure that it validly represents underlying events

and conditions. (FASB Statement of Concepts No. 2, ¶80); and

(g) The principle that conservatism be used as a prudent reaction to uncertainty to try

to ensure that uncertainties and risks inherent in business situations are adequately

considered. The best way to avoid injury to investors is to try to ensure that what is

reported represents what it purports to represent. (FASB Statement of Concepts No. 2,

¶¶95, 97).

91. In agreeing to restate its financial results for 2001 through mid-2004, the

Company has admitted that material errors existed at the time the financial statements were

prepared and thus it failed to provide a fair presentation of its financial results during the Class

Period. See SFAS 16 and APB Opinion No. 20 (restatements of prior periods are required for

material accounting errors that existed at the time financial statements were originally issued).

92. Finally, Fannie Mae has itself admitted that Defendants violated GAAP. In its

Form 8-K filed on December 22, 2004, Fannie Mae reported that:

The Audit Committee of the Board of Directors of Fannie Mae concluded that Fannie Mae’s previously filed interim and audited financial statements and the independent auditors’ reports thereon for the periods from January 2001 through the second quarter of 2004 should no longer be relied upon because such financial statements were prepared applying accounting practices that did not comply with generally accepted accounting principles, or GAAP. (Emphasis added.) B. Defendants’ Violations of SFAS 91

93. In December 1988, Statement of Financial Accounting Standards No. 91,

Accounting for Nonrefundable Fees and Costs Associated with Organization or Acquiring Loans

and Initial Direct Costs of Leases (“SFAS 91”) was issued to establish consistent accounting for


47

nonrefundable fees and costs associated with lending activities. SFAS 91 required the Company

to recognize loan fees, premiums, discounts and other deferred purchase and guarantee fee price

adjustments to income using the effective yield method. This method required that the Company

estimate a constant effective yield for its loans and mortgage-backed securities each time it

reported its financial results. The accounting standard requires that purchases of loans and

mortgage-based securities be recorded at the net purchase price, taking into account premiums,

discounts and other deferred purchase and guarantee fee price adjustments.

94. OFHEO found that, with respect to SFAS 91, Defendants “intentionally

developed accounting policies and selected and applied accounting methods to inappropriately

reduce earnings volatility and to provide themselves with inordinate flexibility in determining the

amount of income and expense recognized in any accounting period. In this regard, the

amortization policies that management developed and the methods they applied created a ‘cookie

jar’ reserve,” which is not permitted under SFAS 91 or GAAP.

95. Fannie Mae anticipated that a certain portion of its loans would be prepaid, and

therefore, as permitted by SFAS 91, incorporated an estimate for prepayments when amortizing

fees, premiums and discounts. If a difference arose between the prepayments anticipated by the

Company and the actual prepayments received, SFAS 91 required the Company to make a

“catch-up” adjustment and immediately book the difference between the revised estimate of

amortization and the actual recorded amortization as an adjustment to interest income. The

guidance on this process provided by SFAS 91 is as follows:

If the enterprise holds a large number of similar loans for which prepayments are probable and the timing and amount of prepayments can be reasonably estimated, the enterprise may consider estimates of future principal prepayments in the calculation of the constant effective yield necessary to apply the interest method. If the enterprise anticipates prepayments in applying the interest method and a difference arises between the prepayments anticipated and actual prepayments


48

received, the enterprise shall recalculate the effective yield to reflect actual payments to date and anticipated future payments. The net investment in the loans shall be adjusted to the amount that would have existed had the new effective yield been applied since the acquisition of the loans. The investment in the loans shall be adjusted to the new balance with a corresponding charge or credit to interest income. Enterprises that anticipate prepayments shall disclose that policy and the significant assumptions underlying the prepayment estimates.

(SFAS 91, ¶19) (Emphasis added).

96. Properly estimating and accounting for the differences between estimated and

actual prepayments, however, would have caused large swings in the amount of the catch-up

adjustments and significant income volatility. To circumvent this periodic charge or credit to

interest income and the resulting earnings volatility, Defendants developed an amortization

policy and selected and applied accounting methods that would allow the Company to avoid

current period volatility and would further provide management with the flexibility to shift

income and minimize the potential for prospective volatility.

97. Both OFHEO and the SEC found that Defendants, in violation of SFAS 91, failed

to record timely adjustments to the recorded amounts of its loans based on changes in the

estimated speed with which those loans would be prepaid. Indeed, Defendants have now

admitted that their methodology for performing calculations to measure the catch-up adjustment

required for balance sheet dates in the periods 2001 through 2002 was not consistent with

GAAP. As detailed above, in the Company’s Form NT-10-Q filed November 15, 2004, which

was signed by Defendant Howard, Defendants admitted that during those periods, “Fannie Mae

should have been calculating its catch-up adjustment with reference to its quarter-end position

rather than its projected year-end position and recording amounts solely on the basis of those

quarterly calculations.”


49

98. OFHEO found that there was a concerted effort to formulate a SFAS 91 policy to

manage the amortization of deferred price adjustments and therefore provide earnings flexibility

and minimize earnings volatility and that the effort “was directed and overseen by Chief

Financial Officer Mr. Tim Howard,” and “[p]olicy analysis was performed for the most part by

personnel within the controllers group, including active involvement by the Controller, Ms.

Leanne Spencer.”

99. One such policy that was found by both OFHEO and the SEC to violate SFAS 91,

was Fannie Mae’s policy to recognize adjustments to the carrying amount of its loans only if

they exceeded a self-defined materiality limit, referred to as a “precision threshold,” which

allowed the Company to avoid making adjustments that otherwise would be required under

SFAS 91. The SEC has reported that Fannie Mae has represented to it that the Company has

initiated changes to eliminate the “precision threshold” and is working with OFHEO to further

amend its accounting practices under SFAS 91.

100. Other specific violations of SFAS 91 noted by OFHEO in the OFHEO Report

include that management had:

• Failed to apply the accounting treatment required by SFAS 91 to Real Estate Mortgage Investment Conduit (REMIC) securities held in its portfolio until 1998, even though SFAS 91 became effective in 1988.

• Inappropriately deferred $200 million of estimated expense in 1998, and

established and executed a plan to record this expense in subsequent fiscal years, to receive 100% of their annual bonus compensation – “[w]ithout such deferral, no bonus would have been paid out.”

• Undertook a concerted effort to develop and adopt accounting policies that would

enable the Company to “spread income or expense over multiple reporting periods.”

• Made discretionary adjustments to the financial statements “for the sole purpose

of minimizing volatility and achieving desired financial results.”


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• Forecasted and managed unrecognized income and expense to measure and maintain a “cookie jar” reserve.

• Recorded reconciliation differences and other errors as “phantom assets and

liabilities.” These phantom assets and liabilities were then amortized in accordance with a 30-year conventional mortgage proxy life.

• Applied discretion to the selection of market rate assumptions in order to achieve

desired accounting results.

• Developed and effected capabilities to iteratively generate and evaluate estimates under varying assumptions, in order to obtain desired outcomes.

• Incorrectly and inconsistently applied adjustments to the estimate of

amortization.

• Failed to properly investigate Mr. Barnes’ concerns regarding illogical or anomalous amortization results, and allegations of an intent to misstate reported income.

• Tolerated significant weaknesses in internal controls “that undermined control

objectives, maintained inadequate segregation of duties, and impeded the review and oversight of accounting processes and results.”

101. Fannie Mae’s use and establishment of the amortization policy also violated

SFAS No. 5, Accounting for Contingencies (“SFAS 5”) which provides that:

An estimated loss from a loss contingency (as defined in paragraph 1) shall be accrued by a charge to income if both of the following conditions are met:

Information available prior to issuance of the financial statements indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements. It is implicit in this condition that it must be probable that one or more future events will occur confirming the fact of the loss.

The amount of loss can be reasonably estimated. (¶8)

102. Moreover, SFAS No. 5 prohibits the establishment of a reserve for general or

unspecified business risks, which by their nature cannot meet the requirement of ¶8. Fannie

Mae’s establishment of a “cookie jar” reserve under SFAS 91 was not based on a probable or

estimable contingency and thus represented a general reserve prohibited by SFAS 5.


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103. The total scope and affect on Fannie Mae of Defendants’ violations of SFAS 91 is

unknown at this time, however OFHEO has said that:

The consequences of the misapplications of GAAP and control breakdowns surrounding [Fannie Mae’s] accounting for amortization are potentially large. The management of Fannie Mae, by recording incorrect and incomplete amounts of premium and discount amortization, has misstated interest income over many reporting periods, as well as balance sheet accounts for unamortized premiums and discounts. Also, because amortization estimates ultimately flow to individual securities, gains or losses recorded on the sale or transfer of securities in previous periods are also questionable. Fannie Mae will need to devote considerable resources to determine the full magnitude of these errors. (Emphasis in original.) 104. During his testimony at an October 6, 2004 hearing before the United States

House of Representative Subcommittee on Capital Markets, Insurance and Government

Sponsored Enterprises, Defendant Howard did not dispute OFHEO’s description of the SFAS 91

cookie jar reserve as a direct violation of GAAP and how it worked. In fact, Defendant Howard

did not even try to minimize the impact this undisclosed reserve had on managing Fannie Mae’s

earnings. Instead, he admitted that he “made the judgment” that smoothing out some of the

volatility SFAS 91 caused in quarterly earnings was necessary because “it preserves the integrity

and the quality of our published financial statements,” despite his public certifications and

statements that Fannie Mae’s financials were accurate and prepared in accordance with GAAP.

In short, Howard conceded that he intentionally caused Fannie Mae to misapply SFAS 91 so

Defendants could achieve their desired goal of smooth and steady earnings growth.

C. Defendants’ Violations of SFAS 133

105. In June 1998, the Financial Accounting Standards Board (“FASB”) issued

Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments

and Hedging Activities (SFAS 133). In May 1999, FASB voted to delay the implementation date

of SFAS 133 for one year, until January 1, 2001. Thus, Fannie Mae was not required to give


52

effect to SFAS 133 until the beginning the first quarter of 2001, and therefore had a significant

amount of time to get ready for the implementation.

106. Indeed, in a presentation at a FAS133.com seminar in November 1999, Kimberly

Rawls, then senior project manager with the Company’s financial standards department, reported

that senior management had been very involved even before the first SFAS 133 exposure draft

was issued, its CFO and President had met with FASB on several occasions to discuss SFAS 133

issues, and therefore when the final statement was issued in June 1998, Fannie Mae was in the

“unusual position of being intimately familiar with many of its concepts.” Ms. Rawls further

said Fannie Mae’s success with respect to the implementation of SFAS 133 was the ongoing

involvement of senior management. She said, “[a]t the beginning of 1999, our CFO mandated

that a team of senior officers be assembled to provide the leadership for this project,” and to

make sure senior managers kept focused on the project, the CFO tied the manager’s performance

goals and bonus for the year to its successes.

107. SFAS 133 established accounting and reporting standards for certain derivative

instruments. Prior to SFAS 133, the rules were inconsistent and lacked transparency and

companies could hide the effects of ineffective, imprecise and simply bad hedges “off balance-

sheet.” SFAS 133 simply requires an entity to record all derivatives as either assets or liabilities

on its balance sheet at their fair value. Changes in a derivative’s fair value are included in

earnings, unless the derivative is designated and qualifies for hedge accounting. Hedge

accounting provides a means for a matching of the earnings effect of a derivative and the related

designated hedged transaction, thereby mitigating the impact on income of marking-to-market

the derivative under SFAS 133. Hedge accounting is elective.


53

108. There are three categories of hedges under SFAS 133: (i) fair value hedge, (ii)

cash flow hedge, and (iii) foreign currency hedge. For a fair value hedge - a derivative

designated as hedging the exposure to changes in the fair value of a recognized asset or liability

or a firm commitment (i.e., interest rate swaps or swaptions as a hedge against changes in the fair

value of fixed rate assets or obligations caused by changing interest rates) - the gain or loss in the

derivative is recorded in earnings in the period of change together with the loss or gain in the fair

value of the hedged item.

109. For a cash flow hedge - derivatives properly designated as hedges of changes in

future cash flows, such as those associated with variable or floating rate assets or obligations -

the effective portion of the change in the fair value of the derivative is recorded on the balance

sheet under “Accumulated Other Comprehensive Income” (a component of equity) and

amortized through the income statement over the periods in which the hedged item impacts the

income statement.

110. In terms of Fannie Mae, the applicable foreign currency hedge accounting rules

merely require the application of the fair value and cash flow hedging accounting model to

Fannie Mae’s foreign currency exposures.

111. One objective of hedge accounting is to immediately reflect in earnings the

extent to which the hedging instrument (normally a derivative) is not effective in achieving

offsetting changes in fair value or cash flows of the hedged item. Derivatives not properly

designated in (or qualifying for) hedging relationships (and the ineffective portion of all hedges)

are marked to fair value through the income statement.

112. SFAS 133 gave investors and analysts much greater clarity about the use of

derivatives and effectiveness (and ineffectiveness) of a company’s hedging activities. Volatility


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in earnings per share increased under SFAS 133 to the extent that a company’s hedges were

ineffective in offsetting the specific risk being hedged. In other words, if there is a low

correlation between changes in the value of a derivative and changes in the value of the hedged

item, investors will generally observe this ineffectiveness through increased volatility of

earnings. SFAS 133 creates a strong incentive for managers of publicly traded companies to use

hedges that are highly effective, as defined by the accounting standard, and meet the

requirements for hedge accounting.

113. During the Class Period, Fannie Mae was one of the world’s largest users of

derivatives. Fannie Mae issues over $800 billion of debt securities each year. Kimberly Rawls,

senior project manager in the Company’s financial standards department, said: “The use of

derivatives products in our business is crucial. We use derivatives to hedge our debt issuance

program.” The majority of Fannie Mae’s derivative instruments were classified as cash flow

hedges or fair value hedges.

114. To qualify for hedge accounting under SFAS 133, certain stringent criteria must

be satisfied. To meet the criteria, an entity must, at the inception of a hedge, create formal

documentation of the hedge relationship and the entity’s risk management objective and strategy

for undertaking the hedge, including: a) the identification of the hedging instrument, the hedged

item (in the case of a fair value hedge) or the hedged transaction (in the case of a cash flow

hedge); b) the nature of risk being hedged; c) the basis upon which effectiveness will be

measured; and d) there must be a reasonable basis to expect that the hedge will be highly

effective. (SFAS 133, ¶¶20, 21, 28, 29). Furthermore, SFAS 133 requires a company to assess

the effectiveness of each hedge transaction on an ongoing basis. An assessment of effectiveness


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is required whenever financial statements or earnings are reported, and at least every three

months.

115. OFHEO and the SEC both found numerous violations of SFAS 133 by

Defendants. The SEC has ordered Fannie Mae to restate its 2001 to mid-2004 financial

statements to totally eliminate the use of hedge accounting. After its review, the SEC

determined that:

Fannie Mae internally developed its own unique methodology to assess whether hedge accounting was appropriate. Fannie Mae’s methodology, however, did not qualify for hedge accounting because of deficiencies in its application of Statement No. 133. Among other things, Fannie Mae’s methodology of assessing, measuring, and documenting hedge ineffectiveness was inadequate and was not supported by the Statement. Fannie Mae failed to comply with the basic designation, documentation, and

effectiveness measurement requirements set forth in SFAS 133.

116. OFHEO found that Fannie Mae implemented SFAS 133 in a manner that placed

minimizing earnings volatility and maintaining simplicity of operations above compliance with

GAAP. OFHEO said that in a March 2003 memorandum that took a retrospective look at Fannie

Mae’s SFAS 133 implementation:

Jonathan Boyles, Senior Vice President for Financial Standards, wrote that the implementation of this standard was driven by management’s desire to minimize earnings volatility, leverage off existing systems, and make the non-GAAP measure of “operating earnings” simple and easy to understand. Mr. Boyles wrote that these goals ‘were intertwined in many of the decisions we made during the implementation process.’ He went on to write that these decisions “were often the joint decisions of management including the CFO.” He further noted that “in hindsight these decisions may not have been the best decisions given what we know now.” 117. OFHEO found that in many cases throughout the Class Period, Fannie Mae did

not assess and record hedge ineffectiveness as required by SFAS 133, and applied hedge

accounting to hedging relationships that do not qualify. Specifically, Fannie Mae’s hedge


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accounting regime assumed that the vast majority of its hedging relationships were “perfectly

effective”; which simplified operations because SFAS 133 did not require effectiveness

assessment or measurement of ineffectiveness for such relationships. However, SFAS 133

prescribes specific rules for assuming perfect effectiveness and hedges that do not meet the

criteria require an assessment of effectiveness to qualify for hedge accounting and a measure of

ineffectiveness for qualifying hedge relationships. OFHEO found that the Company had many

hedging relationships that did not qualify as perfectly effective, but the Company nevertheless

treated them as such. Because Fannie Mae did not perform a proper assessment of hedge

effectiveness for these hedges, those hedge relationships did not qualify for hedge accounting.

Thus, only the fair value changes for derivatives in those relationships should have been

recorded immediately in earnings without being offset by changes in the fair value or cash

flows of any hedged item.

118. Further, even if a hedge relationship qualified for hedge accounting,

“ineffectiveness” (the extent to which changes in the fair value of a derivative are not perfectly

matched with the changes in fair value or cash flows of the hedged item) may exist. Pursuant to

SFAS 133, the ineffective portion of changes in the derivative’s fair value must be recorded in

earnings. OFHEO identified numerous instances in which Fannie Mae improperly ignored the

ineffectiveness in hedges relationships or failed to perform the required assessment tests. For

example, Fannie Mae often re-designated derivatives to different hedged items during the life of

the derivative. OFHEO found that Fannie Mae incorrectly assumed that such derivatives were

perfectly effective upon re-designation, even though the derivatives do not have a fair value of

zero at the time of re-designation, which is required in order to assume perfect effectiveness or to

received matched terms accounting.


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119. When seeking to effectively terminate interest rate swaps, management often

entered into offsetting swaps instead of buying back the existing swap. According to OFHEO,

however, the accounting for offsetting derivatives was inappropriate through the end of 2003,

because Fannie Mae incorrectly treated the original swap and the offsetting swap as perfect cash

flow hedges and recorded changes in their fair value in accumulated other comprehensive

income (AOCI) instead of earnings. In the first quarter of 2004, Fannie Mae modified its

accounting for the offsetting swaps prospectively. However, OFHEO believes the offsetting

swaps were not valid hedging relationships under SFAS 133 in past periods and should not have

received hedge accounting after execution of the second swap.

120. Further, OFHEO found that Fannie Mae applied the “short-cut” method, or the

“matched terms” method, for a broad range of hedge relationships where these methods are

inappropriate and had also applied its own definitions of “matched terms” in certain instances.

Specific examples include:

• receive fixed swaptions hedging the fair value of non-callable debt;

• callable swaps hedging discount notes, which are incorrectly treated as perfectly effective without regard to the option value existing in the derivative but not the hedged item;

• swaps arising from the exercise of a swaption, which are treated as

perfectly effective despite their non-zero fair value at inception;

• the modification of the requirement for matching of reset dates (in order to assume perfect effectiveness) between the hedged item and the swap in cash flow hedges to permit up to a seven day reset date mismatch;

• the modification of the requirement for matching of maturity dates (in

order to assume perfect effectiveness) between the hedged item and the swap in fair value hedges to permit up to a 90 day mismatch; and

• the use of a “duration method” to assume perfect effectiveness in hedges of

anticipated debt issuances. In March 2004, Fannie Mae discontinued the use of duration matching as a method to assess the effectiveness of hedging


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anticipated debt issuances and admitted that this methodology was a known departure from GAAP.

121. OFHEO also identified a number of problems with Fannie Mae’s hedge

documentation. In several examples, the documentation was ambiguous as to the nature of the

hedging relationship or did not clearly identify the hedged risk, hedged item, or its probability of

occurrence. In addition, OFHEO found instances where there was no contemporaneous hedge

documentation, as well as instances where staff created hedge designations retroactively. Under

SFAS 133, the lack of contemporaneous hedge designation documentation precludes a company

from qualifying for hedge accounting. OFHEO found that “this lack of documentation and the

ability to create such documentation retroactively is not only a SFAS 133 violation, but is

evidence of a poor control framework and is a significant safety and soundness problem.”

122. Finally, OFHEO determined that Fannie Mae had made an error in accounting for

changes in the time value and the intrinsic value components of purchased interest rate caps.

Fannie Mae found the error and corrected its methodology only prospectively to new interest rate

caps. OFHEO found that Fannie Mae incorrectly accounted for and reported this error in its

financial statements.

123. Fannie Mae previously announced that if the SEC determined it had been

accounting improperly for derivatives under SFAS 133, which it has, that the Company would

have to record in earnings a net cumulative after-tax loss on its derivative transactions of

approximately $9 billion, with a corresponding decrease to retained earnings and, accordingly,

regulatory capital. Fannie Mae stated that this cumulative after-tax loss would consist of losses

of approximately $13.5 billion on cash flow hedge relationships that had been deferred and were

currently recorded in equity as a component of AOCI and gains of approximately $4.5 billion on

fair value hedges that were currently recorded on Fannie Mae’s balance sheet as an adjustment to


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the hedged item. As a result, after the SEC ordered Fannie Mae to restate its financial for 2001

through mid-2004 to eliminate all hedge accounting, OFHEO declared the Company

“significantly undercapitalized,” finding that it had a $3 billion capital shortfall in its minimum

capital.

D. Defendants’ Violations of Other Accounting Rules

124. Fannie Mae announced on February 23, 2005, that during its on-going

investigation, OFHEO had found evidence of possible further violations of GAAP by

Defendants as well as internal control deficiencies that it believes raise safety and soundness

concerns. Specifically, OFHEO has raised the following concerns:

• With respect to SFAS 115, Accounting for Certain Investments in Debt and Equity Securities, OFHEO has questioned the Company’s compliance with the requirements of for designating when mortgage-backed securities purchased for Fannie Mae’s investment portfolio are designated as “held-to-maturity” or “available-for-sale.” Specifically, OFHEO raised concerns about the timing of the Company’s designation and about whether certain designations ore redesignations subsequent to the acquisition should be accounted for as transfers of securities from one such class to another.

• With respect to SFAS 140, Accounting for Transfers and Servicing of Financial

Assets and Extinguishments of Liabilities, OFHEO raised questions about, among other things, (i) Fannie Mae’s policies and procedures for determining whether securities qualify as “substantially similar” to those sold under FAS 140, (ii) Fannie Mae’s monitoring of these transactions for compliance with the requirements and FAS 140, (iii) Fannie Mae’s policies and procedures regarding when it must be determined that a dollar-roll repurchase transaction has failed to occur as anticipated, and therefore has failed to qualify under FAS 140 for treated as secured financing instead of as a sale, (iv) whether Fannie Mae adequately monitors the collateral in these transactions, (v) Fannie Mae’s compliance with its policies with regard to ensuring the return of substantially similar securities, and (vi) Fannie Mae’s practice for recognizing failed deliveries under the contracts.

• With regard to SFAS 65, Accounting for Certain Mortgage Banking Activities,

OFHEO identified issues relating to Fannie Mae’s classification of loans purchased for its portfolio as either held-for-investment or held-for-sale. Specifically, a systems upgrade in 2004 identified a long-standing practice of improperly designating all loans intended to be securitized as held-for-investment. OFHEO has directed Fannie Mae to identify and properly record these loans, and


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has questioned whether Fannie Mae may treat loans acquired in the future as held-for-investment given the past systems errors.

• OFHEO has questioned whether Fannie Mae’s policies and certain transfers with

respect to the Qualified Special Purpose Entities it uses to issue mortgage-backed securities complies with Financial Interpretation No. 46 (Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin 51) and whether certain transfers have a valid business purpose.

• With respect to SFAS 149, Amendments of Statement 133 on Derivative

Instruments and Hedging Activities, OFHEO has questioned (i) the adequacy of Fannie Mae’s methodology, assumptions and documentation for applying cash flow hedge accounting to certain transactions, and (ii) whether certain transactions have been accounted for inconsistently since the inception of FAS 149 on July 1, 2003.

• OFHEO has raised questions about Fannie Mae’s practice of recognizing interest

expense on short-term debt instruments and interest income on certain liquid investments in a monthly ratable manner rather than pursuant to the contractual accrual convention, which had the effect of smoothing certain income and expense amounts. In addition, OFHEO questioned whether Fannie Mae appropriately deferred recognizing the financial impact of implementing new systems or correcting estimation methodologies.

• OFHEO has raised a number of questions about Fannie Mae’s internal controls

and systems, including questions relating to Fannie Mae’s procedures for preparing, reviewing, validating, authorizing and recording journal entries relating to amortization adjustments; reliance on software applications and systems relating to portfolio accounting that may be ill-suited or ill-equipped for their intended purposes; and controls surrounding database modifications.

• Finally, OFHEO raised additional questions about Fannie Mae’s procedures

relating to adjusting amortization factors for premiums, discounts, and other deferred purchase and guaranty fee price adjustments under SFAS 91.

VII. ADDITIONAL SCIENTER ALLEGATIONS

A. Admissions and Congressional Testimony Concerning Defendants’ Fraudulent Accounting

125. Fannie Mae admitted in its December 22, 2004 Form 8-K, that its “previously

filed interim and audited financial statements and the independent auditors’ reports thereon for

the periods from January 2001 through the second quarter of 2004 should no longer be relied


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upon because such financial statements were prepared applying accounting practices that did not

comply with generally accepted accounting principles, or GAAP,” and that it will restate its

financial statements for 2001 through mid-2004.

126. Specifically, Defendants have admitted that their methodology for performing

calculations to measure the catch-up adjustment required by SFAS 91 for balance sheet dates in

the periods 2001 through 2002 was not consistent with GAAP and that they should have

calculated the catch-up adjustment during those periods with reference to the Company’s

quarter-end position rather than its projected year-end position and recorded amounts solely

based on those quarterly calculations. Defendants also represented to the SEC that they would

initiate changes to eliminate the “precision threshold” in recognizing adjustments to the carrying

amount of its loans that the SEC determined violated SFAS 91.

127. Roger Barnes, former Manager of Financial Accounting, Deferred Assets in

Fannie Mae’s Controller Division, submitted written testimony to the United States House of

Representative Subcommittee on Capital Markets, Insurance and Government Sponsored

Enterprises for their October 6, 2004 hearing on the OFHEO Report. In this testimony, he

described in detail Defendants’ knowledge of, and active participation in or approval of, the

accounting improprieties and violations of GAAP described herein. Barnes was one of the few

employees in the Controller’s Division at Fannie Mae that was both a certified public accountant

and had an MBA. In his written testimony, Barnes said that: “[t]he atmosphere and culture,

particularly within the Controller’s Division, is one of intimidation, restraint of dissenting

opinions, and pressure to be part of the ‘Team,’ giving Chairman Franklin Raines and Vice

Chairman Tim Howard the numbers the Office of the Chairman desired to please the markets.


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Employees like myself who refused to go along with this agenda were ostracized and subjected

to retaliation.”

128. Barnes testified that Defendants implemented an Amortization Integrated

Modeling System (“AIMS”) that was meant to serve as a modeling program to determine the

cash flows and income generated by deferrals on mortgages and Fannie Mae’s MBS products.

Barnes stated that he “repeatedly advised management that it appeared that AIMS had been

designed and employed to manipulate the level of income reported by Fannie Mae in its earnings

statement and/or other public filings, which would constitute fraudulent conduct that violates

federal law.” Barnes testified that he directly brought his concerns about the AIMS design and

use to Raines and Howard in an intra-office memorandum in September 2002.

129. Barnes testified that he was among a group of Fannie Mae employees who

designed AIMS. According to Barnes, Jeffrey Juliane, another manager in the Controller’s

division, said that the purpose of AIMS was to “manage the recognition of income and expenses”

more effectively than the programs in use at the time. Barnes said that in a meeting he told

Juliane, and Janet Pennewell, the Senior Vice President for the Controller’s division, that AIMS

“would be used to manipulate the reporting of income and expenses, rather than for legitimate

accounting purposes, in violation of GAAP, in particular FAS 92.” Barnes also expressed

concern that “use of the system in that manner could cause Fannie Mae to issue materially

inaccurate financial statements.”

130. Fannie Mae nonetheless implemented the AIMS system in 2000. When Barnes

continued to raise concerns about the legitimacy of the AIMS system, Pennewell, Juliane and

Mary Lewers (director of Financial Accounting at Fannie Mae) told Barnes that AIMS was


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established “to accomplish the objective set by Spencer…and Howard, which was to reduce the

Company’s earnings volatility.”

131. Barnes further testified that:

On January 4, 2001, I participated in a meeting with Ms. Lewers, Richard Stawarz, Director of Financial Reporting, and Mr. Juliane, to discuss the effects of a recent cut in interest rates by the Federal Reserve. During this discussion, Mr. Juliane indicated that the rapid fall of rates had led senior management to consider adjusting the “on-tops” – a term the Controller’s division used to refer to manual journal entries that could be used to adjust arbitrarily the Company’s income as the books were closed each month. Senior management had stated that “on-tops” could be used to reflect a desired amount of income for December 2000, which would maintain margin and net interest income levels. Mr. Juliane added that if the Company decided not to make “on tops” adjustments, he would produce modeling runs to support the desired income results. Mr. Juliane indicated that he was prepared to generate any results desired by Ms. Spencer and Mr. Howard through the modeling process. I was extremely troubled by what was clearly improper income management and asked Mr. Juliane if management agreed with this approach, which seemed to violate GAAP. Mr. Juliane told me that the Company’s management embraced this approach. 132. On February 1, 2002, Juliane sent an email in which he stated that he adjusted net

interest income factors “to evenly recognize $75 million of additional income in 2001, which

[was] $50 million less than was originally forecasted in the plan.” According to Barnes, Juliane

said that he “adjusted the guaranty fee factors to make the Company’s actual reported income

comport with “the plan” – i.e., management’s statement of income goals for amortization

purposes.” Barnes complained to Lewers that Fannie Mae was “improperly engaging in income

management.” Lewers ignored Barnes concerns.

133. Barnes also informed Congress that on June 12, 2001, he discovered that during

the closing of Fannie Mae’s books for May 2001, management had posted a $10 million “on

tops” entry in order to increase Fannie Mae’s reported income. Barnes questioned Stawarz about

the entry and Stawarz admitted that “senior management made the “on tops” adjustments so that


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it could report more than Fannie Mae’s actual income for the month, in order to support what

management had previously set as earnings goals and margins.”

134. Barnes testified that he repeatedly attended meetings with Spencer, Lewers and

Pennewell where he raised concerns about Fannie Mae’s apparent income management through

the use of modeling and last minute entries to the Company’s books, as well as retroactive factor

changes that were applied to previously closed accounting periods. The result was that Barnes

was excluded from attending meetings with Spencer, Lewers and Pennewell.

135. On August 10, 2001 Barnes stated that he discussed his concerns with Stawarz.

Barnes told Stawarz of his concerns about the “on top adjustments and use of factor changes to

manipulate the amount of income which Barnes stated he believed violated GAAP. Stawarz

responded that “management often decided how much income they wanted to reflect before

ensuring that such results could be achieved properly.”

136. Barnes discovered, on November 6, 2001, an amortization factor change

requested by management which resulted in a $100 million increase to the Company’s interest

income. Barnes complained to Lewers that this increase demonstrated that the AIMS system

produced flawed financial results. Barnes said that the AIMS system “was designed not to

retain audit trials, making it impossible to accurately review the basis used to support the factors

generated.” Lewers again dismissed Barnes’ concerns and said that Juliane was on top of the

situation.

137. During 2002, Barnes became aware that Fannie Mae was routinely using negative

factors for discounts and premiums in order to revise current period net income. The use of

negative factors allowed management to incorrectly report income by incorporating it into the

balance sheet through accumulated amortization, thereby removing or adding income or


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expenses from the Company’s income statement, even if those amounts had already been

amortized. Barnes reported his concerns to Lewers who again dismissed his concerns

138. Barnes then discovered that Fannie Mae’s use of negative factors had caused

some of the Company’s mortgage and MBS related assets to appreciate rather than to depreciate

– a result completely inconsistent with GAAP and economic realities. He then raised further

concerns to Lewers who referred him to Juliane who disagreed with Barnes.

139. Since his managers would take no action, in September 2002, Barnes formally

raised his concerns in a written memorandum to Defendants Raines and Howard. Barnes

testified that he told Defendants Raines and Howard in this memorandum about the “serious

financial improprieties” that he had repeatedly brought to the attention of his managers. Barnes

said he specifically highlighted the following improprieties in the memorandum:

that reconciliation differences from systems were being input as future deferrals instead of current period’s income and expenses; that the Controller’s division was intentionally limiting the AIMS [amortization] system capabilities so that it would not provide audit trails for modeling; that the division had a practice of using negative factors in amortization and allowed amortization to exceed 100%; that the division routinely understated and overstated income; that the division managed income to meet the Company’s desired objectives; that the division used On Top entries in order to manage income and margin calculations; and that the Company was using a miscellaneous balance sheet account in order to manage reporting of some income in periods other than when it was received.

He also stated that there “were serious problems with the amortization of purchased discount and

premium, and that, ‘the possible impact reaches hundreds of millions of dollars and possibly

affects the integrity of the current financial statements and those we will issue after beginning

compliance with SEC reporting in 2003.’” Neither Raines nor Howard undertook any action to

investigate Barnes’ concerns or take any corrective action. Accordingly, Barnes reported the

accounting improprieties to the company’s internal Audit Division in July 2003, and submitted to

them a substantial amount of materials documenting the pervasive and systematic nature of the


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accounting abuses. The response from the Audit Division, as detailed in the OFHEO Report,

was incomplete, perfunctory, and ineffective.

140. Barnes also testified as follows with respect to an accounting manipulation by

Defendant Spencer:

On January 2, 2003, Ms. Lewers informed me that Ms. Spencer and Ms. Pennewell had decided that a more than $20 million correction to Fannie Mae’s income would not be posted because of a concern that the correction would be noticed and questioned by the Company’s Internal Audit division. Ms. Lewers indicated that the Internal Audit division might disagree with the Controller’s division’s use of “on-top” adjustments, but that the division would wait to see if Internal Audit raised questions before modifying this practice. In an effort to control the information conveyed to the internal auditors about the Company’s use of “on-top” accounts, Ms. Lewers instructed me not to volunteer any information about these adjustments, and not to discuss the “on-top” account unless specifically asked. Ms. Lewers also reminded me of Ms. Spencer’s standing instruction that lower-level staff were not to speak with the Internal Audit division under any circumstances. 141. After sending the detailed September 2002 memorandum to Raines and Howard

who took no action, Barnes again met with Stawarz in April 2003 and again raised his concerns

about Fannie Mae’s accounting practices. Barnes told Stawarz that it was “necessary to make

the Company’s management aware that several of the amortization accounting policies and

procedures were not in compliance with GAAP, and affected the accuracy of Fannie Mae’s

financial reporting.” Stawarz agreed with Barnes that Fannie Mae had significant accounting

problems but that Fannie Mae’s climate was one in which “employees actually joked about

improper income management because it was such a regular occurrence, and a climate in which

employees’ morale suffered because management offered promotions, bonuses and perks only to

employees who support management’s improper goals” so that Barnes should drop his

complaining with regard to Fannie Mae’s accounting practices.


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142. Thereafter, Barnes began an exhaustive analysis of Fannie Mae’s amortization

balances. He documented a large number of irregular unamortized balances and found numerous

amortization factor errors produced by the AIMS system. Barnes then prepared a memorandum

titled “Unamortized Balances and Factor Analysis” that summarized his findings. The

memorandum raised several concerns regarding Fannie Mae’s accounting practices including:

the inadequacy of controls and reviews of accounting process; the AIMS system’s failure to

retain audit trails; the lack of correlation between factors and loan prepayments; the inaccuracy

of Fannie Mae’s financial statements as a result of the arbitrary selection factors; the lack of

adequate check and balances for the AIMS system; the problem of on top adjustments; the

problem of deferred assets being amortized in excess of 100% or in reverse; and the fact that

improper amortization speeds were being used. Barnes provided 60 examples of factor errors to

support his conclusions. The conclusion was the Fannie Mae’s accounting was not in

compliance with GAAP.

143. On August 5, 2003 Barnes gave a copy of his “Unamortized Balances and Factor

Analysis” memorandum to Spencer, Pennewell, Lewers, Stawarz and Juliane. Barnes testified

that a meeting was convened that day with all the people to whom he gave the report and they

berated him for providing this information to Fannie Mae’s internal audit division. No one

raised the idea of that Barnes’ claims should be investigated.

B. Inadequate Controls and Accounting Oversight Support a Strong Inference of Scienter

144. Throughout the Class Period, Defendants knew, or were reckless in not knowing,

that the Company’s internal controls suffered from material weaknesses. These “weak” controls

enabled the Defendants to engage in the accounting manipulations and practices that violated


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GAAP and to provide investors with false financial statements and a false portrayal of the

Company as stable and immune to earnings volatility.

145. As described herein, Defendants knew of their responsibilities to ensure adequate

internal controls and staffing. Indeed, Defendants Raines and Howard falsely certified to the

public on numerous occasions that they had evaluated the Company’s internal controls and

disclosure policies and procedures and that they were effective.

146. An example of Defendants’ knowledge that their statements were false when

made are the representations by Defendants Howard and Spencer in the “Report of

Management” in each of Fannie Mae’s Annual Reports issued during the Class Period, that the

internal Office of Auditing was independent of the activities it reviews.” Defendant Howard

admitted to OFHEO, however, that in fact the internal auditor (Sam Rajappa) had been reporting

directly to Howard, who is in charge of all financial accounting and reporting, on a dotted line

basis from 2002 through 2004. Howard also admitted that he had participated in the annual

performance evaluation of and made compensation recommendations for Mr. Rajappa. Further,

prior to that, according to the OFHEO Report, the internal auditor had reported to the Chief

Operating Officer. This reporting structure and compensation/performance evaluation structure

clearly impaired the independence of the internal Office of Auditing and the Office of Auditing

was not independent from the activities it reviews.

147. Mr. Barnes testified before Congress that Fannie Mae is “plagued by a corporate

culture that uses threats, intimidation, and reprisal, to create an atmosphere where even those

employees with great integrity . . . who rightfully feel duty-bound to report improprieties and

irregularities . . . cannot risk doing so, fearing the retaliation that they know will follow.”


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148. Further, OFHEO found (i) “a lack of proper segregation of duties exists within the

Controller’s Department which has created an environment that is not conducive for developing

safe and sound financial reporting practices,” (ii) based on evidence reviewed during the

examination, the accounting policy development process within the Controller’s Department

lends itself to the formation of accounting policies that are aggressive in nature and which do not

comport with a strict interpretation of GAAP” and (iii) it “identified critical resource shortages

and lack of technical accounting expertise within the Controller’s Department which resulted in

key person dependencies.”

149. With respect to development and approval of accounting policy, for example,

Defendant Howard told OFHEO that Defendant Spencer, as Controller, had the responsibility

and authority for approving accounting policy and that he, as Chief Financial Officer, had

responsibility for the adopted accounting policies. Defendant Spencer relied upon Fannie Mae’s

Financial Standards Group to provide guidance on whether or not accounting policies conformed

to regulatory standards. However, Defendants Howard and Spencer admitted to OFHEO that the

amortization policy that both OFHEO and the SEC have found violated SFAS 91, was directed

by Defendant Howard with significant involvement by Defendant Spencer and other members of

the Controller’s Department, but without any input from the Financial Standards Group. Indeed,

Jonathan Boyles, Senior Vice President – Financial Standards and Tax, told OFHEO that his

department was not involved in the development or approval of the amortization policy and he

agreed that aspects of the policy on its face do not comport with GAAP.

150. With respect to accounting policies on which the Financial Standards Group was

involved, Defendant Howard told OFHEO that whenever Defendant Spencer and the Financial


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Standards Group had a difference of opinion with respect to an accounting policy

recommendation, Defendant Howard made the final decision.

151. Further, OFHEO found no evidence of any formal written procedures that govern

the development of accounting policy at Fannie Mae and, in fact, Fannie Mae did not even have

all of its critical accounting policies together in one place to be accessed by Fannie Mae

personnel.

152. OFHEO found that a wide range of functions fell within Defendant Howard’s

purview of responsibility, several of which potentially impaired his independence. For example,

as admitted by Defendant Howard, he had the authority to approve transactions related to

mortgage acquisitions and derivatives – the authority to set risk management strategies used to

develop the financial forecast – and the authority to determine how the financial transactions are

reported in the financial statements. Howard had the ability to set financial targets through his

duties as Vice Chairman, and the ability to meet the financial targets through his duties as Chief

Financial Officer. This inherent conflict of interest contradicts the public statement made by

Defendant Raines that “[t]hose entering into business transactions and accountable for business

results do not determine the accounting of those transactions.”

153. Janet Pennewell, Senior Vice President – Financial Reporting and Planning, had

responsibility for forecasting income under her business planning function, and the responsibility

for reporting income under her financial reporting function. This conflict of interest is a major

control weakness that undermines the integrity of the financial reporting process.

154. Jeffrey Juliane, Director of Financial Reporting, testified to OFHEO that he was

responsible for both modeling the purchase premium and discount amortization with respect to

SFAS 91, and recording that amortization amount to the financial statements. This dual role is


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another conflict of interest that undermines the integrity of the modeling process and the

reporting process.

155. By entering into the September 27, 2004 Agreement with OFHEO, Fannie Mae

admitted that it had engaged in improper accounting and had inadequate internal controls. There

would be no need to fix anything if it were not broken. However, the OFHEO Agreement

requires the Fannie Mae Board to make a massive overhaul of its accounting policies, internal

controls and staffing. The Agreement requires Fannie Mae to, among other things:

• Implement correct accounting treatments that will bring the Enterprise into compliance with SFAS 91 and SFAS 133 accounting standards.

• Undertake a top-to-bottom review of staff structure, responsibilities,

independence of functions, compensation and incentives. • Appoint an independent chief risk officer and separate other key business

functions currently performed jointly by certain individuals or departments. • Separate the function of business planning and forecasting from the

controller’s (Defendant Spencer’s) function. • Separate modeling and accounting functions. • Take steps to assure the independence of the internal auditor, including the

ability of the auditor to report directly to the Audit Committee or Board. • Put in place policies to assure adherence to accounting rules and new internal

controls. • Board must review accounting policies and other corporate policies to ensure

they reflect Board’s objections in complying with law and regulation and in overseeing operations of Fannie Mae.

156. Further, on December 28, 2004, the Company admitted that KPMG, the

Company’s former independent auditors, had notified the Company that there “existed strong

indicators of material weaknesses in internal control over financial reporting” at the Company.


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157. The failure to establish and implement proper internal controls, which could have

detected and prevented the improper activities and accounting gives rise to a strong inference

that the Defendants acted with scienter.

C. Defendants’ Compensation Was Tied to Defendants’ Ability to Manage Fannie Mae’s Earnings

158. In addition to their desire to meet earnings per share targets to stay in favor with

analysts and investors, Fannie Mae’s compensation structure strongly emphasized and rewarded

employees for hitting earnings per share targets, giving the Individual Defendants an additional

motive for improperly managing earnings in order to reach those targets.

159. In particular, other than base salary, all major elements of Fannie Mae’s

compensation program for the most senior executive officer group was tied to annual and long-

term performance goals. As explained in the Company’s Proxy Statements, the executive

compensation program included three key components: base salary, an annual bonus award

under the Annual Incentive Plan, and variable long-term incentive awards. Fannie Mae’s “pay

for performance” approach provided a cash payment for achieving annual financial goals and

stock-based awards for medium and long-term performance.

160. Under the Annual Incentive Plan bonus program, the Board established financial

goals measured by earnings per share growth at the beginning of each year during the Class

Period and achievement against those goals determined the funding of the bonus pool from

which the actual bonuses were paid.

161. The variable long-term incentive awards were delivered in the form of stock

options and performance shares or restricted stock. Officers at the senior Vice-President level

and above received half of the value of their annual variable long-term incentive award in the

form of performance shares and half in the form of stock options. Performance shares were paid


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based upon financial goals tied to the growth in earnings per share and non-financial goals tied to

Fannie Mae’s strategic plan. The earnings per share goals and strategic goals were given equal

rating (i.e. 50% each) in determining award payout. Incentive awards were determined on a

three-year cycle. In its 2002 Proxy Statement, Fannie Mae reported that for the three-year cycle

from January 1999 through December 2001, maximum payouts of the award opportunity range

were achieved based on targets for growth in earnings per share and the Compensation

Committee’s rating of corporate performance in strategic areas, i.e. risk management, housing

impact, delivery of value through technology and customer relationships, preserving Fannie

Mae’s franchise and work force development. In addition, because of the Company’s purported

extraordinary performance during 2001, the Board approved a special award to each of the

Company’s employees in the form of shares of common stock of the Company.

162. According to the Company’s Proxy Statements and other public sources, the

salary, Annual Incentive Plan bonuses, performance shares, options and other compensation and

benefits paid by Fannie Mae to the Individual Defendants for 2000 – 2003 is as follows:

Annual Compensation Long Term Compensation

Name Year Cash Base

Salary

Annual Incentive

Plan Bonus Other Comp.

Total Annual Comp.

Total Comp. % of Cash Base

Salary

Stock Option Awards

LTIP Payouts(Value of

Performance Shares)

Franklin Raines 2003 $992,250 $4,180,365 $237,246 $5,409,861 18.34% 135,200 $11,621,280 2002 $992,250 $3,300,000 $163,923 $4,456,173 22.27% 311,731 $7,233,679 2001 $992,250 $3,125,650 $3,085 $4,120,985 24.08% 277,335 $6,803,068 2000 $992,250 $2,480,625 $2,907 $3,475,782 28.55% 421,358 $4,588,616 Timothy Howard 2003 $645,865 $1,176,145 $858 $1,822,868 35.43% 112,968 $3,470,578 2002 $498,614 $781,250 $1,169 $1,281,033 38.92% 81,661 $1,947,368 2001 $463,315 $694,983 $1,103 $1,159,401 39.96% 75,617 $1,987,119 2000 $435,540 $544,425 $1,126 $981,091 44.39% 129,142 $2,088,542 Leanne Spencer 2003 N/A N/A N/A N/A N/A N/A N/A 2002 $260,000 $330,000 $1,383,714 18,479 $396,017 2001 N/A N/A N/A N/A N/A N/A N/A


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163. According to a report in the October 8, 2004 edition of Inside Mortgage Finance,

the following total compensation packages were paid by Fannie Mae for the year ending

December 31, 2002, for the top five executives:

Executive Officer Total Compensation

% of Compensation Based Upon EPS and Stock Performance

Frank Raines $17,732,657 91% Daniel Mudd $ 5,156,717 87% Timothy Howard $ 4,499,621 67% Robert Levin $ 4,162,106 89% Thomas Donilon $ 4,270,352 90%

On average, 85% of the total compensation package of the top five executives was related to

earnings per share and the performance of the common stock of Fannie Mae.

164. In addition to the five executives noted above, four other executives had total

compensation packages in 2002 in excess of $3 million, with an average of 80% of that

compensation tied to earnings per share or stock performance. In addition, eleven other

executives had compensation in 2002 in excess of $1 million, with 75% tied to earnings per

share or common stock performance.

165. Base salaries averaging approximately $400,000 were paid to these 20 executives,

but the total compensation paid to these executives was $69,555,933.

166. In its 2000 Proxy Statement, dated April 2, 2001, the Company touted that the

“corporation’s earnings per share (EPS) increased by over 15 percent for the second year in a

row…. These results kept Fannie Mae ahead of schedule to achieve its aggressive goal set in

1999 to double EPS by the end of 2003.”2 Moreover, it stated that “Fannie Mae achieved its

fourteenth consecutive year of record earnings and established new records of financial

performance by once again achieving the double-digit operating earnings per share growth that


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the corporation has posted for over a decade, a record only four other companies in the S&P have

the possibility of matching.”

167. The Company’s 2000 Proxy Statement further revealed that because the Company

attained these EPS goals in 2000, the Individual Defendants benefited as follows:

• Because the EPS goal was achieved, the maximum payouts of the award opportunity range were reached under the Annual Incentive Plan.3

• Approximately 75% of each executive vice president’s annual bonus was

based on corporate performance and 25% was based on the individual contributions to the year’s results.4

• The Board approved a special grant called the “Earnings Per Share Challenge

Option Grants.”5 The purpose of this special grant was to “serve as an incentive to all employees to double the corporation’s earnings per share.” The EPS Challenge Options become exercisable in January 2004 if EPS equals or exceeds $6.46 per share by December 31, 2003. Even if the EPS goal is not met, the options will become exercisable in 25% annual increments beginning in January of each of the next four years.6

168. The Company’s 2001 Proxy Statement, dated April 2, 2002, revealed that,

because the Company attained these EPS goals in 2001, the Individual Defendants benefited as

follows:

• Because the EPS goal was achieved, the maximum payouts of the award opportunity range were achieved under the Annual Incentive Plan.7

• Maximum payouts of the award opportunity range were achieved for the

three-year Performance Share cycle that concluded in 2001 based on targets for growth in EPS and the Compensation Committee’s rating of corporate performance in strategic areas.

• Under the 2000 Earnings Per Share Challenge Option Grants, Raines

received 213,548 shares and Howard received 56,572 shares.8

2 Fannie Mae 2000 Proxy statement, at p.10-11. 3 Fannie Mae 2000 Proxy statement, at p.11; 2001 Proxy statement, at p.11. 4 Fannie Mae 2000 Proxy statement, at p.10. 5 Fannie Mae 2000 Proxy statement, at p.17. 6 Fannie Mae 2000 Proxy statement, at p.17. 7 Fannie Mae 2001 Proxy statement, at p.11. 8 Fannie Mae 2001 Proxy statement, at p.17.


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• The Board approved the “2001 Special Award” under the Annual Incentive

Plan. “During 2001, the corporation’s performance exceeded the highest corporate goal established by the Compensation Committee under the Annual Incentive Plan. In light of this extraordinary performance, the Board of Directors approved a 2001 Special Award for all regular full-time and part-time employees of the corporation. All officers received their special award in the form of shares of Fannie Mae common stock, while the others received their special award in cash.”9

• Under the 2001 Special Award program, Raines received $520,994 in shares

and Howard received $115,839.10

169. According to the Company’s 2002 Proxy Statement, “[f]or 2002, the corporate

financial goal was an aggressive earnings per share (“EPS”) growth measure that Fannie Mae

exceeded.”11

170. The Company’s 2003 Proxy Statement touted, under the CEO’s 2003

achievements section, that “core business earnings per share grew more than 15 percent,

producing Fannie Mae’s 17th consecutive year of double-digit growth.” (Emphasis added.)

171. The manipulation of Fannie Mae’s financial results enabled the Individual

Defendants to receive some of the largest compensation packages offered to executive officers

anywhere. For instance, the August 23, 2004 GSE Report noted that Raines was “one of the

most highly compensated chief executives in America” and that, in 2003, his total compensation

was over $20 million, in contrast to median compensation of $6.2 million for CEOs in America’s

largest companies.12 The GSE Report further stated that Raines was the fifth highest paid

executive in the Washington D.C. area in 2003, receiving $5.3 million in cash compensation in

2003.13

9 Fannie Mae 2001 Proxy statement, at p.11. 10 Fannie Mae 2001 Proxy statement, at p.14. 11 Fannie Mae 2002 Proxy, dated April 14, 2003, at p.17. 12 GSE Report May 24, 2004, at p.20. 13 GSE Report August 23, 2004, at p.16.


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172. OFHEO has already found that the Individual Defendants took accounting actions

for the purpose of increasing their compensation. For example, in the OFHEO Report, OFHEO

concluded that the Individual Defendants inappropriately deferred $200 million of estimated

amortization expense in 1998. This deferral allowed the payment of about $27 million in

bonuses when no bonuses would have been paid without the deferral.

173. Given that a substantial portion of their compensation depended upon the

Company meeting established earnings per share targets during the Class Period, the Individual

Defendants had a strong motive to manipulate the earnings per share numbers each quarter to

meet those targets.

D. Individual Defendants’ Insider Trading

174. In addition to the substantial compensation that the Individual Defendants

received during the Class Period from Fannie Mae as a result of their fraud, they also benefited

significantly from their sales of Fannie Mae common stock at artificially inflated prices during

the Class Period. The Individual Defendants made these sales while they were in possession of

the undisclosed material adverse information about Fannie Mae as described herein.

175. The Individual Defendants began publicly reporting their sales of Fannie Mae

common stock in April 2002. Without taking into account any sales the Individual Defendants

may have made during the first year of the Class Period, from April 2002 until the end of the

Class Period, the Individual Defendants sold Fannie Mae common stock for proceeds totaling

over $23 million.

176. Defendant Raines garnered proceeds of over $6.88 million from his sales of

Fannie Mae stock during this year and a half period, as follows:


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FRANKLIN D. RAINES SALES OF FANNIE MAE COMMON STOCK

Transaction Date Shares Sold Sale Price Gross Sales Proceeds 1/8/03 18,624 $68.685 $1,279,189.44 1/21/03 20,908 $69.43 $1,451,642.44 1/5/04 29,664 $74.495 $2,209,819.68 1/23/04 24,874 $78.315 $1,948,007.31 Totals: 94,070 $6,888,658.87

177. Defendant Howard sold thousands of shares that he owned directly or indirectly

during the Class Period for proceeds totaling over $13.7 million, as follows:

TIMOTHY HOWARD SALES OF FANNIE MAE COMMON STOCK

Transaction Date Shares Sold Sale Price Gross Sales Proceeds 5/16/02 20,000 $80.51 $1,610,200 1/8/03 4,624 $68.685 $317,599.44 1/15/03 470 $69.285 $32,563.95 1/21/03 5,019 $69.43 $348,469.17 5/13/03 10,000 $73.00 $730,000 5/15/03 13,000 $73.40 $954,200 5/15/03 2,000 $73.42 $146,840 11/13/03 300 $69.57 $20,871 11/13/03 4,400 $69.55 $306,020 11/13/03 200 $69.54 $13,908 11/13/03 500 $69.46 $34,730 11/13/03 7,700 $69.45 $534,765 11/13/03 1,000 $69.43 $69,430 11/13/03 500 $69.42 $34,710 11/13/03 2,400 $69.41 $166,584 11/13/30 4,900 $69.40 $340,060 11/13/03 700 $69.39 $48,573 11/13/03 400 $69.38 $27,752 11/13/03 3,200 $69.37 $221,984 1/5/04 6,829 $74.495 $508,726.35 1/23/04 7,825 $78.315 $612,814.87 3/17/04 500* $75.73 $37,865 3/17/04 3,000* $75.75 $227,250 3/18/04 200* $74.63 $14,926 3/18/04 100* $74.62 $7,462 3/18/04 100* $74.68 $7,468


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Transaction Date Shares Sold Sale Price Gross Sales Proceeds 3/18/04 100* $74.67 $7,467 3/18/04 100* $74.65 $7,465 3/18/04 100* $74.70 $7,470 3/18/04 100* $74.75 $7,475 3/18/04 100* $74.55 $7,455 3/18/04 100* $74.57 $7,457 3/18/04 300* $74.59 $22,377 3/18/04 200* $74.54 $14,908 3/18/04 100* $75.20 $7,520 3/18/04 100* $75.26 $7,526 3/18/04 100* $75.25 $7,525 3/18/04 100* $75.21 $7,521 3/18/04 100* $75.22 $7,522 3/18/04 100* $75.32 $7,532 3/18/04 100* $75.34 $7,534 3/18/04 200* $75.35 $15,070 3/18/04 200* $75.30 $15,060 3/18/04 100* $74.88 $7,488 3/18/04 100* $75.05 $7,505 3/18/04 100* $75.00 $7,500 3/18/04 100* $75.19 $7,519 3/18/04 100* $75.13 $7,513 3/18/04 100* $75.14 $7,514 3/18/04 100* $74.61 $7,461 3/18/04 100* $74.79 $7,479 3/18/04 100* $74.66 $7,466 3/31/04 100* $74.64 $7,464 3/31/04 100* $74.60 $7,460 3/31/04 100* $74.66 $7,466 3/31/04 100* $74.70 $7,470 3/31/04 100* $74.77 $7,477 3/31/04 200* $74.48 $14,896 3/31/04 200* $74.49 $14,898 3/31/04 300* $74.40 $22,320 3/31/04 100* $74.46 $7,446 3/31/04 100* $74.47 $7,447 3/31/04 100* $74.56 $7,456 3/31/04 200* $74.50 $14,900 3/31/04 200* $74.53 $14,906 3/31/04 100* $74.55 $7,455 3/31/04 100* $75.23 $7,523 3/31/04 200* $74.36 $14,872 3/31/04 400* $74.39 $29,756 3/31/04 200* $74.34 $14,868


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Transaction Date Shares Sold Sale Price Gross Sales Proceeds 9/16/04 100* $76.48 $7,648 9/16/04 100* $76.44 $7,644 9/16/04 200* $76.46 $15,292 9/16/04 100* $76.41 $7,641 9/16/04 500* $76.59 $38,295 9/16/04 500* $76.56 $38,280 9/16/04 100* $76.55 $7,655 9/16/04 100* $76.52 $7,652 9/16/04 400* $76.50 $30,600 9/16/04 100* $76.54 $7,654 9/16/04 100* $76.29 $7,629 9/29/04 100* $66.67 $6,667 9/29/04 100* $66.66 $6,666 9/29/04 300* $66.40 $19,920 9/29/04 200* $66.44 $13,288 9/29/04 100* $66.41 $6,641 9/29/04 300* $66.50 $19,950 9/29/04 200* $66.55 $13,310 9/29/04 200* $66.58 $13,316 9/29/04 100* $66.59 $6,659 9/29/04 100* $66.26 $6,626 9/29/04 100* $66.30 $6,630 9/29/04 200* $66.45 $13,290 9/29/04 200* $66.31 $13,262 9/29/04 100* $66.33 $6,633 9/29/04 200* $66.37 $13,274 9/29/04 300* $66.34 $19,902 9/29/04 100* $66.32 $6,632 9/29/04 100* $66.35 $6,635 9/29/04 300* $66.36 $19,908 9/29/04 100* $66.38 $6,638 9/29/04 100* $66.96 $6,696 9/30/04 3,500* $63.29 $221,515 10/07/04 100* $68.77 $6,877 10/07/04 100* $67.75 $6,775 10/07/04 200* $68.41 $13,682 10/07/04 100* $68.40 $6,840 10/07/04 100* $68.50 $6,850 10/07/04 100* $68.55 $6,855 10/07/04 100* $68.25 $6,825 10/07/04 100* $68.39 $6,839 10/07/04 100* $68.82 $6,882 10/07/04 200* $69.00 $13,800 10/07/04 200* $68.90 $13,780


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Transaction Date Shares Sold Sale Price Gross Sales Proceeds 10/07/04 100* $68.95 $6,895 10/07/04 100* $68.15 $6,815 10/07/04 100* $68.11 $6,811 10/07/04 100* $67.93 $6,793 Totals: 188,767 $13,700,609.78

*Sales made pursuant to a written stock-trading plan.

178. Defendant Spencer gained proceeds of over $2.6 million from her sales of Fannie

Mae common stock during the Class Period, as follows:

LEANNE G. SPENCER SALES OF FANNIE MAE COMMON STOCK

Transaction Date Shares Sold Sale Price Gross Sales Proceeds 5/17/02 3,200 $80.12 $256,384.00 5/17/02 6,800 $80.06 $544,408.00 5/20/02 206 $80.06 $ 16,492.36 1/8/03 429 $68.685 $ 29,465.86 1/21/03 1,044 $69.43 $ 72,484.92 4/23/03 8,900 $73.26 $652,014.00 4/23/03 500 $73.38 $ 36,690.00 5/19/03 206 $73.905 $ 15,224.43 1/5/04 1,452 $74.495 $108,166.74 1/23/04 1,230 $78.315 $ 96,327.45 1/27/04 3,000 $79.00 $237,000.00 2/19/04 6,200 $79.66 $493,892.00 2/19/04 600 $79.73 $ 47,838.00 5/18/04 194 $68.60 $ 13,308.40 Totals: 33,961 $2,619,696.16

179. Notably, many of these sales occurred right after Defendants announced another

quarter of “record” earnings and “double-digit earnings per share.” For example, the Company

publicly announced its fourth quarter and 2002 year-end results on January 15, 2003. In January

2003, shortly after this earnings release, Defendant Raines sold 39,532 shares for proceeds of

$2.7 million; Defendant Howard sold 5,489 shares for proceeds of $381,033; and Defendant

Spencer sold 4,230 shares for proceeds of $730,892.


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180. Regulators also questioned the timing of Howard’s 2004 trades.14 According to

the September 7, 2004 GSE Report, Howard sold nearly $5 million of Fannie Mae’s stock by

exercising and selling 70,000 options in 2004. In the GSE Report on October 4, 2004, a section

titled “Will insider sales of Fannie Mae stock withstand scrutiny?” stated that just days before

the OFHEO Report was disclosed, Howard “locked in more than $400,000 of his gains in

automatic sales.” In a Wall Street Journal article, Kevin Schwenger, insider-transaction analyst

for Thomson Financial Inc., commented that Howard sold between 84,000-92,800 options in

2004.15 In response, a Fannie Mae spokesperson stated it was a “coincidence” that Howard

initiated the transactions after government regulators began their probe but before the release of

the OFHEO Report.16

VIII. FALSE AND MISLEADING STATEMENTS DURING CLASS PERIOD

181. Throughout the Class Period, Defendants knowingly or recklessly made

materially false and misleading statements concerning, among other things, the Company’s

earnings, financial results, compliance with GAAP, risk management policies and internal

controls. The Defendants’ misrepresentations and material omissions caused the Company’s

common stock price to become and remain artificially inflated throughout the Class Period,

causing harm and damages to Lead Plaintiffs and the other Class members.

A. Statements Concerning Fiscal Year 2001

182. The Class Period begins on April 17, 2001. On that day, Fannie Mae issued a

press release in which it announced its financial results for the first quarter ending March 31,

2001, under the headline: "Fannie Mae Reports Record First Quarter 2001 Financial Results;

14 GSE Report October 4, 2004, at p. 33-34. 15 According to the article, the options were slated to expire in November 2004. 16 Kathleen Day, Finance Chief Wields Broad Influence; Howard Has Not Been Timid in Exercising Clout at Fannie Mae, Regulator Says, The Washington Post, Sept. 24, 2004, at E4.


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Operating Net Income of $1.238 Billion Up 16.6 Percent Over First Quarter 2000; Operating

Earnings Per Diluted Common Share of $1.20 Up 17.6 Percent," which stated, in pertinent part,

as follows:

Fannie Mae (FNM/NYSE), the nation’s largest source of financing for home mortgages, today reported operating net income for the first quarter of 2001 of $1.238 billion, a 16.6 percent increase compared with the first quarter of 2000. Operating earnings per diluted common share (Operating EPS) of $1.20 were 17.6 percent above the same period in 2000.

First Quarter 2001 2000 Change

Operating Net Income (in billions) $1.238 $1.062 16.6% Operating EPS (in dollars) $1.20 $1.02 17.6%

Operating net income and earnings per share exclude the one-time cumulative change in accounting principle and the quarter-to-quarter variability in the market value of purchased options which Financial Accounting Standard 133 (FAS 133) now requires to be included in the income statement. Net income and earnings per diluted common share (EPS) for the first quarter of 2001 including these FAS 133 items were $1.293 billion and $1.25, respectively.

Franklin D. Raines, Fannie Mae’s Chairman and Chief Executive Officer, said, "At a time when many companies are reporting disappointing results, Fannie Mae continues to meet or exceed performance expectations." . . . (Emphasis added.) . . . Raines added that Fannie Mae's revenues grew by over 20 percent compared with the first quarter of 2000, nearly double the growth rate of the company's operating costs over the same period.

* * * Portfolio Investment Business Results

Fannie Mae's portfolio investment business manages the interest rate risk of the company's mortgage portfolio and other investments. The results of this business are largely reflected in net interest income, which in the first quarter of 2001 totaled $1,707 million. Prior to the adoption of FAS 133, net interest income included the amortization expense of purchased options, which was $64.1 million in the first quarter of 2001. This cost now appears in the new "purchased options expense" line item, together with the changes to the market value of these options.

Under FAS 133 adjusted net interest income, which is net interest income less purchased options amortization expense, becomes the more meaningful measure


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of portfolio revenue and is comparable with prior periods. Fannie Mae's adjusted net interest income of $1,643 million in the first quarter of 2001 was 20.6 percent above the first quarter of 2000. This increase was driven by an 18.5 percent rise in the average net investment balance and a one basis point increase in the net interest margin.

. . . The company's average net interest margin was 103 basis points in the first quarter of 2001, up one basis point from the 102 basis point average in the first quarter of 2000.

* * * Capital Fannie Mae's core capital was $21.5 billion at March 31, 2001 compared with $18.6 billion at March 31, 2000. During the first quarter of 2001 Fannie Mae repurchased 1.0 million shares of common stock. Fannie Mae had 1,000.3 million shares of common stock outstanding as of March 31, 2001 compared with 1,007.4 million shares as of March 31, 2000.

* * * Implementation of FAS 133

Fannie Mae adopted FAS 133, Accounting for Derivative Instruments and Hedging Activities, on January 1, 2001. FAS 133 requires that Fannie Mae mark to market only its purchased options and none of its option-based debt or the mortgage investments it hedges with purchased options. At adoption, the mark-to-market of the time value of the purchased options that the company uses as a substitute for callable debt resulted in a cumulative gain of $258.3 million, or $167.9 million after tax. The change in the market value of Fannie Mae's purchased options during the first quarter of 2001 was a loss of $237.6 million. This amount includes $64.1 million in option cost amortization that formerly was included in net interest income. FAS 133 also requires that the company record certain derivatives, primarily interest rate swaps it uses as substitutes for non-callable debt, on the balance sheet at their fair values, with an offsetting entry recorded in a separate component of stockholders' equity called other comprehensive income. At implementation on January 1, 2001, Fannie Mae recorded a $3.9 billion reduction in the other comprehensive income component of stockholders' equity. This amount was a reduction of $5.7 billion, or 0.9 percent of the net mortgage balance, at March 31, 2001. Other comprehensive income is not a component of core capital. At March 31, 2001 Fannie Mae's core capital was $21.5 billion. 183. In a written statement submitted to the Senate Subcommittee on Housing and

Transportation, Senate Committee on Banking, and Urban Affairs on May 8, 2001, Defendant

Raines stated:


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Last October we announced a set of path breaking voluntary initiatives to further strengthen our safety and soundness. Our liquidity management, market discipline, and disclosure practices are now at the vanguard of such practices globally, and we and Freddie Mac are the only U.S. corporations to commit to creating a deep and liquid market for our subordinated debt. (Emphasis added.)

* * * Safety and Soundness

Because Fannie Mae and Freddie Mac play a critical role in providing consumers access to the long-term, fixed-rate financing they prefer, it is essential that the two companies remain at the forefront of global safety and soundness practices.

In 2000, we recognized that there were additional measures we could put in place that would assure policymakers that our safety and soundness protections are at the forefront of evolving world practices. To formulate these measures we turned to the experts: the reports and studies of the Basel Committee on Banking Supervision, OFHEO, the Federal Reserve, and other policymakers and market participants who analyze risk in the financial markets.

After a comprehensive review of these recommendations, Fannie Mae and Freddie Mac, in conjunction with policymakers, crafted a set of initiatives designed to place the two companies at the leading edge of safety and soundness practices. These commitments were announced with Congressman Richard Baker, Congressman Paul Kanjorski, and other Members of the House of Representatives last October. Fannie Mae committed to issue subordinated debt, obtain an annual credit rating, enhance our liquidity planning, disclose more information about interest rate risk and credit risk sensitivity, and implement and disclose the results of an interim risk-based capital standard. Together, these initiatives will give investors and policymakers more information about Fannie Mae's risk exposure and confidence that Fannie Mae can manage that exposure than they can get from any other financial institution. I am happy to announce that Fannie Mae has implemented all six of these commitments. These six new voluntary measures, combined with the regulatory mechanisms Congress enacted in 1992, place Fannie Mae at the vanguard of risk management and disclosure practices worldwide, with cutting-edge regulatory discipline bolstered by cutting-edge market discipline. (Emphasis added.)

This statement was posted on Fannie Mae’s website for investors to review. 184. In remarks delivered to the Sanford Bernstein Strategic Investors Conference on

June 7, 2001, Defendant Raines disclosed his intimate knowledge of the hedge transactions


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engaged in by Fannie Mae, Fannie Mae’s related disclosure policies and Fannie Mae’s obsessive

focus on earnings per share growth, when stating:

As mortgages become more complex, we've had to become increasingly sophisticated in the way we design and execute our hedges in order to maintain the right balance between our assets and liabilities -- the right duration gap -- even as interest rates move and try to upset the balance.

As most portfolio managers know, you don't run a perfectly matched book -- if you did, there would be no money in it. What we try to do is keep the cash flow -- or duration match -- fairly close, between plus or minus six months. As interest rates move, the duration gap also moves. We move it back in line through our mix of funding and the options we purchase. As you can see, that's what happened in late 1998 and early 1999 as interest rates kept rising. We were able to rebalance our portfolio and bring the duration gap back into our comfort zone.

* * * Our single, obsessive focus on risk management -- both in our portfolio business and our credit guaranty business -- explains why Fannie Mae has done so well, 14 years straight, through many different risk environments. (Emphasis added.)

* * * Last year, these questions were raised about Fannie Mae. I believe we resolved them. We resolved them by adopting a series of voluntary initiatives that matched our government regulation with some market-focused discipline and supplemental capital.

Now, with our risk-based standard, our risk disclosures, our regular issues of subordinated debt, our external ratings and other measures, Fannie Mae is now regarded as a new global model for financial institution safety and soundness. We've taken a legitimate policy issue off the table for us in a legitimate way.

* * * Fannie Mae is one of only five companies in America with record, double-digit operating earnings growth for the last 14 consecutive years, 53 consecutive quarters, greatly exceeding the growth rate of the S&P 500 during this period. We've also made great progress against my EPS challenge. In 1999, we re-committed that Fannie Mae would deliver earnings growth of over 10 percent per year. We set an expectation to continue our earnings growth rate of the previous five years of 13.6 percent per year. And our goal was to double earnings over a five-year period, or a 14.9 percent growth per year. We're off to a rousing start. We posted 15.2 percent growth in 1999, 15.3 percent growth in 2000, and 17.6 percent growth in the first quarter of this year. Our relative P/E is also doing better. Back in 1987, we had almost a 60 percent discount. We've been making progress bringing that in line with our value. We slowed down a little in 1999 because of the technology rally and the political noise, but we're now down to


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about 30 percent discount. Obviously, we think there should be no discount, since our earnings are anything but volatile, and our performance is significantly better than the S&P average. Our view is, with our steady earnings record, our stock can bring value to every portfolio, even the most aggressive.

These remarks were posted on Fannie Mae’s website for investors to review.

185. On July 17, 2001, Fannie Mae issued a news release in which it announced its

financial results for the second quarter ended June 30, 2001, under the headline: Fannie Mae

Reports Record Second Quarter 2001 Financial Results; Operating Net Income of $1.314 Billion

up 19.8 Percent over Second Quarter 2000; Operating Earnings Per Diluted Common Share of

$1.27 up 21.0 Percent,” which stated, in pertinent part:

Fannie Mae (FNM/NYSE), the nation’s largest source of financing for home mortgages, today reported operating net income for the second quarter of 2001 of $1.314 billion, or $1.27 per diluted common share. Operating net income was 19.8 percent above the second quarter of 2000, while operating earnings per diluted common share (operating EPS) rose 21.0 percent over the same period. For the first six months of 2001 Fannie Mae’s operating net income was $2.553 billion, or $2.47 per diluted common share, compared with $2.159 billion, or $2.08 per diluted common share, for the same period in 2000. Fannie Mae’s operating EPS for the first six months of 2001 were 18.8 percent above the first six months of 2000.

Operating Net $1.314 $1.097 19.8% $2.553 $2.159 18.2%

Income (in billions)

Operating EPS $1.27 $1.05 21.0% $2.47 $2.08 18.8% (in dollars)

Operating net income and earnings per common share exclude the variability in the market value of purchased options and the one-time cumulative change in accounting principle which resulted from the implementation of Financial Accounting Standard 133 (FAS 133) on January 1, 2001. Net income and EPS for the second quarter of 2001, including FAS 133 market value changes, were $1.402 billion and $1.36, respectively. Net income and EPS for the six months

Second Quarter Six Months Ended June 30

2001 2000 Change 2001 2000 Change


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ended June 30, 2001 including FAS 133 items were $2.696 billion and $2.61, respectively.

* * * Raines said that Fannie Mae's combined book of business - its net mortgage portfolio and outstanding mortgage-backed securities - grew at a 22.3 percent annual rate during the second quarter. At the same time, Raines noted, a rising net interest margin contributed to taxable-equivalent revenue growth of over 29 percent compared with the second quarter of 2000. Finally, Raines added, in spite of the slowing economy the company's credit losses fell to a 17-year quarterly low of $16.2 million. Said Raines, "With very strong business and revenue growth and well contained credit losses, Fannie Mae is extremely well-positioned to continue to play a critical role in providing mortgage credit to the economy, while extending our enviable record of superior financial performance." (Emphasis added.)

* * * Portfolio Investment Business Results

Fannie Mae's portfolio investment business manages the interest rate risk of the company's mortgage portfolio and other investments. The results of this business are largely reflected in adjusted net interest income, which is net interest income less the amortization of purchased options expense. That amortization, which prior to the adoption of FAS 133 was included in net interest income, is now included in the "purchased options income (expense)" line item, along with changes to the market value of these options. The amortization cost of purchased options was $100.1 million in the second quarter of 2001 and $164.2 million year-to-date.

Fannie Mae's adjusted net interest income of $1.799 billion in the second quarter of 2001 was 28.6 percent above the second quarter of 2000. This increase was driven by a 19.6 percent rise in the average net investment balance and a seven basis point increase in the average net interest margin. Adjusted net interest income for the first six months of 2001 was $3.443 billion, up 24.7 percent from $2.761 billion during the comparable period in 2000.

* * * The company's average net interest margin was 109 basis points in the second quarter of 2001 compared with 102 basis points in the second quarter of 2000 and 103 basis points in the first quarter of 2001. . . . The company's interest margin declined from a high of 111 basis points in April to 106 basis points in June as liquidations increased during the second quarter and the company rebuilt the amount of option-based debt in its liability base.

* * * Capital Fannie Mae's core capital was $23.0 billion at June 30, 2001 compared with $21.5 billion at March 31, 2001 and $19.0 billion at June 30, 2000.


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* * * FAS 133 Fannie Mae adopted Financial Accounting Standard No. 133 (FAS 133), Accounting for Derivative Instruments and Hedging Activities, on January 1, 2001. FAS 133 requires that Fannie Mae mark to market only its purchased options and none of its option-based debt or the mortgage investments it hedges with purchased options. At adoption, the mark-to-market of the time value of the purchased options that the company uses as a substitute for callable debt resulted in a cumulative gain of $258.3 million, or $167.9 million after tax. The change in the market value of Fannie Mae's purchased options during the second quarter of 2001 was a net gain of $35.4 million. This amount includes $100.1 million in option cost amortization that formerly was included in net interest income.

FAS 133 also requires that the company record certain derivatives, primarily interest rate swaps it uses as substitutes for non-callable debt, on the balance sheet at their fair values, with an offsetting entry recorded in a separate component of stockholders' equity called other comprehensive income, or OCI. At June 30, 2001, the OCI component of stockholders' equity included a $3.7 billion reduction, or 0.6 percent of the net mortgage balance. The comparable reduction to OCI was $5.7 billion at March 31, 2001. Other comprehensive income is not a component of core capital.

* * *

Voluntary Disclosures As part of Fannie Mae's voluntary market discipline, liquidity and safety and soundness initiatives of October 19, 2000, the company now discloses on a quarterly basis its liquid assets as a percent of total assets, the sensitivity of its future credit losses to an immediate five percent decline in home prices, and whether it has passed or failed an internal interim version of the risk-based capital stress test based on its interpretation of the Federal Housing Enterprises Financial Safety and Soundness Act of 1992. At June 30, 2001 Fannie Mae's ratio of liquid assets to total assets was 8.0 percent, compared with 6.4 percent at March 31, 2001. The company has committed to maintain a portfolio of high-quality, liquid, non-mortgage securities equal to at least five percent of total assets.

* * * At March 31, 2001 the company passed its internal interim risk-based capital test with a capital cushion that exceeded 30 percent of total capital. At December 31, 2000 Fannie Mae passed its risk-based capital test with a cushion of between 10 and 30 percent of total capital. The company intends to manage its risks so that the cushion between total capital and internally calculated risk-based capital is at least 10 percent of total capital.


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186. In remarks delivered to the Bank of America Securities Conference on September

11, 2001, Defendant Raines again boasted of Fannie Mae’s earnings per share growth, safety and

soundness protections and financial disclosures, stating:

For the past 15 years, Fannie Mae has delivered double-digit operating EPS growth to our shareholders.

* * * Over the past two years, I've spent time answering the first question -- that our business model is quite viable -- by showing how we've grown our top-line revenues, outperformed all but four other top companies in the S&P 500, and kept on the path to achieve the five-year goal I set of doubling our EPS by 2003. On the second question, Fannie Mae has laid to rest questions about key policy and regulatory issues by adopting voluntary initiatives making us the world leader in financial institution safety and soundness protections, financial disclosure and risk-based capital. Our regime in many cases is ahead of what the new Basel Accord proposes for other large financial institutions. (Emphasis added.)

* * *

We’ve had similar success with our portfolio business, which involves managing interest rate risk. In this business, Fannie Mae purchases whole loans and mortgage-backed securities with the proceeds of the debt securities we sell to investors. We earn a return from the difference between the yield of the mortgages in our portfolio, and the cost of the debt that funds those mortgages. We manage the interest-rate risk of our portfolio by carefully balancing the maturity and optionality of the mortgages we buy with the debt instruments we issue.

As most portfolio manages know, the goal of a debt-funded mortgage portfolio is to earn a competitive rate of return for incurring and managing mortgage prepayment risk. You don’t try to run a perfectly matched book because that would not produce income. Instead we try to keep our cash flow – or duration – match fairly close, between plus or minus six months. As interest rates move, our duration gap also moves. But the gap doesn’t move that much, and when it does move we are able to bring it back in line by changing our mix of funding and the options we purchase. You can see how this worked in late 1998 and early 1999.

* * * Over the past five years as mortgage debt outstanding grew by 8.2 percent, our operating earnings per share grew by 14.8 percent, or more than 6 percent faster. In any one year, the smallest differential was about 4 percent.


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Our EPS grew faster than the market for the following reasons. First, our total book of business grew 3.2 percent faster than the market. Secondly, growing our mortgage portfolio faster than our book of business added another 3.0 percent to our EPS growth. And while a decline in our business margins took 1.1 percent from EPS growth, we gained 1.5 percent through corporate actions such as share repurchases and other activities.

These remarks were posted on Fannie Mae’s website for investors to review.

187. On October 15, 2001, Fannie Mae issued a press release announcing its financial

results for the third quarter ending September 30, 2001, under the headline: "Fannie Mae Reports

Record Third Quarter 2001 Financial Results; Operating Net Income of $1.377 Billion up 22.5

Percent over Third Quarter 2000; Operating Earnings Per Diluted Common Share of $1.33 up

22.0 Percent," in which it stated, in pertinent part:

Fannie Mae (FNM/NYSE), the nation's largest source of financing for home mortgages, today reported operating net income for the third quarter of 2001 of $1.377 billion, or $1.33 per diluted common share. Operating net income was 22.5 percent above the third quarter of 2000, while operating earnings per diluted common share rose 22.0 percent over the same period. For the first nine months of 2001 Fannie Mae's operating net income was $3.929 billion, or $3.80 per diluted common share, compared with $3.283 billion, or $3.16 per diluted common share, for the same period in 2000. Fannie Mae's operating EPS for the first nine months of 2001 were 20.3 percent above the first nine months of 2000.

Operating net income and operating earnings per common share exclude the variability in the market value of purchased options and the one-time cumulative change in accounting principle which resulted from the implementation of Financial Accounting Standard 133 (FAS 133) on January 1, 2001. Net income and EPS for the third quarter of 2001, including FAS 133 market value changes,

Third Quarter Nine Months Ended Sept. 30 2001 2000 Change 2001 2000 Change

Operating Net Income (in billions)

$1.377 $1.124 22.5% $3.929 $3.283 19.7%

Operating EPS (in dollars)

$1.33 $1.09 22.0% $3.80 $3.16 20.3%


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were $1.230 billion and $1.19, respectively. Net income and EPS for the nine months ended September 30, 2001 including FAS 133 items were $3.925 billion and $3.80, respectively.

Highlights of Fannie Mae's third quarter 2001 performance include:

Taxable-equivalent revenue growth of 30.6 percent

versus the third quarter of 2000. * * *

A net interest margin of 1.10 percent versus 1.00 percent in the third quarter of 2000.

* * *

Raines noted that the strong growth in Fannie Mae's business volume during the third quarter had combined with a rising net interest margin to produce growth in taxable-equivalent revenue of over 30 percent compared with the third quarter of 2000. Raines also said that in spite of the slowing economy the company's credit losses, at $18.7 million, were lower in the third quarter of 2001 than in the third quarter of 2000. Timothy Howard, Fannie Mae's Executive Vice President and Chief Financial Officer, said that the company's net interest margin averaged 110 basis points in the third quarter, and rose to 113 basis points in September. . . .

* * *

Portfolio investment business results Fannie Mae's portfolio investment business manages the interest rate risk of the company's mortgage portfolio and other investments. The results of this business are largely reflected in adjusted net interest income, which is net interest income less the amortization of purchased options expense. Adjusted net interest income was $1.892 billion in the third quarter of 2001, or 32.5 percent above the third quarter of 2000. This increase was driven by a 19.7 percent rise in the average net investment balance and a 10 basis point increase in the average net interest margin. Adjusted net interest income for the first nine months of 2001 was $5.335 billion, up 27.4 percent from $4.188 billion during the comparable period in 2000.

* * * The company's average net interest margin was 110 basis points in the third quarter of 2001 compared with 100 basis points in the third quarter of 2000 and 109 basis points in the second quarter of 2001. . . . The company's net interest margin has averaged 107 basis points year-to-date, up from 101 basis points for the same period last year.

* * *

Capital Fannie Mae's core capital was $23.8 billion at September 30, 2001 compared with $23.0 billion at June 30, 2001 and $19.9 billion at September 30, 2000.


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* * * Voluntary disclosures As part of Fannie Mae's voluntary market discipline, liquidity and safety and soundness initiatives of October 19, 2000, the company now discloses on a quarterly basis its liquid assets as a percent of total assets, the sensitivity of its future credit losses to an immediate 5 percent decline in home prices, and whether it has passed or failed an internal interim version of the risk-based capital stress test based on its interpretation of the Federal Housing Enterprises Financial Safety and Soundness Act of 1992. At September 30, 2001 Fannie Mae's ratio of liquid assets to total assets was 7.8 percent, compared with 8.0 percent at June 30, 2001. The company has committed to maintain a portfolio of high-quality, liquid, non-mortgage securities equal to at least 5 percent of total assets.

* * * At both June 30, 2001 and March 31, 2001, the company passed its internal interim risk-based capital test with a capital cushion that exceeded 30 percent of total capital. The company intends to manage its risks so that the cushion between total capital and internally calculated risk-based capital is at least 10 percent of total capital.

* * * FAS 133 Financial Accounting Standard No. 133 (FAS 133), Accounting for Derivative Instruments and Hedging Activities requires that Fannie Mae mark to market only its purchased options and none of its option-based debt or the mortgage investments it hedges with purchased options. The change in the market value of Fannie Mae's purchased options during the third quarter of 2001 was a net loss of $413.1 million. This amount includes $186.9 million in option cost amortization that formerly was included in net interest income and is currently included in adjusted net interest income.

FAS 133 also requires that the company record certain derivatives, primarily interest rate swaps it uses as substitutes for non-callable debt, on the balance sheet at their fair values, with an offsetting entry recorded in a separate component of stockholders' equity called other comprehensive income, or OCI. At September 30, 2001, the OCI component of stockholders' equity included a $10.6 billion reduction, or 1.5 percent of the net mortgage balance. The comparable reduction to OCI was $3.7 billion at June 30, 2001 and $5.7 billion at March 31, 2001. Other comprehensive income is not a component of core capital. 188. On January 14, 2002, Fannie issued a press release announcing its financial

results for the fourth quarter and year ended December 31, 2001, under the headline: ''Fannie

Mae Reports Record 2001 Financial Results; Operating Net Income of $5.367 Billion up 20.7


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Percent over 2000; Operating Earnings Per Diluted Common Share of $5.20 up 21.2 Percent.

Results Include Contribution of $300 Million in Common Stock to Fannie Mae Foundation," in

which it stated, in pertinent part:

Fannie Mae (FNM/NYSE), the nation's largest source of financing for home mortgages, today reported operating net income for 2001 of $5.367 billion, or $5.20 per diluted common share. Operating net income was 20.7 percent above 2000, while operating earnings per diluted common share rose 21.2 percent over the same period. For the fourth quarter of 2001 Fannie Mae's operating net income was $1.438 billion, or $1.40 per diluted common share, compared with $1.164 billion, or $1.12 per diluted common share, for the fourth quarter of 2000. The company's fourth quarter and full-year 2001 results include a commitment to contribute $300 million of Fannie Mae common stock to the Fannie Mae Foundation.

Operating Net $1.438 $1.164 23.5% $5.367 $4.448 20.7%

Income (in billions) Operating EPS (in $1.40 $1.12 25.0% $5.20 $4.29 21.2% dollars)

Operating net income and operating earnings per common share exclude the variability in the market value of purchased options and the one-time cumulative change in accounting principle which resulted from the implementation of Financial Accounting Standard 133 (FAS 133) on January 1, 2001. Net income and earnings per share (EPS) for 2001 including FAS 133 items were $5.894 billion and $5.72, respectively. Net income and EPS for the fourth quarter of 2001, including FAS 133 market value changes, were $1.969 billion and $1.92, respectively. Page one of the attachments to this release provides a reconciliation of operating net income and net income.

* * * Franklin D. Raines, Fannie Mae's Chairman and Chief Executive Officer, said, "This was an extraordinary year for Fannie Mae in every respect. The company achieved 21 percent growth in operating earnings per share, greatly exceeding consensus expectations of 14 percent earnings growth at the beginning of the year. . . . Our net interest margin rose 10 basis points, and our credit losses continued to fall in spite of the onset of recession last March. With growth in our taxable-equivalent revenues exceeding 30 percent, we were able to make a $300 million stock contribution to the Fannie Mae Foundation, conduct repurchases of high-cost debt, and launch a significant upgrading of our technology infrastructure - all of which will enhance our financial performance in the future." (Emphasis added.)

Fourth Quarter Full Year 2001 2000 Change 2001 2000 Change


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* * *

Outlook * * *

Raines said that Fannie Mae's financial performance in 2001 and prospects for 2002 make it very likely that the company would achieve the goal it set in May 1999 of doubling its earnings per share between 1998 and 2003. "At the time we set this goal," said Raines, "few expected us to attain it. Not only are we very likely to, we will do so without increasing our risk profile, and with unwavering focus on our housing mission." (Emphasis added.)

Fannie Mae's Executive Vice President and Chief Financial Officer, Timothy Howard, said that Fannie Mae's above-trend earnings prospects for 2002 stem from a variety of factors. Howard said that the recent sharp rebound in long-term interest rates was likely to significantly lower the volume of mortgage liquidations over the course of the first half of the year. This would mean, said Howard, that the company's net interest margin - which had benefited from the call and refunding of a large volume of debt during 2001 - would likely be at elevated levels for a longer period of time than previously anticipated.

* * * "Fannie Mae had an exceptional year in 2001, and we are poised for another exceptional year in 2002," said Howard.

* * *

Portfolio Investment Business Results Fannie Mae's portfolio investment business manages the interest rate risk of the company's mortgage portfolio and other investments. The results of this business are largely reflected in adjusted net interest income, which is net interest income less the amortization of purchased options expense. Adjusted net interest income for 2001 was $7.500 billion, up 32.2 percent from $5.674 billion in 2000. This increase was driven by an 18.5 percent rise in the average net investment balance and a 10 basis point increase in the average net interest margin. Adjusted net interest income was $2.165 billion in the fourth quarter of 2001, or 45.8 percent above the fourth quarter of 2000.

* * * The company's net interest margin averaged 111 basis points in 2001, up from 101 basis points in 2000. The net interest margin averaged 121 basis points in the fourth quarter of 2001 compared with 99 basis points in the fourth quarter of 2000 and 110 basis points in the third quarter of 2001. Fannie Mae's net interest margin benefited from this year's sharp declines in short-term interest rates, which enabled the company to call debt early in the year in amounts that substantially exceeded the timing and volume of mortgage liquidations. Much of this debt was reissued with short-term maturities in anticipation of a subsequent rise in mortgage repayments. Although most of Fannie Mae's short-term or


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variable-rate debt has some form of protection against a rise in interest rates, the company's interest costs declined as interest rates fell, and its net interest margin rose as a result. Fannie Mae's interest margin also benefited from attractive spreads on new mortgage purchases during 2001.

* * *

Capital Fannie Mae's core capital was $25.2 billion at December 31, 2001 compared with $23.8 billion at September 30, 2001 and $20.8 billion at December 31, 2000.

* * *

Voluntary Disclosures * * *

At December 31, 2001 Fannie Mae's ratio of liquid assets to total assets was 9.5 percent, compared with 7.8 percent at September 30, 2001. The company has committed to maintain a portfolio of high-quality, liquid, non-mortgage securities, equal to at least 5 percent of total assets.

* * * At both September 30, 2001 and June 30, 2001, the company passed its internal interim risk-based capital test with a capital cushion that exceeded 30 percent of total capital. The company intends to manage its risks so that the cushion between total capital and internally calculated risk-based capital is at least 10 percent of total capital.

* * * FAS 133 During 2001 Fannie Mae adopted Financial Accounting Standard No. 133 (FAS 133), Accounting for Derivative Instruments and Hedging Activities. FAS 133 resulted in changes to accounting presentations on both the company's income statement and balance sheet. FAS 133 requires that Fannie Mae mark to market on its income statement the changes in the time value of its purchased options. FAS 133 requires that only the company's purchased options be marked to market, but none of its option-based debt or mortgage investments. The change in the time value of Fannie Mae's purchased options during 2001 was a net loss of $37.4 million. This amount includes $590.1 million in option cost amortization expense that formerly was included in net interest income and is currently included in adjusted net interest income. The company recorded a cumulative gain of $258.3 million, or $167.9 million after tax upon adoption of FAS 133 on January 1, 2001. At December 31, 2001 the notional balance of Fannie Mae's purchased options - consisting of pay-fixed interest rate swaptions, receive-fixed interest rate swaptions, and interest rate caps - totaled $219.9 billion. At December 31, 2000 the notional balance of Fannie Mae's purchased options was $82.5 billion.


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FAS 133 also requires that the company record any change in the fair values of certain derivatives, primarily interest rate swaps it uses as substitutes for non-callable debt, on the balance sheet in a separate component of stockholders' equity called other comprehensive income, or OCI. FAS 133 does not require non-callable debt to be marked to market. At December 31, 2001, the OCI component of stockholders' equity included a $7.4 billion reduction, or 1.0 percent of the net mortgage balance, from the marking to market of derivatives. The comparable reductions to OCI were $10.6 billion at September 30, 2001 and $3.7 billion at June 30, 2001. Other comprehensive income is not a component of core capital. At December 31, 2001 Fannie Mae had $281.8 billion in interest rate swaps that were marked to market through other comprehensive income. The company had $202.5 billion in comparable derivatives at December 31, 2000. 189. In a presentation given at the Credit Suisse First Boston Financial Services

Conference on February 11, 2002, Defendant Howard made the following remarks on the topic

of making the case for investment in Fannie Mae:

First, we have a superior record of earnings performance. In a world of promises, performance matters. We are coming off an outstanding year in 2001 – during which we posted growth in operating earnings per share of 21 percent, well above the expectation for our growth at the beginning of the year. We also have an enviable long-term track record. We are one of only three companies in the Standard and Poor’s 500 to achieve double-digit growth in operating EPS for each of the past 15 years. Second, we have excellent prospects for long-term growth. We come into 2002 with tremendous momentum from last year. For the longer term our earnings growth prospects rest on two strong pillars: the likelihood that the market in which we operate - residential mortgages - will continue to grow faster than nominal GDP, and the likelihood that our earnings per share will continue to grow faster than the mortgage market. Third, we have just two primary business risks, which we manage uniquely well. Our two main risks are interest rate and credit risk. We have unmatched tools and a highly disciplined set of processes for managing these risks. As a consequence, our earnings are little affected by movements in interest rates or changes in the economic environment.

* * *


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Finally, Fannie Mae shares offer compelling value. Our prospects for market and earnings growth compare extremely favorably with those of a typical company. With a current P/E ratio of just 60% of the Standard and Poor’s 500, there is significant opportunity for Fannie Mae shares to provide investors with an enhanced return as a result of an increase in the company’s relative valuation.

* * * Superior Performance Record Fannie Mae’s fifteenth consecutive year of double-digit operating EPS growth was an exceptional one. With the economy experiencing its worst year in a decade, we achieved an extremely strong set of financial results for 2001. Our operating earnings per share were $5.20, up 21 percent from 2000. Our top-line growth was even stronger than our bottom-line growth. Taxable-equivalent revenues grew by 30 percent compared with 12 percent in 2000. We had 32 percent growth in net interest income, and 10 percent growth in guaranty fees. And our fee and other income rose by nearly $200 million compared with 2000.

* * * Superior Risk Management The stability in our business margins that is apparent in this last exhibit reflects the third fundamental point in the investment case for Fannie Mae-our unique abilities in managing our business risks.


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We have only two principal risks to manage-interest rate and credit risk. We manage those risks on just one asset, residential mortgages, in just one country. In interest rate risk management we have the advantage of operating in two of the broadest, deepest, most transparent and most liquid markets in the world-mortgage-backed securities and agency debt. And on credit risk management, our sole exposure is to an asset type whose quality arguably is without equal.

I still occasionally hear it said that “Fannie Mae is an interest rate play.” In that characterization, we’re supposed to benefit when interest rates fall, and suffer when interest rates rise. Well, the facts don’t bear that out. . . . [F]or the past fifteen years there has been no discernable relationship between interest rates and our earnings per share growth. We’ve done well in all environments. The reason, of course, is our interest rate risk management. We have taken a highly disciplined approach to the management of our mortgage portfolio, as measured by the portfolio’s duration gap, which captures the difference, in months, between the durations or average lives of the portfolio’s assets and liabilities. Our strategy is to have an asset/liability match that is neither overhedged to the detriment of our net income, nor underhedged to the detriment of the sustainability of that income. We want to produce a high and consistent level of income in a wide range of interest rate environments, while still being able to bring the portfolio back into balance in more extreme environments. To accomplish these objectives we set a target band for our duration gap at a range of plus or minus six months. This is a management guideline, not an absolute risk limit. Over the past eight years our duration gap has been outside its


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target range about one-third of the time. Because our portfolio generally is structured to have a close near-term cash flow match, when our duration gap does move outside its target range we can rebalance it over time. Doing this greatly reduces our rebalancing costs-to the point that they generally aren’t detectable by investors-while still allowing us to maintain control of our risk position. We are convinced that our strategy of a close but not an exact initial duration match in our mortgage portfolio-coupled with periodic rebalancings as required-produces the best long-term net income flow for our shareholders. And we have a decade and a half of highly successful portfolio management to support that view.

* * * Policy Positioning

* * * Fannie Mae is exceptionally well positioned for such scrutiny. We make more -and more detailed – financial disclosures than any large financial institution in America. Fannie Mae always has sought to be a leader in financial transparency and disclosure. But in the fall of 2000 we took two additional steps that placed us firmly in the vanguard of best practices. We voluntarily adopted six new measures to enhance our market discipline, liquidity and capital, and we thoroughly explained to investors the impact on our business of the new and potentially confusing accounting standard for derivatives, FAS 133. As part of our October 2000 voluntary initiatives Fannie Mae agreed to and now does provide information on our mortgage portfolio duration gap, net interest income at risk and liquidity position on a monthly basis. On a quarterly basis we provide our credit exposure to an immediate 5 percent decline in home prices, and an assessment of our compliance with an interim version of our statutory risk-based capital requirement. We obtain independent surveillance ratings both on our company and on our possible risk to the government. And we voluntarily issue subordinated debt with an automatic trigger if our capital falls below a certain level, to serve as a market barometer of our risk position. These voluntary disclosures supplement the information we already had been providing, which include monthly reports on our portfolio commitments and purchases, MBS issues, liquidations, net interest margin, and single- and multifamily delinquency rates. In December of 2000 we also held a conference call to explain the effects of the FAS 133 accounting standard to investors, and to answer any questions they had about it. Following adoption of the standard we began providing a clear reconciliation of operating net income and GAAP net income to investors each quarter. We also have added disclosure of our notional balance of derivatives used to fund our mortgage portfolio to our quarterly earnings press release.


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Today, no company tells its investors more about its financial condition, with more clarity, than Fannie Mae. Our financial safeguards and disclosure represent the corporate best practices that investors and the public deserve. Relative Value So – great track record, excellent long-term growth prospects, only two primary risks that are very well managed, and placement on the right side of key policy issues. What more could we possibly offer?

* * * We also have a proven ability to increase our EPS faster than the growth in our market, through product innovations that increase our market share and disciplined risk management that allows us to translate volume growth into net income growth. Over the next several years Fannie Mae will strive to continue our record of earnings outperformance. If we can simply do that, Fannie Mae stock will be a rewarding investment.

This presentation was posted on the Fannie Mae website under Investor Relations for investors to

review.

190. In April 2002, Fannie Mae released its 2001 Annual Report to shareholders,

confirming the fiscal year financial results published in the January 14, 2002 press release

(“2001 Annual Report”). The Annual Report included a letter to shareholders from Defendant

Raines in which he stated, in pertinent part, as follows:

Fannie Mae's record-breaking service to the American Dream produced our single best financial performance ever. Our combined book of business grew by 19 percent, taxable equivalent revenues grew by 30 percent, credit losses fell to their lowest level since 1983, and operating earnings per share grew by 21 percent over the previous year. With this performance, Fannie Mae is one of only three companies in the Standard & Poor's 500 index to achieve double-digit growth in operating earnings per share for each of the past 15 years. Also in 2001, Fannie Mae set an important new standard for corporate best practices by implementing the strongest transparency and disclosure practices of any large financial institution in the country. At a time when the market, shareholders, policy makers, and the public are seeking -- and deserve -- additional assurance and confidence in their public companies, Fannie Mae is a


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model for openness, transparency, regulatory oversight, capital protections, and market discipline.

2001 Annual Report, at 2.

191. The 2001 Annual Report also included a statement from Defendant Howard

entitled, “Shareholder Value” which contained, in pertinent part, the following statements:

Timothy Howard, Executive Vice President and Chief Financial Officer, talks about Fannie Mae's stellar performance, strong growth prospects, and model safety, soundness, and transparency practices. How has Fannie Mae achieved such a superior performance record? Fannie Mae is one of only three companies in the S&P 500 to have produced double-digit growth in operating earnings per share in each of the last 15 years. Fannie Mae's operating earnings per share rose by 21 percent in 2001, and for the past five years we have increased our operating EPS at an average rate of 16 percent per year. We have been able to achieve this record because we are at the center of a large and growing market -- residential mortgages. We are the low-cost provider in that market, and we manage our business risks exceptionally well.

* * * Financial companies are thought to be sensitive to economic fluctuations. Why does Fannie Mae perform so well through all economic ups and downs? Fannie Mae has been able to deliver double-digit growth in operating EPS, year after year, through all types of economic and financial market environments for the last 15 years.

The reason is simple. At Fannie Mae we are risk managers, not passive risk takers. In our credit guaranty business, we share credit risk with our mortgage insurance partners and, at times, our lenders. And in our mortgage portfolio we share the prepayment risk of fixed-rate mortgages with the buyers of our callable debt securities and option-based derivatives. We also have only two principal risks to manage -- interest rate risk and credit risk. We manage those risks on just one asset, residential mortgages, in just one country. We do not engage in commercial lending, credit card issuance, or other types of lending activities. As a consequence, we can and do focus our full attention on the key risks that determine mortgage credit and prepayment performance.


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Finally, in interest rate risk management we have the advantage of operating in two of the broadest, deepest, most transparent, and most liquid markets in the world -- mortgage-backed securities and agency debt. And in credit risk management, our sole exposure is to an asset type that is backed by solid collateral -- the value on the homes we finance -- and whose quality arguably is without equal.

* * * Fannie Mae has been called "a new global model" for financial institution safety, soundness, transparency, and market discipline. Why is that, and why is that important? Fannie Mae's mission involves raising low-cost capital for U.S. housing from investors across the globe. For this to be done with maximum success, investors need to understand and have confidence in Fannie Mae's financial strength and stability. Regulatory oversight, an ample capital cushion against risk, and maximum transparency and financial disclosure are critical underpinnings of this understanding and confidence.

* * * In 2001, we put into place a set of voluntary initiatives to regularly disclose key details about our business and risk management, including regular reports about our credit risk and interest rate risk exposure . . . Fannie Mae now gives more information, more frequently, on more aspects of our financial condition and risk management than any other financial institution in America.

2001 Annual Report, at 6-9.

192. The 2001 Annual Report included the following statements made under the

section entitled, “Management’s Discussion and Analysis of Financial Condition and Results of

Operation.”

2001 Overview Fannie Mae achieved exceptional operational and financial results in 2001, surpassing its earnings targets and posting its 15th consecutive year of record operating earnings while taking a number of actions to strengthen the company’s future financial performance. Despite a weaker economic environment, operating earnings and operating earnings per diluted common share (EPS) increased 21 percent over 2000 to $5.367 billion and $5.20, respectively. The increase in earnings was driven primarily by strong portfolio and net interest margin growth.

* * * Fannie Mae’s financial statements are based on the application of generally accepted accounting principles, which are described in the Notes to Financial Statements under Note 1, “Summary of Significant Accounting Policies.” . . .


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Management believes Fannie Mae’s critical accounting policies include determining the adequacy of the allowance for losses, the amortization of purchased discounts or premiums and other deferred price adjustments on mortgages and mortgage-backed securities (MBS), and the amortization of upfront guarantee fee adjustments.


* * * Risk Management Fannie Mae is subject to three major areas of risk: interest rate risk, credit risk, and operations risk. Active management of these risks is an essential part of Fannie Mae’s operations and a key determinant of its ability to maintain steady earnings growth. The following discussion highlights Fannie Mae’s strategies to manage these three risks.

* * * Fannie Mae’s overall objective in managing interest rate risk is to deliver consistent earnings growth and target returns on capital in a wide range of interest rate environments. Central elements of Fannie Mae’s approach to managing interest rate risk include: (1) investing in assets and issuing liabilities that perform similarly in different interest rate environments, (2) assessing the sensitivity of portfolio profitability and risk to changes in interest rates, and (3) taking rebalancing actions in the context of a well-defined risk management process.

* * * Fannie Mae was successful in meeting its interest rate risk management objectives in 2001 despite significant interest rate moves and unprecedented levels of interest rate volatility. . . . Fannie Mae’s disciplined risk management process was the cornerstone to management’s success in meeting the company’s interest rate risk objectives throughout this challenging environment.


193. With respect to operations risk management, the 2001 Annual Report stated:

Operations risk is the risk of potential loss resulting from a breakdown in established controls and procedures, examples of which include circumvention of internal controls, fraud, human error, and systems malfunction or failure. Fannie Mae has established extensive policies and procedures to decrease the likelihood of such occurrences. Fannie Mae’s Office of Auditing tests the adequacy of and adherence to internal controls and established policies and procedures. Financial system data are regularly reconciled to source documents to ensure the accuracy of financial system outputs.



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194. With respect to amortization of deferred purchase price adjustments, the 2001

Annual Report Stated:

Fannie Mae applies the interest method to amortize purchase price adjustments over the estimated life of the loans. Calculating the constant effective yield necessary to apply the interest method in the amortization of mortgage purchase discounts or premiums and other deferred purchase price adjustments is a critical accounting policy that requires estimating future mortgage prepayments. . . . Fannie Mae tracks and monitors actual prepayments received against anticipated prepayments and regularly assesses the sensitivity of prepayments to changes in interest rates on a monthly basis. Based upon this analysis, Fannie Mae determines whether it should change the estimated prepayment rates used in the amortization calculation. If changes are necessary, Fannie Mae recalculates the constant effective yield and adjusts the net mortgage investment balance to reflect the amount that would have been recorded had the new effective yield been applied since acquisition of the mortgages or MBS.

2001 Annual Report, at 37. A similar statement was made with respect to the amortization of

guaranty fee adjustments underlying the mortgage-backed securities. 2001 Annual Report at 46.

195. With respect to derivative instruments and hedging activities, the 2001 Annual

Report stated:

Derivative Instruments and Hedging Activities Effective January 1, 2001, Fannie Mae adopted Financial Accounting Standard No. 133 (FAS 133), Accounting for Derivative Instruments and Hedging Activities, as amended by Financial Accounting Standard No. 138, Accounting for Certain Derivative Instruments and Certain Hedging Activities. FAS 133 requires that all derivatives be recognized as either assets or liabilities on the balance sheet at their fair value. Subject to certain qualifying conditions, a derivative may be designated as either a hedge of the cash flows of a variable rate instrument or anticipated transaction (cash flow hedge) or a hedge of the fair value of a fixed-rate instrument (fair value hedge).

* * * If a derivative no longer qualifies as a cash flow or fair value hedge, Fannie Mae discontinues hedge accounting prospectively. The derivative continues to be carried on the balance sheet at fair value with fair value gains and losses recorded in earnings until the derivative is settled. For discontinued cash flow hedges, the gains or losses previously deferred in AOCI are recognized in earnings in the same period(s) that the hedged item impacts earnings. For discontinued fair value hedges, the hedged asset or liability is no longer adjusted for changes in its fair value and previous fair value adjustments to the basis of the hedged item are


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subsequently amortized to earnings over the remaining life of the hedged item using the effective yield method. The adoption of FAS 133 on January 1, 2001, resulted in a cumulative after-tax increase to income of $168 million and an after-tax reduction in AOCI of $3.9 billion. In addition, investment securities and MBS with an amortized cost of approximately $20 billion were reclassified from held-to maturity to available-for-sale upon the adoption of FAS 133. At the time of this non-cash transfer, these securities had gross unrealized gains and losses of $164 million and $32 million, respectively.

* * * Fannie Mae formally documents all relationships between hedging instruments and the hedged items, including the risk-management objective and strategy for undertaking various hedge transactions. Fannie Mae links all derivatives to specific assets and liabilities on the balance sheet or to specific forecasted transactions and designates them as cash flow or fair value hedges. Fannie Mae also formally assesses, both at the hedge’s inception and on an ongoing basis, whether the derivatives that are used in hedging transactions are highly effective in offsetting changes in the cash flows or fair values of the hedged items.

* * * Fannie Mae discontinues hedge accounting prospectively when (1) it determines that the derivative is no longer effective in offsetting changes in the cash flows or fair value of a hedged item; (2) the derivative expires or is sold, terminated, or exercised; (3) the derivative is dedesignated as a hedge instrument because it is unlikely that a forecasted transaction will occur; or (4) it determines that designation of the derivative as a hedge instrument is no longer appropriate.

2001 Annual Report, at 54, 64.

* * * Financial Statement Impact Consistent with FAS 133, Fannie Mae records changes in the fair value of derivatives used as cash flow hedges in AOCI to the extent they are perfectly effective hedges. Fair value gains or losses in AOCI are amortized into the income statement and are reflected as either a reduction or increase in interest expense over the life of the hedged item. The income or expense associated with derivatives has historically been recognized in interest expense as an adjustment to the effective cost on the hedged debt. Fannie Mae estimates it will amortize approximately $4.7 billion out of AOCI and into interest expense during the next 12 months. The amortization of the $4.7 billion into interest expense from AOCI does not produce a different result in the income statement versus prior periods. Actual results in 2002 will likely differ from the amortization estimate because actual swap yields during 2002 will change from the swap yield curve assumptions at December 31, 2001.


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The reconciliation below reflects the change in AOCI, net of taxes, during the year ended December 31, 2001 associated with FAS 133:

Year Ended December 31,

2001 Dollars in millions

Transition adjustment to adopt FAS 133, January 1, 2001 . . . . . . . . . . . . . . . . . . . . . . . . $(3,972) Losses on cash flow hedges, net . . . . . . . . . . . . . . . . . . . . . (5,530) Less: reclassifications to earnings, net . . . . . . . . . . . . . . . . . 2,143 Balance at December 31, 2001 . . . . . . . . . . . . . . . . . . . . . . . $(7,359) . . . If there is any hedge ineffectiveness or derivatives do not qualify as cash flow hedges, Fannie Mae records the ineffective portion in the fee and other income (expense) line item on the income statement. For the year ended December 31, 2001, fee and other income (expense) includes a pre-tax loss of $3 million related to the ineffective portion of cash flow hedges.

* * * Financial Statement Impact Fannie Mae records changes in the fair value of derivatives used as fair value hedges in the fee and other income (expense) line item on the income statement along with offsetting changes in the fair value of the hedged items attributable to the risk being hedged. Fannie Mae’s fair value hedges produced no hedge ineffectiveness during the year ended December 31, 2001.


196. Fannie Mae’s Annual Report for 2001 also contained the following

representations in a “Report of Management” signed by Defendants Howard and Spencer:

The management of Fannie Mae is responsible for the preparation, integrity and fair presentation of the accompanying financial statements and other information appearing elsewhere in this report. In our opinion, the financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America appropriate in the circumstances, and the other financial information in this report is consistent with such statements. In preparing the financial statements and in developing the other financial information, it has been necessary to make informed judgments and estimates of the effects of business events and transactions. We believe that these judgments and estimates are reasonable, that the financial information contained in this report reflects in all material respects the substance of all business events and transactions to which the corporation was a party, and that all material uncertainties have been appropriately accounted for or disclosed.


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The management of Fannie Mae is also responsible for maintaining internal control over financial reporting that provides reasonable assurance that transactions are executed in accordance with appropriate authorization, permits preparation of financial statements in conformity with accounting principles generally accepted in the United States of America, and establishes accountability for the assets of the corporation. Internal control over financial reporting includes controls for the execution, documentation, and recording of transactions, and an organizational structure that provides an effective segregation of duties and responsibilities. Fannie Mae has an internal Office of Auditing whose responsibilities include monitoring compliance with established controls and evaluating the corporation’s internal controls over financial reporting. Organizationally, the internal Office of Auditing is independent of the activities it reviews.

* * * Management recognizes that there are inherent limitations in the effectiveness of any internal control environment. However, management believes that, as of December 31, 2001, Fannie Mae’s internal control environment, as described herein, provided reasonable assurance as to the integrity and reliability of the financial statements and related financial information. 197. The statements contained in ¶¶ 182 through 196 above were each materially false

and/or misleading when made because Defendants failed to disclose and/or misrepresented the

following adverse facts, among others:

a. As now admitted by Defendants, the financial statements were not

prepared in accordance with GAAP and could not be relied upon.

b. Defendants had used accounting for amortizing purchase premiums and

discounts on securities and loans as well as amortizing other deferred charges that was not in

accordance with SFAS 91. As Defendants admitted in Fannie Mae’s November 14, 2004 Form

NT 10-Q, its methodology for performing calculations to measure the catch-up adjustment

required by SFAS 91 for balance sheet dates in 2001 was not consistent with GAAP – it should

have calculated its catch-up adjustment during 2001 with reference to its quarter-end position

rather than its projected year-end position.


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c. In violation of the requirements of SFAS 133, Defendants, among other

things, (i) did not assess and record hedge ineffectiveness as required, and (ii) failed to properly

document hedging activity. As a result, Defendants applied hedge accounting to hedging

relationships that do not qualify under SFAS 133.

d. As a result of the foregoing GAAP violations, Fannie Mae’s reported net

income, earnings per share, net interest income, core capital, other comprehensive income and/or

other reported results were materially incorrect.

e. Contrary to Defendants’ claims, Fannie Mae’s risk management practices,

liquidity management, market discipline and disclosure practices were not the “vanguard” of

such practices globally, Fannie Mae was not the “new global model” for financial institution

safety and soundness, and Fannie Mae was not a “leader in financial transparency and

disclosure.” Rather, Defendants adopted and implemented policies and procedures and engaged

in accounting practices that violated GAAP to allow them to manipulate Fannie Mae’s earnings

and they actively hid their misconduct from investors.

f. Contrary to Defendants’ representations, Fannie Mae’s internal control

environment did not provide reasonable assurance as to the integrity and reliability of the

financial statements and related financial information. In fact, Defendants knowingly tolerated

weak, insufficient, inadequate and in some instances non-existent accounting oversight and

internal controls, which included poor segregation of duties, lack of technical accounting

expertise, ineffective reviews by the Office of Auditing, lack of written accounting policies and

procedures, poor or non-existent audit trails, and a process for developing accounting policies

that lent itself to the formation of policies that were aggressive and did not comport with GAAP.


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g. Defendants had established and maintained a corporate culture that

emphasized stable earnings at the expense of accurate financial disclosures, which permitted the

GAAP violations and other misconduct alleged herein.

B. Statements Concerning Fiscal Year 2002

198. On April 15, 2002, the Company issued a news release in which it announced its

financial results for the first quarter ended March 31, 2002, under the headline: "Fannie Mae

Reports Record First Quarter 2002 Financial Results; Operating Net Income of $1.519 Billion up

22.7 Percent Over First Quarter 2001; Operating Earnings Per Diluted Common Share of $1.48

up 23.3 Percent” which stated, in pertinent part:

Fannie Mae (FNM/NYSE), the nation’s largest source of financing for home mortgages, today reported operating net income for the first quarter of 2002 of $1.519 billion, a 22.7 percent increase compared with the first quarter of 2001. Operating earnings per diluted common share (operating EPS) of $1.48 were 23.3 percent above the same period in 2001.

First Quarter 2002 2001 Change

Operating Net Income (in billions) $1.519 $1.238 22.7% Operating EPS (in dollars) $1.48 $1.20 23.3%

Operating net income and operating EPS exclude the variability in earnings from both changes in the market value of purchased options and the one-time cumulative change in accounting principle from the implementation of Financial Accounting Standard 133 (FAS 133) on January 1, 2001. Net income and EPS for the first quarter of 2002 including FAS 133 items were $1.209 billion and $1.17, respectively, compared with $1.293 billion, or $1.25 per share, in the first quarter of 2001.

Timothy Howard, Fannie Mae’s Executive Vice President and Chief Financial Officer, said, "We believe that the income statement volatility which results from the inclusion of unrealized gains or losses under FAS 133 does not accurately reflect the operating performance of the company. Under FAS 133, operating net income is a more accurate measure of the company’s performance." Under FAS 133 net income in the first quarter of 2002 was $310.1 million less than operating net income. In the first quarter of 2001 net income was $55.0 million more than operating net income and in


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the fourth quarter of 2001 net income exceeded operating net income by $531.0 million. Page one of the attachments to this release provides a reconciliation of net income to operating net income. (Emphasis added.)

* * *

Franklin D. Raines, Fannie Mae’s Chairman and Chief Executive Officer, said, "Continued strong growth in top-line revenues enabled Fannie Mae to report its 57th consecutive quarterly increase in operating earnings per share during the first quarter of 2002. This is a performance record few other companies can match. " (Emphasis added.)

* * * Raines said that Fannie Mae’s recent strong earnings growth had been accompanied by excellent management of its principal business risks. Raines said, "Fannie Mae’s credit costs remain extremely low for this stage of the business cycle, we are maintaining a good match between the assets and liabilities in our portfolio, and over the past 12 months we have added $4.0 billion to our core capital.". . . (Emphasis added.)

* * * Portfolio investment business results Fannie Mae's portfolio investment business manages the interest rate risk of the company's mortgage portfolio and other investments. The results of this business are largely reflected in adjusted net interest income, which is net interest income less the amortization expense of purchased options. Adjusted net interest income for the first quarter of 2002 was $2.120 billion, up 29.0 percent from $1.643 billion in the first quarter of 2001. This increase was driven by a 15.1 percent rise in the average net investment balance and a 12 basis point increase in the average net interest margin.

* * * The company's net interest margin averaged 115 basis points in the first quarter of 2002, compared with 103 basis points in the first quarter of 2001 and 121 basis points in the fourth quarter of 2001. During the quarter the margin was as low as 111 basis points in January, but rose to 119 basis points in March. Fannie Mae's net interest margin continues to benefit from the sharp declines in short-term interest rates in 2001, which enabled the company to call debt early in that year in amounts which substantially exceeded the timing and volume of mortgage liquidations.

* * * Capital Fannie Mae’s core capital was $25.5 billion at March 31, 2002 compared with $25.2 billion at December 31, 2001 and $21.5 billion at March 31, 2001.

* * *


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Voluntary disclosures * * *

At March 31, 2002, Fannie Mae’s ratio of liquid assets to total assets was 7.1 percent, compared with 9.5 percent at December 31, 2001.

* * * At both December 31st and September 30, 2001, the company passed its internal interim risk-based capital test with a capital cushion that exceeded 30 percent of total capital.

* * *

Derivatives and FAS 133 * * *

Fannie Mae accounts for its derivatives under Financial Accounting Standard No. 133 (FAS 133), Accounting for Derivative Instruments and Hedging Activities. The company implemented this standard, which resulted in changes to accounting presentations on both the company’s income statement and balance sheet, on January 1, 2001.

* * * The mark to market of Fannie Mae’s purchased options during the first quarter of 2002 resulted in a net loss of $787.2 million compared with a net gain of $577.9 million in the fourth quarter of 2001. The large change in the time value of Fannie Mae’s purchased options between the fourth quarter of 2001 and the first quarter of 2002 was primarily the result of a significant change in interest rate volatility, which affected the time value of all options. Purchased options expense in the first quarter of 2002 includes $310.2 million in amortization of the cost to purchase these options, which was included in net interest income prior to the adoption of FAS 133 and currently is included in adjusted net interest income and in operating earnings. At March 31, 2002 the notional balance of Fannie Mae’s purchased options totaled $238 billion. At December 31, 2001 the notional balance of Fannie Mae’s purchased options was $220 billion.

* * * At March 31, 2002, the AOCI component of stockholders’ equity included a $4.8 billion reduction, or 0.7 percent of the net mortgage balance, from the marking to market of these derivatives, down from $7.4 billion at December 31, 2001. Accumulated other comprehensive income is not a component of core capital. At March 31, 2002 Fannie Mae had $290 billion in interest rate swaps that were marked to market through accumulated other comprehensive income. The company had $282 billion in comparable derivatives at December 31, 2001. Fannie Mae’s primary credit exposure on derivatives is that a counterparty might default on payments due, which could result in Fannie Mae having to replace the


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derivative with a different counterparty at a higher cost. Fannie Mae’s exposure on derivative contracts (taking into account master settlement agreements that allow for netting of payments and excluding collateral received) was $1,033 million at March 31, 2002. All of this exposure was to counterparties rated A-/A3 or higher. Fannie Mae held $833 million of collateral through custodians for these instruments. Fannie Mae’s exposure, net of collateral, was $200 million. 199. In remarks delivered at the Sanford Bernstein Strategic Investors Conference on

June 5, 2002, Defendant Raines made the following statements:

In June 2000, I focused on why we were so confident about our future -- in particular, our strong growth potential and our ability to achieve the five-year goal I set in 1999 to double our earnings per share by 2003. Then, in June 2001, I came back and focused on why we were still confident about the future, and how we remained on course to meet our EPS goal, even though the market as a whole had gotten much more volatile and uncertain.

Today I want to talk with you about four topics that often come up when we meet with investors – performance, growth, risk, and the policy issues in Washington. As your will see, our approach to these matters has a common thread that draws them together. They all demonstrate that you can count on Fannie Mae to do the right thing. Reliability is always important. But in times like these when there is so much uncertainty and even disappointment in the market, having an investment you can count on becomes especially valuable. So let me touch on the four areas that illustrate our reliability, starting with our performance.

Fannie Mae’s Performance What I mean by performance is that we set big goals, and then we meet them.

* * * Our fourth promise was about financial performance. We said that by enhancing our business operations, e-commerce would enhance our top-line revenue growth. Specifically, I said that our revenues would grow faster in the five years from 1999 to 2003 than they did in the preceding five years. And once again, we performed. From 1994 to 1998, our taxable equivalent revenues grew at an average rate of 10 percent. In 1999, our revenues grew by 11 percent. In 2000, our revenues grew by 12 percent. Last year our revenues grew by 30 percent. And in the first quarter of this year, our revenues grew by 25 percent.


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Finally, our fifth promise -- our fifth success metric -- was about bottom-line financial performance. We said that our top-line revenue growth would fuel our bottom-line earnings growth, helping us to reach the five-year EPS goal I set in 1999. If you recall, I said we were committed to double-digit earnings growth every year. And that we expected to match our previous five years, which was 13.6 percent. And I also said that we had set a stretch goal of doubling our earnings by 2003, from $3.23 at the time to $6.46, which would require operating EPS growth each year of 14.9 percent.

And we performed. So far, our operating EPS grew by 15 percent in 1999, 15 percent in 2000, and 21 percent in 2001. And our first quarter operating earnings this year rose by 23 percent. We’re on the home stretch to $6.46 per share. Bottom line, if we reach the market consensus for the end of the year, our earnings will have increased by 90 percent in just four years. At a time when disappointment in the market is common and exuberance is much more rational, how many other companies have delivered 90 percent growth in operating earnings in four years? No matter how you measure it, our performance is exceptional.

* * * Fannie Mae’s Growth

* * * Let’s talk about interest rates. The fact is that interest rates have gone up and rates have gone down and we’ve still produced record earnings. That was what our disciplined interest-rate-risk management has done.

* * *

Fannie Mae’s Growth and Risk Dispersal

* * * The same goes for our interest rate risk. We share the risk of holding long-term, fixed-rate mortgages with investors who purchase our callable debt securities, but also with our derivatives counterparties. As interest rates rise and fall, we constantly adjust the rate we pay to fund our mortgages. To help us do that we enter into derivatives contracts with highly rated financial institutions, so they can take and further redistribute some of the risk.

Derivatives give us an alternative to issuing debt in the cash market.

* * * For us, derivatives are a good tool for managing interest rate risk. But we’re still a very small user. And even if somehow the economy collapsed and all our derivatives contracts were not performed on, our net exposure would come to only about $200 million as of March 31st, which is less than three percent of our pre-tax income last year.


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All of this is to say, when you look closely at Fannie Mae, and see how we do business, you get real answers to questions about our growth and risk management. It’s not a mystery. It’s not “trust me.”

* * *

Fannie Mae and Policy Issues

* * * Then questions arose about our capital. We’ve been operating since 1993 under a risk-based capital model with a stress test, which is designed to ensure we have enough capital to survive a ten-year economic depression. Our financial regulator has been working to develop a computer model to verify our compliance. So we worked with our regulator to make our risk-based capital model workable, and they will be announcing the results later this year.

* * *

In fact, our disclosures now meet or exceed SEC requirements in all material respects, and without disrupting the housing finance system. And we’re working with our regulator and others to make sure that our disclosures are the best in class.

* * * Conclusion

* * * All of these approaches have a common theme. And that is, you can count on Fannie Mae to do the right thing, whether it comes to our mission, our business, policy issues or shareholders. A company you can count on might be particularly valuable. And the correlation between a company’s values, and its valuation, is direct -- and in the long run, a key success factor. Fannie Mae is a company built on strong values. We’re also a company with 15 consecutive years of double-digit operating earnings growth. That is no coincidence. Strong corporate values and strong performance are what you can continue to expect from Fannie Mae.


review.

200. On July 15, 2002, Fannie Mae issued a press release announcing its financial

results for the second quarter of 2002 under the headline: "Fannie Mae Reports Record Second

Quarter 2002 Financial Results; Operating Net Income of $1.573 Billion up 19.7 Percent over


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Second Quarter 2001; Operating Earnings Per Diluted Common Share of $1.55 up 22.0 Percent."

Therein, the Company stated:

Fannie Mae (FNM/NYSE), the nation's largest source of financing for home mortgages, today reported operating net income for the second quarter of 2002 of $1.573 billion, a 19.7 percent increase compared with the second quarter of 2001. Operating earnings per diluted common share (operating EPS) of $1.55 rose 22.0 percent above the same period in 2001. For the first six months of 2002, Fannie Mae's operating net income was $3.091 billion, compared with $2.553 billion for the same period in 2001. Operating EPS for the first six months of 2002 was $3.03, or 22.7 percent above the first six months of 2001.

Second Quarter

Six Months Ended June 30

2002 2001 Change 2002 2001 Change Operating Net $1.573 $1.314 19.7% $3.091 $2.553 21.1% Income (in billions) Operating EPS $1.55 $1.27 22.0% $3.03 $2.47 22.7% (in dollars)

Operating net income and operating EPS exclude the variability in earnings that results from including unrealized gains and losses from the change in the market value of purchased options under Financial Accounting Standard No. 133 (FAS 133). Also excluded is the one-time cumulative change in accounting principle from the adoption of FAS 133 on January 1, 2001. Operating net income and operating EPS provide consistent accounting treatment for purchased options and the options embedded in callable debt, and are the performance measures used by company management.

Net income for the second quarter of 2002 including FAS 133 items was $1.464 billion, an increase of 4.4 percent over the second quarter of 2001. EPS including FAS 133 items was $1.44, 5.9 percent above the same period last year. Net income and EPS for the six months ended June 30, 2002, including FAS 133 items, were $2.672 billion and $2.61, respectively.

* * * Highlights of Fannie Mae’s financial performance in the second quarter of 2002 compared with the second quarter of 2001 include:

Growth in taxable-equivalent revenues of 21.4 percent; Growth in adjusted net interest income of 22.4 percent; An average net interest margin of 116 basis points compared

with 109 basis points; Growth in guaranty fee income of 18.6 percent;


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* * * Franklin D. Raines, Fannie Mae's Chairman and Chief Executive Officer, said, "Strong business volumes, a rising net interest margin, and a continued low level of credit losses enabled Fannie Mae to report its 58th consecutive quarterly increase in operating earnings per share during the second quarter of 2002." Raines said that taxable-equivalent revenues in the second quarter of 2002 were 21.4 percent higher than the same period one year ago. Raines added that in part because of a higher-than-expected net interest margin, the second quarter slowdown in portfolio growth due to narrow mortgage-to-debt spreads would have little discernable effect on the company's financial performance. (Emphasis added.)

Raines said that the first application of the risk-based capital stress test by the company's financial regulator, the Office of Federal Housing Enterprise Oversight (OFHEO), showed that Fannie Mae's total capital was $6.1 billion in excess of the risk-based requirement as of March 31, 2002. The company had previously reported that its equity capital as of the same date was $0.9 billion above the statutory minimum. Said Raines, "This initial application of the OFHEO risk-based standard confirms that Fannie Mae is managing its business risks with exceptional discipline and prudence." Raines noted that OFHEO would not be using the risk-based standard to classify the company for regulatory capital purposes until the end of the third quarter 2002. The higher of the risk-based or the minimum capital standard will be binding, Raines said. (Emphasis added.) Outlook

* * * Howard said that Fannie Mae's portfolio growth slowed to 4.9 percent during the second quarter, as mortgage-to-debt spreads remained narrow. Howard said, "We will continue to be disciplined in our approach to portfolio growth -- growing quickly when spreads are wide and more slowly or not at all when spreads are less favorable." Howard noted that with the reduced pace of mortgage commitments during the first half he now expected portfolio growth for the full year to be in the low-to-mid teens range.

* * * Howard commented that Fannie Mae's credit performance was continuing to exceed expectations. "For the first half of 2002 credit losses are running at a pace that is below the first six months of 2001," he said. Howard noted that the single-family delinquency rate had fallen by 7 basis points between January and May 2002, which was a positive indicator for future credit losses. Said Howard, "We keep anticipating that our credit losses will rise from their extremely low levels, but so far they have not."

* * *


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Portfolio investment business results * * *

Adjusted net interest income for the second quarter of 2002 was $2.202 billion, up 22.4 percent from $1.799 billion in the second quarter of 2001. This increase was driven by a 13.9 percent rise in the average net investment balance and a 7 basis point increase in the average net interest margin. Adjusted net interest income for the first six months of 2002 was $4.322 billion, up 25.5 percent from $3.443 billion during the comparable period in 2001.

* * * The company's net interest margin averaged 116 basis points in the second quarter of 2002, compared with 109 basis points in the second quarter of 2001 and 115 basis points in the first quarter of 2002. The company's net interest margin has averaged 116 basis points year-to-date, up from 106 basis points for the first six months of 2001. Fannie Mae's net interest margin for the second quarter and first six months of 2002 continued to benefit from an unusually steep yield curve and low short-term interest rates. Fannie Mae's net mortgage portfolio grew at an annual rate of 4.9 percent during the second quarter of 2002, ending the quarter at $741 billion. Portfolio growth in June fell to an annual rate of 0.8 percent, as mortgage purchases slowed in response to tighter mortgage-to-debt spreads and liquidation rates remained relatively high.

* * * Capital Fannie Mae’s core capital was $26.4 billion at June 30, 2002 compared with $25.5 billion at March 31, 2002 and $23.0 billion at June 30, 2001.

* * *

Voluntary disclosures * * *

At June 30, 2002 Fannie Mae's ratio of liquid assets to total assets was 7.8 percent, compared with 7.1 percent at March 31, 2002. Fannie Mae has committed to maintain a portfolio of high-quality, liquid, non-mortgage securities equal to at least 5 percent of total assets.

* * *

At both March 31, 2002 and December 31, 2001, the company passed its internal interim risk-based capital test with a capital cushion that exceeded 30 percent of total capital. The company intends to manage its risks so that the cushion between total capital and internally calculated risk-based capital is at least 10 percent of total capital.

* * *


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Derivatives and FAS 133 * * *

Fannie Mae accounts for its derivatives under Financial Accounting Standard No. 133 (FAS 133), Accounting for Derivative Instruments and Hedging Activities, which was adopted on January 1, 2001. The implementation of this standard resulted in significant accounting presentation changes to both the company’s income statement and balance sheet.

* * * The mark to market of Fannie Mae’s purchased options during the second quarter of 2002 resulted in a net unrealized loss of $498.2 million. Purchased options expense in the second quarter of 2002 includes $330.4 million in amortization of the cost to purchase these options, which was included in net interest income prior to the adoption of FAS 133 and currently is included in adjusted net interest income and in operating earnings. FAS 133 also requires that the company record any change in the fair values of certain derivatives, primarily interest rate swaps it uses as substitutes for noncallable debt, on the balance sheet in accumulated other comprehensive income (AOCI), which is a separate component of stockholders’ equity. For these types of transactions, FAS 133 does not require or permit noncallable debt to be marked to market. At June 30, 2002, the AOCI component of stockholders’ equity included a reduction of $9.5 billion, or 1.3 percent of the net mortgage balance, from the marking to market of these derivatives, up from a reduction of $4.8 billion at March 31, 2002. Accumulated other comprehensive income is not a component of core capital. At June 30, 2002, the notional balance of Fannie Mae purchased options totaled $251 billion compared with $238 billion at March 31, 2002. Fannie Mae also had $305 billion in interest rate swaps that were marked to market through accumulated other comprehensive income at June 30, 2002. The company had $290 billion in comparable swaps at March 31, 2002. Fannie Mae’s primary credit exposure on derivatives is that a counterparty might default on payments due, which could result in Fannie Mae having to replace the derivative with a different counterparty at a higher cost. Fannie Mae’s exposure on derivative contracts (taking into account master settlement agreements that allow for netting of payments and excluding collateral received) was $958 million at June 30, 2002. All of this exposure was to counterparties rated A-/A3 or higher. Fannie Mae held $680 million of collateral through custodians for these instruments. Fannie Mae’s exposure, net of collateral, was $278 million at June 30, 2002 versus $200 million at March 31, 2002. The replacement cost at June 30, 2002 represents less than two weeks of annualized pre-tax operating earnings.

201. On July 15, 2002, the Company held its second quarter 2002 earnings conference

call during which Defendants Raines and Howard made the following relevant statements:


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J. Timothy Howard - Federal National Mortgage Association - Chief Financial Officer & Executive Vice President

* * * This has been a terrific quarter, in a wide variety of ways. We've put together another outstanding financial performance, beating the concensus analysts’ estimates by 3 cents.

* * *

Franklin Raines, Federal National Mortgage Association - Chairman & Chief Executive Officer Thank you, Tim. As Tim mentioned, I have been actively involved in the area of corporate governance now in my role at the business round table. Let me give you general conclusions how we think about it at Fannie Mae. First, we believe that the serious wrongdoing that we have found in the -- so many corporations needs to be dealt with quite seriously and wrong doers need to be prosecuted and punished promptly to the full extent of the law.

* * * Now, as it applies directly to Fannie Mae, we believe that the developments in recent times have provided a level of assurance to our shareholders that is matched by no other company. First, we now will be subject to the SEC's disclosure rules that are well known and provide access within the SEC and disclosure system. Second, Fannie Mae will be adopting leading corporate governance principles to assure that we have the strongest corporate governance process. Third, investors will still be able to benefit from the wide range of voluntary initiatives we made with regard to disclosures that put us at the forefront of disclosures by financial firms worldwide.

* * * J. Timothy Howard - Federal National Mortgage Association - Chief Financial Officer & Executive Vice President

* * * The voluntary registration with the SEC would have been enough investor protection for any three-month period. But, as you know, we did even more than that this past quarter. On June 27th, our regulator, OFHEO announced the results of the first application of the risk-based capital test of Fannie Mae. With the implementation of this standard we are now subject to the most rigorous regulatory discipline on risk taking of any financial institution in the world. OFHEO applied this test to our book of business at March 31st, 2002 and calculated a risk-based capital


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requirement of $20.228 billion. That was 23% below our actual total capital on that same day, which was $26.29 billion. You might recall that the relevant capital measure for the risk-based standard is our total capital, which includes our $800 million loss reserve in addition to our equity capital.

* * *

The reason Fannie Mae was able to pass the initial application of this test isn't because it is easy, it is because we have known for some time that it has been coming. We have put in place a very large amount of option-based tests to help us pass the interest rate stress test, and have combined disciplined underwriting with extensive use of third-party credit enhancement to help us pass the credit test. Few companies in the world incur anything close to the costs we do, to hedge our risks. For the last several years, we have run and managed ourselves against our own internal version of the risk-based capital test and statute. As part of our voluntary disclosures we reported on how we fared against that test beginning with our December 2000 book. From our March 2001 book forward, we have consistently reported that our hedging structure has enabled us to pass our internal version of the risk-based test by an amount that exceeded 30% of our total capital. We passed the new OFHEO test by a smaller margin with only a 23% cushion but we still passed it. We now have the OFHEO version of the risk-based capital test up and running in house and we soon will be able to link it to our daily asset acquisition and funding decisions. This will have two valuable benefits for investors. First, it will make it very likely that we will be able to know what hedges we will need to maintain or add to keep us in compliance with the risk-based standard so that our minimum capital requirement will remain the binding one. Second, and perhaps even more importantly, investors will know that Fannie Mae now has a binding risk governor that literally prohibits us from straying from our conservative risk management posture, without incurring the immediate penalty of having to hold a sizable amount of additional capital. We and Freddie MAC are now the only companies in America and probably the world will such an externally imposed discipline.

* * * J. Timothy Howard - Federal National Mortgage Association - Chief Financial Officer & Executive Vice President

* * * As we undertook discussions with not only the SEC but also others in the administration, we, I believe, were able to convince them of the exceptionally


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high quality of our disclosures, and of the fact that our disclosures, passed and, in some cases, exceeded prevailing SEC requirements. So we do not plan or have any need to be supplementing our disclosures based on the agreement we made on Friday. As far as the obverse, namely pulling back on disclosures, no. We have no intention of doing that. For as long as I have been Chief Financial Officer of Fannie Mae, we have had a fundamental commitment to thorough, frequent comprehensive disclosure, because we think that it enhances investor understanding of our business and makes for more informed investment decisions. And the -- our stand on disclosures will not change that one whit.

* * * J. Timothy Howard, Federal National Mortgage Association - Chief Financial Officer & Executive Vice President

* * * I think because of our access to a wide range of debt combinations, callable, noncallable derivatives, cash-based, we do have lots of tools for making competitive bids for mortgage products at hurdle rates that meet or exceed our requirements. And I am optimistic that we will be able to maintain good, if not spectacular, rates of growth on the portfolio. Even if the yield curve does remain steep. One thing I will say, though, is that if spreads get to a level where it is not economic long-term to buy mortgages with the proper degree of hedging that is not only consistent with our risk management approach, but now essentially required by risk-based capital standard we will not bid for mortgages under those circumstances. So you as investors do not have to worry about us buying product that will not be good investments in the long term. Paul Miller, Freedman Billings Ramsay How would that impact your 15% EPS growth rate over the next couple of years, then? J. Timothy Howard, Federal National Mortgage Association - Chief Financial Officer & Executive Vice President Well, first of all, we don’t have a 15% EPS growth rate over the next couple of years. We never announced a fixed EPS growth target. We did announce a goal of doubling our earnings per share between 1998 and 2003 which works out to about 15% per year during those periods. If you annualize our EPS in the second quarter, 155 times four is 620. So based on that, you can estimate that we will very likely achieve the goal of doubling EPS between ’98 and 2003.

* * *


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Joel Hoff, Wakovia Thanks. Just a couple of questions. Clarification. Number one, did I hear you say, Tim that the standard would be workable soon and will it be workable on a daily basis by the end of September when the risk-based capital standards go into effect? And the second question. I didn’t understand why your EPS growth to volatility, you expect that to move up. Given the larger company, it seems like it should work the other way. J. Timothy Howard, Federal National Mortgage Association - Chief Financial Officer & Executive Vice President . . . The [sic] we have not yet had sufficient time to thoroughly understand the workings of the OFHEO standard to be able to hook it up, if you will, to the models that we use for making daily decisions on either interest rate risk management or credit risk management. We have a target date for doing so that target date is beyond the date at which the standard is going to be binding, which is the third quarter of this year. But we will accomplish that as soon as we possibly can. We have a reasonably good idea of what the requirement will produce. And as such, as interest rates move, we are confident that we will be able to maintain a level of hedging and a structure of hedging that permits us to pass the risk-based capital test with the amount of capital that we have on end. What we are talking about with hooking up the standard to our transaction analytics is more enhancing the efficiency with which we not only do our economic hedging but also a hedge to meet the risk-based capital requirement. I would think at the moment we are not as efficient as ultimately we can be and as we get more familiar with the standard that will improve. The point about likely increased -- I wouldn’t say increased volatility, but less extraordinary stability of earnings, is the larger we get, particularly on the portfolio side, the less latitude I feel we have to make significant changes in pacing of risk management decisions, in order to produce a smoother pattern of earnings. Previously we had been able to take more timing views, now given the fact that we are larger, we are doubled the size we were four years ago. And given the fact that we are larger, that to some extent takes away some of the flexibility that we used to have to make these timing decisions. And as a result, I think it is prudent to expect somewhat more of variability quarter to quarter and year to year. We will still be one of the most stable earnings companies in the S&P 500 just not as incredibly stable, I think, as we have been historically.


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202. On July 31, 2002 Defendant Raines made the following relevant remarks as part

of his presentation to the FDIC Panel entitled, “The Rise of Risk Management: Challenges for

Policy Makers”:

* * * Fannie Mae recognizes we have a unique responsibility to provide leadership. We are the second largest financial institution in America in terms of assets, and sixth in the world. We play a central role in the U.S. economy by funding the housing sector. To fulfill that purpose, we depend daily on access to the international capital markets. Investor confidence is critical to our success. So we have a keen interest not only in maintaining investor confidence in Fannie Mae, but also in doing our part to lift the overall market. Crisis in Confidence We are at a time of crisis in corporate America, and the crisis is well deserved. Periodically, throughout history, capitalism and selfish motives that underlie the system fall out of balance. We are in one of those periods right now. Three phenomena stand out. The first is a trend in compensation structures. Some compensation structures have fallen out of balance, in particular the overemphasis on stock option compensation. This can encourage management to make judgments that produce short-term financial performance and stock gains over the long-term health and growth of the company.

The idea of rewarding performance with stock options was intended to make management act like owners, which is good. But in some cases where the reliance on options was too great, management forgot that they were stewards of the company for the shareholders. Decisions that should have been made to serve the interests of all the owners morphed into decisions that primarily served the short-term interests of management.

The second phenomenon is a flight from the fundamentals, both by management and shareholders. Management has fled from the fundamentals of running the company to produce real profits backed up by real cash. And investors are looking for fast returns, not how a company is run, whether it has strong fundamentals, and what its prospects are for the long term.

The third phenomenon is the worst of all. It is the denial of responsibility by management. To be a CEO of a Fortune 500 corporation is a major responsibility to employees, customers, shareholders, and stakeholders. To hear CEOs claim they did not know, could not know, or did not need to know about how their companies took risks and made money was appalling. (Emphasis added.)


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As the crisis in confidence in corporate America deepens, the question is not whether, what, or when action is needed. We all agree we need action now.

Wrongdoers must be punished. The American people expect that, and we shouldn't treat white-collar crime any differently than we treat any other crime.

* * * Risk taking, management, and mitigants Risk taking and risk management are at the heart of capitalism. This is most clear when talking about financial companies, which take credit, interest rate, and operational risks. Risk management is issue number one for Fannie Mae. Managing risk on residential mortgages is what Congress chartered Fannie Mae as a private company to do.

* * * The best evidence is that for the last 15 years, through all kinds of economic scenarios, Fannie Mae has continued to produce double-digit growth in our operating earnings per share. Our credit losses remain at historic lows. Our mortgage portfolio duration remains in comfortable balance. And we have continued to expand homeownership to more people and more places. It all comes down to risk management.

* * * Given Fannie Mae’s large size and presence in the financial system, and our dependence on the capital markets and investor confidence, we have a keen interest in embracing the state-of-the-art risk mitigants, and even adopting the best ideas voluntarily. And indeed, that is what we have tried to do. As many of you know, back in October of 2000, Fannie Mae and Freddie Mac announced that we were going to adopt several cutting-edge voluntary initiatives to further enhance our transparency, liquidity, and market discipline. We were pleased at the time that Moody's called our initiatives "a new standard ... for the global financial market." (Incidentally, Moody's also suggested that our initiative "could usher in a wave of enhanced financial risk disclosure," but of course it took Enron to start that off.) Since that time, we have continued to examine and adopt new risk mitigants to further strengthen our safety and soundness, as well as the confidence of investors and policy makers. And today, our risk management practices are bolstered by seven major risk mitigants.

* * *

Our seventh risk mitigant is our financial disclosure regime, which provides both a static and an active picture of our financial condition and risk profile.


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Disclosure is critical to Fannie Mae. It's in our self-interest. We can't operate in the capital markets every day without giving investors a lot of detailed information about us. Investors also rely on the concept that "risk varies inversely with knowledge."

* * * We like making these disclosures because, again, we manage our risks and maintain enough capital to protect us against virtually any economic scenario you can imagine, even a meltdown. So we significantly hedge our risks, and we want investors to know that. But even with these disclosures, we've continued to look for more ways to open our books and improve our disclosures in both quality and quantity. For example, following the President's challenge to corporate leaders to increase transparency, we announced we would voluntarily register our common stock with the SEC and permanently become subject to its corporate disclosure requirements. We also announced that we would treat stock options as an expense to make our income statements even more clear.

These remarks were posted on the Fannie Mae website under Investor Relations for investors to

review.

203. On September 5, 2002 Defendant Raines made the following relevant remarks as

part of his presentation at the Merrill Lynch Banking and Services Investor Conference:

We're coming together at an important moment for Corporate America and the financial community, a time when we need to restore and strengthen investor trust and confidence in the market.

Our financial system, our economy and our companies cannot thrive without a healthy flow of investor capital. And right now, the steady stream of bad news about what seemed to be good companies has made investors more skeptical than ever. They want to see real business, real returns, real value and real numbers that add up. They want companies they can trust.

In other words, we're seeing a reemphasis on the fundamentals of free enterprise. And it is about time.


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We all know the fundamentals. They're the same whether you're a Fortune 500 corporation or the corner dry cleaners. You have to be a strong company in a strong market. You have to be competitive. You need to understand and manage your risks. You need be honest, open and accountable. And of course, you need to create value for the owners. These are basic and obvious principles. They are also success factors. And if there is any silver lining in this cloud over Corporate America, it is that the market will now reward companies that focus on their fundamentals, and yield strong, steady returns by doing what they do well. Fannie Mae has always been a company you can trust. For the last 15 consecutive years, through bull markets and bear markets, through all credit and market risk conditions, through the tech boom and bust, the recession of 2001 and now in this "Enron hangover" period, we've continued to focus on our fundamentals, and achieved strong, steady returns.

* * * [W]e have a competitive edge by earning a funding advantage, managing a safe asset, and specializing in the lowest-cost mortgage on the market. But we also have a competitive advantage over other mortgage holders that’s less obvious. It has to do with another fundamental of business, and that’s how we manage our risk. Does the company understand and hedge its risks?

* * * We manage our interest rate risk in a similar way. We manage our portfolio of mortgages with a goal of keeping the duration of the mortgages we own, and the


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securities we issue to purchase them, within a six-month range of each other, plus or minus. Every day we look to see how any change in interest rates might have affected our portfolio balance. If interest rates move by enough to push our duration gap outside our comfort zone, as will happen from time to time, we have a full range of tools to use, including how we fund new purchases and canceling or adding swaps, to move our portfolio back into balance. By purchasing derivatives such as interest rate swaps and options, we can convert our short-term debt into long-term debt, or turn bullet debt into callable debt. But let me note that Fannie Mae is a relatively small user of derivatives. We mostly use the most common and most liquid derivatives -- swaps and options. Our activity accounts for only one half of one percent, and 1 ½ percent, of those markets, respectively. A vast majority of our derivative counterparties are rated A or better. For counterparties with ratings below AAA, we require collateral to be posted. The result is that our net exposure is quite minimal compared with other participants in the derivatives market. At the beginning of this year, the largest commercial bank dealer in derivatives had $63 billion in derivatives credit exposure. Against that $63 billion credit exposure, they held $21 billion in collateral, giving them a net exposure of $42 billion -- $16 billion of which is with derivative counterparties rated below single A. In contrast, at the same time Fannie Mae had only $1 billion in derivatives credit exposure, and we held over $800 million in collateral against that, giving us a net exposure of only $200 million. And none of our net exposure was with counterparties below single A. By issuing securities and purchasing derivatives, we disperse our interest-rate risk to investors and derivative counterparties. The result is that for the last 15 years, through all kinds of economic scenarios, Fannie Mae has continued to produce double-digit growth in our operating earnings per share. Our credit losses remain at historic lows. Active portfolio management has enabled us to keep our mortgage portfolio duration gap within our preferred target band about two thirds of the time. And we have continued to expand homeownership to more people and more places. It all comes down to risk management.

* * *


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Is the company honest, open, and accountable? Disclosure is critical to Fannie Mae. It's in our self-interest. We can't operate in the global capital markets every day without giving investors a lot of detailed information about us, even more than we are required to provide.

* * * Does the company make real money?

* * * We’re one of only three companies in the S&P 500 that have produced double-digit growth in operating earnings per share for 15 years straight. And so far this year, strong business volumes, a rising net interest margin and continued low credit losses all bode well to extend our record for a 16th year. In fact, we continue to expect that growth in operating EPS this year will be above our already favorable long-term trend. And growth in operating EPS next year should continue to be strong even if below the exceptional growth rates for 2001 and 2002. And again, we’ve offered these steady, solid returns through all sorts of housing markets and economic conditions, through many ups and downs for other financial institutions, through the collapse of the thrift industry, through recessions, recoveries, credit crunches, and all sorts of booms and busts. No matter what, Fannie Mae has continued to do precisely what Congress chartered us to do: expand homeownership and provide a strong return for investors.


review.

204. On September 24, 2002 Defendant Howard made the following relevant remarks

as part of his presentation at the Banc of America Securities Investment Conference:

Today I intend to focus the bulk of my remarks on risk management issues, since these currently are being accorded the most investor and media attention. But I also want to highlight the other important components of the Fannie Mae investment story. Over the longer term, they will continue to underpin the company's earnings growth and overall value.

As investors return to fundamentals in the wake of a renewed focus on corporate responsibility and governance, there are five reasons to consider an investment in Fannie Mae.


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First, Fannie Mae is in a strong and growing market, residential mortgages. Second, our two businesses -- guaranteeing mortgages and holding them in portfolio -- each should grow faster than the mortgage market as whole. Third, we are disciplined risk managers, not simply risk takers, which allows us to translate top-line growth into bottom-line growth. Fourth, we are transparent and accountable. And finally, we offer compelling relative value.

* * * Disciplined Risk Management In order to turn growth in business volumes into growth in earnings, we need to manage the credit and interest-rate risks inherent in our businesses. And we do that, in a disciplined fashion. We carefully measure the risks that exist, choose which ones we wish to retain, and disperse the rest among a broad range of counterparties.

* * * The goal of Fannie Mae’s interest-rate risk management is to produce a growing amount of net interest income that has a high degree of stability over a very wide range of interest rate environments. The risk we take in the mortgage portfolio business is the potential for a mismatch between mortgage repayments and debt repricings. Our strategy for managing this risk has three components: ● First, matching the initial durations of our mortgages and debt;

● Second, issuing amounts and structures of callable debt and derivatives whose option values are equal to about half the values of the options in the mortgages we own, and


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● Third, using new mortgage purchases and debt issuance to rebalance the portfolio whenever its duration gap moves outside a range of plus-or-minus six months.

* * *

Any mortgage portfolio with less than a perfect option match between its assets and liabilities will have a duration gap that changes to some extent as interest-rates change. [O]ur portfolio’s duration gap exhibits this characteristic. We have set as an internal guideline to begin to rebalance our portfolio whenever its duration gap moves outside a range of plus or minus six months. Our strategy is to rebalance over time rather than immediately, and to use a combination of mortgage purchases, debt issuances, and derivatives to minimize the cost and market impact of this rebalancing.

* * * Transparency and Accountability Bumps in the disclosure road like those which now are occurring with our duration gap will not change our approach to openness and transparency, however. Fannie Mae is fully committed to being in the forefront of transparency, accountability, and best-in-class corporate governance practices. We believe they are in our long-term self-interest.

* * * Translating Top-line Growth into Bottom-line Growth We have also been one of the most consistently profitable. We are one of only three companies in the Standard and Poor’s 500 to have produced double-digit growth in operating earnings per share for the past fifteen years. We have done so through all sorts of housing markets and economic conditions, through many ups and downs for other financial institutions, through the problems in the thrift industry, and through credit crunches, recoveries and recessions. That’s not to say there hasn’t been variability in our quarterly or annual growth in net income or earnings per share. There has been, and will continue to be. But as you can see from this exhibit, the variability that has occurred in our operating EPS growth has been around a high average level. And for the past several years -- in fact, for more than the past decade -- our operating earnings per share growth has consistently and considerably exceeded the growth in mortgage debt outstanding.


review.

205. On October 15, 2002, Fannie Mae issued a press release announcing its financial

results for the third quarter of 2002 under the headline: "Fannie Mae Reports Record Third


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Quarter 2002 Operating Results; Operating Net Income of $1.631 Billion up 18.4 Percent over

Third Quarter 2001; Operating Earnings Per Diluted Common Share of $1.62 up 21.8 Percent;

Net Interest Margin Stable at 116 Basis Points." Therein, the Company stated:

Fannie Mae (FNM/NYSE), the nation's largest source of financing for home mortgages, today reported operating net income for the third quarter of 2002 of $1.631 billion, an 18.4 percent increase compared with the third quarter of 2001. Operating earnings per diluted common share (operating EPS) of $1.62 rose 21.8 percent above the same period in 2001. For the first nine months of 2002 Fannie Mae's operating net income was $4.722 billion, compared with $3.929 billion for the same period in 2001. Operating EPS for the first nine months of 2002 was $4.65, or 22.4 percent above the first nine months of 2001.

Third Quarter

Nine Months Ended September 30

2002 2001 Change 2002 2001 Change Operating Net $1.631 $1.377 18.4% $4.722 $3.929 20.2% Income (in billions) Operating EPS $1.62 $1.33 21.8% $4.65 $3.80 22.4% (in dollars)

Operating net income and operating EPS exclude the variability in earnings that results from including unrealized gains and losses from the change in the time value of purchased options as required under Financial Accounting Standard No. 133 (FAS 133). Also excluded is the one-time cumulative change in accounting principle from the adoption of FAS 133 on January 1, 2001. Operating net income and operating EPS provide consistent accounting treatment for purchased options and the options embedded in callable debt, and are the performance measures used by company management.

Net income on a Generally Accepted Accounting Principles (GAAP) basis for the third quarter of 2002 including the above FAS 133 items was $994.3 million, a decrease of 19.1 percent compared with the third quarter of 2001. GAAP EPS was $0.98, 17.6 percent below the same period last year. The decline in GAAP net income and EPS in the third quarter was due to a $965.2 million increase in unrealized losses in the time value of purchased options. This increase was driven by a change in interest rates that caused a shift in the value under FAS 133 between the time value and the intrinsic value of purchased options that is unrelated to portfolio rebalancing actions during the quarter. Moreover, because Fannie Mae holds options to maturity or exercise, mark-to-market losses in time value are never realized. The effects of FAS 133 are discussed more fully in the FAS 133 section later in this release. GAAP net income and EPS were $3.667 billion and $3.59 for the nine months ended September 30, 2002, and $3.925


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billion and $3.80 for the nine months ended September 30, 2001. Page one of the attachments to this release provides a reconciliation of net income and operating net income. Highlights of Fannie Mae’s financial performance in the third quarter of 2002 include:

* * * An average net interest margin of 116 basis points, level with the

second quarter of 2002 and 6 basis points above the third quarter of 2001;

An increase in fee and other income of $43 million versus the third quarter of 2001;

* * *

Franklin D. Raines, Fannie Mae's Chairman and Chief Executive Officer, said, "Very strong volumes and stable-to-increasing business margins enabled Fannie Mae to produce another record quarter of operating earnings per share." . . . (Emphasis added.)

Timothy Howard, Fannie Mae's Executive Vice President and Chief Financial Officer, said that commitments to purchase mortgages for the company's portfolio were $57 billion for September and $128 billion for the quarter, both record amounts. Howard noted that because actual mortgage purchases had lagged well behind commitments -- at $34 billion for September and $74 billion for the quarter -- portfolio growth in the third quarter slowed to a 5.9 percent annual rate. Howard said that it was not unusual in a refinance period for portfolio commitments to outpace purchases, and added that the balance of outstanding commitments had risen to a record $84 billion at the end of September. Said Howard, "Given the large amount of commitments currently outstanding and the likelihood of a continued strong pace of commitments for at least another few months, the outlook for portfolio growth through the first part of 2003 seems very promising. " Howard said that guaranty fee income had continued to increase at an exceptionally rapid pace. Fueled by very strong growth in outstanding MBS and a relatively stable average guaranty fee rate, the company's third quarter guaranty fee income was 20.5 percent above the third quarter of 2001. Howard noted that as typically occurs in a period of very low interest rates, the duration gap on Fannie Mae's mortgage portfolio widened somewhat during the quarter. Howard said that the portfolio's duration gap fell from minus four months in June to minus fourteen months at the end of August, before narrowing to minus ten months at the end of September. Said Howard, "The movement in our duration gap last quarter is within the range of what we have experienced historically. As the refinance wave plays out, we expect it to return to a more


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normal level." Howard emphasized that the company's duration gap, which is not a reliable predictor of the company's net income, had no negative effects on Fannie Mae's financial results in the third quarter. Howard noted that Fannie Mae's primary portfolio risk management measure, four-year net interest income at risk, moved by considerably less than the duration gap -- from 2.4 percent in June to 6.7 percent in August, then back to 3.9 percent in September. Howard added that during the quarter Fannie Mae's percentage of option-based debt rose from 58 percent to 68 percent, reflecting increased portfolio rebalancing.

* * * Portfolio investment business results Fannie Mae's portfolio investment business manages the interest rate risk of the company's mortgage portfolio and other investments. The results of this business are largely reflected in adjusted net interest income, which is net interest income less the amortization expense of purchased options. Adjusted net interest income for the third quarter of 2002 was $2.192 billion, up 15.9 percent from $1.892 billion in the third quarter of 2001. This increase was driven by a 9.9 percent rise in the average net investment balance and a 6 basis point increase in the average net interest margin. Adjusted net interest income for the first nine months of 2002 was $6.514 billion, up 22.1 percent from $5.335 billion during the comparable period in 2001.

Concurrent with the effective date of Fannie Mae's risk-based capital requirement on September 13, 2002, the company elected to transfer $135 billion of portfolio and investment securities, classified as held-to-maturity, to the available-for-sale category. This change had no effect on net income. In conjunction with this change, Fannie Mae revised the calculation of its mortgage portfolio growth statistic to exclude the effect of any unrealized gains or losses. The calculation now will be based on unpaid principal balance, which also excludes deferred balances and the allowance for losses. Fannie Mae's gross mortgage portfolio -- before unrealized gains or losses on available for sale securities, deferred balances, and the allowance for losses -- grew at an annual rate of 5.9 percent during the third quarter of 2002, ending the quarter at $751 billion. Portfolio growth in September rose to an annual rate of 8.9 percent, as mortgage purchases increased in response to lower mortgage interest rates and a high rate of mortgage refinance activity. The company's net mortgage portfolio -- including unrealized gains or losses on available for sale securities, deferred balances, and the allowance for losses -- was $758 billion at the end of the third quarter of 2002 compared with $741 billion at the end of June.

* * *

The company's net interest margin averaged 116 basis points in the third quarter of 2002, equal with the second quarter and up 6 basis points from the third quarter of 2001. The company's net interest margin has averaged 116 basis points


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year-to-date, up from 107 basis points for the first nine months of 2001. Fannie Mae's net interest margin for the third quarter and first nine months of 2002 continued to benefit from an unusually steep yield curve and low short-term interest rates.

* * * Capital Fannie Mae's core capital, which is the basis for the company's statutory minimum capital requirement, was $26.5 billion at September 30, 2002 compared with $23.8 billion at September 30, 2001 and $26.4 billion at June 30, 2002. Core capital was an estimated $729 million above the statutory minimum at September 30, 2002. At June 30, 2002, core capital was $1.155 billion above the statutory minimum. Total capital, which includes core capital and the general allowance for losses and is the basis for the risk-based capital stress test, was $27.3 billion at September 30, 2002 compared with $24.6 billion at September 30, 2001 and $27.2 billion at June 30, 2002. The risk-based capital standard utilizes a stress test to determine the amount of capital needed to protect against credit and interest rate risks, and requires 30 percent in additional capital to protect against unspecified management and operations risks. Office of Federal Housing Enterprise Oversight (OFHEO) will begin to use its risk-based standard for regulatory purposes for the third quarter and release the results in December. The higher of the risk-based or minimum capital standard will be binding.

* * * Derivatives and FAS 133

* * * Fannie Mae accounts for its derivatives under FAS 133, Accounting for Derivative Instruments and Hedging Activities, which was adopted on January 1, 2001. The implementation of this standard resulted in significant accounting presentation changes to both the company’s income statement and balance sheet. FAS 133 requires that Fannie Mae mark to market on its income statement the changes in the time value, but not the total value, of its purchased options -- interest rate swaptions and interest rate caps. The mark to market of the time value of Fannie Mae’s purchased options during the third quarter of 2002 resulted in a net unrealized loss of $1.378 billion, which is reported on the purchased option expense line of the income statement. Purchased options expense in the third quarter of 2002 includes $399.2 million in amortization expense, which was included in net interest income prior to the adoption of FAS 133 and currently is included in adjusted net interest income and in operating earnings. This amortization expense represents the straight-line amortization of the up-front premium paid to purchase the options.

* * *


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At September 30, 2002, the AOCI component of stockholders’ equity included a reduction of $16.5 billion, or 2.2 percent of the net mortgage balance, from the marking to market of these derivatives, compared with a reduction of $9.5 billion at June 30, 2002. Partially offsetting the reduction in AOCI from the mark to market of derivatives was a $5.0 billion unrealized gain on the available-for-sale securities portfolio. Accumulated other comprehensive income is not a component of core capital.

* * * Fannie Mae’s exposure on derivative contracts (taking into account master settlement agreements that allow for netting of payments and excluding collateral received) was $2.723 billion at September 30, 2002. All of this exposure was to counterparties rated A-/A3 or higher. Fannie Mae held $2.322 billion of collateral through custodians for these instruments. Fannie Mae’s exposure, net of collateral, was $401 million at September 30, 2002 versus $278 million at June 30, 2002. The replacement cost at September 30, 2002 represents about three weeks of annualized pre-tax operating earnings. 206. On January 15, 2003, Fannie Mae reported financial results for the fourth quarter

and year ended December 31, 2002, under the headline:

Fannie Mae Reports 2002 Financial Results GAAP net income at $4,619 million, down 21.6 percent; Net income per diluted common share at $4.53, down 20.8 percent

Operating net income at $6,349 million, up 19.1 percent; Operating net income per diluted common share at $6.31, up 21.3 percent.

The release stated in pertinent, part:

Fannie Mae (FNM/NYSE), the nation’s largest source of financing for home mortgages, today reported financial results for the year ended December 31, 2002.

GAAP Earnings Operating Earnings

2002 2001 Change 2002 2001 Change

Net Income $4,619 $5,894 (21.6)% $6,394 $5,367 19.1% (in millions) EPS $4.53 $5.72 (20.8)% $6.31 $5.20 21.3% (in dollars)


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GAAP Earnings Fannie Mae’s net income was $4,619 million in 2002 compared with $5,894 million in 2001, and earnings per diluted common share (EPS) were $4.53 in 2002 compared with $5.72. For 2002 strong growth in net interest income of 30.6 percent and guaranty fee income of 22.5 percent were more than offset by a $4,507 million increase in mark-to-market losses in the time value of purchased options used to hedge the company’s interest rate risk. These unrealized mark-to-market losses were recorded in accordance with Financial Accounting Standard No. 133 (FAS 133), Accounting for Derivative Instruments and Hedging Activities. For the fourth quarter of 2002 Fannie Mae’s income was $952 million, or $0.94 per diluted common share, compared with $1,969 million, or $1.92 per diluted common share, for the fourth quarter of 2001. In the fourth quarter of 2002 $1,881 million of mark-to-market losses on purchased options were recorded compared with $578 million of mark-to-market gains in the fourth quarter of 2001.

Operating Earnings Operating net income and operating EPS are non-GAAP (generally accepted accounting principles) measures that are the primary performance measures used by Fannie Mae’s management. Operating net income and EPS provide consistent accounting treatment for purchased options and the options embedded in callable debt by allocating the cost of purchased options over their expected lives, comparable to the accounting used for these items prior to the adoption of FAS 133. Fannie Mae’s operating net income measure may not be comparable to similarly titled measures used by other companies. Page one of the attachments to this release provides a reconciliation of GAAP to operating net income. Management believes that operating net income and operating EPS more accurately reflect the financial results of the company than GAAP measures which include the FAS 133 treatment of purchased options.

Operating net income was $6,394 million in 2002 compared with $5,367 million in 2001. Operating EPS in 2002 was $6.31 or 21.3 percent above 2001. Operating net income for the fourth quarter of 2002 was $1,672 million, a 16.3 percent increase compared with the fourth quarter of 2001. For the fourth quarter of 2002 operating EPS of $1.66 rose 18.6 percent above the same period in 2001. During 2002, GAAP net income was $1,775 million less than operating net income because of $4,545 million (on a pre-tax basis) in mark-to-market losses in the time value of purchased options -- interest rate swaptions and interest rate caps. Mark-to-market losses on these options were the result of increased use of options and significant declines in interest rates during the year, mitigated by an increase in interest rate volatility. The unrealized mark-to-market losses in purchased option time value in 2002 were more than offset by increases in the intrinsic value of these options, which are not reflected in GAAP net income. Because Fannie Mae generally holds purchased options to maturity or exercise, quarterly fluctuations in time value will net to the initial option premium over the


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expected lives of these options, and total purchased options expense therefore will equal the purchased option amortization expense included in operating net income. In 2001 GAAP net income was $527 million more than operating net income.

2002 Financial Performance Summary Highlights of Fannie Mae’s 2002 financial performance include:

* * * Taxable-equivalent revenue of $11.9 billion, up 16.8 percent

compared with 2001; An average net interest margin of 115 basis points compared

with 111 basis points in 2001;

* * * Franklin D. Raines, Fannie Mae’s Chairman and Chief Executive Officer, said, "In an extremely difficult business environment that affected virtually every company in America, Fannie Mae's operating results in 2002 were among the best in the company's history." Raines noted that in 2002 Fannie Mae reported a second consecutive year of growth in operating earnings per share in excess of 20 percent, and posted its 16th consecutive year of double-digit growth in operating earnings per share. Raines said credit-related losses remained at historically low levels in 2002, and that in spite of volatile interest rates the duration gap on the company's mortgage portfolio remained within its preferred range for all but three months of the year. Said Raines, "Fannie Mae's disciplined risk management in the fast-growing market of residential mortgage finance has enabled us to achieve a record of growth and consistency of earnings over the past decade and a half that is without equal in financial services." (Emphasis added.)

Fannie Mae’s Chief Financial Officer, Timothy Howard, said that the company's 21.3 percent growth in operating earnings per share in 2002 was paced by 16.8 percent growth in taxable equivalent revenues. Adjusted net interest income -- net interest income less purchased options amortization expense -- grew by 16.7 percent during the year, while guaranty fees grew by 22.5 percent. Paced by record transactions and technology fees, Fannie Mae's fee and other income rose by $81 million during the year.

* * *

Portfolio investment business results Fannie Mae’s portfolio investment business manages the interest rate risk of the company’s mortgage portfolio and other investments. The results of this business are largely reflected in net interest income. Net interest income for 2002 was $10,566 million, up 30.6 percent from $8,090 million in 2001. Adjusted net


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interest income, which is net interest income less the amortization expense of purchased options, was $8,752 million, up 16.7 percent from $7,500 million in 2001. This increase was driven by a 12.2 percent rise in the average net investment balance and a 4 basis point increase in the average net interest margin. Net interest income was $3,012 million in the fourth quarter of 2002 compared with $2,404 million during the comparable period in 2001. Adjusted net interest income was $2,238 million in the fourth quarter of 2002, up 3.4 percent from $2,165 million during the comparable period in 2001.

* * * The company’s net interest margin averaged 115 basis points in 2002, up from 111 basis points in 2001. The company’s net interest margin averaged 114 basis points in the fourth quarter of 2002 compared with 121 basis points in the fourth quarter of 2001 and 116 basis points in the third quarter of 2002. Fannie Mae’s net interest margin continued to benefit from an unusually steep yield curve and low short-term interest rates.

* * * Purchased option expense -- the mark-to-market of the time value of purchased options -- was a net mark-to-market loss of $4,545 million during 2002, compared with a net mark-to-market loss of $37.4 million during 2001. Purchased option expense totaled $1,881.1 million in the fourth quarter of 2002, compared with $577.9 million of income during the same period in 2001. During the fourth quarter Fannie Mae prospectively adopted a preferred method for measuring the time value on interest rate caps at purchase. This change will not affect the total expense that will be recorded in the income statement over the life of the caps, and has no effect on operating earnings, but resulted in a pre-tax decline in purchased options expense of $282.3 million in the current quarter.

* * * Capital Fannie Mae’s core capital, which is the basis for the company’s statutory minimum capital requirement, was $28.1 billion at December 31, 2002 compared with $25.2 billion at December 31, 2001 and $26.5 billion at September 30, 2002. Core capital was an estimated $877 million above that statutory minimum at December 31, 2002. At September 30, 2002, core capital was $729 million above the statutory minimum. Total capital, which includes core capital and the general allowance for losses and is the basis for the risk-based capital stress test, was $28.9 billion at December 31, 2002 compared with $26.0 billion at December 31, 2001 and $27.3 billion at September 30, 2002. The risk-based capital standard developed by Fannie Mae’s regulator, the Office of Federal Housing Enterprise Oversight (OFHEO), became binding during the third quarter. This standard utilizes a stress test to determine the amount of total capital the company needs to hold to protect against credit and interest rate risk, and requires an additional 30 percent capital for management


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and operations risk. At September 30, 2002, Fannie Mae’s total capital exceeded the OFHEO risk-based capital requirement by $5.8 billion. The higher of Fannie Mae’s risk-based or minimum capital standard is binding.


* * * Fannie Mae accounts for its derivatives under FAS 133, which was adopted on January 1, 2001. The implementation of this standard resulted in significant accounting presentation changes to both the company’s income statement and balance sheet.

* * * The mark-to-market of the time value of Fannie Mae’s purchased options during 2002 resulted in a net mark-to-market loss of $4.545 billion, which is reported on the purchased option expense line of the income statement. Purchased option expense in 2002 includes $1.814 billion in amortization expense, which was included in net interest income prior to the adoption of FAS 133 and currently is included in adjusted net interest income and in operating net income. This amortization expense represents the straight-line amortization of the up-front premium paid to purchase the options over the expected life of the options.

* * * At December 31, 2002, the AOCI component of stockholders’ equity included a reduction of $16.3 billion, or 2.0 percent of the net mortgage balance, from the marking to market of these derivatives. The comparable reductions to AOCI were $16.5 billion at September 30, 2002 and $9.5 billion at June 30, 2002. Partially offsetting the reduction in AOCI from the mark to market of derivatives was a $4.5 billion mark-to-market gain on the available-for-sale securities portfolio. Accumulated other comprehensive income is not a component of core capital.

* * * Fannie Mae’s exposure on derivative contracts (taking into account master settlement agreements that allow for netting of payments and excluding collateral received) was $3.301 billion at December 31, 2002. All of this exposure was to counterparties rated A-/A3 or higher. Fannie Mae held $3.104 billion of collateral through custodians to offset the risk of the exposure for these instruments. Fannie Mae’s exposure, net of collateral, was $197 million at December 31, 2002 versus $401 million at September 30, 2002. The replacement cost at December 31, 2002 represents about one week of annualized pre-tax operating net income.

207. On January 15, 2003, during Fannie Mae’s Fourth Quarter Earnings Conference

Call, Defendant Howard stated the following:


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Tim Howard – Fannie Mae – CFO

* * * The last two years saw exceptional growth in operating EPS of over 21% each year.

* * * Now, let me close with a few words about interest rate risk management. We have, for the past dozen years or so, followed risk management strategies consistent with the attainment of our objective of low risk growth. Low risk growth is exactly what it sounds like, growth but only if it can be obtained consistent with well defined, conservatively set risk parameters. Those risk parameters come first, but the internally set guidelines are our statutory risk-based capital standard. We take our risk guidelines very seriously, and our financial results show it. We have a decade and a half record of earnings growth and consistency that would not have been possible without strict adherence to very conservative risk standards.

* * * Our goal continues to be to structure our assets and liabilities so that our duration GAAP stays within a range of plus or minus six months about two-thirds of the time. Our experience is if this posture allows us to maximize long term returns to our shareholders while maintaining a highly conservative risk position.

* * * Given the rigor of our risk based capital standard, our objective from the time it was first described in statute has been to have asset liability structure and an approach to underwriting and reinsuring credit risk that would enable us to pass the risk base capital test with a comfortable cushion. We define comfortable as being large enough that there's no realistic chance of falling short, even if interest rates move dramatically at the end of the quarter. We did not then and do not now have a goal of exceeding the requirement of the risk base capital standard by as much as we can. Our approach to the risk based capital standard is the same as our approach to the minimum capital standard. In each case, we want a capital cushion that's large enough to ensure we won't fall short of the requirement, but not so large as to raise concerns that we are being inefficient with our use of capital, from the standpoint either of the shareholders or policy makers. To be clear here again, the way we measure ourselves with respect to the risk base capital standard is not the amount by which we exceed it. It's meeting it with a comfortable margin. Because of the rigor of the standard, we believe that investors, policy makers and others can be assured that we're operating at an exceptionally high level of safety as long as our risk base capital is less than core capital. We think we have struck the right balance between disciplined risk management and the potential for long-term earnings growth. We, of course, could increase our spending on hedges if we wanted to reduce the degree of movement in the monthly risk measures, but we wouldn't reduce them very much and we certainly wouldn't eliminate it. In doing that, we would likely have the long-term cost of diminished future earnings cost.


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* * *

Dean Unger - New Berger Berman - Analyst Right. I guess my question is, what -- so excluding the option expense, what was going on there? I mean, it's not a given that that thing automatically goes up like that. I want to know, what were the factors that made it increase so much in the quarter? Tim Howard - Fannie Mae - CFO Let's say if we were to put on non-callable debt and add an a option to it, the short data debt. We would have a low, high gross net interest income. Later on the cost of whether it's a cap or any type of a hedge, what we do on operating income or adjusted net interest income is take the cost of the purchase options, amortize them over the life, net the two to get the best estimate of the effective cost of the combination of non-callable debt. That's what operating does. If you look at GAAP net interest income, you are capturing the effect of the lower cost of shorter dated non-callable debt which expands the reportable GAAP. That's many reasons why the GAAP number is hard to interpret on its own. 208. On March 31, 2003, Fannie Mae, for the first time, filed its annual report for the

2002 fiscal year with the SEC on Form 10-K (“2002 10-K”). The Company's 2002 10-K was

signed by Raines, Howard and Spencer and reaffirmed the Company's previously announced

financial results and incorporated its financial results for the fiscal year ending December 31,

2001. Defendants Raines and Howard also filed certifications with the report, as required by the

Exchange Act, in which they certified that: (i) the report did not contain any untrue statement of

a material fact or omit to state any material fact necessary to make the statements made not

misleading; (ii) the financial statements and financial information included in the report fairly

presented in all material respects the financial condition, results of operations and cash flows of

the Company as of and for the periods represented; and (iii) that Raines and Howard were

responsible for establishing and maintaining disclosure controls and procedures as defined in the

Exchange Act for the Company and that they had designed, or supervised the design, of such


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controls and procedures to ensure that material information relating to the Company was made

known to them by others in the Company.

209. The 2002 Form 10-K also contained the following representations and disclosures

regarding the Company’s earnings per share and FAS 133:

2002 OVERVIEW 2002 was a year of notable achievements for Fannie Mae. We produced strong financial results and made continued progress on our key strategic initiatives in an uncertain economic environment marked by significant interest rate volatility and more intense competition for mortgages in the secondary market. We reported net income of $4.619 billion and diluted earnings per share (“diluted EPS”) of $4.53 in 2002, compared with $5.894 billion and $5.72 in 2001, and $4.448 billion and $4.29 in 2000. Our reported results are based on generally accepted accounting principles (“GAAP”), which include the effects of our January 1, 2001 adoption of Financial Accounting Standard No. 133 (“FAS 133”), Accounting for Derivative Instruments and Hedging Activities.

* * *

During 2002, we made progress on several key strategic initiatives to support our mission of increasing homeownership and affordable rental housing for all Americans. We align our strategies with and measure our performance against six long-term corporate goals.

* * *

Optimal Risk Management: Our financial success depends on the ability of our two core lines of business to effectively manage interest rate risk and credit risk on home mortgages. By taking an active, highly disciplined approach in managing these risks, we have honed our risk management tools over the years to reduce our risk exposure, expand our service to American homebuyers, and deliver double-digit core business earnings growth for the last 16 years through all kinds of economic scenarios. Record Financial Performance: One of our key financial performance goals, announced in 1999, is a five-year goal to double Fannie Mae’s core business diluted earnings per share to $6.46 by the end of 2003. With an increase in core business earnings of nearly 90 percent over the last 4 years, we are on track to achieve this five-year goal.

* * *

Because of Fannie Mae’s critical role in the housing finance system, one of our core commitments is to maintain the highest standard of transparency in our financial disclosures. In our on-going efforts to enhance Fannie Mae’s transparency, we announced in 2002 our voluntary initiative to register Fannie


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Mae’s common stock with the Securities and Exchange Commission under Section 12(g) of the Securities Exchange Act of 1934. This report is our first periodic report filed pursuant to our voluntary initiative.

* * *

Cumulative Effect of Change in Accounting Principle Effective January 1, 2001, we adopted FAS 133, as amended by Financial Accounting Standard No. 138, Accounting for Derivative Instruments and Certain Hedging Activities— an amendment of FASB Statement No. 133. Our adoption of FAS 133 on January 1, 2001, resulted in a cumulative after-tax increase to income of $168 million ($258 million pre-tax) in 2001. The cumulative effect on earnings from the change in accounting principle was primarily attributable to recording the fair value of the time value of purchased options, which are used as a substitute for callable debt securities.

* * *

APPLICATION OF CRITICAL ACCOUNTING POLICIES Fannie Mae’s financial statements and reported results are based on GAAP, which requires us in some cases to use estimates and assumptions that may affect our reported results and disclosures. We describe our significant accounting policies in the Notes to Financial Statements under Note 1, “Summary of Significant Accounting Policies.” . . . Our critical accounting estimates include determining the adequacy of the allowance for loan losses and guaranty liability for MBS; projecting mortgage prepayments to calculate the amortization of deferred price adjustments on mortgages and mortgage-related securities held in portfolio and guaranteed mortgage-related securities; and estimating the time value of our purchased options. Management has specifically discussed the development and selection of each critical accounting estimate with the Audit Committee of Fannie Mae’s Board of Directors. Our Audit Committee has also reviewed our disclosures in this MD&A regarding Fannie Mae’s critical accounting estimates.

2002 10-K, at 23-25, 55.

210. With respect to Fannie Mae’s accounting for premiums paid on interest rate caps,

the 2002 10-K stated:

During the fourth quarter of 2002, we refined our methodology for estimating the initial time value of interest rate caps at the date of purchase and prospectively adopted a preferred method that resulted in a $282 million pre-tax reduction in purchased options expense and increased our diluted EPS for 2002 by $.18. . . . This approach is more consistent with our estimate of time value subsequent to the initial purchase date.


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2002 10-K, at 26, 32. A similar statement is made at p. 60 and in the Notes to Financial

Statements at p. 113.

211. With respect to Fannie Mae’s compliance with SFAS 91 in accounting for

amortization of deferred price adjustments, the 2002 10-K contained the following statements:

We apply the interest method to amortize the premiums, discounts, and other purchase price adjustments into income. …On a periodic basis, we evaluate whether we should change the estimated prepayment rates used in the amortization calculation. We reassess our estimate of the sensitivity of prepayments to changes in interest rates and compare actual prepayments versus anticipated prepayments. If changes are necessary, we recalculate the constant effective yield and adjust net interest income or guaranty fee income for the amount of premiums, discounts, and other purchase price adjustments that would have been recorded if we had applied the new effective yield since acquisition of the mortgage assets or inception of a guaranty.

2002 10-K, at 57.

212. Similarly, the 2002 10-K also represented:

In accordance with FAS 91, we use actual principal prepayment experience and estimate future principal prepayments to calculate the constant effective yield necessary to apply the interest method in the amortization of purchase discount or premium and other deferred price adjustments. We aggregate mortgage-related securities by similar characteristics such as loan type, acquisition date, interest rate, and maturity to evaluate prepayments. We use historical prepayment data and expected prepayment performance under varying interest rate scenarios to estimate future prepayments.

2002 10-K, at 110.

213. Describing how the Company addressed interest rate risk management, the 2002

10-K stated:

Interest Rate Risk Management Interest rate risk is the risk of loss to future earnings or long-term value that may result from changes in interest rates. . . . The Board of Directors oversees interest rate risk management through the adoption of corporate goals and objectives and the review of regular reports on performance against them. Senior management is responsible for ensuring that appropriate long-term strategies are in place to achieve the goals and objectives. Management establishes reference points for the key performance measures that we use to signal material changes in risk and to


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assist in determining whether we should adjust portfolio strategy to achieve long-term objectives. Management regularly reports these measures and reference points to the Board of Directors.

* * * Many of our projections of mortgage cash flows in our interest rate risk measures depend on our proprietary prepayment models. …We maintain a research program to constantly evaluate, update, and enhance these assumptions, models, and analytical tools as appropriate to reflect management’s best assessment of the environment.

* * * Management develops rebalancing actions based on a number of factors that include the relative standing of both net interest income at risk and duration gap, as well as analyses based on additional risk measures and current market activities and conditions. We establish internal, reference points, or indicators, for our risk measures to signal when we should re-examine the risk profile of our assets. . . . As these risk measures begin to move beyond our internally established reference points, we consider actions to bring them within our preferred ranges in a manner that is consistent with achieving Fannie Mae’s earnings objectives. As a risk measure moves further outside our preferred range, we place significantly greater emphasis on reducing our risk exposure and less emphasis on earnings objectives. We have not established a specific time horizon over which rebalancing actions must take place.

2002 10-K, at 61-62, 64.

214. With respect to its management of operations risk, Defendants said the following

in the 2002 Form 10-K:

Operations Risk Management Operations risk is the risk of potential loss resulting from a breakdown in, or failure to establish, controls and procedures. Examples of control breakdowns include circumvention of internal controls, human error, systems failure and fraud. Management has implemented extensive policies and procedures to both establish and monitor internal controls to decrease the likelihood of any control breakdowns. Fannie Mae’s Office of Auditing also independently tests the adequacy of, and adherence to, internal controls and related policies and procedures. We actively manage Fannie Mae’s operations risk through numerous oversight functions, such as:

• Exception reporting and management oversight of financial and forecasting information through verification, reconciliation and independent testing

• Management questionnaires that identify key risks, controls in place to mitigate those risks, and control weaknesses


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• Key performance indicators (KPIs) that track operational metrics and potential risk exposure

• Quarterly senior and executive management internal control certifications

• Internal audit work that substantiates the adequacy of the internal control environment as well as direct reporting of this work to the Audit Committee of the Board of Directors

• Comprehensive disaster recovery planning and testing Management regularly reconciles financial and accounting information and model results to source documents to ensure completeness and accuracy of financial reporting. Financial forecast model results are regularly reconciled to actual results and the models are recalibrated as necessary to mitigate modeling risk. The Office of Auditing also periodically benchmarks the critical models, evaluates the reasonableness of the underlying assumptions, and validates the key algorithms embedded within them. Control weaknesses are identified as well as the steps being taken to address them. The Office of Auditing reviews and validates these assessments for reasonableness and accuracy.

* * * On a quarterly basis, senior and executive management certify that internal controls are adequate … and that all significant issues or control weaknesses that could have a material impact on the financial statements have been disclosed. The Office of Auditing reviews these certifications for reasonableness. The quarterly certifications are one of the key inputs for our Chief Executive Officer and Chief Financial Officer’s written certifications that our financial statements fairly present Fannie Mae’s financial condition and results of operations in all material respects. In addition to the oversight functions indicated above, the Office of Auditing assesses risk and the underlying control environment annually throughout the company and then implements a comprehensive audit plan to assess risk and validate key controls.

2002 10-K, at 94-95.

215. Also, in the 2002 Form 10-K, Defendants Raines and Howard said that they had

reviewed and determined the internal controls were effective, stating in pertinent part as follows:

Controls and Procedures Within 90 days prior to the date of this report, we carried out an evaluation, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures. Based on this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were


159

effective. Disclosure controls and procedures are controls and procedures that are designed to ensure that information we disclose in our periodic reports is recorded, processed, summarized, and reported within the designated time periods. In addition, based on this most recent evaluation, we have concluded that there were no significant changes in our internal controls or in other factors that could significantly affect these controls subsequent to the date of their last evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.

2002 10-K, at 95-96.

216. With respect to derivative instruments and hedging activities, the 2002 10-K

stated in pertinent part:

Derivative Instruments and Hedging Activities . . . Subject to certain qualifying conditions, we may designate a derivative as either a hedge of the cash flows of a variable-rate instrument or anticipated transaction (cash flow hedge) or a hedge of the fair value of a fixed-rate instrument (fair value hedge). . . . For a derivative not qualifying as a hedge, or components of a derivative that are excluded from any hedge effectiveness assessment, we report fair value gains and losses in earnings. If a derivative no longer qualifies as a cash flow or fair value hedge, we discontinue hedge accounting prospectively. We continue to carry the derivative on the balance sheet at fair value and record fair value gains and losses in earnings until the derivative is settled. For discontinued cash flow hedges, we recognize the gains or losses previously deferred in AOCI in earnings in the same period(s) that the hedged item affects earnings. For discontinued fair value hedges, we no longer adjust the carrying amount of the hedged asset or liability for changes in its fair value. We then amortize previous fair value adjustments to the carrying amount of the hedged item to earnings over the remaining life of the hedged item using the effective yield method.

2002 10-K, at 112.

217. With respect to Fannie Mae’s documentation of its hedging activity, the 2002 10-

K stated:

We formally document all relationships between hedging instruments and the hedged items, including the risk management objective and strategy for undertaking various hedge transactions. We link all derivatives to specific assets and liabilities on the balance sheet or to specific forecasted transactions and


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designate them as cash flow or fair value hedges. We also formally assess, both at the hedge’s inception and on an ongoing basis, whether the derivatives that we use in hedging transactions are highly effective in offsetting changes in the cash flows or fair values of the hedged items.

2002 10-K, at 136-37.

218. The 2002 10-K also noted that, “Consistent with FAS 133, we record changes in

the fair value of derivatives used as cash flow hedges in AOCI to the extent they are effective

hedges. We amortize fair value gains or losses in AOCI into the income statement and reflect

them as either a reduction or increase in interest expense over the life of the hedged item. . . . If

there is any hedge ineffectiveness or derivatives do not qualify as cash flow hedges, we record

the ineffective portion in the ‘Fee and other income, net’ line item on the income statement. We

included a pre-tax loss of $.4 million in 2002 and $3 million in 2001 related to the ineffective

portion cash flow hedges in ‘Fee and other income, net.’” 2002 10-K, at 138.

219. With respect to changes in the fair value of derivatives used as fair value hedges,

the 2002 10-K stated:

We record changes in the fair value of derivatives used as fair value hedges in the “Fee and other income, net” line item on the income statement along with offsetting changes in the fair value of the hedged items attributable to the risk being hedged. Our fair value hedges produced hedge ineffectiveness totaling $.2 million of expense during the year ended December 31, 2002. Our fair value hedges produced no hedge ineffectiveness during the year ended December 31, 2001.

2002 10-K, at 139.

220. At the end of the 2002 Form 10-K, Defendants included a section entitled “Report

of Management,” which was signed by Defendants Howard and Spencer. According to this

report, which is addressed to the stockholders of Fannie Mae:

The management of Fannie Mae is responsible for the preparation, integrity, and fair presentation of the accompanying financial statements and other information appearing elsewhere in this report. In our opinion, the financial statements have


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been prepared in conformity with accounting principles generally accepted in the United States of America appropriate in the circumstances, and the other financial information in this report is consistent with such statements. In preparing the financial statements and in developing the other financial information, it has been necessary to make informed judgments and estimates of the effects of business events and transactions. We believe that these judgments and estimates are reasonable, that the financial information contained in this report reflects in all material respects the substance of all business events and transactions to which the corporation was a party, and that all material uncertainties have been appropriately accounted for or disclosed.

221. Defendants Howard and Spencer also assured investors in this report that

management reviewed the Company’s internal controls and found them adequate:

The management of Fannie Mae is also responsible for maintaining internal control over financial reporting that provides reasonable assurance that transactions are executed in accordance with appropriate authorization, permits preparation of financial statements in conformity with accounting principles generally accepted in the United States of America, and establishes accountability for the assets of the corporation. Internal control over financial reporting includes controls for the execution, documentation, and recording of transactions, and an organizational structure that provides an effective segregation of duties and responsibilities. Fannie Mae has an internal Office of Auditing whose responsibilities include monitoring compliance with established controls and evaluating the corporation’s internal controls over financial reporting. Organizationally, the internal Office of Auditing is independent of the activities it reviews.

* * * Management recognizes that there are inherent limitations in the effectiveness of any internal control environment. However, management believes that, as of December 31, 2002, Fannie Mae’s internal control environment, as described herein, provided reasonable assurance as to the integrity and reliability of the financial statements and related financial information.

2002 10-K, at 147.

222. The Company’s annual report to shareholders for the fiscal year 2002 contained

the same or substantially the same false and misleading statements identified in the 2002 10-K

(“2002 Annual Report”). In addition, in a letter to shareholders signed by Defendant Raines,


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Raines reiterated over and over again that he was personally responsible for ensuring that Fannie

Mae operates in an ethical manner and that investors could trust him and the Company:

I want to tell you about our exceptional performance in 2002 for our mission and business of expanding homeownership in America. However, I also recognize the need for companies and their chief executive officers to help restore and strengthen shareholder trust and confidence in corporate America. Certainly, Fannie Mae is no exception. Indeed, investor trust in our company is crucial to our business and mission as we raise capital from investors to finance homes. Fannie Mae aspires to be a model company that inspires the confidence of our shareholders. As I describe our corporate performance for 2002, I also want to share with you Fannie Mae’s cutting-edge corporate governance practices that exemplify our values. It is our exceptional values that make our exceptional performance as a company possible.

* * *

Fannie Mae’s growth, however, is “disciplined,” meaning that we put a premium on stable financial performance and consistent return to investors under all economic conditions. The result has been extraordinarily low volatility and high stability in core business earnings growth for 16 years in a row. The fact that 2002 was an exceptional year for Fannie Mae in spite of the slow economy and unusually volatile interest rates is a testament to our disciplined growth model.

* * *

Fannie Mae’s governance principles: openness, integrity, responsibility, accountability What fuels the success of our mission and business are the principles that underly our approach to corporate governance and management: Openness. Integrity. Responsibility. Accountability. Fannie Mae puts a premium on upholding these simple, core principles in our corporate mission, business, and culture for an important reason: Trust is uniquely crucial to our company.

* * *

To earn and ensure that trust, Fannie Mae operates by the following principles of corporate governance: Openness. Fannie Mae’s standard is to maintain best-in-class financial disclosures. Our goal is to provide investors, shareholders, and other stakeholders with the clear, comprehensive information they need to understand and have confidence in Fannie Mae and make our financial disclosures easy to obtain and use. In our financial disclosures, we strive to provide more than is required, and anticipate and address fundamental questions about our company and business.

* * *


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Integrity. To ensure trust in Fannie Mae, Fannie Mae must be trustworthy. Every individual at Fannie Mae — from our Board of Directors to the Chairman and CEO to senior management to every employee — is held to the highest standards of honesty and integrity. Integrity is woven into the Fannie Mae culture. As CEO, I strive to establish the highest standards of integrity by policy and by example. Our highly independent Board of Directors holds me, as CEO, as well as senior management and the entire company, accountable for our high standards of integrity.

* * *

Responsibility. The Chairman and CEO is responsible for Fannie Mae, its management and employees, and to shareholders and other stakeholders. As Chairman and CEO, I am personally responsible for ensuring that Fannie Mae operates in an effective, ethical manner that produces long-term value for shareholders. I must not put my personal interests ahead of — or in conflict with — the interest of the company or shareholders. Also, it is my duty to ensure that I know how Fannie Mae earns income and the risks we are undertaking in the course of business. Indeed, before it was required of us, Fannie Mae announced that our CEO and Chief Financial Officer would sign and certify as to the honesty and accuracy of our financial statements, and we have a rigorous review process to ensure that. As a CEO, one of the most offensive things about the corporate scandals that emerged recently was to hear CEOs claim that they did not know, they could not know, and they could not be expected to know about the activities that brought down their companies.


223. The 2002 Annual Report also represented that, “Our reported results are based on

generally accepted accounting principles (“GAAP”),” and that “Because of Fannie Mae’s critical

role in the housing finance system, one of our core commitments is to maintain the highest

standards of transparency in our financial disclosures.” 2002 Annual Report, at 23-24.

224. With respect to “Risk Management,” the 2002 Annual Report stated in pertinent

part:

We establish internal reference points, or indicators, for our risk measures to signal when we should re-examine the risk profile of our assets. . . . As these risk measures begin to move beyond our internally established reference points, we consider actions to bring them within our preferred ranges in a manner that is consistent with achieving Fannie Mae’s earnings objections. As a risk measure


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moves further outside our preferred range, we place significantly greater emphasis on reducing our risk exposure and less emphasis on earnings objectives. We have not established a specific time horizon over which rebalancing actions must take place.


225. The 2002 Annual Report also contained a “Report of Management,” signed by

Defendants Howard and Spencer which stated in pertinent part:

The management of Fannie Mae is responsible for the preparation, integrity, and fair presentation of the accompanying financial statements and other information appearing elsewhere in this report. In our opinion, the financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America appropriate in the circumstances, and the other financial information in this report is consistent with such statements. . . . We believe that these judgments and estimates are reasonable, that the financial information contained in this report reflects in all material respects the substance of all business events and transactions to which the corporation was party, and that all material uncertainties have been appropriately accounted for or disclosed.

***

Management recognizes that there are inherent limitations in the effectiveness of any internal control environment. However, management believes that, as of December 31, 2002, Fannie Mae’s internal control environment, as described herein, provided reasonable assurance as to the integrity and reliability of the financial statements and related financial information.


226. On January 29, 2003 Defendant Raines delivered the following remarks at the

Solomon Smith Barney Financial Services Conference:

Over the past 16 years, investors have come to know Fannie Mae as a disciplined growth company. But, what does it mean to be a "disciplined growth" company?

For Fannie Mae, "growth" means that our earnings have grown faster than the S&P and the NASDAQ over the past 16 years. Growth means for the past 16 years, we have produced double-digit increases in operating earnings per share, a record few other companies in the S&P 500 can match.

And for Fannie Mae, "disciplined" means we have produced this kind of steady growth in all environments, whether the economy is good or bad, or interest rates are moving up or down.


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For Fannie Mae, disciplined growth means we put a premium on low-risk, reliable growth.

* * *

Like the ancient Greek philosopher Diogenes wandering the city of Athens with a lantern searching for that one honest man, investors are scanning the market for companies they can trust.

Today, I want to demonstrate how Fannie Mae is one of those companies you can trust to provide disciplined growth, and how we create that disciplined growth through careful management of a single safe, strong, well performing asset -- the mortgage on your home.

I will demonstrate today the following points: • How our strong growth is based on the strong growth of our market. • How our steady performance comes from our disciplined approach to

doing our business. • How we set very high standards for ourselves, publish those standards

and track them publicly. • And how the result is outstanding performance, defined as better

growth in operating EPS than the S&P 500, and low volatility in earnings growth year after year.

* * *

Fannie Mae sets, publishes, tracks high standards

* * *

At Fannie Mae . . . , [w]e make a priority of maintaining the highest standards of transparency because investor confidence is crucial to us. Plus, the transparency keeps us disciplined. And the numbers prove that Fannie Mae is a disciplined growth company.

So we set high standards for ourselves, we track our performance against those standards, and we make those standards public.

For instance, every month we report our business volumes, our delinquency rate, our net interest margin, our net interest income at risk, and our duration gap.

* * * Comparison of Fannie Mae results to others

* * * [T]he growth in our operating net income remained fairly stable over the past three years. This is fairly remarkable given the recession and the extraordinary volatility in interest rates last year.


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In contrast, as you can see, the operating net income growth of Bank of America and JP Mortgage Chase -- again, both fine institutions -- were fairly typical for financial firms in volatile rate environments.

While I cannot speak for other large financial companies, at Fannie Mae, we make low-risk earnings growth stability a high priority in our businesses.

And that is the secret to how we have achieved 16 straight years of double-digit growth in operating earnings. That is what I mean by "disciplined growth."

Conclusion

We believe we can continue our record of disciplined growth for the same reasons we have grown for the past 16 years. We play a key role in a strong growth market that grows faster than the economy. We can grow faster than our market because we are the low-cost provider of the most popular mortgage that itself grows faster than the market. And by being very disciplined about how we manage our growth, we will continue to deliver steadily to the bottom line.

This is good for shareholders. It is also good for homebuyers. By growing our earnings, we grow our capital. By growing our capital, we can grow our business. By growing our business, we can provide our benefit -- lower-cost funds -- to more homebuyers. [O]ur disciplined growth business has steadily increased our operating earnings from 39 cents a share in 1987 to $6.31 in 2002, despite changes in the economy and interest rates over this period. And we just increased the quarterly dividend on our common stock by 18 percent, which reflects our confidence in our earnings going forward.

These statements were posted on the Fannie Mae website under Investor Relations for investors

to review.

227. On February 27, 2003, Defendant Howard prepared the following remarks for the

Solomon Smith Barney Global Agency Debt Conference:

* * * We have placed a premium on disclosure. As you can see here, we are a company that makes monthly disclosures of things like our business volumes, our net interest margins, delinquency rates, and portfolio risk measures. Very few other companies make monthly disclosures of this type. We do, and we make monthly disclosures on more things than these. We also make quarterly disclosures. We have a rather complex standard for accounting for derivatives, FAS 133, which puts some volatility into our reported GAAP net income and earnings per share numbers. We now calculate and publish an


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operating earnings per share and net income number that adjusts for that that investors and analysts have told us they find quite useful. That's now published quarterly. We publish the results of our risk-based capital stress test, our derivative exposure, and option-based funded percentage. Lots and lots of information because we want investors to have the information they need to ask us any question they can think of about our business strategy, our financial results, or our credit quality. This has been a strategy that, so far, has been, we think, quite successful. We have an informed investor base, and that ultimately will redound to our advantage. We also as you know are quite closely regulated. We think this, too, should give comfort to our investor base. We have a minimum capital requirement. We have a true risk base capital requirement, and I say true because it is derived by taking our existing book of business -- our on balance sheet mortgage portfolio and off balance sheet mortgage backed securities -- and running the cash flows through a defined stress, interest rate and credit stress, and requiring that we have a combination of initial capital and good enough hedges both on the credit side and interest rate risk side to survive that stress for 10 years with no management action, no new business, and assuming on top of that we hold 30 percent capital for good measure for management and operations risk. We publish these results quarterly, and investors and rating agencies take great comfort from the fact that we manage ourselves to that stress. We have examiners from our regulator onsite all year looking at every aspect of our business. Those examiners make an annual report to Congress, which other examiners do not do, and finally, last year we volunteered to register our common stock with the SEC. So in addition to doing the disclosures that we've always done, we now do them in a form that is exactly the same as required by all other SEC registrants. All this is consistent with our commitment to you to be a very transparent company, and to give you the information that we think you should have in order to make appropriate financial judgments about investments in our securities of all types.


to review.

228. The statements contained in ¶¶ 198 through 227 above were each materially false




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(a) As now admitted by Defendants, the financial statements were not

prepared in accordance with GAAP and the financial reports did not fairly present in all material

respects the financial condition, results of operations and cash flows of the Company as of and

for the periods represented.

(b) Defendants had used accounting for amortizing purchase premiums and


accordance with SFAS 91. As Defendants admitted in Fannie Mae’s November 14, 2004 Form

NT 10-Q, its methodology for performing calculations to measure the catch-up adjustment

required by SFAS 91 for balance sheet dates in 2002 was not consistent with GAAP – it should

have calculated its catch-up adjustment during 2002 with reference to its quarter-end position

rather than its projected year-end position.

(c) In violation of the requirements of SFAS 133, Defendants, among other




(d) Defendants incorrectly accounted for and reported the fourth quarter 2002

change in the Company’s accounting for the premium paid at inception for interest rate caps.

The change was incorrectly implemented prospectively as merely a change in accounting rather

than a correction of an error, which would require the prior period financial statements to be

restated.

(e) As a result of the foregoing GAAP violations, Fannie Mae’s reported net




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(f) Contrary to Defendants’ claims, Fannie Mae did not manage its business

risks with “exceptional discipline and prudence,” the Company did not hold every employee to

the “highest standards of honesty and integrity,” and the Company’s governing principles were

not “openness,” “accountability” and “integrity.” Further, it was not at the “forefront” of

financial disclosures, transparency and accountability,” and did not have “exceptionally high

quality” financial disclosures. Rather, defendants adopted and implemented policies and

procedures and engaged in accounting practices that violated GAAP to allow them to manipulate

Fannie Mae’s earnings and they actively hid their misconduct from investors.

(g) Contrary to Defendants’ representations, Fannie Mae’s internal control








(h) Contrary to the representations of Defendants Howard and Spencer in their

“Report to Management” that the Company’s internal Office of Auditing was independent of the

activities it reviewed, the internal auditor in fact reported directly to Defendant Howard, who

substantially controlled all of the Company’s accounting policies and practices and financial

disclosures.


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(i) Defendants had established and maintained a corporate culture that



C. Statements Concerning Fiscal Year 2003

229. On April 14, 2003, Fannie Mae reported its financial results for the first quarter of

2003, under the headline:

Fannie Mae Reports First Quarter 2003 Financial Results Net income at $1,941 million, up 60.5 percent over the first quarter of 2002; Diluted earnings per share at $1.93, up 65.0 percent Core business earnings of $1,850 million, up 21.8 percent over the first quarter of 2002; Core business diluted earnings per share at $1.84, up 24.3 percent

The release stated, in pertinent part:

Fannie Mae (FNM/NYSE), the nation’s largest source of financing for home mortgages, today reported financial results for the first quarter of 2003.

Reported GAAP Results Core Business Earnings

Q1 Q1 Change Q1 Q1 Change 2003 2002 2003 2002 Net Core Income $1,941 $1,209 60.5% Business $1,850 $1,519 21.8% (in Earnings millions) (in millions) Core EPS* Business (in $1.93 $1.17 65.0% EPS* $1.84 $1.48 24.3% dollars) (in dollars) *Diluted

The Company’s reported results are based on generally accepted accounting principles (GAAP). Management also tracks and analyzes Fannie Mae’s financial results based on a supplemental non-GAAP measure called “core business earnings” (previously referred to as "operating net income" or "operating earnings"). While core business earnings is not a substitute for GAAP net income, management relies on core business earnings in operating Fannie Mae’s business because it believes that core business earnings provides management and investors with a better measure of the company’s financial results and better reflects its risk management strategies than GAAP net income. Core business earnings were developed in conjunction with the company’s


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January 1, 2001 adoption of Financial Accounting Standard No. 133, Accounting for Derivative Instruments and Hedging Activities (FAS 133), to adjust for accounting differences between alternative transactions used to hedge interest rate risk that produce similar economic results but require different accounting treatment under FAS 133. (Emphasis added.)

The difference in the values and percentage changes between net income and core business earnings, and EPS and core business EPS are entirely attributable to those accounting differences for interest rate hedges. Refer to the attachments to this release for a reconciliation of the company’s non-GAAP financial measures to its GAAP results. Reported Results Fannie Mae’s reported net income for the first quarter of 2003 was $1,941 million, a 60.5 percent increase compared with $1,209 million in the first quarter of 2002. Diluted earnings per share (EPS) were $1.93 in the first quarter of 2003, up 65.0 percent from $1.17 in the first quarter of 2002.

Strong growth in net interest contributed significantly to the company’s reported results. Net interest income for the first quarter of 2003 was $3,368 million, up 38.6 percent from the first quarter of 2002. This increase was driven by an 11.7 percent rise in the average net investment balance and a 29 basis point increase in the net interest yield. The company’s net interest yield averaged 160 basis points in the first quarter of 2003 compared with 131 basis points in the first quarter of 2002. Fannie Mae’s net interest yield benefited from an increase in the amount of purchased options used as a substitute for callable debt, since the cost of these options is not included in our net interest income or net interest yield. Prior to the adoption of FAS 133 the company included the amortization of purchased option premiums as a component of interest expense. This amortization expense is now included as a component of purchased options expense on the income statement and excluded from interest expense. Net interest margin, discussed below, is calculated consistently with the company’s previous methodology.

In the first quarter of 2003 the company recorded $625 million mark-to-market losses on purchased options compared with $787 million in the first quarter of 2002. These unrealized losses were recorded in accordance with FAS 133. The reduction in the unrealized losses positively affected reported results. Core Business Earnings Core business earnings for the first quarter of 2003 was $1,850 million, a 21.8 percent increase compared with $1,519 million in the first quarter of 2002. Core business diluted EPS for the first quarter of 2003 was $1.84, or 24.3 percent above the first quarter of 2002. Growth in core business earnings and diluted EPS was paced by a 10 basis point increase in the net interest margin, a 34.1


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percent increase in guaranty fee income, and a $110 million increase in feel and other income.

Highlights Highlights of Fannie Mae’s financial performance in the first quarter of 2003 compared with the first quarter of 2002 include:

Core taxable-equivalent revenue of $3,603.2 million, up 26.9

percent; An average net interest margin of 125 basis points compared

with 115 basis points; Core net interest income of $2,604.1 million, up 22.8 percent; Guaranty fee income of $546.6 million, up 34.1 percent; Fee and other income of $113.3 million compared with $3.6

million;

* * * Franklin D. Raines, Fannie Mae’s Chairman and Chief Executive Officer, said, "Fannie Mae recorded extremely strong and balanced growth during the first quarter of 2003, continuing a record of financial performance that few other companies have matched." Raines noted that compared with the first quarter of 2002 the company experienced double-digit growth in both its mortgage portfolio and outstanding MBS, and also posted increases in its net interest margin and average guaranty fee rate. . . (Emphasis added.) Fannie Mae’s Chief Financial Officer, Timothy Howard, said that the company's 24.3 percent growth in core business diluted earnings per share compared with the first quarter of 2002 was paced by a 26.9 percent increase in core taxable-equivalent revenue over the same period. Strong growth in core net interest income, MBS guaranty fees and fee and other income all contributed to this increase, Howard said.

Howard said that during the three months ended March 31, 2003 the company's total book of business grew at an annual rate of 24.7 percent. Howard said that Fannie Mae's outstanding MBS grew at a 34.0 percent annual rate during this period, while the company's mortgage portfolio grew at a 13.3 percent annual rate. Howard noted that the company's mortgage portfolio had grown at a slower rate than its outstanding MBS during seven out of the last eight quarters. Said Howard, "Fannie Mae takes a disciplined approach to portfolio growth. Recently, commercial banks and other investors have been strong bidders for fixed-rate mortgages. We have been able to accommodate these demands by stepping up our issuance of MBS, and doing relatively less purchasing of mortgages and MBS ourselves." Howard added that Fannie Mae reported improvements in all measures of capital adequacy during the quarter, and at the same time took advantage of market


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opportunities to repurchase 8.6 million shares of common stock. Between December 31, 2002 and March 31, 2003 the company's core capital rose from $28.1 billion to $29.5 billion, while its excess of core capital relative to the statutory minimum rose from $877 million to $1.291 billion. Fannie Mae's total capital exceeded its risk-based capital requirement by $11.4 billion at December 31, 2002 -- the latest date for which a risk-based capital requirement has been determined -- compared with a $5.8 billion surplus at September 30, 2002. Fannie Mae's total capital plus subordinated debt was 3.7 percent of total assets at March 31, 2003, approaching the 4.0 percent target for this measure set by the company in October 2000 as part of its voluntary initiatives.

* * * Portfolio Investment Business Results . . . Core net interest income for the first quarter of 2003 was $2,604 million, up 22.8 percent from $2,120 million in the first quarter of 2002. This increase was driven by a 11.7 percent rise in the average net investment balance and a 10 basis point increase in the net interest margin.

* * * The company's net interest margin averaged 125 basis points in the first quarter of 2003 compared with 115 basis points in the first quarter of 2002 and 114 basis points in the fourth quarter of 2002. Fannie Mae's net interest margin continued to benefit from an unusually steep yield curve and low short-term interest rates, along with a benefit from the difference in timing between the settlement of mortgage commitments, mortgage liquidations, and funding.

* * * Capital Fannie Mae's core capital, which is the basis for the company's statutory minimum capital requirement, was $29.5 billion at March 31, 2003 compared with $28.1 billion at December 31, 2002 and $25.5 billion at March 31, 2002. Core capital was an estimated $1,291 million above the statutory minimum at March 31, 2003. At December 31, 2002, core capital was $877 million above the statutory minimum. Total capital includes core capital and the total allowance for loan losses and guaranty liabilities for MBS, less any specific loss allowances, and is the basis for the risk-based capital standard. Total capital was $30.3 billion at March 31, 2003 compared with $28.9 billion at December 31, 2002 and $26.3 billion at March 31, 2002. Fannie Mae's total capital exceeded the risk-based requirement by $11.4 billion as of December 31, 2002, the latest period for which a risk-based capital requirement has been determined. The risk-based standard uses a stress test to determine the amount of total capital the company needs to hold in order to protect against credit and interest rate risk, and requires an additional 30 percent capital for management and operations risk. The higher of Fannie Mae's risk-based or minimum capital standard is binding.


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* * * Voluntary Disclosures At March 31, 2003, Fannie Mae’s ratio of liquid assets to total assets was 6.7% compared with 6.9% at December 31, 2002.


* * * FAS 133 requires that Fannie Mae mark to market on its income statement the changes in the time value, but not the total value, of its purchased options -- interest rate swaptions and interest rate caps. The mark to market of the time value of Fannie Mae's purchased options during the first quarter of 2003 resulted in a net mark-to-market loss of $624.6 million compared with a net mark-to-market loss of $787.2 million in the first quarter of 2002, which is reported on the purchased option expense line of the income statement. Purchased option expense in the first quarter of 2003 includes $764.3 million in amortization expense, which was included in net interest income prior to FAS 133 and currently is included in core net interest income and in core business earnings. This amortization expense represents the straight-line amortization of the up-front premium paid to purchase the options over the expected life of the options. FAS 133 also requires that the company record any change in the fair values of certain derivatives, primarily interest rate swaps it uses as substitutes for noncallable debt, on the balance sheet in accumulated other comprehensive income (AOCI), which is a separate component of stockholders' equity. For these types of transactions FAS 133 does not require or permit noncallable debt to be marked to market. At March 31, 2003, the AOCI component of stockholders' equity included a reduction of $15.8 billion, or 1.9 percent of the net mortgage balance, from the marking to market of these derivatives. Accumulated other comprehensive income is not a component of core capital.

Fannie Mae's primary credit exposure on derivatives is that a counterparty might default on payments due, which could result in Fannie Mae having to replace the derivative with a different counterparty at a higher cost. Fannie Mae's exposure on derivative contracts (taking into account master settlement agreements that allow for netting of payments and excluding collateral received) was $3.256 billion at March 31, 2003. All of this exposure was to counterparties rated A-/A3 or higher. Fannie Mae held $3.0 billion of collateral through custodians to offset the risk of the exposure for these instruments. Fannie Mae's exposure, net of collateral, was $256 million at March 31, 2003 versus $197 million at December 31, 2002.


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230. On April 14, 2003, the Company held its first quarter 2003 earnings conference

call in which Defendants Raines, Howard and Spencer participated. Defendant Howard made

the following statements:

Timothy Howard - Fannie Mae - Executive Vice President and Chief Financial Officer

* * * . . . By now I’m sure that everyone knows that our core business earnings and core EPS were extremely strong last quarter. Our GAAP results were even stronger, but that’s not the measure we emphasize, or the one we use as a gauge of our financial performance.

* * *

Jane Shauntel - Fannie Mae - Senior Vice President of Investor Relations The next question will be one that we received earlier this week via e-mail: As you are well aware, Warren Buffet is very nervous about the derivatives market. In his latest letter to shareholders, he wrote, “We view them as time bombs, both from the parties that deal in them and the economic system” and quote, “in our view, however, derivatives are financial weapons of mass destruction carrying dangers that, while now latent, are potentially lethal.” Could you comment on your analysis of the industry wide risk factors regarding derivatives? I think it would be greatly appreciated, especially if you do not share Mr. Buffet’s gloomy outlook? Timothy Howard - Fannie Mae - Executive Vice President and Chief Financial

Officer * * *

At Fannie Mae . . . we use very straightforward derivatives, things like interest rate swaps and options on interest rate swaps for which there are very broad and liquid markets, and indeed, one of the ways that we manage our counter party risk is through collateral arrangements where we and our dealer firm agree on the value of a position, and determine how much collateral should be posted if the counter party owes us money. The mere fact that we can determine an amount of collateral posting means that there is a true market valuation for these derivatives, and the phenomenon of marking to myth that Mr. Buffet cited is not anything that could occur in the large and liquid markets that we operate in. We view the types of derivatives we use as very important ways of managing our interest rate risk. You know, they diversify our sources for both fixed term debt through the swap market and option based debt through the options market, the so called “swaptions” or interest rate swaps. And so we believe, along with Alan Greenspan, that having these instruments available to us is a quite important and highly useful tool for managing interest rate risk, and keeping our business risk profile extremely low through a variety of rate environments.


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231. On April 15, 2003, Fannie Mae filed with the SEC a Form 8-K attaching its April

14, 2003 press release which reported Fannie Mae’s first quarter 2003 financial results.

232. On April 30, 2003, Defendant Raines prepared the following remarks for the UBS

Warburg Global Financial Services Conference:

[Gary Gordon]:

"OK, then, what about the derivatives market? Is that deep enough for you to hedge your prepayment risk?"

The short answer is yes.

In addition to issuing bullet and callable debt to match fund and hedge mortgages, Fannie Mae uses derivatives to create synthetic bullet and callable debt. But we use a very small portion of the derivatives market to accomplish that goal.

At the end of 2002, Fannie Mae had outstanding $656 billion notional balance of derivatives. That might seem like a lot. But it was just 0.4 percent of a derivatives market that has over $150 trillion of notional balance outstanding.

But some say, "wait a minute -- you're talking about the whole derivatives market. What about the segment you rely on?"

Well, no matter how you slice it, we're still a small part of the market.

Our $652 billion in interest rate derivatives were only 0.7 percent of the interest rate derivatives market.

Our $398 billion in interest rate options were only 1.6 percent of the $24 trillion interest rate options market, or only 3.2 percent of the $12.6 trillion market for over-the-counter interest rate options.

Finally, our $275 billion of interest rate options with maturities over one year is still only 3 percent of that $9.3 trillion market.

Granted, this data on the derivatives market includes end-user and trading of notional balances. But the point is, this market is plenty deep and liquid enough to handle the business we do, and it has plenty of counterparties and we see very competitive pricing.

* * * [Gary Gordon]:

"OK, Frank, we don't need to worry about a housing bubble. But let me ask you about some other things critics say about Fannie Mae. Like, aren't you just a


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thinly capitalized, highly leveraged hedge fund? I'll bet you have a slide for this too."

You know, I think we do.

People sometimes use the label "hedge fund" because it sounds dangerous. But let me take a stab at what a hedge fund really is compared to our portfolio business, and then let you decide.

A hedge fund is a private investment pool. Fannie Mae is a publicly owned and traded corporation on the New York Stock Exchange.

A hedge fund is neither registered with the SEC, nor a regulated company at all. Fannie Mae is highly regulated. OFHEO is our safety and soundness regulator. HUD regulates our housing mission. And the Treasury oversees our debt issuance. And most recently, the SEC oversees us as a public company.

Hedge funds lack transparency. They do not disclose their investments, or their business strategies, for that matter. They are the proverbial mystery wrapped in an enigma.

Fannie Mae has state-of-the-art disclosure, including the traditional 10-K and quarterly supplements, but also we provide business data on a monthly basis, as well as risk measures such as net interest income at risk, duration gap, and the results of the home price shock test we just discussed, as well as a risk based capital test.

Also, hedge funds invest in just about anything they want -- fixed income, equity, derivatives and financial exotica. They have unlimited flexibility. Fannie Mae invests in residential mortgages, which are among highest-quality and most liquid investments in the world.

Then, to borrow funds to make additional investments, hedge funds must pledge their assets as collateral. If they can't roll over their borrowing, then they have to sell assets. That was the problem with Long Term Capital Management.

Fannie Mae, on the other hand, does not pledge assets as collateral in order to borrow funds. We access the debt market based on the fact that we are a highly rated company. We don't have to worry about rolling over our debt because we maintain a close cash flow match -- that is, our debt comes due about the same time our assets liquidate.

Plus, we have a liquidity plan that would enable us to fund ourselves for at least three months even without access to the public debt markets.

There is another important difference between hedge funds and Fannie Mae.

Hedge funds are primarily traders. They take a market point of view and trade in and out of positions. Fannie Mae is a hold-to-maturity investor. We seek to earn a spread over time. We do not seek capital gains or trading profits.


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For example, if we operated like some mortgage hedge funds, we would buy mortgages and fund them with short-term money. If we did, we'd have an expected return that looked very good. But . . . the range of possible returns is quite wide. And there is a very good chance -- 34 percent -- that we would earn nothing or even lose money.

In contrast, our business model is designed to match fund our mortgages -- that is, we fund long term mortgages with a blend of debt that matures as the mortgages are expected to repay. In addition, we have options on our debt to offset about half of the "optionality" of those mortgages -- that is, the consumer's option to refinance and prepay.

* * * [Gary Gordon]:

All right Frank, let me ask one more question. With FAS 133, haven't your financial statements become too complicated to understand?

Not at all. To be perfectly honest, we would have been very happy if FAS 133 had never happened. We believe pre-FAS 133 accounting better matched up with the reality of our business operations. But that's water under the bridge.

FAS 133 is partial mark to market accounting. It requires that certain -- but not all -- transactions to be marked to market through the income statement. In Fannie Mae's case, we have to mark to market the time value of our purchased options. And most of our interest rate swaps must be marked to market through the balance sheet.

To deal with this requirement, and still give investors a clear picture of our business results, Fannie Mae publishes two sets of numbers. First, we report the GAAP numbers to reflect the adoption of FAS 133. Then also, we report our core business earnings that reflect accounting pre-FAS 133.

We think the latter -- our core business results -- much more clearly describe our true financial performance.

But the only difference between the two income statements is the treatment of a single line item -- "purchased option expense."

Prior to FAS 133, our purchased option expense was the cost of our options amortized evenly over the life of our options. That accounting treatment made sense because it was consistent with the accounting treatment for the cost of our callable debt.

Under FAS 133, our purchased option expense is the mark to market of the time value of the option. It's now divorced from the accounting treatment for the cost of our callable debt.

We believe there are two problems with this new GAAP accounting.


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The first is, we believe it overstates net interest income because it includes the cost of the options we buy through our callable debt, but not the cost of the options we buy in the derivatives market.

Second, the time value of a purchased option fluctuates in a way that makes it impossible for investors to differentiate between an unrealized gain or loss that will net to zero over time, and the true dollar value actually paid for the option.

[T]o get from core business earnings to GAAP net income, you must first remove our purchased options amortization expense . . . .

And then you add or subtract the "purchase options expense," which is the mark to market of the time value of our options.

That is it. The only difference between the two measures of earnings are the two ways of calculating the cost of options -- one calculated by amortization, and the other calculated by an unrealized mark to market.

The only effect here over time is that reported GAAP earnings will fluctuate around our core business earnings -- sometimes quite dramatically -- as these marks to market cancel out over time because we hold these options to maturity.

With respect to the balance sheet, again, there's only one line item investors need to focus on -- "other comprehensive income -- cash flow hedging results." In this line item, FAS 133 requires us to mark to market our swaps through shareholder equity. When interest rates move lower, the mark to market will be negative. When interest rates move up, the mark to market will turn positive.

Financial regulators understand that this is only a partial mark to market, and that these gains and losses in shareholder equity are not realized. Therefore, they look to total capital and core capital to determine the safety and soundness of banks and other financial institutions. Do we wish the accounting standards board had not experimented with FAS 133? Sure. Does it make it so complex investors can't understand our income statements? No -- I don't think so. We give you all the information you need, and there are really very few line items you need to focus on.


to review.

233. On May 15, 2003, Fannie Mae filed its quarterly report with the SEC on Form 10-

Q for the first quarter ended March 31, 2003 (“First Quarter 2003 10-Q”). The First Quarter

2003 10-Q repeated the performance results described in Defendants’ April 14, 2003 first quarter

earnings press release and was signed by Defendants Howard and Spencer. Defendants Raines


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and Howard also filed certifications with the report, as required by the Exchange Act, in which

they certified that: (i) the report did not contain any untrue statement of a material fact or omit to

state any material fact necessary to make the statements made not misleading; (ii) the financial

statements and financial information included in the report fairly presented in all material

respects the financial condition, results of operations and cash flow of the Company as of and for

the periods presented; and (iii) that Raines and Howard were responsible for establishing and

maintaining disclosure controls and procedures as defined in the Exchange Act and that they had

(a) designed such disclosure controls and procedures, or caused such disclosure controls and


the Company was made know to them by others within the entity, particularly during the period

in which the report was being prepared; and (b) evaluated the effectiveness of the Company’s

disclosure controls and procedures and presented in the report their conclusions about the

effectiveness of the disclosure controls and procedures. Additionally, the Company represented

that "[t]he interim financial information provided in this report reflects all adjustments that, in

the opinion of management, are necessary for a fair presentation of the results for such periods."

Further, in Footnote 1 to the Financial Statements, Defendants represented that “[t]he

accompanying unaudited condensed financial statements have been prepared in accordance with

generally accepted accounting principles in the United States of America (“GAAP”) for interim

financial information.”

234. In the First Quarter 2003 10-Q, Defendants represented compliance with FAS 133

as follows:

FAS 133 requires that changes in the fair value of derivative instruments be recognized in earnings unless specific hedge accounting criteria are met. Although Fannie Mae’s derivatives may be effective economic hedges and critical in our interest rate risk management strategy, they may not meet the hedge


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accounting criteria of FAS 133. At March 31, 2003, we had $197 million in outstanding notional amount of derivatives that did not qualify for hedge accounting under FAS 133, which we are required to mark-to-market through earnings. The following table shows the change in AOCI, net of taxes, associated with FAS 133 for the three months ended March 31, 2003:

FAS 133 Impact on AOCI

(Dollars in millions) Balance at December 31, 2002............................................................ $ (16,251) Losses on cash flow hedges, net.......................................................... (840) Reclassifications to earnings, net ........................................................ 1,242

Balance at March 31, 2003 .................................................................. $ (15,849)

First Quarter 2003 10-Q, at 39.

235. In the First Quarter 2003 10-Q, Defendants also represented that they had

evaluated and found effective the internal disclosure controls and procedures, stating:

Item 4. Controls and Procedures Within 90 days prior to the filing date of this quarterly report, we carried out an evaluation, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures. Based on this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective. In addition, based on this most recent evaluation, we have concluded that there were no significant changes in our internal controls or in other factors that could significantly affect those controls subsequent to the date of their last evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.

First Quarter 2003 10-Q, at 39. 236. On May 20, 2003, Fannie Mae announced the election of Defendant Howard as

Vice Chairman of the Board. Defendant Raines stated in the press release:

“Tim’s extraordinary records of service, experience and financial leadership at Fannie Mae have been key to our disciplined growth, cutting-edge transparency and long trend of record financial performance.


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Tim’s new role as Vice Chairman will further ensure our success in fulfilling the American Dream and serving the investors who provide the capital to make it possible,” said Frank Raines, Fannie Mae’s Chairman and Chief Executive Officer.

237. On June 4, 2003, Defendant Raines prepared the following remarks for the

Sanford Bernstein Strategic Decision Conference:

Today, I want to describe how -- even in volatile markets -- Fannie Mae has continued to produce double-digit growth in core business earnings per share for 16 years straight. The reason for that success is our disciplined approach to growth.

* * * Discipline defines the type of company we are, just as much as growth does. While growth is what our charter has in mind when it calls for us to expand affordable housing, our discipline constrains any impulse we might have to grow for growth's sake. Our charter clearly intends us to, as it states, do business "in the interest of assuring sound operation."

Without our discipline we could grow faster, of course, but that would increase the risk of our company and our mission. Our risk appetite is low, and growth must fit within the context of our risk appetite.

* * * Even though we have plenty of room to grow, that does not mean we will grow for the sake of growth alone. We grow in a disciplined way to balance our risk and returns and achieve strong, steady earnings growth even in volatile markets.

* * * Discipline In Portfolio Funding

* * * From our decade and a half of match funding mortgages, we have found that we have been able to get the best combination of low risk and earnings stability by match funding, adding options at about the 50 percent level, and also taking actions to rebalance our portfolio -- that is, by adjusting the duration of either our mortgages or their funding. We have several means to rebalance our portfolio. For example, we can purchase more or fewer new mortgages, which have longer durations. We can issue more funding that has shorter or longer durations. Or we can cancel or add derivative options or swaps that adjust the duration of our funding. Over the past 16 years, we have experienced very challenging interest rate environments, from the interest rate spikes of the early 1990s to the record plunge in rates last fall. We have proven that the earnings of a large financial company do not have to be an interest rate play.


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The principle of this example of discipline is that match funding our portfolio protects us from unexpected interest rate movements. Discipline Through Use of Derivatives The third example of our discipline is the way that we use derivatives.

* * * We use the most common and liquid form of derivatives such as interest rate swaps, which make up the vast bulk of the derivatives market. And we use derivatives to lower our risk. We do not trade, speculate or take positions in derivatives. We use them to help match fund our mortgage portfolio and offset the option we've given the homeowner to refinance. Typically we will do that in the cash market by issuing bullet debt or callable debt. In callable debt we can match funds and we can buy back some of the options that we provided to the homeowner. Now, in theory we can run our whole business in a cash market. But to obtain the best pricing, we want to have as broad a range of investors as possible. So we use derivatives to create synthetic debt. For example, we will use an interest rate swap to turn an adjustable rate instrument into a fixed rate instrument so it mimics our bullet debt. We'll also use swaptions -- options to enter into swaps -- and create equivalents of callable debt. That's all we do with derivatives. And they allow us on any given day to have a choice in funding our mortgage purchases -- is the best execution in the cash markets, or is it a combination of cash and derivatives?

* * * Conclusion: Measuring success in disciplined growth Let me sum up today by recapping the principles from the examples of our discipline that I have just described.

Our portfolio growth is governed by spreads in the marketplace. Match funding our portfolio and adding options to our funding protects us

from unexpected interest rate movements. Our use of derivatives gives us access to more funding options with low

risk. By pricing for credit risk as we expand our market, we continue to

maintain our attractive returns on equity. By sharing credit risk as we grow, we can disperse the credit risk and

reduce our credit losses. And Fannie Mae's capital requirements impose the ultimate risk limits.

What all of these principles mean to investors is that over a very long period of time, Fannie Mae has produced a much steadier pattern of earnings than most


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companies that have higher P/E ratios. Our disciplined growth has yielded success no matter how you measure success.

* * * So no matter how you measure it, our disciplined approach to growth has produced great results for Fannie Mae and our shareholders.

Fannie Mae is fortunate to be in a strong-growth market and to be the low-cost provider in our market. That means that unlike many companies, we do not have to worry about where our growth is going to come from. That frees us to focus on how much we want to grow, given our low appetite for risk.

As I said earlier, discipline defines the type of company we are, just as much as growth does. And the result of striking this balance between growth and discipline has been 16 years of strong, steady returns for shareholders in all risk environments.


to review.

238. On June 17, 2003, Business Week Senior Writer Paula Dwyer interviewed Raines

regarding how Freddie Mac’s scandal was affecting his company, and when asked whether it is

fair that “[b]ecause of similarities between Fannie and Freddie, you are tarred by the same

brush,” Raines reportedly responded by stating:

I don’t know much about how Freddie operates. But when it came to accounting for derivatives, we spent millions of dollars on internal systems [and] we maintain strict control over what kind of derivatives can be used and our accounting for them. Everyone who has looked at it, from our external auditors to our regulators, found that we are doing this in a state-of-the-art way. We are compulsive about managing risk.17 239. On July 15, 2003, Fannie Mae reported its financial results for the second quarter

of 2003, under the headline:

Fannie Mae Reports Second Quarter 2003 Financial Results Net income of $1,102 million, down 24.7 percent over the second quarter of 2002; Diluted earnings per share at $1.09, down 24.3 percent

17 Frank Raines Takes on the Critics, Business Week, Number 3839, June 30, 2003, at p. 38.


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Core business earnings at $1,860 million, up 18.2 percent over the second quarter of 2002; Core business diluted earnings per share at $1.86, up 20.0 percent Common stock dividend increased to $.45 per share


Fannie Mae (FNM/NYSE), the nation’s largest source of financing for home mortgages, today reported financial results for the second quarter of 2003. The company’s reported results are based on generally accepted accounting principles (GAAP). Management also tracks and analyzes Fannie Mae’s financial results based on a supplemental non-GAAP measure called “core business earnings,” which management uses as its primary measure in operating Fannie Mae’s business (see "Core Business Earnings” and attachments).

Reported GAAP Results For the Quarter Ended For the Six Months June 30, Ended June 30,

2003 2002 Change 2003 2002 Change Net Income (in millions) $1,102 $1,464 (24.7)% $3,042 $2,672 13.8%

EPS* (in dollars) $1.09 $1.44 (24.3%) $3.02 $2.61 15.7%

Core Business Earnings For the Quarter Ended For the Six Months June 30, Ended June 30,

2003 2002 Change 2003 2002 Change Core Business $1,860 $1,573 18.2% $3,710 $3,091 20.0%

Earnings (in millions) Core Business $1.86 $1.55 20.0% $3.70 $3.03 22.1% EPS* (in dollars) *Diluted

Highlights Highlights of Fannie Mae's financial performance in the second quarter of 2003 compared with the second quarter of 2002 include:

Reported net interest income of $3,500.3 million, up 38.2

percent; Core net interest income of $2,784.5 million, up 26.5

percent; Guaranty fee income of $632.3 million, up 49.3 percent;


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Fee and other income of $231.5 million compared with $41.6 million;

* * * Fannie Mae's combined book of business grew at an annualized rate of 29.0 percent during the quarter, including a 55.9 percent annualized increase in outstanding mortgage-backed securities (MBS) and a 1.7 percent annualized decrease in the mortgage portfolio. Franklin D. Raines, Fannie Mae’s Chairman and Chief Executive Officer, said, "Fannie Mae delivered an extremely strong financial performance in the second quarter, again demonstrating the success of our balanced and disciplined strategies for growth. With interest rates at their lowest levels in 45 years, the efficiency of our business model enabled us to finance a truly extraordinary volume of mortgage product." Said Raines, "The quality and liquidity of our mortgage-backed securities have proven to be invaluable in this environment. Our outstanding mortgage-backed securities increased at a 56 percent rate during the quarter, and over the past four quarters they have grown by more than 30 percent, to over $1.2 trillion. We anticipate that these loans will generate profitable revenues for us for many years to come." Raines added that the company strengthened its capital base by $1.2 billion during the quarter, while at the same time taking advantage of market opportunities to repurchase 5.3 million shares of common stock. (Emphasis added.)

Fannie Mae’s Vice Chairman and Chief Financial Officer, Timothy Howard, said, “Each of our primary businesses delivered exceptional financial performance in the second quarter, including substantial increases in both core net interest income and guaranty fee income." Howard added that the company's performance benefited significantly from very low mortgage rates and high levels of refinancing, which resulted in a further temporary increase in the company's net interest margin during the second quarter, to an average of 130 basis points. As a consequence, core net interest income during the second quarter of 2003 was 26.5 percent above the second quarter of 2002. Howard said that the record amounts of refinancing volumes during the quarter had a number of other positive effects on the company's top-line revenues. In the credit guaranty business, rapid refinancings not only fueled extremely strong MBS growth, but also led to a rise in the effective guaranty fee rate, to an average of 21.2 basis points, as rapid prepayments caused deferred guaranty fee revenues to be recognized more quickly. Record business volumes also resulted in very high levels of transaction and technology fee income during the quarter. In addition, said Howard, credit-related expenses remained at very low levels, totaling just $22.6 million in the second quarter which was $1.6 million lower than the same quarter a year ago.


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Howard said that the 1.7 percent annualized decline in the company's mortgage portfolio during the second quarter reflected its disciplined approach to purchasing. Howard noted that Fannie Mae took advantage of favorable pricing in the forward market to make many of its mortgage purchase commitments during the quarter for delayed settlement. Howard said that during the second quarter retained commitments exceeded purchases by $63 billion. Accordingly, unsettled commitments rose to a record $135 billion at June 30. Said Howard, "As these commitments settle during the second half of the year, Fannie Mae's portfolio growth should accelerate noticeably." Howard added that assuming mortgage-to-debt spreads are relatively favorable for the balance of the year the company continues to anticipate recording mid-teens portfolio growth for the year as a whole.

* * * Reported Results Fannie Mae's reported net income for the second quarter of 2003 was $1,102 million, a 24.7 percent decline compared with $1,464 million in the second quarter of 2002. Diluted earnings per share (EPS) were $1.09 in the second quarter of 2003, down 24.3 percent from $1.44 in the second quarter of 2002. Reported net income for the first six months of 2003 was $3,042 million, up 13.8 percent from the first six months of 2002. Diluted earnings per share were $3.02 during the first six months of 2003, up 15.7 percent from the comparable period the previous year. The company recorded $1,883 million of mark-to-market losses on purchased options during the second quarter of 2003 compared with $498 million in mark-to-market losses in the second quarter of 2002. These unrealized losses were recorded in accordance with Financial Accounting Standard No. 133, Accounting for Derivative Instruments and Hedging Activities (FAS 133). The increase in unrealized losses was due to the declining interest rate environment and an increase in the balance of purchased options used to hedge interest rate risk. This was the primary factor behind the decline in reported net income during the quarter. Strong growth in net interest income contributed positively to the company's reported results in the quarter. Net interest income for the second quarter of 2003 was $3,500.3 million, up 38.2 percent from the second quarter of 2002. This increase was driven by an 11.0 percent rise in the average net investment balance and a 30 basis point increase in the net interest yield. The company's net interest yield averaged 163 basis points in the second quarter of 2003 compared with 133 basis points in the second quarter of 2002. Fannie Mae's net interest yield benefited from an increase in the amount of purchased options used as a substitute for callable debt, since the cost of these options is not included in net interest income or net interest yield. Since the adoption of FAS 133 in January of 2001 this amortization expense has been included as a


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component of purchased options expense on the income statement and excluded from interest expense. Net interest margin, discussed below, includes purchased options amortization expense and is calculated consistently with the company's previous methodology. Core Business Earnings Core business earnings for the second quarter of 2003 were $1,860 million, an 18.2 percent increase compared with $1,573 million in the second quarter of 2002. Core business diluted EPS for the second quarter of 2003 were $1.86, or 20.0 percent above the second quarter of 2002. Growth in core business earnings and diluted EPS was paced by a 26.5 percent increase in core net interest income, a 49.3 percent increase in guaranty fee income, and a $189.9 million increase in fee and other income.

* * * Corporate Financial Disciplines Fannie Mae Chairman Raines said that the company had just completed a year-long assessment of its corporate financial disciplines, and had reviewed the results of this assessment with its Board of Directors. Said Raines, "Our disciplined growth strategies have served the company well over the last 15 years. With our regulatory risk-based capital standard in place, and with the likelihood of continued financial market volatility in the future, we felt it was an appropriate time to take a comprehensive look at the internal financial disciplines and risk management strategies that govern our business."

* * * Said Raines, "Financial discipline is at the core of Fannie Mae's business. Our intent in updating our risk management strategies, and making them explicit to investors and policymakers, is to make as clear as possible that as we continue to carry out our housing mission in a growing mortgage market our commitment to financial safety and soundness will be absolute."

* * * Capital Fannie Mae's core capital, which is the basis for the company's statutory minimum capital requirement, was $30.7 billion at June 30, 2003, compared with $28.1 billion at December 31, 2002, and $26.4 billion at June 30, 2002. Core capital was an estimated $1,527 million above the statutory minimum at June 30, 2003. At December 31, 2002, core capital was $877 million above the statutory minimum. Total capital includes core capital and the total allowance for loan losses and guaranty liabilities for MBS, less any specific loss allowances, and is the basis for the risk-based capital standard. Total capital was $31.5 billion at June 30, 2003, compared with $28.9 billion at December 31, 2002, and $27.2 billion at June 30, 2002. Fannie Mae's total capital exceeded the risk-based requirement by $13.8


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billion as of March 31, 2003, the latest period for which a risk-based capital requirement has been determined. The risk-based standard uses a stress test to determine the amount of total capital the company needs to hold in order to protect against credit and interest rate risk, and requires an additional 30 percent capital for management and operations risk. The higher of Fannie Mae's risk-based or minimum capital standard is binding.

* * *

Voluntary Disclosures At June 30, 2003, Fannie Mae’s ratio of liquid assets to total assets was 7.5% compared with 6.9 percent at December 31, 2002.


* * * FAS 133 requires that Fannie Mae mark to market on its income statement the changes in the time value, but not the total value, of its purchased options -- interest rate swaptions and interest rate caps. The mark to market of the time value of Fannie Mae's purchased options during the second quarter of 2003 resulted in a net mark-to-market loss of $1,882.7 million compared with a net mark-to-market loss of $498.2 million in the second quarter of 2002, which is reported on the purchased option expense line of the income statement. Purchased option expense in the second quarter of 2003 includes $715.8 million in amortization expense, which was included in net interest income prior to FAS 133 and currently is included in core net interest income and in core business earnings. This amortization expense represents the straight-line amortization of the up-front premium paid to purchase the options over the expected life of the options together with any acceleration of expense related to options extinguished prior to exercise.

* * * At June 30, 2003, the AOCI component of stockholders' equity included a reduction of $17.0 billion, or 2.1 percent of the net mortgage balance, from the marking to market of these derivatives. Accumulated other comprehensive income is not a component of core capital. Fannie Mae's primary credit exposure on derivatives is that a counterparty might default on payments due, which could result in Fannie Mae having to replace the derivative with a different counterparty at a higher cost. Fannie Mae's exposure on derivative contracts (taking into account master settlement agreements that allow for netting of payments and excluding collateral received) was $5.384 billion at June 30, 2003. All of this exposure was to counterparties rated A-/A3 or higher. Fannie Mae held $5.087 billion of collateral through custodians to offset the risk of the exposure for these instruments. Fannie Mae's exposure, net of collateral, was $297 million at June 30, 2003, versus $197 million at December 31, 2002.


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This press release was also issued in Form 8-K filed with the SEC on July 14, 2003 and signed

by Defendant Spencer.

240. On July 15, 2003, the Company held its second quarter 2003 earnings conference

call during which Defendant Howard made the following statements:

Tim Howard - Fannie Mae - Vice Chairman, CFO

* * * As I'm sure you saw this morning, last quarter we posted another extremely strong set of financial results, once again, demonstrating our balance and disciplined strategies for growth. Our core earnings per share in the second quarter were $1.86, 20% above the second quarter of 2002. This means that for eight of the last nine quarters our core EPS has been 20% or more above the comparable period the previous year. Each of our two businesses delivered exceptional financial performance last quarter, including substantial increases in both core and net interest income and guarantee fee income. With interest rates at 45-year lows we had unusually strong growth in our business volumes, particularly in mortgage backed securities. The acknowledged quality and liquidity of our MBS proved to be exceptionally beneficial in this environment. Our outstanding MBS grew at a 56% annual rate last quarter and over the last four quarters it's grown by more than 30% to over $1.2 trillion. These MBS should generate profitable revenues for us for many years into the future. Last quarter we also had record amounts of technology and transactions fee income and our credit costs remain remarkably low. And with the net interest margin rising still further to an average of 130 basis points, we were able to incur $740 million in costs for debt repurchases and calls while still reporting another very strong core EPS result.

* * * As these commitments are delivered during the second half of the year, our portfolio growth should accelerate markedly. So assuming that mortgage to debt spreads stay favorable, we still expect to achieve mid-teens portfolio growth this year.

* * * As we noted in our press release, we just completed a comprehensive assessment of our corporate financial disciplines which we reviewed with our board this week. We actually began this assessment last summer.


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We felt that with our risk-based capital standard in place and given the growing scale of our business, and the potential for continued financial market volatility, it was prudent to review our financial disciplines, and to consider updating the business risk management strategies they govern. During our review, we formalized three internal financial discipline objectives. These are: First, to maintain a stand-alone risk to the government credit rating from Standard & Poor's of at least double A minus and to maintain a stand-alone bank financial strength credit rating from Moody's of at least A minus. Second, to sufficiently capitalize and hedge our mortgage portfolio and credit guarantee businesses so that each are able to withstand internal and external stress tests set to at least a double A standard. And third, to keep our mortgage prepayment and credit risks low enough that over time, our business earnings are less variable than the median of all double A and triple A S&P 500 companies.

* * * In order to continue to earn our stand-alone ratings, we know we must tightly manage our interest rates and credit risks, be very well capitalized relative to the risks we take, and show a stable and predictable pattern of earnings as benefits a well-managed and high quality company. These attributes are addressed by our third, or second and third financial discipline objectives.

* * * A second important indicator of the quality of our financial discipline is the pattern of our net income over time. Risky companies have unpredictable and highly variable net income strains. The net income patterns of less risky companies are more stable. We examined the net income pattern over the past ten years of all of the companies that were able to maintain ratings of double A minus, double A three or higher during the entire period. From this review, we determined that we should set as an objective to manage our interest rate and credit risks so that Fannie Mae's long-term earnings variability remains below the median of all double A and triple A companies. In conjunction with our very conservatively set stress test standards, we believe that meeting this income variability objective will allow to us maintain our stand-alone ratings with a comfortable margin of safety and possibly to improve them. I should add a note to our earning stability objective. The way we will be tracking our performance against this objective will be with core business earnings.


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While there currently is a lively debate in the accounting profession as to whether a historical cost accounting model or a fair value accounting model best portrays a company's financial results and condition, virtually everyone agrees that these two models should not be mixed within the financials of a single line of business. Yet that's precisely what's happened to Fannie Mae with the application of Financial Accounting Standard 133, the accounting for derivatives standard. We have a historical cost accounting model that has one fair value element, FAS 133 applied to it. The result is very difficult for investors to understand or interpret. Our response has been to emphasize our measure of core business earnings. Core business earnings treats the cost of a purchase option comparably with the cost of an option embedded in callable debt, and is consistent with the GAAP treatment of purchased options prior to FAS 133. We believe the core business earnings better reflects our financial condition and performance and we intend to continue to use it as our primary financial performance measure for the foreseeable future in response to strong investor demand that we do so. Now, following the specific articulation of our financial discipline objectives, the next step in our assessment was to determine how best to explicitly link these objectives with the risk management strategies of our portfolio investment and credit guarantee businesses.

* * * Our goal in setting and communicating to the public our corporate financial disciplines and in detailing the risk management strategies we will follow to adhere to them is to leave no doubt at all among investors, policy makers and others, that our commitment to an extremely high level of financial strength is absolute. The outlook for Fannie Mae's financial performance has to be viewed in the context of the boundaries of our financial disciplines.

* * * [W]e do expect to be able to grow our core EPS somewhat faster than our market. We believe we'll be able to achieve this faster growth through the skill and innovation of management in producing moderate increases in our market shares and business margins and through active management of our capital account. And in all cases, the core earnings and EPS growth we produce will be consistent with the boundaries of our risk management disciplines to which we will adhere rigorously. Over the last ten quarters, from the fourth quarter of 2000 to the second quarter of this year, the growth rate in our core EPS has averaged 22% per year. This has been well above the previous long-term average for our earnings growth. And also well above the long-term earnings growth we would expect in the future.


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* * * Now, I'll close with a brief comment on valuation. Fannie Mae stock currently trades at a price earnings ratio that is about half that of a typical S&P 500 company. Historically our earnings growth has far outpaced the typical companies.

* * * Fannie Mae has a track record of exceptional risk management in the past and we now have set forth an even more ambitious public commitment to superior risk management going forward. Furthermore, we intend to maintain very high stand-alone credit ratings and the goal we've set to have our long-term earnings growth be more stable than the median double A or triple A company should make our earnings dramatically more stable than the typical S&P 500 company overall.

* * * The opening remarks by Defendant Howard were also posted on the Fannie Mae website under

Investor Relations for investors to review.

241. On June 12, 2003, Fannie Mae issued a press release touting its increased

disclosures concerning mortgage-backed securities. In the press release, Defendant Raines

stated: “To that end, we are enhancing our disclosures to continue providing the market a great

degree of transparency while protecting the liquidity and market efficiency that participants have

come to value."

242. Defendants also went out of their way to distance themselves from Freddie Mac

when its accounting problems came to light. On June 13, 2003, Fannie Mae’s spokesman,

Chuck Greener, issued a statement reaffirming Fannie Mae’s financial disclosure compliance:

• Fannie Mae made a permanent and irrevocable decision to become an SEC registrant when we filed our fully audited financial statements with our Form 10 [Q] and Form 10-K on March 31, 2003. Subsequently, on May 14, 2003, we filed our first Form 10-Q with our financial statements for the first quarter of this year. And as part of the filing process, the SEC reviewed our critical accounting policies and the disclosure of those policies.

• The issues raised to date appear to be financial management and accounting policy issues that are within the purview of the SEC.


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Therefore Fannie Mae, as an SEC registrant, is subject to SEC oversight and enforcement with regard to such issues.

• Fannie Mae is a highly regulated company, and subject to a rigorous risk-based capital standard enforced by OFHEO. We have always supported having a strong, well-funded regulator consistent with our role in supporting an efficient, well-functioning housing finance system. We are confident that any actions that policymakers consider would be undertaken with a desire to support the housing market -- the most critical aspect of the economy today -- and the vital role Fannie Mae plays in this system. Therefore we do not believe Congress will take action to change our status, or in any way impair our mission or operations in serving the US housing finance system.

• As you saw in Fannie Mae's quarterly and monthly financial reports, including our May Monthly Summary issued this week, we believe this year will be a record year for mortgage originations at $3.7 trillion. Fannie Mae is supporting this record mortgage activity with record business volumes under our disciplined approach to growth.

• We look forward to the resolution of the issues raised this week, and to the SEC registration and filing of fully audited financial statements by all the housing GSEs in the best interest of national housing policy.

243. On July 30, 2003, Defendant Raines held a two-hour conference call with

investors and security analysis where he assured investors that Fannie Mae did not have the same

accounting issues as Freddie Mac:

* * * AUDIENCE MEMBER: Mr. Raines, talk a little, if you will, about the OFHEO review of the accounting. Is it underway, in depth, and then looking at it, and where do you expect that to go? FRANKLIN RAINES: The director of OFHEO indicated that, not only had they undertaken a special investigation of Freddie Mac, but they were also going to be reviewing the accounting policies of Fannie Mae, even though he said that he did not have reason to believe that there were any issues. We've had some preliminary discussions with them with regard to the kinds of information that they would like us to provide. But at the moment I believe that they have, appropriately, they are focused on their investigation with Freddie Mac.


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We welcome the review by OFHEO, because we have a great deal of confidence in our application of appropriate accounting principles. And having just gone through the process of registering with the SEC, we have the benefit of having third parties look at our accounting policies and ask us detailed questions about them. Our external auditor, KPMG, has always treated us as though we were an SEC registrant, and has applied those standards throughout history. So we feel quite comfortable with our accounting policies. (technical difficulty) Further, and say that we have looked at each of the issues that Freddie Mac has publicly identified, and looked to see whether we have similar issues, whether we engaged in similar transactions. And I can say that of the issues that they have identified, that we do not have any of the same issues and we have not had the same transactions. So in terms of a direct relationship to Freddie Mac, we are quite comfortable that we have none of those issues. But beyond that we believe that we have applied quite conservative accounting principles that are clearly outlined in our (technical difficulty) K, which we are required to identify our critical accounting policies. And we do outline each of those and explain why it is a critical accounting policy, and ensure that our internal controls and our external auditors are focused on these most important accounting policies.

AUDIENCE MEMBER: Mr. Raines, two questions; one a follow up. When you say that OFHEO is now focusing on Freddie Mac, is that to say that OFHEO (inaudible) cover two courts at the same time? FRANKLIN RAINES: . . . OFHEO has many parts. The OFHEO examiners who examine Fannie Mae on a daily basis continue to do their work unabated, unchanged by anything that has gone on at Freddie Mac. As well, the people to manage their risk-based capital calculations continue to do that work. They have set up a special task force, however, looking at the issue of accounting. And that special task force is, of course, giving its primary attention to Freddie Mac. But we expect that they will be engaged with us, in carrying out the director's desire to take a look at our policies. Indeed I think the more they learn about Freddie Mac the more it will help them to hone their own questions about us; it will simply make it more efficient, rather than doing two parallel activities without the benefit of learning from the others.

AUDIENCE MEMBER: Another follow up. You said that Fannie Mae didn't engage in any of the transactions that you saw at Freddie Mac. But you have got to say that beginning at the end of 19 (technical difficulty) the introduction of FAS and quarters thereafter that Fannie Mae never did any smoothing. That they never did (technical difficulty) transaction (technical difficulty) FRANKLIN RAINES: This was one of the extraordinary statements that came out in the report issued by the independent counsel who looked at Freddie Mac.


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And that was the decision that Freddie Mac made to not simply adopt FAS 133, but then to try to influence the impact of FAS 133 on their earnings. I can tell you that at Fannie Mae we took no steps whatsoever to try to ameliorate the impact of FAS 133. In fact we did just the opposite.

We spent (technical difficulty) preparing to implement FAS 133. We spent millions of dollars on new systems, hired new people, made sure our people were up on this very complicated accounting standard, so that they could apply it appropriately. We went through and made sure that we had, for every type of derivative transaction that we engaged in, that we had prior approval before the transactions were engaged in, not only by Fannie Mae's internal accounting team (technical difficulty) by our external auditors. Before any transactions could be carried out, they had to be in a book as an approved transaction (technical difficulty) had been approved as well. Then when we got to the first announcements of our results under FAS 133, we made a very conscious choice of saying is there -- here is what the GAAP is now with FAS 133. We differ as to whether or not this gives an accurate portrayal of our (technical difficulty) We are going to give you another measure, which we called originally operating earnings, which we now call core business earnings, that takes out the effect of FAS 133. So we gave people the complete results 133; and we gave them the results without FAS 133. (technical difficulty) effort to try to smooth FAS 133 earnings or to in any way distort what the actual impact of FAS 133 was on Fannie Mae.

This is a good point, I think, to make a clarification that sometimes these things get confused; and we ought to make sure we are all on the same basis. You basically have two schools of thought about accounting, particularly for financial institutions. One of them is thought of as historical cost accounting. What anybody who went to (technical difficulty) took any accounting course, any time in your past, you know about historical cost accounting. You put things on your books at its acquisition cost; and then you (technical difficulty) amortized or bring it into earnings as you use up the entity. Whether it is a building or it is a derivative contract. And you start historical costs and then you move things into earnings over the period of time you use them. That is the traditional accounting. That is what accounting was for Fannie Mae and everyone before FAS 133.

There is another view of accounting which you call fair value accounting. Which is not historical cost. It is not bringing things in as you use them up. It is a mark to market. On a daily basis, monthly basis, quarterly basis, yearly basis, you mark things (technical difficulty) on an instantaneous basis. (technical difficulty)

What happened with FAS 133 is they took historical accounting and they brought in a piece of fair value, so you had a hybrid. What we operate under now is a hybrid; some historical costs, and some is fair value. We have been very clear both in the U.S. accounting discussion (technical difficulty) international


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accounting discussions, we think this is a mistake. We think you are far better off to have historical cost accounting or fair value; putting the two together is very confusing, even for the experts.

With FAS 133 they took a piece of fair value. They said, value some of your derivatives using fair value; but none of your assets. Which is a direct contradiction of what fair value is about, which is to mark to market both your assets and your liabilities. That is why it was so confusing. Our answer to that wasn't, well, let's go in and see if we can change the FAS 133 results. It was, report those; but also report them the way we reported them prior to FAS 133. And that is what we do. And we leave it up to the investors to determine which of these they would like to rely on, and what meaning they get from them.

* * *

AUDIENCE MEMBER: Mr. Raines, you have said Fannie Mae has not done the specific things that Freddie Mac did. But more broadly, has Fannie Mae used any accounting practices or any accounting-driven (technical difficulty) that have either distorted your financial presentations or that might appear questionable if known to the public?

FRANKLIN RAINES: Let me be specific about why I answered the first question the way I did, and then I'll deal with your question. We don't have any insight as to what happened in Freddie Mac that is different than yours. So all we know is what they, special counsel, has told us. So when I answer that question I'm trying to answer it directly based on what we know, without speculating about anything that happened at Freddie Mac that we don't know. (Emphasis added.)

With regard to Fannie Mae, the question of the appropriateness of our accounting is something I'm quite focused on. Because as an SEC registrant, I am required every quarter to personally certify that I believe that the financial statements that we provided and the information we provide with those financial statements fairly represents our financial condition. So I, every quarter, put my name on the line saying that these statements represent our financial results. So I can say to you that (technical difficulty) undertaken any transactions to distort our true financial condition.

As to the question of the light of day question (technical difficulty) us know what the question of the day will be when any of these things come in. So I don't want to be speculating as to whether or not something will be vitally important to people that they have never heard of two days before and didn't care about at all when they first heard about it. That I think would get me in the realm of rank speculation. But we have tried to be very fastidious in our accounting to reflect the economics of our business. That is why we care so much about reporting our (technical


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difficulty) earnings. Because that is what management uses to run the company. And the SEC has very specific rules now about what kind of accounting statements you can put out, what kind of non-GAAP measures you can put out. And their test is that management has to demonstrate why they are using this non-GAAP measure. And (technical difficulty) process, I personally went to the SEC to discuss with them, how do we put out core business earnings?

And the reason was, this is what we believe is the best representation of how our business operates. And this is what we use day to day in running the Company. We wanted to be sure that the SEC agreed with us that that met at their standard; and they did agree with it. I personally went to make that case at the SEC, because I felt so strongly that if I was going to be giving a certification, that it had to be clear what I was certifying to and the importance that we placed on ensuring that investors knew how we think about the business. That is why we report our GAAP earnings and we report our core business earnings; and we (technical difficulty). So that every accounting period, you can go from one to the other and you can see that the only real difference between the two is how you calculate the cost of our options. One of them says, figure how much you paid for it, bring that cost in over the time you used that option; and the other one says mark it to market, period by period. That is the only difference between our two accounting statements that we put out.

AUDIENCE MEMBER: Just to (technical difficulty) statements that you can possibly make on this subject, has Fannie Mae done anything to circumvent accounting (technical difficulty) Has Fannie Mae used any accounting judgment that either its employees or its auditors considered debatable? FRANKLIN RAINES: The answer to that is clearly, no. We have not. If we had, I would have violated the law in certifying our financial results. If we had, our auditors would be obligated to publicly do something about that. So I do not think that there is any question on that, of our taking any steps to subvert accounting. And I think that is an important thing to get across.

It is one of the things that I think is indicative of the fact that we became an SEC registrant, is that the process of becoming an SEC registrant -- we are the largest financial registrant the SEC has ever had. But that process was multi-month process, where we went back and forth with the SEC about our accounting principles and policies; and gave them the opportunity to ask lots of questions and to clarify our presentations. Such that when we filed our Form 10-K we had all of their comments. We didn't have to wait to get their comments after the fact. We had all of their comments before we filed, and we did that in order to be able to present the most clear presentation of our accounting. But let me -- just in -- I have seen a number of these sort of scandal fests before, where the issues become of vital importance that were not of any importance


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previously. Some people seem to be of the belief that if you manage your company (technical difficulty) the accounting results, that that is somehow a suspicious activity. I don't (technical difficulty) that is not managed with an eye to what the accounting is going to say at the end of the period. So let's be very clear, every company undertakes business decisions with a view to, is this going to be recorded as a profit or a loss? That is a normal part of business.

I hope we don't get to the position where someone says, have you ever thought about two alternatives, one of which would have a more favorable impact on you and the other would have a less favorable; that somehow that is suspicious. It is not suspicious. It is the normal course of conducting a business, any business, not just a business like Fannie Mae. But keep in mind that the actions that Freddie Mac has now admitted to were very discrete actions that, as they said, were results oriented. And the result that they were trying to seek was to defeat the impact of FAS 133 on their accounting; which is something that we simply said, we lost the debate; we just simply now have to live with the difference. And your publications, many of them have taken strong positions on this. Some of them have insisted that you will only report GAAP earnings. Some have said you'll report (technical difficulty) will report our core business earnings. So there have been positions taken by a lot of people around FAS 133. Ours has been very clear from the beginning. And that is, we will give our accounting on two bases; one GAAP, and the other on core business earnings. AUDIENCE MEMBER: (technical difficulty) (inaudible) FRANKLIN RAINES: Okay, let's do a couple things. One, the accounting in our presentation is dictated by GAAP. So we don't have a choice as to how we present GAAP accounting. Let's just be very clear about that. There is an implication that we had a choice to be made there. That is all dictated by GAAP, and we believe it to be appropriate. Second, what you are referring to, the other comprehensive income section of the capital account, is heavily affected by mark to market accounting, and can move depending on the direction of interest rates. And so the movement down in that number could equally move up going forward. And therefore (technical difficulty) to say that there is some portion of that is irretrievably a loss. That is why it is in that account. If it were irretrievably a loss it would have run through the income statement. And (technical difficulty) included in the equity itself.

244. A July 31, 2003 Washington Post article titled Fannie Mae Defends Its

Reputation: CEO Decries Confusion with Freddie Mac, also reported several statements by

Raines to deter the market from drawing the wrong conclusion about Fannie Mae and the


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similarities between Freddie Mac and Fannie Mae. This article quoted Raines as stating that,

“[u]nlike Freddie Mac, we didn’t do any of these things.” (internal quotes omitted). Raines was

also quoted as saying that Fannie Mae has “not undertaken any transactions to distort our true

financial condition.” When asked “if Fannie had used any accounting judgments that its

employees or auditor considered debatable”, Raines responded that “[t]he answer to that is

clearly no.”18

245. Indeed, during that period the Frequently Asked Questions section of Fannie

Mae’s website included the following statement:

Fannie Mae’s reported financial results follow Generally Accepted Accounting Principles to the letter. . . . There should be no question about our accounting. 246. On August 14, 2003, Fannie Mae filed its quarterly report with the SEC on Form

10-Q for the second quarter ended June 30, 2003 (“Second Quarter 2003 10-Q”). The Second

Quarter 2003 10-Q reiterated the financial results reported in Defendants’ July 15, 2003 press

release and was signed by Defendants Howard and Spencer. Defendants Raines and Howard

also filed certifications with the report, as required by the Exchange Act, in which they certified

that: (i) the report did not contain any untrue statement of a material fact or omit to state any

material fact necessary to make the statements made not misleading; (ii) the financial statements

and financial information included in the report fairly presented in all material respects the

financial condition, results of operations and cash flows of the Company; and (iii) that Raines

and Howard were responsible for establishing and maintaining disclosure controls and

procedures as defined in the Exchange Act and that they had (a) designed such disclosure

controls and procedures, or caused such disclosure controls and procedures to be designed under

their supervision, to ensure that material information relating to the Company was made know to

18 David S. Hilzenrath, Fannie Mae Defends Its Reputation; CEO Decries Confusion with Freddie Mac Woes, The


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them by others within the entity, particularly during the period in which the report was being

prepared; and (b) evaluated the effectiveness of the Company’s disclosure controls and

procedures and presented in the report their conclusions about the effectiveness of the disclosure

controls and procedures. In the report, the Company reaffirmed its previously announced

quarterly financial results and represented that "[t]he interim financial information provided in

this report reflects all adjustments that, in the opinion of management, are necessary for a fair

presentation of the results for such periods." Further, in Footnote 1 to the Financial Statements,

Defendants made the representation that “[t]he accompanying unaudited condensed financial

statements have been prepared in accordance with generally accepted accounting principles in

the United States of America (”GAAP”) for interim financial information.”

247. Also in the Second Quarter 2003 10-Q, Defendants represented compliance with

FAS 133 as follows:

FAS 133 requires that changes in the fair value of derivative instruments be recognized in earnings unless specific hedge accounting criteria are met. Although Fannie Mae’s derivatives may be effective economic hedges and critical in our interest rate risk management strategy, they may not meet the hedge accounting criteria of FAS 133. At June 30, 2003, we had $444 million in outstanding notional amount of derivatives that did not qualify for hedge accounting under FAS 133, which we are required to mark-to-market through earnings.

Second Quarter 2003 10-Q, at 47.

The following table shows the change in AOCI, net of taxes, associated with FAS 133 between December 31, 2002 and June 30, 2003:

FAS 133 Impact on AOCI (Dollars in millions) Balance at December 31, 2002........................................................... $ (16,251) Losses on cash flow hedges, net......................................................... (840) Reclassifications to earnings, net ....................................................... 1,242

Balance at March 31, 2003................................................................. (15,849) Losses on cash flow hedges, net......................................................... (2,301) Reclassifications to earnings, net ....................................................... 1,198

Balance at June 30, 2003.................................................................... $ (16,952)

Washington Post, July 31, 2003, at E1.


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248. In the Second Quarter 2003 10-Q, Defendants also represented that they had

investigated and found effective the internal disclosure controls and procedures, stating:

Item 4. Controls and Procedures We carried out an evaluation, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures as of the end of the period covered by this quarterly report. Based on this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective. In addition, based on this most recent evaluation, we have concluded that there were no changes in our internal control over financial reporting that occurred during the period covered by this quarterly report that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

Second Quarter 2003 10-Q, at 48.

249. On September 9, 2003, Defendant Raines prepared and made the following

statements at the Lehman Investor Conference:

Fannie Mae has successfully managed its mortgage portfolio through the ups and downs of interest rates for nearly two decades. The major rating agencies - S&P and Moody's - and our regulator all affirm that our risks are well managed and we have sufficient capital for the level of risk we take.

* * * Even with interest rates rising and the housing market cooling off, our growth prospects remain very strong. And even, perhaps especially, in the context of this very volatile interest rate environment, our financial and risk management disciplines continue to differentiate us among the range of market participants I have described today. Because of these factors, I am quite comfortable ending today by reaffirming the earnings guidance we provided earlier this summer.

That is, we expect to report core business EPS growth this year of between 12 and 14 percent compared with 2002.

* * * Disciplined growth is what we offer to our shareholders, and it is what we intend to deliver.


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250. On October 16, 2003, Fannie Mae issued a news release in which it announced its

financial results for the third quarter ended September 2003, which it subsequently revised on

October 29, 2003. The revised October 29, 2003 release contained the following headline:

REVISED – October 29, 2003

Fannie Me Reports Third Quarter 2003 Financial Results

Net income at $2,666 million, up 168 percent over the third quarter of 2002; Diluted earnings per share at $2.69, up 175 percent

Core business earnings at $1,826 million, up 12 percent over the third quarter of 2002; Core business diluted earnings per share at $1.83, up 13 percent


Fannie Mae (FNM/NYSE), the nation’s largest source of financing for home mortgages, today reported financial results for the third quarter of 2003. The company’s reported results are based on generally accepted accounting principles (GAAP). Management also tracks and analyzes Fannie Mae’s financial results based on a supplemental non-GAAP measure called “core business earnings,” which management uses as its primary measure in operating Fannie Mae’s business (see “Core Business Earnings” and attachments).

Reported GAAP Results

For the Quarter Ended For the Six Months September 30, Ended September 30,

2003 2002 Change 2003 2002 Change Net Income (in millions) $2,666 $994 168.2% $5,708 $3,667 55.7%

EPS* (in dollars) $2.69 $0.98 174.5% $5.70 $3.59 58.8%

Core Business Earnings For the Quarter Ended For the Six Months September 30, Ended September 30,




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Highlights Highlights of Fannie Mae's financial performance in the third quarter of 2003 compared with the third quarter of 2002 include:

Reported net interest income of $3,489.3 million, up 34.7

percent; Core net interest income of $2,668.8 million, up 21.7

percent; Guaranty fee income of $613.2 million, up 32.6 percent;

* * * A $185.1 million after-tax gain resulting from the

adoption of FASB Statement No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities ("FAS 149").

Franklin D. Raines, Fannie Mae’s Chairman and Chief Executive Officer, said, "Fannie Mae delivered outstanding financial results in the third quarter, driven by record business volume and portfolio growth. In a quarter marked by historic levels of volatility in the fixed income markets, our company continued to benefit from the disciplined strategies for growth that have resulted in consistently strong financial performance through a wide range of economic and financial environments. The 21.9 percent year-to-date growth rate in our mortgage portfolio was achieved even as refinancing activity slowed and portfolio liquidations reached an all-time high. The strength of our performance also enabled us to repurchase nearly $6.8 billion in higher cost outstanding debt, which will benefit our shareholders in the future."

Raines added, "We are particularly pleased by the demonstrated effectiveness of our corporate risk disciplines in a period of sustained volatility and stress in the financial markets. Our duration gap remained within our preferred range in each month of the third quarter, and while our credit loss ratio increased slightly compared with the second quarter of 2003, this measure remains at extremely low historical levels. "

* * *

Fannie Mae’s Vice Chairman and Chief Executive Officer, Timothy Howard, said, "The consistency and strength of our financial performance was not compromised by an extremely challenging and volatile market. Our core business earnings per share increased by 13.0 percent compared with the third quarter of 2002. This growth rate was substantially reduced by the impact of over $900 million in costs associated with the repurchase of outstanding debt, partially offset by a one-time after-tax gain of $185 million associated with the adoption of FAS 149, an amendment to FAS 133 that will result in the majority of Fannie Mae's mortgage purchase commitments being accounted for as derivatives. Our portfolio business recorded exceptional financial performance in the third


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quarter, with core net interest income up 22 percent over the third quarter of 2002. Guaranty fee income increased by 33 percent compared with the prior year quarter."

Howard said that the 62.4 percent annualized increase in the company's mortgage portfolio during the third quarter was driven by record purchases of $254 billion. These purchases reflected a combination of the settlement of outstanding commitments, which totaled $135 billion at June 30, 2003, and new commitments made during the quarter. Said Howard, "In addition to seeing the very positive impact of the settlement of outstanding commitments, we were able to take advantage of attractive mortgage-to-debt spreads at different points during the quarter, and also benefited from intermittent selling of MBS by banks and other investors." Howard added that outstanding portfolio mortgage commitments were $30 billion at September 30, 2003. Howard noted that the duration gap on Fannie Mae's mortgage portfolio averaged a positive one month in September. Howard said, "Our duration gap stayed within our preferred range during each month of a quarter in which yields on 10-year treasuries surged 105 basis points and then declined by 66 basis points in September. That is a very positive testament to the effectiveness of our stringent, publicly-disclosed financial and risk disciplines." Howard added, "During the quarter we capitalized on particularly attractive opportunities to repurchase shares of Fannie Mae common stock, while at the same time significantly strengthening our capital position to support the extraordinary growth of our mortgage portfolio." Specifical1y, Howard said, Fannie Mae repurchased 5.5 million shares of common stock during the quarter, while the company's core capital rose to $32.8 billion compared with $30.7 billion at June 30, 2003. Reported Results Fannie Mae’s reported net income of $2,666 million for the third quarter of 2003 increased 168.2 percent over reported net income of $994 million in the third quarter of 2002. Diluted earnings per share (EPS) were $2.69 in the third quarter of 2003, up 174.5 percent from $0.98 in the third quarter of 2002.

Reported net income for the first nine months of 2003 was $5,708 million, up 55.7 percent from the first nine months of 2002. Diluted EPS were $5.70 during the first nine months of 2003, up 58.8 percent from the comparable period the previous year.

In accordance with FAS 133, the company recorded $472 million of unrealized mark-to-market gains on purchased options during the third quarter of 2003 compared with $1,378 million in unrealized mark-to-market losses in the third quarter of 2002. These unrealized gains were due primarily to increases in the


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fair value of the time value of purchased options during the quarter that resulted from the generally higher interest rate environment. Strong growth in net interest income contributed positively to the company’s reported results for the quarter. Net interest income for the third quarter of 2003 was $3,489 million, up 34.7 percent over the third quarter of 2002. This increase primarily resulted from a 15.3 percent rise in the average net investment balance and a 21 basis point increase in the net interest yield.

The company’s net interest yield averaged 156 basis points in the third quarter of 2003 compared with 135 basis points in the third quarter of 2002. The increased amount of purchased options used as a substitute for callable debt compared with the prior year quarter had a positive effect on Fannie Mae’s net interest yield, because the cost of purchased options is not reflected in net interest yield or reported net interest income. Core net interest income and net interest margin, supplemental non-GAAP measures discussed below, include purchased options amortization expense and are calculated consistently with Fannie Mae’s methodology prior to the adoption of FAS 133. Core Business Earnings Core business earnings for the third quarter of 2003 totaled $1,826 million, a 12.0 percent increase over core business earnings of $1,631 million in the third quarter of 2002. Core business diluted EPS for the third quarter of 2003 were $1.83, or 13.0 percent above the third quarter of 2002. Growth in core business earnings and diluted EPS was paced by a 21.7 percent increase in core net interest and a 32.6 percent increase in guaranty fee income. Fannie Mae management relies on core business earnings in operating the company’s business. Management believes that core business earnings better reflects the company’s risk management strategies, and provides investors with a better measure of the company’s financial results than GAAP net income. Core business earnings was developed in conjunction with the company’s January 1, 2001, adoption of Financial Accounting Standard No. 133, Accounting for Derivative Instruments and Hedging Activities (FAS 133), to adjust for the use of purchased options as an alternative to issuing callable debt, alternatives that produce similar economic results but require different accounting treatment under FAS 133. The difference in the amounts and percentage changes between net income and core business earnings, and EPS and core business EPS, are entirely attributable to these accounting differences for interest rate hedges. The attachments to this release include a reconciliation of the company’s non-GAAP financial measures to GAAP results.

* * *

Portfolio Investment Business Results Fannie Mae's portfolio investment business manages the interest rate risk of the company's mortgage portfolio and other investments. The results of this business


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are largely reflected in core net interest income, which is net interest income less the amortization expense of purchased options. Core net interest income for the third quarter of 2003 was $2,668.8 million, up 21.7 percent from $2,192.1 million in the third quarter of 2002. This increase was driven by a 15.3 percent rise in the average net investment balance and a four basis point increase in the net interest margin.

* * * The company's net interest margin averaged 120 basis points in the third quarter of 2003 compared with 116 basis points in the third quarter of 2002 and 130 basis points in the second quarter of 2003. Fannie Mae's net interest margin declined from the second quarter of this year as record low interest rates during the spring drove heavy mortgage liquidations of older, higher-coupon mortgages that were replaced with new, current-coupon mortgages. For the third quarter of 2003 the company realized losses from debt repurchases and debt calls of $902.0 million compared with losses of $138.0 million in the third quarter of 2002. Losses on debt repurchases totaled $878.2 million during the quarter, while losses on debt calls totaled $23.8 million. Debt repurchased and debt called in the third quarter totaled $6.8 billion and $56.9 billion, respectively. Fannie Mae regularly calls or repurchases debt as part of its interest rate risk management program.

* * *

Capital Account Management Fannie Mae’s core capital, which is the basis for the company’s statutory minimum capital requirement, was $32.8 billion at September 30, 1003, compared with $28.1 billion at December 31, 2002, and $26.5 billion at September 30, 2002. Core capital was an estimated $1.316 billion above the statutory minimum at September 30, 2003. At June 30, 2003, core capital was $1.527 billion above the statutory minimum. Voluntary Disclosures

* * * At September 30, 2003, Fannie Mae’s ratio of liquid assets to total assets was 5.6 percent compared with 6.9 percent at December 31, 2002. Liquid assets totaled $57.4 billion at September 30, 2003.

* * * Derivatives and FAS 133 . . . Beginning in the third quarter of 2003 with the implementation of FAS 149, the company also accounts for certain commitments to purchase mortgages and MBS as derivatives.

FAS 133 requires that Fannie Mae mark to market on its income statement the changes in the time value, but not the total value, of its purchased options -- interest rate swaptions and interest rate caps. The mark to market of the time


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value of Fannie Mae's purchased options during the third quarter of 2003 resulted in a net mark-to-market gain of $471.7 million compared with a net mark-to-market loss of $1,378.3 million in the third quarter of 2002, which is reported on the purchased option expense line of the income statement. Purchased option expense in the third quarter of 2003 includes $820.5 million in amortization expense, which was included in net interest income prior to FAS 133 and currently is included in core net interest income and in core business earnings. This amortization expense represents the straight-line amortization of the up-front premium paid to purchase the options over the expected life of the options together with any acceleration of expense related to options extinguished prior to exercise.

FAS 133 also requires that the company record any change in the fair values of certain derivatives, including interest rate swaps it uses as substitutes for noncallable debt, on the balance sheet in AOCI. For these types of transactions FAS 133 does not require or permit noncallable debt to be marked to market. At September 30, 2003, the AOCI component of stockholders' equity included a reduction of $16.1 billion, or 1.7 percent of the net mortgage balance, from the marking to market of these derivatives. This compares to a reduction of $17.0 billion at June 30, 2003, and $16.3 billion at December 31, 2002. In addition, the company recorded a reduction of $2.6 billion in AOCI related to the fair value of certain mortgage-related purchase and sell commitments designated as cash flow hedges by FAS 149. Accumulated other comprehensive income is a separate component of stockholders' equity and is not a component of core capital for regulatory purposes.

Fannie Mae's primary credit exposure on derivatives is that a counterparty might default on payments due, which could result in Fannie Mae having to replace the derivative with a different counterparty at a higher cost. Fannie Mae's exposure on derivative contracts (taking into account master settlement agreements that allow for netting of payments and excluding collateral received) was $5.684 billion at September 30, 2003. All of this exposure was to counterparties rated A-/A3 or higher. Fannie Mae held $5.455 billion of collateral through custodians to offset the risk of the exposure for these instruments. Fannie Mae's exposure, net of collateral, was $229 million at September 30, 2003, versus $197 million at December 31, 2002. 251. On October 29, 2003, Fannie Mae filed with the SEC on Form 8-K/A a copy of a

revised press release dated October 29, 2003, in which the Company reported its third quarter

2003 financial results. The October 29, 2003 Form 8-K/A was signed by Defendant Spencer.

252. On November 14, 2003, Fannie Mae filed its quarterly report with the SEC on

Form 10-Q for the third quarter ended September 30, 2003 (“Third Quarter 2003 10-Q”). The


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Third Quarter 2003 10-Q reiterated the financial results contained in Defendants’ October 29,

2003 press release and was signed by Defendants Howard and Spencer. Defendants Raines and

Howard also filed certifications with the report, as required by the Exchange Act, in which they

certified that: (i) the report did not contain any untrue statement of a material fact or omit to state

any material fact necessary to make the statements made not misleading; (ii) the financial

statements and financial information included in the report fairly presented in all material

respects the financial condition, results of operations and cash flows of the Company; and (iii)

that Raines and Howard were responsible for establishing and maintaining disclosure controls

and procedures as defined in the Exchange Act and that they had (a) designed such disclosure

controls and procedures, or caused such disclosure controls and procedures to be designed under

their supervision, to ensure that material information relating to the Company was made know to

them by others within the entity, particularly during the period in which the report was being

prepared; and (b) evaluated the effectiveness of the Company’s disclosure controls and

procedures and presented in the report their conclusions about the effectiveness of the disclosure

controls and procedures. In the report, the Company reaffirmed its previously announced

financial results for the third quarter and represented that "[t]he interim financial information

provided in this report reflects all adjustments that, in the opinion of management, are necessary

for a fair presentation of the results for such periods." Further, in Footnote 1 to the Financial

Statements, Defendants made the representation that “[t]he accompanying unaudited condensed

financial statements have been prepared in accordance with generally accepted accounting

principles in the United States of America (”GAAP”) for interim financial information.”

253. Also in the Third Quarter 2003 10-Q, Defendants represented compliance with

FAS 133 as follows:


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FAS 133 requires that changes in the fair value of derivative instruments be recognized in earnings unless specific hedge accounting criteria are met. Although Fannie Mae’s derivatives may be effective economic hedges and critical in our interest rate risk management strategy, they may not meet the hedge accounting criteria of FAS 133. At September 30, 2003, we had $69 million in outstanding notional amount of derivatives that did not qualify for hedge accounting under FAS 133, which we are required to mark-to-market through earnings. We also had $46 billion in notional amount of mortgage commitments accounted for as derivatives that we did not designate for hedge accounting. The following table shows the impact of FAS 133 on AOCI, net of taxes, between December 31, 2002 and September 30, 2003 related to all contracts accounted for as derivatives.

Nine Months Ended September 30,

2003 2002

(Dollars in millions) Impact on AOCI: Balance at January 1.................................................................................... $ (16,251) $ (7,359) Losses on cash flow hedges related to derivatives, net ........................... (3,621) (13,273) Losses on cash flow hedges related to mortgage commitments, net ....... (2,640) — Reclassifications to earnings, net ............................................................. 3,869 4,137

Balance at September 30............................................................................. $ (18,643) $ (16,495)

Third Quarter 2003 10-Q, at 52.

254. In the Third Quarter 2003 10-Q, Defendants also represented that they had


Item 4. Controls and Procedures We carried out an evaluation, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures as of the end of the period covered by this quarterly report. Based on this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective. In addition, based on this most recent evaluation, we have concluded that there were no changes in our internal control over financial reporting that occurred during the period covered by this quarterly report that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

Third Quarter 2003 10-Q, at 52.


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255. On October 16, 2003, the Company filed Form 8-K, signed by Defendant

Spencer, which included the monthly financial summary release for the month of September

2003 in which stated amounts were represented in compliance with FAS 133.

256. On November 19, 2003, Defendant Howard prepared and made the following

statements at the Merrill Lynch Banking and Financial Services Conference:

Steady, Consistent EPS Growth Overwhelmingly, participants in our study listed the consistent growth of core business EPS as a top reason to own Fannie Mae. Since year-end 1998, Fannie Mae has delivered compound annual growth in core business EPS of over 17 percent. Some of you will recall that we set as a goal to double our core business EPS during the period represented on this slide. With year-to-date core EPS of $5.52 through the third quarter, we are well on the way to exceeding that objective. Two items worth mention . . . . First, our record of uninterrupted double-digit core EPS growth actually extends back to 1987, a record matched by only one other S&P 500 company. Second, and perhaps most importantly, the strong and consistent growth . . . was achieved within the stringent constraints of our financial and risk disciplines, which I'll address in more detail later on.

* * *

Strong EPS Growth/Interest Rate Cycles * * *

Fannie Mae's core business EPS has grown consistently through a broad range of interest rate environments -- over the past 10 years at a compound annualized rate of 15.6 percent. And in 1994, 1996 and 1999 -- years in which 10-year Treasury rates rose on average by over 150 basis points -- we delivered core EPS growth of 13.5, 15.4 and 15.2 percent, respectively.

* * * Risk management is a perennial area of focus for our investors, simply because as a one-asset company we have to be in the business of managing the interest rate and credit risks associated with this asset. We are, and we manage those risks uniquely well. Financial Discipline Objectives In our second quarter earnings release we announced our commitment to meeting the three financial discipline objectives that you see described on this exhibit. These objectives provide a stringent and absolute risk framework for our business activities. I won't go into the exact details of these objectives -- you can read


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about them on the IR page of our Web site. But I do want to make clear that these objectives were put into place and made public because it will always be in Fannie Mae's financial interest to be recognized as a low-risk, very high credit quality company. Being recognized as one of the lowest risk financial institutions in the world is critical to our ability to retain the support of policymakers, to preserve our low-cost access to debt, and to maintain the liquidity of our mortgage-backed securities -- and it is a distinction that meeting our publicly disclosed discipline objectives should allow us to sustain. To this end, our corporate financial discipline objectives are tied explicitly to each of our businesses.

* * * Portfolio Discipline/Duration Specifically, we actively rebalance our portfolio to maintain a desired tolerance on our duration gap. We announced with our second quarter earnings that we would be conducting rebalancing actions to maintain a tighter tolerance on our portfolio's duration gap. We expect that with this tighter tolerance, our duration gap will remain within a range of plus or minus six months substantially all of the time. As you might recall, this approach was immediately put to the test in July, when 10-year swap rates rose by 114 basis points -- the greatest increase over the course of a single month in more than 15 years. Even in the face of this dramatic move, our duration gap stayed within our targeted range, at positive six months. This is an extraordinary achievement when you consider that the Lehman MBS Index -- a stylized portfolio that tracks the performance of fixed rate mortgage-backed securities --saw a duration increase of over 24 months during that same period. In a time of historic volatility, our process worked...And we have reported duration gaps in August, September and October of positive four, one and one months, respectively.

* * * The company that I have described today is the leading competitor in a dynamic and growing market. It has a demonstrated ability to deliver strong, consistent earnings growth through a range of economic and financial environments, and...It has made a public commitment to stringent financial discipline that should result in better than average earnings growth going forward, and greater stability in long-term earnings than a typical AA or AAA company. We are confident that the facts produced by our business performance ultimately will win out over the fictions produced by our critics. And as this becomes more widely perceived, Fannie Mae's valuation should begin to look increasingly attractive to a larger and larger number of investors.


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257. On January 21, 2004, Fannie Mae issued a news release in which it announced its

financial results for the fourth quarter and year ended December 31, 2003 under the headline:

Fannie Mae Reports 2003 Financial Results Net income at $7,905 million, up 71.1 percent; Diluted earnings per share at $7.91, up 75.0 percent Core business earnings at $7,306 million, up 14.3 percent; Core business diluted earnings per share at $7.29, up 15.7 percent The release stated, in pertinent part: Fannie Mae (FNM/NYSE), the nation’s largest source of financing for home mortgages, today reported financial results for the year ended December 31, 2003. The company’s reported results are based on generally accepted accounting principles (GAAP). Management also tracks and analyzes Fannie Mae’s financial results based on a supplemental non-GAAP measure called “core business earnings,” which management uses as its primary measure in operating Fannie Mae’s business (see “Core Business Earnings” and attachments).

Reported GAAP Results For the Quarter For the Twelve Months Ended December 31, Ended December 31,

2003 2002 Change 2003 2002 Change Net Income (in millions) $2,196 $952 130.7% $7,905 $4,619 71.1%

EPS* (in dollars) $2.21 $0.94 135.1% $7.91 $4.52 75.0%

Core Business Earnings For the Quarter Ended For the Twelve Months December 31, Ended December 31,




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Highlights Highlights of Fannie Mae’s 2003 financial performance include:

* * * Reported taxable equivalent revenues of $17.9 billion, up

30.4 percent; Core taxable equivalent revenues of $14.8 billion, up 24.4

percent; Record reported net interest income of $13.6 billion, up

28.4 percent; Record core net interest income of $10.5 billion, up 19.7

percent; Record guaranty fee income of $2.4 billion, up 32.7

percent; Record fee and other income of $437.0 million, up 88.2

percent;

* * * Franklin D. Raines, Fannie Mae’s Chairman and Chief Executive Officer said, “Fannie Mae delivered outstanding business results in 2003, capitalizing on opportunities and meeting the significant challenges posed by a year of historic refinance and purchase volumes and volatility in our market. Our financial performance was balanced and strong by virtually every measure, as we recorded our 17th consecutive year of double-digit growth in core business earnings per share (EPS). We also met our goal -- established in 1999 -- to double our core business earnings in five years. Equally important, we achieved our mission objectives, building on our demonstrated record of lowering costs, removing barriers, and increasing homeownership opportunities for American families.” (Emphasis added.) Raines added, “Our business volumes in 2003 reached extraordinary levels -- over 67 percent above those recorded in 2002 -- and our capacity to handle these enormous demands for housing finance benefited home buyers and our shareholders alike. Even as liquidations reached record levels, our total book grew by 21 percent, and we delivered solid growth in each of our businesses. Strong year-over-year increases in core net interest and guaranty fee income, and the maintenance of credit losses within a historically low range, contributed to a 15.7 percent increase in core business EPS. This exceptional financial performance in an extremely challenging environment is a testament to the balance of our business model, and our strict adherence to the financial and risk disciplines that govern it.” (Emphasis added.)

Raines continued, “These business and mission successes were at times obscured during the year by regulatory and legislative concerns growing out of the situation at Freddie Mac.” Raines said, “We believe that Congress will not enact any changes to our regulatory status that would harm our ability


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to perform our mission and produce returns for our shareholders.” (Emphasis added.) Fannie Mae’s Vice Chairman and Chief Financial Officer, Timothy Howard, said, "The strength of our full year financial results is especially gratifying given the extreme financial market volatility over the past year, with interest rates declining to 45-year lows in mid-June before rebounding sharply over the balance of the summer. As a consequence of this volatility, the growth rates of Fannie Mae's two businesses diverged substantially, and showed significant variability on a quarterly basis." (Emphasis added.)

Howard added, "While low interest rates during the first half of the year spurred record mortgage originations, aggressive purchasing of mortgages by banks and other investors resulted in relatively narrow mortgage to debt spreads and lower than expected sales into the secondary market. Our portfolio business maintained investment discipline throughout the year, purchasing mortgages when spreads exceeded our hurdle rates and when supply was available in the market. Opportunistic purchasing resulted in a sporadic pattern of portfolio growth during the year, including two quarters of declines that were more than offset by annualized growth of over 60 percent in the third quarter. For the full year our portfolio grew close to our expectation, by 13 percent."

Howard noted that the growth of Fannie Mae's outstanding mortgage-backed securities (MBS) benefited substantially from the record amount of refinancing during the year. Although outstanding MBS declined by 8.3 percent in the third quarter, balances grew at an annual rate of 32.8 percent to a record $1.3 trillion in the fourth quarter, and by 26.3 percent during all 12 months of 2003. Howard said that the margins on both the portfolio and credit guaranty business rose in 2003 compared with 2002. Said Howard, "Our core net interest margin averaged a higher than anticipated 120 basis points for the year, compared with 115 basis points in 2002. And partly because of the effect of an accelerated recognition of deferred guaranty fees, our effective guaranty fee rate also rose, averaging 20.2 basis points in 2003 compared with 19.1 basis points in 2002."

Howard added that Fannie Mae's credit costs rose moderately in 2003. Said Howard, "A continued rise in the number of foreclosed properties, coupled with a gradual increase in our loss per case on foreclosure from historic lows, led to a modest increase in credit-related expenses in 2003, to $112 million compared with $92 million in 2002." Howard said that Fannie Mae's credit loss ratio -- the company's credit-related losses as a percent of average net mortgage portfolio and outstanding mortgage-backed securities -- remained extremely low at 0.6 basis points in 2003. Howard concluded, "The strength of our financial performance in 2003 was accompanied by significant steps taken during the year to further strengthen our


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risk disciplines and capital position. The stringent financial and risk tolerances to which we publicly committed in July were tested and proven effective by the extreme volatility of the fixed income markets during the past year. Our portfolio's duration gap -- our most closely followed measure of interest rate risk -- remained within our preferred range in each month of 2003, and averaged minus one month for the year. We also met our voluntary initiative -- announced in October of 2000 -- to issue subordinated debt in an amount sufficient to bring the sum of total capital and subordinated debt to 4 percent of on-balance sheet assets, after providing for capitalization of off-balance sheet MBS. At year-end, our combined total capital and subordinated debt was over $41.7 billion, or 4.1 percent of on-balance sheet assets. In effect, the issuance of subordinated debt has allowed our company to add an additional cushion to our capital base of over 40 percent, substantially strengthening our capital position."

Reported Results Fannie Mae's reported net income of $7,905 million for 2003 increased 71.1 percent over reported net income of $4,619 million in 2002. Diluted EPS were $7.91 in 2003, up 75.0 percent from $4.52 in 2002. Growth in net income was driven by strong growth in net interest income of 28.4 percent and a decline in unrealized mark-to-market losses on purchased options. For the fourth quarter of 2003 Fannie Mae's reported net income was $2,196 million, or $2.21 per diluted common share, compared with $952 million, or $0.94 per diluted common share, for the fourth quarter of 2002. The primary driver of the increases in reported net income and diluted EPS compared with the prior year quarter was a $1,748 million decline in unrealized mark-to-market losses on purchased options. Net interest income for 2003 was $13,569 million, up 28.4 percent over 2002. This increase primarily resulted from a 13.6 percent rise in the average net investment balance and a 16 basis point increase in the net interest yield. Net interest income for the fourth quarter of 2003 was $3,211 million, a 6.6 percent increase compared with net interest income of $3,012 million for the fourth quarter of 2002. The company's net interest yield averaged 154 basis points in 2003 compared with 138 basis points in 2002. The increased amount of purchased options used as a substitute for callable debt compared with the prior year had a positive effect on Fannie Mae's net interest yield, because the cost of purchased options is not reflected in net interest yield or reported net interest income. The company's net interest yield averaged 137 basis points in the fourth quarter of 2003, compared with 151 basis points in the prior year quarter. Core net interest income and net interest margin, supplemental non-GAAP measures discussed below, include purchased options amortization expense and are calculated consistently with Fannie Mae's methodology prior to the adoption of FAS 133. In accordance with FAS 133, the company recorded $2,168 million of unrealized mark-to-market losses on purchased options during 2003, compared with $4,545


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million in unrealized mark-to-market losses in 2002. In the fourth quarter of 2003, the company recorded $133 million of mark-to-market losses on purchased options compared with $1,881 million in the fourth quarter of 2002. Unrealized losses recorded for both the full year and fourth quarter periods were due primarily to changes in the fair value of the time value of purchased options that resulted from interest rate movements and the normal seasoning of our options. Core Business Earnings Core business earnings for 2003 totaled $7,306 million, a 14.3 percent increase over core business earnings of $6,394 million in 2002. Core business diluted EPS for 2003 were $7.29, or 15.7 percent above 2002. Growth in core business earnings and diluted EPS was paced by a 19.7 percent increase in core net interest income and a 32.7 percent increase in guaranty fee income, partially offset by a $1,551 million increase in losses resulting from the call and repurchase of outstanding debt. Core business earnings for the fourth quarter of 2003 totaled $1,770 million, or $1.77 per diluted common share, compared with $1,672 million, or $1.66 per diluted common share, for the fourth quarter of 2002. Increases in core business earnings and EPS compared with the prior year quarter were primarily attributable to an 8.2 percent increase in core net interest income and an 18.4 percent increase in guaranty fee income, partially offset by higher administrative expenses and lower fee and other income. Fannie Mae management relies on core business earnings in operating the company's business. Management believes that core business earnings better reflects the company's risk management strategies, and provides investors with a better measure of the company's financial results than GAAP net income. Core business earnings was developed in conjunction with the company's January 1, 2001, adoption of Financial Accounting Standard No. 133, Accounting for Derivative Instruments and Hedging Activities (FAS 133), to adjust for the use of purchased options as an alternative to issuing callable debt, alternatives that produce similar economic results but require different accounting treatment under FAS 133. The difference in the amounts and percentage changes between net income and core business earnings, and EPS and core business EPS, are entirely attributable to these accounting differences for interest rate hedges. The attachments to this release include a reconciliation of the company's non-GAAP financial measures to its GAAP results.

* * * Portfolio Investment Business Results Fannie Mae's portfolio investment business manages the interest rate risk of the company's mortgage portfolio and other investments. The results of this business are largely reflected in core net interest income, which is net interest income less the amortization expense of purchased options. Core net interest income for 2003 was $10,479 million, up 19.7 percent from $8,752 million in 2002. This increase was driven by a 13.6 percent rise in the average net investment balance and a five basis point increase in the net interest margin. Core net interest income was


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$2,422 million in the fourth quarter of 2003, up 8.2 percent from $2,238 million during the same quarter of 2002.

* * * The company's net interest margin averaged 120 basis points in 2003, up from 115 basis points in 2002. In the fourth quarter of 2003, the net interest margin declined to an average of 105 basis points compared with 114 basis points in the fourth quarter of 2002, and 120 basis points in the third quarter of 2003. This decline was attributable to changes in funding costs that the company had anticipated in a rising interest rate environment, as well as changes in asset yields. Record mortgage liquidations and purchases of current-coupon mortgages during the third quarter led to a decline in the average note rate on the company's portfolio. In addition, with the rise in interest rates beginning in June the company reduced its balances of short-term debt, causing the average cost of debt to rise somewhat in the fourth quarter as low cost short-term debt was retired. For the full year 2003, the company realized losses from debt repurchases and debt calls of $2,261.0 million compared with losses of $710.5 million in 2002. During the year the company realized $2,182.8 million of losses on debt repurchases and $78.2 million of losses on debt calls. Debt repurchased and debt called during the year totaled $19.8 billion and $246.0 billion, respectively. Fannie Mae regularly calls or repurchases debt as part of its interest-rate risk management program.

* * * Capital Account Management Fannie Mae's core capital, which is the basis for the company's statutory minimum capital requirement, was $34.4 billion at December 31, 2003, compared with $28.1 billion at December 31, 2002, and $32.8 billion at September 30, 2003. Core capital was an estimated $2.885 billion above the statutory minimum at December 31, 2003.

* * * Voluntary Disclosures At December 31, 2003, Fannie Mae’s ratio of liquid assets to total assets was 6.5 percent compared with 5.6 percent at September 30, 2003. Liquid assets totaled $65.6 billion at December 31, 2003.


* * * Beginning in the third quarter of 2003 with the implementation of FAS 149, the company also accounts for certain commitments to purchase or sell mortgages and MBS as derivatives.


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FAS 133 requires that Fannie Mae mark to market on its income statement the changes in the time value, but not the total value, of its purchased options -- interest rate swaptions and interest rate caps. The mark to market of the time value of Fannie Mae's purchased options during 2003 resulted in a net mark-to-market loss of $2.168 billion, which is reported on the purchased option expense line of the income statement. Purchased option expense in 2003 includes $3.090 billion in amortization expense, which was included in net interest income prior to the adoption of FAS 133 and currently is included in core net interest income and in core business earnings. For the fourth quarter of 2003 the company recorded a net mark-to-market loss of $132.8 million compared with a net mark-to-market loss of $1,881.1 million in the fourth quarter of 2002. Purchased option expense in the fourth quarter of 2003 includes $789.2 million in amortization expense. This represents the amortization of the up-front premium paid to purchase the options over the expected life of the options.

FAS 133 also requires that the company record any change in the fair values of certain derivatives, including interest rate swaps it uses as substitutes for noncallable debt, on the balance sheet in accumulated other comprehensive income (AOCI). FAS 133 does not require or permit noncallable debt to be marked to market. At December 31, 2003, the AOCI component of stockholders' equity included a reduction of $12.2 billion, or 1.4 percent of the net mortgage balance, from the marking to market of these derivatives. This compares to a reduction of $16.1 billion at September 30, 2003, and $16.3 billion at December 31, 2002. In addition, at December 31, 2003, the company recorded a reduction of $2.5 billion in AOCI related to the fair value of certain mortgage-related purchase and sell commitments designated as cash flow hedges by FAS 149. Accumulated other comprehensive income is a separate component of stockholders' equity and is not a component of core capital for regulatory purposes. Fannie Mae's primary credit exposure on derivatives is that a counterparty might default on payments due, which could result in Fannie Mae having to replace the derivative with a different counterparty at a higher cost. Fannie Mae's exposure on derivative contracts (taking into account master settlement agreements that allow for netting of payments and excluding collateral received) was $7.129 billion at December 31, 2003. All of this exposure was to counterparties rated A-/A3 or higher. Fannie Mae held $6.615 billion of collateral through custodians to offset the risk of the exposure for these instruments. Fannie Mae's exposure, net of collateral, was $514 million at December 31, 2003, versus $229 million at September 30, 2003.

This press release was also included in the filing of Form 8-K filed on January 21, 2004 and

signed by Defendant Spencer.


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258. On January 21, 2004, the Company held its fourth quarter 2003 earnings

conference call during which Defendant Howard made the following statements:

Timothy Howard - Fannie Mae - Vice Chairman of the Board, Chief Financial Officer

* * * Risk management continued to be a strength for us last year and we expect it will be a strength again this year. Despite historic interest rate volatility, we were able to keep the duration gap on our mortgage portfolio within the plus or minus six month target range in every month of 2003. And we were successful in adding to the optionality of our liabilities last year. Those were the two goals we set for ourselves with a new interest rate risk management disciplines we announced in July and we hit them. We intend to hit them again this year.

* * *

Timothy Howard - Fannie Mae - Vice Chairman of the Board, Chief Financial Officer * * *

I want to make a quick comment on the increase in surplus capital this year. You'll note, if you look at the change in our GAAP net income versus our core business earnings, our GAAP net in income was up $3.3 billion in 2002. Our core business earnings were up $900 million. as we've said continually, the GAAP net income measure is very volatile because it incorporates these temporary unrealized marks to market on our purchased options expense. In 2003, we had a very low cost to purchase options on a GAAP basis. It was about $2 billion. We took more than that, over a billion dollars more, through our expense statement by amortizing the cost of purchase options. As a result, since the GAAP net income flows through our income statement to our capital account, we had a surge in retainer earnings in 2003 on a GAAP basis. I would not expect all of that additional retained earnings to stay on the balance sheet. I think going forward it's more likely than not that GAAP net income will grow less rapidly than core business earnings and as a result, the surplus capital will decline unless we act to replenish it. So, it's important to view the change in surplus capital in the context of a unusually low amount of purchased options expense coming through GAAP because of FAS 133. So, abstracting from that, if we have somewhat slower growth in our business, which we're not expecting, we've indicated we believe we'll have or would be able to achieve double-digit portfolio growth and think that our business growth in general be there, as well. If we fall somewhat short of that we will build up surplus capital and think the growth will come back at some point. Beyond that, we will continue to balance the way we return capital to shareholders between


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dividends and share repurchases with the exact calibration of that being a function of our perception of which of those means is most valuable in our investors in the current environment.

* * * Eric Wasserstrom - UBS - Analyst Great, thanks for that, Tim. And, Tom, just one thing came up in the media recently was that there was some criticism from the, I think it was the Senate Banking Committee that Fannie Mae was reluctant to produce a fair value balance sheet and on a quarterly basis, which is something that phrase is committed to and I guess also they also want Fannie to do similarly. Is that "A," accurate? And if it is accurate, you know, why not produce it if it basically makes them happy?

* * *

Timothy Howard - Fannie Mae - Vice Chairman of the Board, Chief Financial Officer

You know, we're currently evaluating whether to begin to publish a fair value balance sheet on a quarterly basis. I will state that we already are in the forefront of industry practice in publishing a full fair value balance sheet on an annual basis. You know, under GAAP, companies are required to disclose the fair value of their financial instruments but not their full balance sheet and because we include valuation of the entire balance sheet, that additional valuation becomes a non-GAAP measure, which our auditors have noted. Very few companies today disclose the fair value of their balance sheets, even annually. Before we can begin to publish a non-GAAP balance sheet on a quarterly basis, we have to resolve a number of critical issues. One of these is that those who are calling for us to release a fair value balance sheet on a quarterly basis, generally contend that the change in fair value from quarter-to-quarter, adjusted for equity issuance or distributions, results in a measure of financial performance that is comparable to or perhaps even superior than GAAP earnings and any such net income oriented measure would be a non-GAAP measure and would need to be reconciled to GAAP. We need to figure out how to do that. A second issue that we're working with is that publishing a quarterly fair value balance sheet would give prominence to a non-GAAP measure that we don't currently emphasize in managing our business. Now, many of the companies who publish fair value disclosures, the ones mandated by FAS 107, caution investors against using them, noting among other things, they're not a primary tool of management. And finally, there is no standardization in the calculations of fair value and this places a very heavy burden on a company that prominently features a non-GAAP fair value measure, to disclose the basis of valuation assumptions, particularly for less liquid or higher value financial assets. So, we do think that fair value has a role in assessing the financial status of a company, particularly a financial company, but it's also got these drawbacks that


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investors have to be aware of. We'll be studying in the next few months, whether there is a way consistent with GAAP accounting and consistent with our high values of disclosure for us to provide a more frequent update of the risk management information we convey in the fair value balance sheet while avoiding the pitfalls that I've noted earlier and we intend to keep investors closely apprised of our progress in doing this. 259. On January 21, 2004 Defendant Spencer signed and the Company filed Form 8-K,

including the monthly financial summary release for the month of December 2003 in which the

Company stated core business earnings and purchased option expense as excluding unrealized

gains or losses in compliance with FAS 133.

260. On February 2, 2004, Dow Jones reported that Fannie Mae warned Congress

about releasing information on how much money Fannie Mae pays its top 20 executives.

According to the article, Fannie Mae warned that release of this information could subject those

responsible to "criminal proceedings."

261. As reported on February 26, 2004 by The Wall Street Journal, Fannie Mae

spokesman Chuck Greener denied accusations from OFHEO that the Company employed

manual systems to account for its derivatives. In response, Greener stated that Fannie Mae “is a

leader in the use of technology in financial services," and that “virtually every financial

institution in America” has similar manual systems, also known as end-user systems. Greener

also stated that the company is “very comfortable we will be able to respond to Ofheo’s request

fully.”

262. On March 10, 2004, the Financial Times reported that Fannie Mae paid $25.1

billion on derivative transactions in fewer than four years, nearly all of which may represent

losses that could not be recouped. In response, Fannie Mae issued a statement criticizing the

Financial Times, stating their calculation was “based on a wholly invented methodology that we

told the reporter is wrong. His calculation and methodology are flawed and the subsequent


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implications are wrong. The methodology he employed incorrectly calculated unrealized losses,

and as a result, he arrived at an erroneous conclusion. This has resulted in a gross

misrepresentation. Anyone who is seriously interested in looking at this should wait for our 10-K

filing next week.”

263. On March 15, 2004, Fannie Mae filed its annual report for the 2003 fiscal year

with the SEC on Form 10-K (“2003 10-K”). The Company's 2003 10-K was signed by the

Individual Defendants and reaffirmed the Company's previously announced financial results and

incorporated its financial results for the 2002 fiscal year. Defendants Raines and Howard also

filed certifications with the report, as required by the Exchange Act, in which they certified that:

(i) the report did not contain any untrue statement of a material fact or omit to state any material

fact necessary to make the statements made not misleading; (ii) the financial statements and

financial information included in the report fairly presented in all material respects the financial

condition, results of operations and cash flows of the Company; and (iii) that Raines and Howard

were responsible for establishing and maintaining disclosure controls and procedures as defined

in the Exchange Act and that they had (a) designed such disclosure controls and procedures, or

caused such disclosure controls and procedures to be designed under their supervision, to ensure

that material information relating to the Company was made know to them by others within the

entity, particularly during the period in which the report was being prepared; and (b) evaluated

the effectiveness of the Company’s disclosure controls and procedures and presented in the

report their conclusions about the effectiveness of the disclosure controls and procedures.

264. In the 2003 10-K, Defendants Howard and Spencer signed the “Report of

Management” addressed to the Shareholders of Fannie Mae in which the following

representations were made:


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The management of Fannie Mae is responsible for the preparation, integrity and fair presentation of the accompanying financial statements and other information appearing elsewhere in this report. In our opinion, the financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America appropriate in the circumstances, and the other financial information in this report is consistent with such statements. In preparing the financial statements and in developing the other financial information, it has been necessary to make informed judgments and estimates of the effects of business events and transactions. We believe that these judgments and estimates are reasonable, that the financial information contained in this report reflects in all material respects the substance of all business events and transactions to which the corporation was a party, and that all material uncertainties have been appropriately accounted for or disclosed. The management of Fannie Mae is also responsible for maintaining internal control over financial reporting that provides reasonable assurance that transactions are executed in accordance with appropriate authorization, permits preparation of financial statements in conformity with accounting principles generally accepted in the United States of America, and establishes accountability for the assets of the corporation. Internal control over financial reporting includes controls for the execution, documentation, and recording of transactions, and an organizational structure that provides an effective segregation of duties and responsibilities. Fannie Mae has an internal Office of Auditing whose responsibilities include monitoring compliance with established controls and evaluating the corporation’s internal controls over financial reporting. Organizationally, the internal Office of Auditing is independent of the activities it reviews.

* * * Management recognizes that there are inherent limitations in the effectiveness of any internal control environment. However, management believes that, as of December 31, 2003, Fannie Mae’s internal control environment, as described herein, provided reasonable assurance as to the integrity and reliability of the financial statements and related financial information.

2003 10-K, at 171. 265. In the 2003 10-K, Defendants also represented that they had investigated and

found effective the internal disclosure controls and procedures, stating:

Item 9A. Controls and Procedures Our Chief Executive Officer and Chief Financial Officer are responsible for ensuring that we maintain disclosure controls and procedures that are designed to provide reasonable assurance that material


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information and other information required under the securities laws to be disclosed is identified and communicated to senior management, including our Chief Executive Officer and Chief Financial Officer, on a timely basis. We carried out an evaluation, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures as of the end of the period covered by this annual report. Based on this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective in providing such reasonable assurance as of the end of the period covered by this annual report. Additionally, there were no changes in our internal control over financial reporting identified in connection with the evaluation that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

2003 10-K, at 175.

266. The 2003 10-K also repeated the representations made in prior filings with respect

to Fannie Mae’s accounting for premiums paid on interest rate caps; again noted that “projecting

mortgage prepayments to calculate the amortization of the deferred price components of

mortgages and mortgage-related securities held in portfolio” as well as “estimating the time

value of our purchase options” were critical accounting estimates; and further represented that:

We evaluate our critical accounting estimates and judgments on an ongoing basis and update them as necessary based on changing conditions. Management has specifically discussed the development and selection of each critical accounting estimate with the Audit Committee of Fannie Mae’s Board of Directors. Our Audit Committee has also reviewed our disclosures in this MD&A regarding Fannie Mae’s critical accounting estimates.

2003 10-K, at 40.

267. With respect to Fannie Mae’s compliance with FAS 91 in accounting for

amortization of deferred price adjustments, the 2003 10-K stated:

We recognize premiums, discounts, and other deferred purchase and guaranty fee price adjustments over the estimated life of purchased or guaranteed assets as an adjustment to income in accordance with Financial Accounting Standard No. 91, Accounting for Nonrefundable Fees and Costs Association with Originating or Acquiring Loans and Initial Direct Costs of Leases (“FAS 91”).

* * *


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We amortize premiums, discounts, and other deferred purchase price and guaranty fee price adjustments into income using the effective yield method, adjusted for prepayment activity. . . . We regularly evaluate whether it is necessary to change the estimated prepayment rates used in our amortization calculation based on changes in interest rates and expected mortgage prepayments.

2003 10-K, at 42.

268. With respect to changes in the fair value of Fannie Mae’s derivatives, the 2003

10-K stated:

The fair value of our derivatives is affected by changes in the level of interest rates and implied market volatility, together with activity in the derivatives book, which includes additions of new derivative contracts and the maturity or termination of existing contracts. The fair value of our derivatives increased to $6.633 billion at December 31, 2003, from negative $2.031 billion at December 31, 2002 and negative $4.115 billion at December 31, 2001. . . . Under FAS 133 we are required to record the fair value gains and losses on derivatives designated as cash flow hedges in the AOCI component of stockholders’ equity. Gains and losses on derivatives designated as fair value hedges and purchased options time value are not included in AOCI.

* * * We may from time to time terminate, discontinue, or change the designation of the hedging relationship for certain derivative instruments as a result of interest rate risk management activities. Our interest rate risk management actions are driven by the economics of the transaction and the market environment that exists at that time and not by the hedge accounting designations. . . . Of the $12.192 billion net after-tax losses in AOCI at December 31, 2003 related to derivative cash flow hedges, $5.334 billion is attributable to unrealized losses on open hedges while $6.858 billion is attributable to realized losses on cash flow hedges that have been either terminated or discontinued.

2003 10-K, at 79-80.

269. The 2003 10-K also stated with respect to derivative instruments and hedging

activities:

We formally document all relationships between hedging instruments and the hedged items, including the risk management objective and strategy for undertaking various hedge transactions. We link derivatives that qualify for hedge accounting to specific assets and liabilities on the balance sheet or to specific forecasted transactions and designate them as cash flow or fair value hedges. We also formally assess, both at the hedge’s inception and on an ongoing


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basis, whether the derivatives that we use in hedging transactions are highly effective in offsetting changes in the cash flows or fair values of the hedged items. Any ineffectiveness present in the hedge relationship is recognized in current earnings.

* * * FAS 133 requires that changes in the fair value of derivative instruments be recognized in earnings unless specific hedge accounting criteria are met. Although Fannie Mae’s derivatives may be effective economic hedges and critical in our interest rate risk management strategy, they may not meet the hedge accounting criteria of FAS 133. We discontinue hedge accounting prospectively when ● the derivative is no longer effective in offsetting changes in the cash flows

or fair value of a hedged item; ● the derivative expires or is sold, terminated, or exercised; ● the derivative is de-designated as a hedge instrument because it is unlikely

that a forecasted transaction will occur; or, ● designation of the derivative as a hedge instrument is no longer

appropriate.

2003 10-K, at 159-160. 270. In Fannie Mae’s 2003 Annual Report to Shareholders (“2003 Annual Report”),

the Defendants provided “Financial Highlights” including figures expressly stated to be

determined on basis of FAS 133. Defendant Raines also made the following representations in a

“Letter to Shareholders”:

“Best-in-class” corporate governance and disclosure Another defining element of our company is that we are committed to “best-in-class” corporate governance and financial disclosure practices. As a private company with a public mission, we have a two-fold obligation: We have to demonstrate our value and integrity both to the public we serve, and to the private investors that supply the capital we raise. Before they entrust us with their money, investors need to trust Fannie Mae.



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271. On March 2, 2004 Defendant Howard made the following remarks in his

presentation at the HSBC Central Bank Conference:

* * * But more credible and even tougher safety and soundness regulation is another matter. Our central position in the mortgage finance system demands that we operate to the highest standards of safety and soundness, and we agree that our risk management practices must meet such standards. I would like to spend just a few minutes reviewing each of the elements of safety and soundness . . . elements that collectively have provided a high degree of assurance to investors, policymakers, and ratings agencies that relative to the risks we undertake, Fannie Mae is one of the lowest risk, highest quality and best capitalized financial institutions in the world.

* * * Moving to interest rate risk management, last year we implemented even tighter tolerances for interest rate risk -- initiating portfolio rebalancing actions sooner to maintain narrower bands around our portfolio's duration gap, and moderately increasing the amount of optionality in our liability base.

* * * Our goal is to provide disclosures and information to investors that are on the cutting edge of best practices. The monthly and quarterly disclosures . . . exceed in both scope and detail the information provided to investors by virtually any other financial institution.

* * * Even before we became an SEC registrant, to be sure that we were delivering the level of disclosure and transparency that we believe our investors deserve, we commissioned Standard & Poor's to provide an objective appraisal of our policies. And I'd like to share just a few quotes from their report:

● "Fannie Mae has consistently undertaken to provide disclosure to its shareholders and stakeholders at a level that meets, or in some cases, exceeds that required by the SEC."

● "In recent years, a combination of voluntary initiatives and specifics of OFHEO's oversight have resulted in disclosure about Fannie Mae's financial health that is unavailable from other, similar financial institutions."

Given our obvious commitment to giving our investors the information they need, and the likelihood of a strengthened safety and soundness regulator in the near future, I believe it is safe to assume that Fannie Mae will continue to operate at the leading edge of transparency and disclosure going forward.


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review.





prepared in accordance with GAAP and the financial reports did not fairly present in all material

respects the financial condition, results of operations and cash flows of the Company as of and

for the periods represented.



accordance with SFAS 91.





(d) As a result of the foregoing GAAP violations, Fannie Mae’s reported net



(e) Contrary to Defendants’ claims, Fannie Mae did not manage its business

risks with “exceptional discipline and prudence,” the Company did not hold every employee to

the “highest standards of honesty and integrity,” and the Company’s governing principles were

not “openness,” “accountability” and “integrity.” Further, it was not at the “forefront” of


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financial disclosures, transparency and accountability,” and did not have “exceptionally high

quality” financial disclosures. Rather, defendants adopted and implemented policies and

procedures and engaged in accounting practices that violated GAAP to allow them to manipulate

Fannie Mae’s earnings and they actively hid their misconduct from investors.

(f) Contrary to Defendants’ representations, Fannie Mae’s internal control








(g) Contrary to the representations of Defendants Howard and Spencer in their

“Report to Management” that the Company’s internal Office of Auditing was independent of the

activities it reviewed, the internal auditor in fact reported directly to Defendant Howard, who

substantially controlled all of the Company’s accounting policies and practices and financial

disclosures.

(h) Defendants had established and maintained a corporate culture that



D. Statements Concerning First Two Quarters of 2004

273. On April 19, 2004, Fannie Mae issued a press release in which it announced its

financial results for the first quarter ended March 31, 2004 under the headline:


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Fannie Mae Reports First Quarter 2004 Financial Results Strong Fees and Margins Spur Performance in Transitioning Market; Strengthened Capital Base Positions Portfolio to Capitalize on Growth Opportunities


Fannie Mae (FNM/NYSE), the nation’s largest source of financing for home mortgages, today reported financial results for the first quarter of 2004 and updated its performance outlook for the full year.

Reported GAAP Results* Core Business Earnings* Q1 Q1 Change Q1 Q1 Change 2004 2003 2004 2003 Net Core Income $1,899.4 $1,940.5 -2.1% Business $2,019.7 $1,849.7 9.2% ($ in Earnings millions) ($ in millions) Core EPS* * Business (in $1.90 $1.93 -1.6% EPS* * $2.03 $1.84 10.3% dollars) (in dollars)

*The company’s reported results are based on generally accepted accounting principles (GAAP). Management uses a supplemental non-GAAP measure called “core business earnings” as its primary measure in operating Fannie Mae’s business (see “Non-GAAP Financial Measures”). **Diluted earnings per share (EPS). Highlights of Fannie Mae's financial performance in the first quarter of 2004 included:

* * * Core capital of $35.7 billion, a 21.0 percent increase over

the first quarter of 2003; and Franklin D. Raines, Fannie Mae's Chairman and Chief Executive Officer, said, "Fannie Mae's financial performance -- exemplified by a 10.3 percent increase in core business EPS -- continued to benefit from the balance and flexibility of our business model. . . . Looking forward, Raines noted, "With our strong capital base, the demonstrated effectiveness of our risk disciplines, and the sustained high level of purchase originations flowing into our market, we are well positioned to continue to support our mission and to capitalize on opportunities for profitable growth in the coming quarters." (Emphasis added.)


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Consolidated Performance Summary Reported Results Fannie Mae’s reported net income declined by 2.1 percent to $1,899.4 million for the first quarter of 2004 compared to the prior year quarter. These results were driven by an increase in unrealized mark-to-market losses on the time value of purchased options, a 5.1 percent decline in net interest to $3,195.9 million, and a $111.1 million decline in fee and other income, partially offset by a $365.5 million reduction in pre-tax losses on the call and repurchase of debt and a 34.8 percent increase in guaranty fee income. Taxable-equivalent revenue for the first quarter of 2003 was $4,301.1 million compared with $4,367.5 million in the same quarter in the prior year. Our reported net interest yield declined 20 basis points to 1.40 percent in the first quarter of 2004 compared to the same quarter in the prior year, but increased 3 basis points from the fourth quarter of 2003.

The company recorded $959.3 million of unrealized mark-to-market losses on purchased options during the first quarter of 2004 in accordance with Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities (FAS 133), compared with $624.6 million in unrealized mark-to-market losses in the first quarter of 2003. Unrealized losses recorded for each of these first quarter periods were due primarily to changes in the fair value of the time value of purchased options that resulted from fluctuations in interest rates.

Core Business Results Core business earnings is the non-GAAP measure used by management in operating the company's business (see "Non-GAAP Financial Measures"). The tables following this release include a reconciliation of core business earnings to reported net income. Core business earnings for the first quarter of 2004 totaled $2,019.7 million, a 9.2 percent increase over core business earnings of $1,849.7 million in the first quarter of 2003. Core taxable-equivalent revenue for the first quarter of 2003 was $3,526.9 million compared with $3,603.2 million in the same quarter prior year. Core business diluted EPS for the first quarter of 2004 was $2.03, or 10.3 percent above the first quarter of 2003. Growth in core business earnings and diluted EPS was driven by the $365.5 million decline in losses resulting from the call and repurchase of outstanding debt and a 34.8 percent increase in guaranty fee income, partially offset by a 7.0 percent decline in core net interest income and a $111.1 million decrease in fee and other income.

* * *


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Performance Review and Outlook Timothy Howard, Fannie Mae’s Vice Chairman and Chief Financial Officer, said “Given an additional quarter’s perspective and our current assessment of the dynamics of the market, we have adjusted our expectations for several components of our core business earnings and our balance sheet but have not changed our outlook for growth in core business earnings per share in 2004 compared with the guidance we gave in January.” Howard said, “We anticipated that in a transitioning market our financial results in 2004 would include a greater degree of variability on a quarterly basis than we have experienced in recent years. Our first quarter results are consistent with that expectation, and also reflect a pattern of earnings with greater strength in the first half of the year than previously projected.” Howard added, “The decline in our mortgage portfolio during the first quarter was substantially in line with our expectations. However, the impact of lower portfolio balances on core net interest income was mitigated by a higher than anticipated net interest margin, which benefited from the effect of lower prevailing interest rates on our funding costs.”

* * * Core Net Interest Income: Core net interest income for the first quarter of 2004 was $2,421.7 million compared with $2,604.1 million in the first quarter 2003. This decline was in line with management’s expectations, and resulted from an 18 basis point decrease in the net interest margin, partially offset by an 8.9 percent rise in the average net investment balance between these two periods. Net Interest Margin: The company’s net interest margin averaged 107 basis points in the first quarter of 2004 compared with 125 basis points in the first quarter of 2003 and 105 basis points in the fourth quarter of 2003. The decline from the first quarter of 2003 was consistent with the company’s expectations, as during the second half of 2003 high levels of liquidations and the purchase of current coupon mortgages led to a decline in the average note rate on the company’s portfolio, while a significant reduction in balances of short-term debt led to an increase in the average cost of debt. The 2 basis point increase in the margin compared with the fourth quarter of 2003 reflected the favorable impact of a higher percentage of short-term funding in the lower interest rate environment that prevailed during the quarter.

* * * Core Capital Fannie Mae’s core capital, which is the basis for the company’s statutory minimum capital requirement, was $35.7 billion at March 31, 2004 compared with $34.4 billion at December 31, 2003 and $29.5 billion at March 31, 2003. Core capital was an estimated $4,347 million above the statutory minimum at March 31, 2004.

* * *


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Non-GAAP Financial Measures Management relies primarily on core business earnings, a supplemental non-GAAP measure developed in conjunction with Fannie Mae's adoption of FAS 133, to evaluate Fannie Mae's financial performance and measure the results of our lines of business. While core business earnings is not a substitute for GAAP net income, Fannie Mae relies on core business earnings in operating its business because Fannie Mae believes core business earnings provides management and investors with a better measure of Fannie Mae's financial results and better reflects our risk management strategies than GAAP net income. The attachments to this release include a reconciliation of Fannie Mae's non-GAAP financial measures to its GAAP results. Investors should also refer to Fannie Mae's Annual Report on Form 10-K for the year ended December 31, 2003 for a discussion of our use of core business earnings. 274. On April 19, 2004, Fannie Mae filed with the SEC a Form 8-K, attaching a copy

of its April 19, 2004 press release which reported Fannie Mae’s first quarter 2004 financial

results. The Form 8-K was signed by Defendant Spencer.

275. On May 6, 2004, Fannie Mae spokesman Chuck Greener issued a statement

stating that the Company’s financials statements comply with GAAP:

We have received the letter from OFHEO setting forth its determination with regard to the accounting treatment of certain items, and we will be submitting the information required within the timeframe requested. As we have said previously, it is appropriate for our safety and soundness regulator to ask for information necessary to carry out its regulatory responsibilities. We look forward to continuing to discuss our views with OFHEO. As has been reported in the media, we are seeking guidance from the SEC on these issues as they relate to our filings with the Commission. With regard to the issues raised in the letter issued by OFHEO, Fannie Mae believes our accounting complies with GAAP, and KPMG, our independent auditor, concurs. Additionally, Ernst and Young, the advisor to our outside legal counsel, concurs with the views of the company and KPMG. 276. On May 10, 2004, Fannie Mae filed with the SEC on Form 10-Q its quarterly

report for the first quarter of 2004 (“First Quarter 2004 10-Q”), repeating the financial results

stated in the April 2004 press release. Defendants Howard and Spencer signed the Form 10-Q.

Defendants Raines and Howard also filed certifications with the report, as required by the


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Exchange Act, in which they certified that: (i) the report did not contain any untrue statement of

a material fact or omit to state any material fact necessary to make the statements made not

misleading; (ii) the financial statements and financial information included in the report fairly

presented in all material respects the financial condition, results of operations and cash flows of

the Company; and (iii) that Raines and Howard were responsible for establishing and

maintaining disclosure controls and procedures as defined in the Exchange Act and that they had

(a) designed such disclosure controls and procedures, or caused such disclosure controls and


the Company was made know to them by others within the entity, particularly during the period

in which the report was being prepared; and (b) evaluated the effectiveness of the Company’s

disclosure controls and procedures and presented in the report their conclusions about the

effectiveness of the disclosure controls and procedures. In the report, the Company reaffirmed

its previously announced quarterly financial results and represented that "[t]he interim financial

information provided in this report reflects all adjustments that, in the opinion of management,

are necessary for a fair presentation of the results for such periods." Further, in Footnote 1 to the

Financial Statements, Defendants made the representation that “[t]he accompanying unaudited

condensed financial statements have been prepared in accordance with generally accepted

accounting principles in the United States of America (”GAAP”) for interim financial

information.”

277. In the First Quarter 2004 10-Q, Defendants represented compliance with FAS 133

as follows:

* * * The following table shows the outstanding notional balances of our derivative instruments and mortgage commitments accounted for as derivatives at March 31, 2004 and December 31, 2003 based on the hedge classification. We had no open


236

hedge positions on the anticipatory issuance of debt at March 31, 2004. However, we had open commitment positions for the forecasted purchase of mortgage loans or mortgage-related securities with a maximum length of time over which we were hedging of 106 days at March 31, 2004.

March 31, 2004 December 31, 2003

Other Risk Other Risk Cash Flow Fair Value Management Cash Flow Fair Value Management Hedges Hedges Derivatives Total Hedges Hedges Derivatives Total

(Dollars in millions)

Interest rate swaps: Pay-fixed $ 221,951 $ 33,144 $ 23,434 $ 278,529 $ 300,536 $ 34,566 $ — $ 335,102 Receive-fixed 73,034 91,813 18,785 183,632 148,923 53,556 — 202,479 Basis 35,754 — 2,951 38,705 32,260 — — 32,260 Forward starting 34,475 — 5,350 39,825 30,475 — — 30,475 Interest rate caps 135,650 — — 135,650 130,350 — — 130,350 Swaptions: Pay-fixed 155,980 — — 155,980 163,980 — — 163,980 Receive-fixed 59,871 68,724 500 129,095 64,221 76,974 — 141,195 Other(1) 1,011 4,381 38 5,430 854 3,858 43 4,755

Total $ 717,726 $ 198,062 $ 51,058 $ 966,846 $ 871,599 $ 168,954 $ 43 $ 1,040,596

Mortgage commitments:(2) Forward contracts to purchase whole loans and mortgage-related securities $ 19,491 $ — $ 19,465 $ 38,956 $ 4,953 $ — $ 13,419 $ 18,372 Forward contracts to sell mortgage- related securities 1,499 — 23,990 25,489 2,050 4,669 13,401 20,120

(1) Includes foreign currency swaps, forward starting swaps, asset swaps, and other derivatives used to hedge anticipated debt issues. (2) Effective with our July 1, 2003 adoption of FAS 149, mandatory mortgage purchase and sell commitments and optional purchase and sell commitments with a fixed

price are accounted for as derivatives and recorded on Fannie Mae’s balance sheet at fair value.

The reconciliation below shows AOCI activity, net of taxes, for the first quarter of 2004 related to all contracts accounted for as derivatives:

AOCI (net of taxes)

(Dollars in millions) Balance at December 31, 2003 .............................................................. $ (14,650) Losses on cash flow hedges related to derivatives, net ......................... (5,598) Losses on cash flow hedges related to mortgage commitments, net ..... 11 Reclassifications to earnings, net ........................................................... 1,664

Balance at March 31, 2004 .................................................................... $ (18,573)

Balance related to: Losses on cash flow hedges related to derivatives, net ...................... $ (16,198) Losses on cash flow hedges related to mortgage commitments, net (2,375)

$ (18,573)

Accounting for Derivatives Under FAS 133, we recognize all derivatives as either assets or liability on the balance sheet at their fair value. FAS 133 requires that all derivatives be marked


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to market through earnings unless the derivative is designated and qualifies for hedge accounting. Subject to certain qualifying conditions, we may designate a derivative as either a hedge of the case flows of a variable-rate instrument or anticipated transaction (cash flow hedge) or a hedge of the fair value of a fixed-rate instrument (fair value hedge).

***

We traditionally have designated and accounted for substantially all of our derivatives as cash flow or fair value hedges. However, we may from time to time terminate, discontinue, or change the designation of the hedging relationships for certain derivative instruments for interest rate risk management purposes. Our interest rate risk management actions are driven by the economics of the transaction and the market environment that exists at that time and generally not be the hedge accounting designations.

***

FAS 133 imposes hedge effectiveness, documentation, and testing criteria that must be met to qualify for hedge accounting. Beginning January 2004, as part of our routine and ongoing assessment of Fannie Mae’s accounting and business practices, we explained our classification of derivatives not designated for hedge accounting under FAS 133. Even though these derivatives are not designated for hedge accounting, they are subject to Fannie Mae’s risk management controls that govern their use, purpose, credit exposure and financial reporting. As shown in Table 20, we refer to this category of derivatives as “other risk management derivates.” This additional classification provides our Portfolio Investment business with increased flexibility and operational efficiency in executing risk management actions. The accounting effect is that we are required under FAS 133 to report changes in the fair value of our other risk management derivatives in earnings. However, because these transactions are economically matched, we anticipate that the gains and losses will largely offset and not have a material impact on our reported net income or core business earnings. We recognized as a component of fee and other income a pre-tax net loss of $13 million related to changes in the fair value of our other risk management derivatives during the first quarter of 2004.

***

We had $51 billion in outstanding notional amount of derivatives not designated for hedge accounting under FAS 133 at March 131, 2004, compared to $43 million at December 31, 2003. Our other risk management derivatives primarily consist of receive-fixes swaps that are economically matched to pay-fixes swaps. With this expanded category of derivatives, we can more efficiently implement strategies to rebalance our portfolio when interest rates change.


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First Quarter 2004 10-Q, at 25-27. (A similar representation and explanation is found at pp. 49-

51).

278. In the First Quarter 2004 10-Q, Defendants also represented that they had

investigated and found effective the Company’s internal disclosure controls and procedures,

stating:

Item 4. Controls and Procedures

Our Chief Executive Officer and Chief Financial Officer are responsible for ensuring that we maintain disclosure controls and procedures that are designed to provide reasonable assurance that material information and other information required under the securities laws to be disclosed is identified and communicated to senior management, including our Chief Executive Officer and Chief Financial Officer, on a timely basis. We carried out an evaluation, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures as of the end of the period covered by this quarterly report. Based on this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective in providing such reasonable assurance as of the end of the period covered by this quarterly report. Additionally, there were no changes in our internal control over financial reporting identified in connection with the evaluation that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

First Quarter 2004 10-Q, at 52. 279. In his presentation on May 11, 2004 at the UBS Financial Services Conference,

Defendant Raines made the following statements:

* * *


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* * *

Another measure of portfolio performance through volatile rate environments is the consistency of your net interest income. Our strategy is to grow our net interest income through a wide variety of rate environments. [W]e have been pretty successful. Our portfolio net interest income has continued to increase steadily over the past 10 years, which has included a wide array of interest rate environments, both rising and falling.

* * *

Let me add, however, that we not only have enough capital for our risk, but we've also buttressed our balance sheet by issuing subordinated debt. So our capital plus the subordinated debt comes to 4 percent of on-balance sheet assets after


240

providing capital for the off-balance sheet mortgage-backed securities that we guarantee. Last year, we added $6 billion of retained earnings and $1.4 billion of preferred stock to our capital base and issued $4 billion of subordinated debt.

* * * We also make our business exceptionally transparent, with disclosures – particularly of our risk measures – that other financial institutions do not provide. The more investors trust us, the less they charge us.

This presentation was posted on the Fannie Mae Website under Investor Relations for investors

to review.

280. On May 12, 2004, at a UBS Warburg Financial Services Conference, Defendant

Raines blamed Fannie Mae’s derivative reporting for the delay in releasing its balance sheet in

April 2004: "We have thousands of items that we have to mark-to-market through the balance

sheet, including every loan that we've agreed to buy in a quarter." The Company previously

disclosed May 10, 2004 that OFHEO has required it to use more conservative accounting

methods in the way it records losses for certain investments. At the Conference, Defendant

Raines reiterated the Company's position that it didn't have to restate its earnings as a result,

although OFHEO officials stated it was still a possibility.

281. In a May 17, 2004 Barron’s article, Fannie Mae put the blame for many of its

current problems on reaction to the Freddie Mac accounting issues. According to Fannie Mae

spokesman Chuck Greener: "We're getting picked apart because we release so much data and

employ best practices in all our financial reporting . . . It's just not fair." In a June 21, 2004

Barron’s letter to the editor , Chuck Greener further elaborated on Fannie Mae’s disclosures and

absolute compliance with GAAP:

It is ironic that our massive disclosures were used as the source material to accuse us of obfuscation. Our financial statements are prepared in accordance with GAAP. Fannie Mae's financial statements have been audited by an independent auditor, certified to by our chief executive officer and chief financial officer, and a number of the accounting policies utilized have been subjected to review by the


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SEC. We have supplemented our financial statements with extensive disclosures that allow readers to reach their own judgments about our businesses. Accounting standards have shortcomings, but the blame for those shortcomings should be placed with the accounting standards setters, not with the companies required by law to comply with GAAP. Laing's main quarrel is with how Federal [sp] Accounting Standard 133 mandates the treatment of derivatives in the income statement and balance sheet. Prior to the promulgation of FAS 133, Fannie Mae primarily used historical cost accounting for debt issued in the cash market and the economically equivalent liabilities synthetically created using the cash market and derivatives. FAS 133 mandated derivatives to be marked to market and recognized in either the income statement or on the balance sheet. The assets held to maturity and funded with debt and derivatives cannot be marked to market while the derivative hedges must be marked to market. We do not see how this partial mark-to-market approach can give the reader of our financial statements a clear understanding of the results of our portfolio business. We argued against the approach with the Financial Accounting Standards Board, to no avail. We supplement our GAAP financials with core business earnings, which provide more consistent treatment of debt and derivatives by substituting amortization for the FAS 133 mark to market of options. We recently supplemented our balance-sheet disclosures, providing extensive data on derivatives, our equity account, and Accumulated Other Comprehensive Income. Within the requirements to give due emphasis to GAAP, Fannie Mae has gone to extraordinary lengths to inform investors about the performance of our portfolio business. We know that FAS 133 has given our relatively simple business complicated accounting. So do our investors. Our disclosures are presented to help fair-minded analysts come to independent conclusions about the quality of our business. Fannie Mae continually passes a stringent risk-based capital stress test developed by our regulator. It ensures that we will be adequately capitalized even under extremely adverse conditions.

282. On July 21, 2004, Fannie Mae issued a news release in which it announced its

financial results for the second quarter ended June 30, 2004 under the headline:

Fannie Mae Reports Second Quarter 2004 Financial Results Return to Positive Portfolio Growth, Exceptional Credit Results Mark Solid Performance; Capital Position Further Strengthened, Risk Measures Remain Strong and Stable


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Net income at $1,112 million, up 0.9 percent over the second quarter of 2003; Diluted earnings per share at $1.10, up 0.9 percent Core business earnings at $1,896 million, up 1.9 percent over the second quarter of 2003; Core business diluted earnings per share at $1.91, up 2.7 percent


Fannie Mae (FNM/NYSE), the nation’s largest source of financing for home mortgages, today reported financial results for the second quarter of 2004 and updated its performance outlook for the full year.

Reported GAAP Results*

For the Quarter For the Six Months Ended June 30, Ended June 30,

2004 2003 Change 2004 2003 Change Net Income (in millions) $1,112.2 $1,101.9 0.9% $3,011.6 $3,042.4 -1.0%

EPS** (in dollars) $1.10 $1.09 0.9% $3.01 $3.02 -0.3%

Core Business Earnings* For the Quarter Ended For the Six Months Ended June 30, June 30,

2004 2003 Change 2004 2003 Change Core Business $1,896.3 $1,860.4 1.9% $3,916.0 $3,710.1 5.5%

Earnings (in millions) Core Business $1.91 $1.86 2.7% $3.94 $3.70 6.5% EPS ** (in dollars)

*The company’s reported results are based on generally accepted principles (GAAP). Management uses a supplemental non-GAAP measure called “core business earnings” a its primary measure in operating Fannie Mae’s business (see “Non-GAAP Financial Measures”). **Diluted earnings per share

Highlights of Fannie Mae's financial performance in the second quarter of 2004 included:

* * * Net interest margin of 104 basis points compared with 107

basis points in the previous quarter; Guaranty fee income of $656.7 million, a 3.9 percent

increase over the second quarter of 2003; Credit-related losses of $16.6 million, down $6.3 million

from the second quarter of 2003; and,


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Core capital of $36.1 billion, a 17.7 percent increase over the second quarter of 2003.

Franklin D. Raines, Fannie Mae's Chairman and Chief Executive Officer, said, "Fannie Mae delivered a solid second quarter performance in a challenging market characterized by significant volatility, continued strong investor competition for mortgages, and a marked shift among consumers to alternative mortgage products." Raines continued, "Business volumes increased notably over the first quarter of 2004, and our mortgage portfolio returned to positive growth for both June and the second quarter as a whole. Equally important, our results reflected Fannie Mae's continued focus on disciplined risk management, as credit losses remained at exceptionally low levels by historical standards and our portfolio's duration gap remained well within our preferred range even as interest rates moved significantly during the quarter. In addition, we are pleased that Standard & Poor's reaffirmed our company's corporate governance score of 9 on a 10 point scale, citing 'governance practices that are consistently strong or very strong.'" Raines concluded, "Given the balance and flexibility of Fannie Mae's business model and the demonstrated effectiveness of our risk disciplines, we believe we are well positioned to address the continued challenges presented by a transitioning market through the remainder of the year and beyond."

Consolidated Performance Summary Reported Results Fannie Mae’s reported net income was $1,112.2 million for the second quarter of 2004, substantially unchanged from the prior year quarter. These results were driven by a $763.3 million decline in losses from the call and repurchase of outstanding debt and a 3.9 percent increase in guaranty fee income, partially offset by a 11.1 percent decline in net interest and a $401.6 million decrease in fee and other income. The decline in fee and other income resulted largely from the recording of $278.2 million of other-than-temporary impairment expense. The substantial majority of this amount related to impairment of our investment in debt securities, including manufactured housing securities, which resulted from the implementation of a new estimation process for recognizing impairment as defined by our regulator. Taxable-equivalent revenue for the second quarter of 2004 was $4,032.3 million compared with $4,695.6 million in the same quarter in the prior year. Our reported net interest yield declined to 1.37 percent in the second quarter of 2004 from 1.63 percent during the same quarter of the prior year.

The company recorded $1,979.7 million of unrealized mark-to-market losses on purchased options during the second quarter of 2004 in accordance with Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities (FAS 133), compared with $1,882.7 million in unrealized mark-to-market losses in the second quarter of 2003. Unrealized losses recorded for each of these second quarter periods were due primarily to changes in the fair


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value of the time value of purchased options that primarily resulted from fluctuations in interest rates and interest rate volatility.

* * * Core Net Interest Income: Core net interest income for the second quarter of 2004 was $2,340.1 million compared with $2,784.5 million in the second quarter of 2003.

* * * Net Interest Margin: The company’s net interest margin averaged 104 basis points in the second quarter of 2004 compared with 130 basis points in the second quarter of 2003 and 107 basis points in the first quarter of 2004.

Capital Account Management Core Capital: Fannie Mae's core capital, which is the basis for the company's statutory minimum capital requirement, was $36.1 billion at June 30, 2004 compared with $35.7 billion at March 31, 2004 and $30.7 billion at June 30, 2003. Core capital was an estimated $4,927 million above the statutory minimum at June 30, 2004.

Total Capital: Total capital includes core capital and the total allowance for loan losses and guaranty liabilities for MBS, less any specific loss allowances, and is the basis for the risk-based capital standard. Total capital was $36.9 billion at June 30, 2004 compared with $36.5 billion at March 31, 2004 and $31.5 billion at June 30, 2003. Fannie Mae's total capital exceeded the risk-based requirement by $10,520 million as of March 31, 2004, the latest period for which a risk-based capital requirement has been determined. The risk-based standard uses a stress test to determine the amount of total capital the company needs to hold in order to protect against credit and interest rate risk, and requires an additional 30 percent capital for management and operations risk. The higher of Fannie Mae's risk-based or minimum capital standard is binding.

* * *

Non-GAAP Financial Measures Management relies primarily on core business earnings, a supplemental non-GAAP measure developed in conjunction with Fannie Mae's adoption of FAS 133, to evaluate Fannie Mae's financial performance and measure the results of our lines of business. While core business earnings is not a substitute for GAAP net income, Fannie Mae relies on core business earnings in operating its business because Fannie Mae believes core business earnings provides management and investors with a better measure of Fannie Mae's financial results and better reflects our risk management strategies than GAAP net income. The attachments to this release include a reconciliation of Fannie Mae's non-GAAP financial measures to its GAAP results. Investors should also refer to Fannie Mae's Annual Report on Form 10-K for the year ended December 31, 2003 for a discussion of our use of core business earnings.


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283. On July 21, 2004, Fannie Mae filed with the SEC a Form 8-K, attaching a copy of

its July 21, 2004 press release that reported Fannie Mae’s second quarter 2004 financial results.

The Form 8-K was signed by Defendant Spencer.

284. On August 9, 2004, Fannie Mae filed with the SEC on Form 10-Q its quarterly

report for the second quarter ended June 30, 2004 (“Second Quarter 2003 10-Q”), repeating the

financial results stated in the July 21, 2004 press release. Defendants Howard and Spencer

signed this Form 10-Q. Defendants Raines and Howard also filed certifications with the report,

as required by the Exchange Act, in which they certified that: (i) the report did not contain any

untrue statement of a material fact or omit to state any material fact necessary to make the

statements made not misleading; (ii) the financial statements and financial information included

in the report fairly presented in all material respects the financial condition, results of operations

and cash flows of the Company; and (iii) that Raines and Howard were responsible for

establishing and maintaining disclosure controls and procedures as defined in the Exchange Act

and that they had (a) designed such disclosure controls and procedures, or caused such disclosure

controls and procedures to be designed under their supervision, to ensure that material

information relating to the Company was made know to them by others within the entity,

particularly during the period in which the report was being prepared; and (b) evaluated the

effectiveness of the Company’s disclosure controls and procedures and presented in the report

their conclusions about the effectiveness of the disclosure controls and procedures. In the report,

the Company reaffirmed its quarterly financial results set forth in its July 21, 2004 earnings press

release and also represented that "[t]he interim financial information provided in this report

reflects all adjustments that, in the opinion of management, are necessary for a fair presentation

of the results for such periods." Further, in Footnote 1 to the Financial Statements, Defendants


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made the representation that “[t]he accompanying unaudited condensed financial statements have

been prepared in accordance with generally accepted accounting principles in the United States

of America (”GAAP”) for interim financial information.”

285. In the Second Quarter 2004 10-Q, Defendants represented compliance with FAS

133 as follows:

* * *

Under FAS 133, we recognize all derivatives as either assets or liabilities on the balance sheet at their fair value. . . . For a derivative designated as a cash flow hedge, we report fair value gains or losses in a separate component of AOCI, net of deferred taxes, in stockholders’ equity to the extent the hedge is effective. We recognize these fair value gains or losses in earnings during the period(s) in which the hedged item affects earnings. For a derivative designated as a fair value hedge, we report fair value gains or losses on the derivative in earnings along with fair value gains or losses on the hedged item attributable to the risk being hedged. For a derivative not designated as a hedge, not qualifying as a hedge, or components of a derivative that are excluded from any hedge effectiveness assessment, we report fair value gains and losses through earnings.

* * *

The following reconciliation shows AOCI activity, net of taxes, for the six months ended June 30, 2004 related to all contracts accounted for as derivatives:

AOCI Activity

(Dollars in millions) Impact on AOCI (net of taxes): Balance at December 31, 2003........................................................... $ (14,650) Gains on cash flow hedges related to derivatives, net ....................... 707 Losses on cash flow hedges related to mortgage commitments, net (390) Reclassifications to earnings, net ....................................................... 3,305

Balance at June 30, 2004 .................................................................... $ (11,028)

Balance related to: Losses on cash flow hedges related to derivatives, net ...................... $ (8,266) Losses on cash flow hedges related to mortgage commitments, net . (2,762)

$ (11,028)

We traditionally have designated and accounted for substantially all of our derivatives as cash flow or fair value hedges. However, we may from time to time terminate, discontinue, or change the designation of the hedging relationship


247

for certain derivative instruments for interest rate risk management purposes. Our interest rate risk management actions are driven by the economics of the transaction and the market environment that exists at that time and generally not by the hedge accounting designations.

* * *

FAS 133 imposes hedge effectiveness, documentation and testing criteria that must be met to qualify for hedge accounting. Beginning January 2004, as part of our routine and ongoing assessment of Fannie Mae’s accounting and business practices, we expanded our classification of derivatives not designated for hedge accounting under FAS 133.

* * *

We had $14 billion in outstanding notional amount of derivatives not designated for hedge accounting under FAS 133 at June 30, 2004, compared with $51 billion at March 31, 2004 and $43 million at December 31, 2003.

Second Quarter 2004 10-Q, at 31-32. (Similar representations were made at pp. 58-60 in the

“Notes to Financial Statements”).

286. In the Second Quarter 2004 10-Q, Defendants also represented that they had


Item 4. Controls and Procedures We maintain disclosure controls and procedures that are designed to provide reasonable assurance that material information and other information required under the securities laws to be disclosed is recorded, processed, summarized and reported on a timely basis. We carried out an evaluation, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures as of the end of the period covered by this quarterly report. Based on this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective in providing such reasonable assurance as of the end of the period covered by this quarterly report. Additionally, there were no changes in our internal control over financial reporting that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.


248


and misleading when made because they failed to disclose and/or misrepresented the following

adverse facts, among others:


prepared in accordance with GAAP and did fairly present in all material respects the financial

condition, results of operation and cash flow of the Company as of and for the periods presented.



accordance with SFAS 91.





(d) As a result of Defendants’ GAAP violations, Fannie Mae’s reported net


other reported financial results were incorrect.

(e) Contrary to Defendants’ representations, Fannie Mae’s internal control







249



(f) Defendants had established and maintained a corporate culture that

emphasized stable earnings at the expense of accurate financial disclosures and compliance with

GAAP. Contrary to statements made to the investing public, Fannie Mae management sacrificed

employee and management integrity in the pursuit of steady earnings growth and their personal

interests.

IX. CLASS ACTION ALLEGATIONS

288. Lead Plaintiffs bring this action as a class action pursuant to Rules 23(a) and

(b)(3) of the Federal Rules of Civil Procedure on behalf of a class comprised of all those who

purchased Fannie Mae common stock and call options, or sold put options, during the Class

Period and suffered damages thereby (the "Class"). Excluded from the Class are: (i) the

Defendants, (ii) any person who was an officer or director of the Company or any of its parents

or subsidiaries during the Class Period, (iii) the members of the immediate family of each of the

Individual Defendants, (iv) any entity in which any Defendant had a controlling interest during

the Class Period, (v) any parent or subsidiary of Fannie Mae, (vi) any incentive, retirement, stock

or other benefit plan that benefited solely the Individual Defendants; and (vii) the legal

representatives, heirs, predecessors, successors or assigns of any of the excluded persons or

entities specified in this paragraph.

289. The members of the Class are dispersed throughout the United States and are so

numerous that joinder of all members is impracticable. While the exact number of Class

members is unknown to Lead Plaintiffs at this time and can only be ascertained through

appropriate discovery, Lead Plaintiffs believe that Class members number, at a minimum, in the


250

hundreds of thousands. As of July 31, 2004, Fannie Mae had approximately 967,903,726 shares

of common stock issued and outstanding and its common stock and options were actively traded

on the NYSE. Members of the Class may be identified from records maintained by Fannie Mae

or its stock transfer agent and may be notified of the pendency of this action by mail, using a

form of notice similar to that customarily used in securities class actions.

290. Lead Plaintiffs’ claims are typical of the claims of the other members of the Class

as Lead Plaintiffs and all members of the Class suffered damages arising out of Defendants'

wrongful conduct in violation of federal securities laws alleged herein.

291. Lead Plaintiffs will fairly and adequately protect the interests of the members of

the Class and have retained counsel competent and experienced in class actions and securities

litigation. Lead Plaintiffs have no interests antagonistic to, or in conflict with, the Class.

292. A class action is superior to other available methods for the fair and efficient

adjudication of the claims asserted herein because joinder of all members of the Class is

impracticable. Furthermore, because the damages suffered by the individual members of the

Class may be relatively small, the expense and burden of individual litigation make it virtually

impossible for Class members individually to redress the wrongs done to them by Defendants.

Lead Plaintiffs anticipate no difficulties in the management of this action as a class action.

293. Common questions of law and fact exist as to members of the Class and

predominate over any questions affecting individual members of the Class. Among the questions

of law and fact common to the Class are:

(a) whether Defendants' Class Period public statements and reports

misrepresented and/or omitted material information;


251

(b) whether Defendants violated federal securities laws by the acts and/or

omissions alleged herein;

(c) whether Defendants acted with scienter in issuing false and misleading

statements during the Class Period; and

(d) whether the Individual Defendants are liable as control persons under the

federal securities laws; and

(e) whether the members of the Class have sustained damages and, if so, the

proper measure of damages.

X. NO SAFE-HARBOR

294. The statutory safe harbor provided for forward-looking statements under certain

circumstances does not apply to any of the allegedly false statements or material omissions plead

in this Complaint. The statements alleged to be false and misleading herein all relate to then-

existing facts and conditions. In addition, to the extent certain of the statements alleged to be

false may be characterized as forward looking, they were not identified as "forward-looking

statements" when made, and there were no meaningful cautionary statements identifying

important factors that could cause actual results to differ materially from those in the purportedly

forward-looking statements. Alternatively, to the extent that the statutory safe harbor is intended

to or does apply to any forward-looking statements pled herein, Defendants are liable for those

false forward-looking statements because at the time each of those forward-looking statements

was made, the speaker knew that the forward-looking statement was materially false or

misleading, and/or the forward-looking statement was authorized or approved by an executive

officer of Fannie Mae who knew that the statement was false and/or misleading when made.


252

XI. CAUSES OF ACTION

COUNT I Violations of Section 10(b) of the Exchange Act and

SEC Rule 10b-5 Promulgated Thereunder Against All Defendants

295. Lead Plaintiffs repeat and reallege each of the allegations set forth above as if set

forth fully herein.

296. Throughout the Class Period, Defendants, directly or indirectly, by the use of

means or instrumentalities of interstate commerce, the United States mails, interstate telephone

communications and a national securities exchange, employed a device, scheme, or artifice to

defraud, made untrue statements of material facts and omitted to state material facts necessary in

order to make the statements made, in light of the circumstances under which they were made,

not misleading, and engaged in acts, practices, and a course of business which operated as a

fraud and deceit upon Lead Plaintiffs and the other members of the Class in connection with their

purchases of the common stock and call options, or sales of put options, of Fannie Mae during

the Class Period, all in violation of Section 10(b) of the Exchange Act (15 U.S.C. § 78j(b)) and

SEC Rule 10b-5 promulgated thereunder (17 C.F.R. § 240.10b-5).

297. The Company and the Individual Defendants, as the most senior officers of

Fannie Mae during the Class Period, are liable as direct participants in all of the wrongs

complained of herein. Through their positions of control and authority, the Individual

Defendants were in a position to and did control all of the Company’s false and misleading

statements and omissions, including the contents of all of its public filings and reports and press

releases, as more particularly set forth above. In addition, certain of these false and misleading

statements constitute “group published information,” which the Individual Defendants were


253

responsible for creating. The Company is liable for each of the statements of the Individual

Defendants through the principles of respondeat superior.

298. As detailed above, the Defendants had actual knowledge of the misrepresentations

and omissions of material facts set forth herein, or acted with reckless disregard for the truth in

that they failed to ascertain and to disclose such facts, even though such facts were available to

them. Such material misrepresentations and/or omissions were made knowingly or recklessly

and for the purpose and effect of concealing Fannie Mae’s earnings volatility and true financial

and operating condition from the investing public and supporting the artificially inflated price of

Fannie Mae’s common stock.

299. Lead Plaintiffs and the other members of the Class relied upon the Defendants’

statements and/or on the integrity of the market in purchasing shares of Fannie Mae’s common

stock and Fannie Mae call options, or selling Fannie Mae put options, during the Class Period.

300. In bringing these claims, Lead Plaintiffs and the members of the Class are entitled

to the presumption of reliance established by the fraud-on-the-market doctrine. At all times

relevant to this Complaint, the market for Fannie Mae common stock and options was an

efficient market for the following reasons, among others:

(a) Fannie Mae common stock and options were listed and actively traded on

the NYSE, a highly efficient and automated market. The average weekly trading volume of

Fannie Mae common stock throughout the Class Period was 19.1 million shares;

(b) Fannie Mae published quarterly earnings press releases and Annual

Reports and filed annual, quarterly and other public reports with the SEC and made such releases

and reports available to its investors on its website www.fanniemae.com;


http://www.fanniemae.com/

254

(c) Fannie Mae regularly communicated with public investors via established

market communication mechanisms, including through regular disseminations of press releases

on the national circuits of major newswire services and through other wide-ranging public

disclosures, such as communications with the financial press and other similar reporting services;

and

(d) Fannie Mae’s common stock was followed by numerous securities

analysts employed by major brokerage firms who wrote reports which were distributed to the

sales force and certain customers of their respective brokerage firms. Each of these reports was

publicly available and entered the public marketplace.

(e) As a result of the foregoing, the market for Fannie Mae common stock and

options promptly digested current information regarding Fannie Mae from all publicly available

sources and reflected such information in the market price for Fannie Mae common stock. Under

these circumstances, all purchasers of Fannie Mae common stock during the Class Period

suffered similar injury through their purchase of Fannie Mae common stock at artificially

inflated prices and a presumption of reliance applies.

301. As a direct and proximate cause of the wrongful conduct described herein, Lead

Plaintiffs and the other members of the Class suffered damages in connection with their

purchases of Fannie Mae common stock and call options, or sales of put options, at artificially

inflated prices during the Class Period. Had Lead Plaintiffs and the other members of the Class

known of the material adverse information not disclosed by the Defendants, or been aware of the

truth behind the Defendants’ material misstatements, they would not have purchased Fannie Mae

common stock and call options, or sold put options, at artificially inflated prices during the Class

Period.


255

302. By virtue of the foregoing, Defendants violated Section 10(b) of the Exchange

Act and SEC Rule 10b-5 promulgated thereunder and are liable to Lead Plaintiffs and the

members of the Class who have been damaged as a result of such violations.

COUNT II Violation of Section 20(a) of the Exchange Act

Against the Individual Defendants

303. Lead Plaintiffs repeat and reallege each of the allegations set forth above as if

fully set forth herein.

304. As set forth in Count I above, Fannie Mae and the Individual Defendants each

violated Section 10(b) of the Exchange Act (15 U.S.C. § 78j(b)) and SEC Rule 10b-5

promulgated thereunder (17 C.F.R. § 240.10b-5) by their acts and omissions as alleged in this

Complaint.

305. Throughout the Class Period, the Individual Defendants were controlling persons

of Fannie Mae within the meaning of Section 20(a) of the Exchange Act. By virtue of their

board membership and/or high-level positions, their stock ownership and contractual rights

and/or their specific acts described above, the Individual Defendants had the power to and did,

directly or indirectly, exercise control over Fannie Mae, including the content and dissemination

of the various statements and financial reports which Lead Plaintiffs contend are false and

misleading. Each of the Individual Defendants either made, participated in the preparation of,

were responsible for and/or were provided with or had unlimited access to the Company’s

reports, financial statements, press releases, public filings and other statements alleged by Lead

Plaintiffs to be misleading prior to and/or shortly after they were issued and had the ability to

prevent the issuance of the statements or cause the statements to be corrected. Each of the

Individual Defendants had direct and supervisory responsibility for, and involvement in, the day-


256

to-day operations of the Company and induced Fannie Mae to engage in the acts constituting the

violations of the federal securities laws alleged herein.

306. As a result of Fannie Mae’s false and misleading statements and omissions

alleged herein, the market price of Fannie Mae common stock and options was artificially

inflated during the Class Period. Under such circumstances, the presumption of reliance

available under the fraud-on-the-market doctrine applies, as more particularly set forth in Count I

above. The members of the Class relied upon either the integrity of the market or upon the

statements and reports of the Defendants in purchasing Fannie Mae common stock and call

options, and selling put options, at artificially inflated prices during the Class Period.

307. As a direct and proximate result of the Defendants’ wrongful conduct, Lead

Plaintiffs and the other members of the Class suffered damages in connection with their

purchases of the Company’s common stock and call options, or sales of put options, during the

Class Period. Had Lead Plaintiffs and the other members of the Class known of the material

adverse information not disclosed by Fannie Mae, or been aware of the truth behind its material

misstatements, they would not have purchased Fannie Mae common stock at artificially inflated

prices.

308. By virtue of their positions as controlling persons of Fannie Mae, the Individual

Defendants are liable pursuant to Section 20(a) of the Exchange Act to Lead Plaintiffs and the

members of the Class who have been damaged as a result of Fannie Mae’s underlying securities

violations.

XII. PRAYER FOR RELIEF

WHEREFORE, Lead Plaintiffs, on behalf of themselves and all other Class members,

pray for relief and judgment as follows:


257

A. A determination that this action is a proper class action pursuant to Rule

23(a) and (b)(3) of the Federal Rules of Civil Procedure on behalf of the Class defined herein,

and a certification of Lead Plaintiffs as class representatives pursuant to Rule 23 of the Federal

Rules of Civil Procedure;

B. An award of compensatory damages in favor of Lead Plaintiffs and the

other Class members against all Defendants, jointly and severally, for all damages sustained as a

result of Defendants' wrongdoing, in an amount proven at trial, including pre-judgment and post-

judgment interest thereon;

C. An award to Lead Plaintiffs and the Class of their reasonable costs and

expenses incurred in this action, including reasonable attorneys’ fees, expert and consultant fees

and other costs; and

D. A grant of such other relief as the Court may deem just and proper.

JURY TRIAL DEMANDED Lead Plaintiffs hereby demand a trial by jury in this action of all issues so triable.

Dated: April 17, 2006 Respectfully submitted,

ATTORNEY GENERAL OF OHIO

JIM PETRO

WAITE, SCHNEIDER, BAYLESS & CHESLEY CO., L.P.A.

/s/ Stanley M. Chesley Stanley M. Chesley /s/ James R. Cummins James R. Cummins (D.C. Bar #OH0010) Melanie S. Corwin 1513 Fourth & Vine Tower One West Fourth Street Cincinnati, Ohio 45202 Telephone: (513) 621-0267 Facsimile: (513) 621-0262 E-mail: [email protected] Special Counsel for the Attorney General of Ohio and Lead Counsel for Lead Plaintiffs


mailto:[email protected]

258

BERMAN DEVALERIO PEASE TABACCO BURT & PUCILLO

/s/ Jeffrey C. Block Jeffrey C. Block Kathleen M. Donovan-Maher Julie A. Richmond One Liberty Square Boston, MA 02109 Telephone: (617) 542-8300 Facsimile: (617) 542-1194 E-mail: [email protected] Co-Lead Counsel for Lead Plaintiffs

COHEN, MILSTEIN, HAUSFELD & TOLL, P.L.L.C. /s/ Steven J. Toll Steven J. Toll (DC Bar #225623) Daniel S. Sommers (DC Bar #416549) Matthew K. Handley (DC Bar #489946) 1100 New York Avenue, N.W. Washington, D.C. 20005 Telephone: (202) 408-4600 Facsimile: (202) 408-4699 E-mail: [email protected]

Local Counsel for Lead Plaintiffs OF COUNSEL:

BARRETT & WEBER L.P.A. Michael R. Barrett (0018159) Suite 500, 105 East Fourth Street Cincinnati, Ohio 45202 Telephone: (513) 721-2120 Facsimile: (513) 721-2139 E-mail: [email protected] Special Counsel for the Attorney General Of Ohio

STATMAN, HARRIS, SIEGEL & EYRICH, LLC Alan J. Statman (0012045) Jeffrey P. Harris (0023006) 2900 Chemed Center, 255 East Fifth Street Cincinnati, Ohio 45202-2912 Telephone: (513) 621-2666 Facsimile: (513) 587-4477 E-mail: [email protected] E-mail: [email protected]







259

CERTIFICATE OF SERVICE

I certify that on April 17, 2006, I electronically filed the foregoing Amended

Consolidated Class Action Complaint (“Complaint”) with the Clerk of Court by e-mailing a copy

of the Complaint to the Court’s generic ECF Email address at [email protected].

Service was accomplished on all counsel listed below by carbon copy of this e-mail and by

overnight delivery this 17th day of April, 2006.

John Beisner, Esq. Jeffrey W. Kilduff, Esq. O’Melveny & Meyers, LLP 1625 Eye Street, N.W. Washington, DC 20006 and Seth Aronson, Esq. O’Melveny & Meyers, LLP 400 South Hope Street, 15th Floor Los Angeles, CA 90071-2899 Counsel for Defendant Fannie Mae Kevin M. Downey, Esq. Joseph M. Terry, Esq. Williams & Connolly, LLP 725 Twelfth Street, N.W. Washington, DC 20005-5901 Counsel for Defendant Franklin D. Raines David S. Krakoff, Esq. Mark W. Ryan, Esq. Mayer, Brown, Rowe & Maw LLP 1909 K Street, N.W. Washington, DC 20006-1101 Counsel for Defendant Leanne G. Spencer

Steven M. Salky, Esq. Carole Yanofsky, Esq. Eric Delinsky, Esq. Zuckerman Spaeder LLP 1800 M Street, N.W., 10th Floor Washington, D.C. 20036 Counsel for Defendant J. Timothy Howard Frank J. Johnson, Esq. Brett M. Weaver, Esq. Law Office of Frank J. Johnson 402 W. Broadway, 27th Floor San Diego, CA 92101

Counsel for Plaintiff Sassan Shahrokhinia Stuart M. Grant, Esq. Grant & Eisenhofer P.A. Chase Manhattan Centre 1201 N. Market Street Wilmington, DE 19801

Counsel for Evergreen Trust Plaintiffs and Franklin Funds Plaintiffs

/s/ Matthew K. Handley _____

Matthew K. Handley, Esq.


in re: fannie mae securities litigation 04-cv-01639...

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