Fannie And Freddie: Massive Fraud Breakdown

So, the tax payers get stuck with this mess!  Phonie and Fraudie got busted cooking the books.  We will see if Paulson does the right thing here. He has a chance. Bill Ackman laid out a great plan two months ago that would work fine.

I believe Gretchen Morganson’s story out late yesterday changes the game here. This bailout is not some sort of a proactive, warm and fuzzy, well-thought out move as its being portrayed.  As it turns out, this looks like the largest two business failures in history due to absolute fraud.  Freddie Mac was the primary target and Fannie had to give in due to it. But Fannie would have likely suffered the same fate anyhow.

I have been a complete advocate of nationalization and ‘explicit’ loan guarantees going forward. This will promote healthy buying of Fannie/Freddie debt and makes it so nationalization does not interrupt the healing of the mortgage and housing sectors.  This is despite what Bill Gross says. But it is not some magic bullet by any means. For all intents and purposes nothing changes with respect to mortgage lending to consumers from Friday. 

This is exactly the reason they were taken over this weekend. Things were about to change in a very bad way. Due to massive fraud within these companies, they were about to implode.  Deloitte and Morgan Stanley discovered this.  As you can imagine, an outright implosion of the two would have done bad things to the financial markets. 

What I am still most freightened of and what I believe will do bad things to US Treasuries, the Gov’t and the tax payers balance sheets is the retroactive, open-ended backing of the $5.2 trillion in total loan guarantees, much made during the worst years of mortgage finance. 

The GSE’s have a total combined $1.2 TRILLION in Subprime and Alt-A exposure that they have told us about. But, we know now that they covered up many other things so exposure is likely greater. On top of this, they likely have another $1 to $1.5 trillion in higher grade guarantees that will act much closer to Subprime and Alt-A in the future.  This is due to their faulty automated underwriting systems, DU and LP respectively, set to ‘way too easy’ mode during the bubble years.

Lets pretend they have $2.5 trillion in ‘at-risk’ mortgage exposure. If 50% lose thier home at a 60% loss, which is about typical now but should increase in the future, then we are talking about $800 billion in losses. Well, what do you know!  Paulson got the debt ceiling raised by $800 billion two months back.

Let’s go through Gretchen Morganson’s story and pull out the good stuff.

Loan Giant Overstated the Size of Its Capital Base By GRETCHEN MORGENSON and CHARLES DUHIGG Published: September 6, 2008

As a result of the government’s intervention, the cost of borrowing for Fannie Mae and Freddie Mac should decline, because the government will be insuring their debts. Equally important, because the government is backing the companies, they will continue to buy and selling home loans. (I agree. If they ‘explicit guaranty loans going forward, their MBS will sell just fine. But how much lower can rates fall with most thinking the ‘implicit’ was ‘explicit’ anyway. I do not think this will have much impact. As a matter of fact, saddling the US Treasury and US tax payer with open-ended, retroactive backing of the $5.2 trillion in past guarantees could tear apart US Treasuries increasing borrowing costs for everyone)

But the plan will probably do little to stop home prices from falling further. And foreclosures are almost certain to rise.

(Funny - the words ‘last month’ and ‘always used here) The Treasury secretary, Henry M. Paulson Jr., who won authority from Congress last month to use taxpayer money to bolster the companies, always maintained that he hoped never to use that power.

FRAUD

last week, advisers from Morgan Stanley hired by the Treasury Department to scrutinize the companies came to a troubling conclusion: Freddie Mac’s capital position was worse than initially imagined.

Freddie Mac had made accounting decisions that pushed losses into the future and postponed a capital shortfall until the fourth quarter of this year, which would not need to be disclosed until early 2009. Fannie Mae has used similar methods, but to a lesser degree,

While Freddie Mac’s accounting woes make it easier for regulators to force the company into conservatorship, there was more resistance from Fannie Mae, according to people familiar with the discussions. Once the government took action against Freddie Mac, however, confidence in Fannie Mae would certainly waver. Given Fannie Mae’s declining financial condition, the company has few options but to concede to the government’s demands.

(the former CEO’s look like super-stars) Accusations of questionable accounting are not new for either company. Earlier this decade, both companies paid large fines and ousted their top executives after accounting scandals.  Freddie Mac’s current chief executive and chairman, Richard F. Syron, joined the company in 2003 after the former managers revealed they had manipulated earnings by almost $5 billion. The following year Fannie Mae’s chief executive, Daniel H. Mudd, was promoted to the top spot after that company was accused of accounting errors totaling $6.3 billion. People familiar with Treasury’s plan say that both men, as well as other executives, will be forced to leave the companies.

Capital Cushion, Alt-A/Subprime, Accounting ‘Irregularities’ and Outright Bulls***

For example, while Freddie Mac’s portfolio contains many securities backed by subprime loans, made to the riskiest borrowers, and alt-A loans, one step up on the risk ladder, the company has not written down the value of many of those loans to reflect current market prices. Executives have said that they intend to hold the loans to maturity, meaning they will be worth more, and they need not write down their value. But other financial institutions have written down similar securities, to comply with “mark-to-market” accounting rules. Freddie Mac holds roughly twice as many of those securities as Fannie Mae.

(they) have also inflated their financial positions by relying on deferred-tax assets — credits accumulated over the years that can be used to offset future profits. Fannie maintains that its worth is increased by $36 billion through such credits, and Freddie argues that it has a $28 billion benefit.  But such credits have no value unless the companies generate profits. They have failed to do so over the last four quarters and seem increasingly unlikely to the next year. Moreover, even when the companies had soaring profits, such credits often could not be used. That is because the companies were already able to offset taxes with other credits for affordable housing. Most financial institutions are not allowed to count such credits as assets. The credits cannot be sold and would disappear in a receivership. Removing those credits from assets would probably push both companies’ capital below the regulatory requirements.

Regulators are also said to be scrutinizing whether the companies were trying to manage their earnings by waiting to add to their reserves. Both companies have gradually increased their reserves for loan losses — Fannie’s reserves today stand at $8.9 billion, and Freddie’s at $5.8 billion.  Other companies, like private mortgage insurers, have been quicker to identify large losses and have set aside much greater amounts. Fannie and Freddie have dribbled out bad news with each quarterly announcement, suggesting they may be trying to manage this process.

(classic, sounds just like Wells Fargo last quarter) Finally, regulators are concerned that the companies may have mischaracterized their financial health by relaxing their accounting policies on losses, according to people familiar with the review. For years, both companies have effectively recognized losses whenever payments on a loan are 90 days past due. But, in recent months, the companies said they would wait until payments were two years late. As a result, tens of thousands of loans have not been marked down in value. The companies have injected their own capital into pools of securities containing these loans, arguing that their new policies are helping more borrowers…people briefed on the accounting inquiry said that Freddie Mac may have delayed losses with the change.

“We have just had to nationalize the two largest financial institutions in the world because of policy makers’ inaction,” said Josh Rosner, an analyst at Graham Fisher, an independent research firm in New York, and a longtime critic of the government-sponsored enterprises. “Since 2003, when these companies’ accounting came under question, policy makers have done nothing. Even though they had every reason to know that the housing market’s problems would not be contained to subprime and would bring down the houses of Fannie and Freddie.”

 

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