Shady Accounting Pressed the Treasury to Take Action

I am going to roll this stuff out to you this weekend as I find it. This is unbelievable. It looks like both GSE's were using borderline fraudulent accounting to hide losses. Geez...Where are the cops?

This story has just begun to be unfold folks. This is from the New York Times. Is this Enron part 2? You decide. Here is the link:

"The government’s planned takeover of Fannie Mae and Freddie Mac, expected to be announced as early as this weekend, came together hurriedly after advisers poring over the companies’ books for the Treasury Department concluded that Freddie’s accounting methods had overstated its capital cushion, according to regulatory officials briefed on the matter.

The proposal to place both mortgage giants, which own or back $5.3 trillion in mortgages, into a government-run conservatorship also grew out of deep concern among foreign investors that the companies’ debt might not be repaid. Falling home prices, which are expected to lead to more defaults among the mortgages held or guaranteed by Fannie and Freddie, contributed to the urgency, regulators said.

The accounting issues that brought so much urgency to the bailout appear to center on Freddie Mac’s capital cushion, the assets that regulators require them to keep on hand to cover losses.
The methods used to bolster that cushion have caused serious concerns among the companies’ regulator, outside auditors and some investors. 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.

Freddie Mac and Fannie Mae 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.

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.
Under conservative accounting methods, changing these policies would not have any impact on the companies’ books. However, 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.”

Bailout Likely to be Announced Sunday

Good Afternoon!

Ok folks, I have spent the entire afternoon sorting through everything. The New York Times says one thing and the Washington Post says another. The differences between the two are described in a Bloomberg article. Here is the first Bloomberg story from today:

"The Washington Post reported that the government would make quarterly injections of funds as the companies' losses warranted, avoiding a large up-front taxpayer cost, citing sources it didn't name. Debt and preferred shares would be protected, and common stock would be diluted while not wiped out, the Post said.

The New York Times said most or all of both the common and preferred shares would be worth little or nothing"

Bloomberg Updated

There is a lot more updated and detailed info here so I will use this article to explain whats going on.

It looks like the CEO is out and analysts are speculating that all $5.2 trillion dollars will be guaranteed:

"Sept. 6 (Bloomberg) -- Treasury Secretary Henry Paulson will use his authority to rescue Fannie Mae and Freddie Mac, likely placing the beleaguered mortgage-finance companies under government control as early as this weekend.

Paulson informed House Financial Services Committee Chairman Barney Frank that the Treasury intends to use the powers that Congress provided last month to ensure the ``stable functioning'' of Fannie and Freddie, according to a statement today from the lawmaker. The government would make periodic injections of funds by buying either convertible preferred shares or warrants in the companies as needed, avoiding a large up-front taxpayer cost, according to a person briefed on the plan.

Holders of the companies' corporate debt and preferred shares would probably be protected, while the chief executive officers won't, said the person, who declined to be identified. Paulson met with Fannie Mae CEO Daniel Mudd and Freddie Mac CEO Richard Syron yesterday to tell them of the decision to put the companies into conservatorship, and remove the executives from their jobs, according to two people briefed on the discussions.

Shareholders' Fates

Analysts have speculated that the Treasury would wipe out common shareholders, while seeking to shield preferred stockowners from total loss. Fannie and Freddie preferred shares are typically owned by banks and insurance companies. Their $5.2 trillion of debt outstanding is held by investors including Asian central banks, and would probably be guaranteed, analysts said.

Mudd was accompanied in his meetings at FHFA yesterday by Fannie General Counsel Beth Wilkinson and Chairman Stephen Ashley. Last week, he shook up the company's management in an effort to restore investor confidence, replacing three top deputies."

My Take:

There is a lot to digest here. We still don't know what the details are so this is all pure speculation. It appears that this is going to be rolled out tomorrow before the Asian markets open. How dare they do this on the first day of football season!!!

Here is the key question: Will they just pump liquidity in as its needed and not guarantee the $5.2 trillion in debt or do they inject liquidity and guarantee the $5.2 trillion in trash?

If the $5.2 trillion gets the guaranteed, then the bond market is going to go apesh*t. Yields will go through the roof. Spreads on Fannie debt will narrow because its guaranteed. The government hopes this narrowing will lower mortgage rates and get housing moving again.

The problem the Treasury/government has here is the bond market is going to take long term rates higher because we will have just doubled our national debt overnight by taking over these two bloated pigs. They have no power to stop the bond market folks. ZERO, ZILCH,NADA.

Bottom Line

This is the best update I can give you right now. I will have much more insight tomorrow if they announce the details. I wouldn't want to be a Fannie/Freddie common shareholder right now. It looks like they get wiped out here.

I really don't have a clue as to how the market will take this. They tend to cheer bailouts so I wouldn't be surprised to see a bounce. If the bond market vigilantes send the 10 year to the moon then the bullish sentiment on Wall St. will be short lived.

WSJ: Treasury Close to Fannie/Freddie Bailout

This is hitting the wires everywhere.

Get ready folks, here come the fireworks. Word is the bailout could be announced as soon as tomorrow. Here is the news from Bloomberg:

"Sept. 5 (Bloomberg) -- Treasuries fell amid speculation the U.S. is close to reaching a plan to help troubled mortgage finance companies Fannie Mae and Freddie Mac, easing the haven appeal of government debt.

Yields climbed after the Wall Street Journal reported that the Treasury Department could announce a plan as early as tomorrow. Bonds rallied earlier as a government report showed the economy lost jobs for an eighth consecutive month in August, increasing speculation the Federal Reserve will cut rather than raise interest rates.

``We are seeing some selling of Treasuries off of this because it creates a safer environment,'' said Glen Capelo, a Treasury trader at RBS Greenwich Capital in Greenwich, Connecticut, one of 19 primary dealers required to bid at government debt sales.

The yield on the benchmark 10-year note rose 7 basis points to 3.69 percent at 4:42 p.m. in New York, according to bond broker BGCantor Market Data. It reached 3.55 percent earlier today, the lowest since April 15. The 4 percent security due August 2018 fell 17/32, or $5.31 per $1,000 face amount, to 102 18/32.

Ten-year note yields touched the lowest in almost five months before paring gains as stocks rebounded from the worst week since May. Futures show that traders see a 9 percent chance central bankers will reduce borrowing costs by year-end, compared with 43 percent odds for an increase a month ago.

Payrolls fell by 84,000, and revisions added another 58,000 to job losses for the prior two months, the Labor Department said today in Washington. The median forecast in a Bloomberg News survey of 76 economists was for a loss of 75,000. The jobless rate jumped to 6.1 percent, matching a high reached in September 2003, from 5.7 percent the prior month."

Quick Take:

Well it looks like the bailout is going down this weekend. Monday will be interesting. You could potentially see a wicked rally on the announcement. It all comes down to the language and what they plan on doing.

There are many questions that I have here regarding this announcement. Do the common shareholders get wiped out? What about the preferred? How does the bond market react to this. How high do the yields on the 10-year go if a bailout is announced?

It looks like yields rose just on the rumor that this was going down this weekend. This explains the big rally this afternoon on Wall St. There is not much else to say here until we see the details.

Bottom Line:

Whatever the Treasury decides to do, it does not change the fundamental problems in the housing market and the economy. Any bounce we get on this news becomes the shorting opportunity of a lifetime IMO.

This is the last big stick save! The Treasury better get it right. "Moral Hazard" is in play here folks. Next week will be historic.

Update:

Fannie/Freddie now plummeting after hours according to CNBC after initially bouncing. It looks like the common shareholders might get wiped out.

Hold on tight folks. Its gonna be a wild ride!