And You Thought You Could Quit Worrying About Fannie and Freddie For Now

It would be nice if Fannie and Freddie would have the good taste to stay out of the spotlight, particularly since bad news is a sign of higher odds that Things Are Not Going Well, Especially for Bagholders Taxpayers.

However, it looks like we may not be so lucky. Bloomberg’s Jonathan Weil did some digging into the GSE’s reports, and they are even less pretty than we thought. Remember Poole’s remark that Freddie is “technically insolvent’? That view is based on a reading of the GSE’s “fair value” report (the comparable figure for Fannie as of March 31 is a not very encouraging $12.2 billion). The GSEs of course maintain that these reports are irrelevant and misleading, yet that methodology is more comparable to the published financials of banks and investment banks than the presentation more commonly used.

Weil tells us even those reports are overly rosy. From Bloomberg:

Forget everything you’ve read about how woefully undercapitalized Fannie Mae and Freddie Mac are. The situation is much worse….

Deferred-tax assets consist of tax-deductible losses and expenses carried forward from prior periods, which companies can use to offset future tax bills. Under generally accepted accounting principles, they are valuable only to companies that are profitable and paying income taxes. To the extent a company doesn’t expect to have enough profits to use them, it’s supposed to record a valuation allowance on its GAAP balance sheet.

Fannie and Freddie so far have recorded no such allowances

As noted above, Fannie’s fair value, which is tantamount to its mark-to-market net worth, is a mere $12.2 billion, and as former Fed president William Poole and others have discussed, Freddie’s is negative. Weil tells readers that the deferred taxes are one of the reasons the GSEs, which are not subject to SEC requirements, can report higher equity levels in their public financial statements:

….core capital includes deferred-tax assets. Commercial banks, by comparison, normally don’t get to count these in their capital, because they can’t be sold by themselves and, thus, can’t be used as a cushion against losses….

But even the fair value balance sheets contain this adjustment:

Without that $14.3 billion of tax adjustments, the fair value of Fannie’s net assets would have been negative $2.1 billion, by my math. Exclude deferred-tax assets entirely, and it would have been negative $19.9 billion as of March 31….take out the tax write-up, and Freddie’s net assets had a fair value of negative $15.3 billion. Exclude deferred-tax assets entirely, and that falls to negative $31.9 billion….

And removing these adjustments means both GSEs have negative net worth.

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8 comments

  1. Anonymous

    Wow, just wow. We are witnessing the greatest transfer of wealth from the taxpayer to the uber wealthy ever seen in history. When will we wake up?

  2. etc

    shhhhhh, the GSEs, the Fed, and Treasury are hunting foolish bottom-fishers and taxpayers.

  3. RK

    So, when your company heads for the toilet, and your bonds are trading at 10 cents on the dollar, you get to book that as a gain. Conversely, losses carried
    forward to offset future profits are also an asset. So, is there anything that, here in Wonderland, is NOT an
    asset??

  4. Anonymous

    I think there’s a lot that may be misleading in this article.

    For starters:

    “Another reason is that core capital includes deferred-tax assets. Commercial banks, by comparison, normally don’t get to count these in their capital, because they can’t be sold by themselves and, thus, can’t be used as a cushion against losses….”

    This can’t be true. If it were, banks taking large write-offs in a particular quarter would show no difference between pre-tax and after-tax write offs, which is clearly not the case.

    More to the point, the idea of recognizing value in deferred tax assets for any bank is equivalent to recognizing that the bank has a franchise value – i.e. future earning power, apart from the possibility of further asset write offs. This isn’t an unreasonable assumption unless and until the company is wound up. But even then, deferred taxes assets still have value in the new organization once it is recapitalized.

    Finally, the embedding and decomposition of deferred tax assets within a larger fair value category as described is irrelevant to the issue. The only relevant thing is whether the book value of deferred tax assets is counted as an asset in the calculation of the book value of capital. The number finally used in the calculation of capital is the book value. The Bloomberg writer misinterpreted the embedded fair value “adjustment” of deferred tax assets and/or its relevance in the calculation of capital.

    What it really means is that if current fair value losses are eventually realized in the income statement, the book value of deferred tax assets indeed will increase at that time. Hence the fair value “write-up” to deferred tax assets. But the fair value of deferred tax assets is irrelevant to current capital calculations. It’s the current book value, not the current fair value, of tax assets that is used in the calculation of capital. If current fair value losses end up being reflected in future income statements, the company will be closer to bankruptcy due to the after-tax erosion of book capital, even while the book value of deferred tax assets is still increasing. But even if this comes to pass, the successor organization will still be entitled to the benefit of these tax assets.

  5. AnoninCA

    I agree with anon 8:28. I think the fair value issue for Fannie and Freddie is overblown. (But I also think that they need to be at a minimum reduced in size.)

    Fannie and Freddie are basically insurance companies, they are not trading companies. It’s my understanding that insurance accounting typically lets firms operate with what for a bank would be negative capital for the simple reason that insurers can be expected to have low book value when chance gives them a lot of policies payouts. As long as cash flows are solid and there’s evidence that the book value will improve before the cash flow situation deteriorates, there’s no reason the insurer should not continue operating.

    I’d be much more worried if I were seeing analyses that said that under worse case situations, cash flows are expected to deteriorate by 2011. Remember Fannie and Freddie are NOT in the monoline situation of being unable to write new business.

  6. Michael Blomquist

    Who knows how much toxic waste Fannie/Freddie took on as result of the Stimulus Act ($729,750)?

    Link?

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