Huh?

Link?

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.

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.

WTF!!! You are joking, right?