NY Times: Freddie Overstated Its Capital

The New York Times, in “Loan Giant Overstated Its Capital Base,” sets forth an interesting bill of particulars as to where Freddie deviated from what one might consider a full and fair statement of its financial condition. Indeed, the article says that the widely-expected Sunday intervention was triggered by the GSE’s regulator determining that the firms’ capital was short of the reported level (note that Fannie’s practices were not as aggressive as Freddie’s). Bloomberg had indicated yesterday that the rescue was being announced prior to a FHFA [Federal Housing Finance Agency] evaluation of their capital. We noted:

… it seems likely that there was something due to be released [in the report] that either gave James Lockhart, the head of FHFA, the smoking gun to intervene, or was sufficiently troubling to run the risk of an adverse market reaction…

Yet, as Calculated Risk pointed out, the Times had an artfully worded comment (emphasis ours)

The company had made decisions that, while not necessarily in violation of accounting rules, had the effect of overstating the companies’ capital resources and financial stability.

CR said, “I doubt Freddie violated any accounting rules this time” without explaining why. I’m cynical enough that the powers that be would like to tone down any suggestion that questionable accounting treatments might have been fraudulent (that opens up all sorts of cans of worms, including litigation, which are distractions that would make the job of any new conservator all the more difficult.

But his view may be based on this accounting contretemps with Freddie reported in the Washington Post earlier this year:

Years after Fannie Mae and Freddie Mac were found to have misrepresented their earnings by billions of dollars, a federal regulator is warning them to follow both the spirit and the letter of a new accounting rule.

The Office of Federal Housing Enterprise Oversight said it would consider taking action against the government-sponsored mortgage funding companies if their handling of the new rule raises concerns, even if their conduct “technically complies with the accounting standard.”

The OFHEO statement came less than a week after the regulatory agency said it found “certain issues” in Freddie Mac’s implementation of accounting standards which “raise concerns” about the company’s capital…

Sounds familiar, no? Nevertheless, the Times’ list of, shall we say, items of note, is striking, with the biggest surprise last:

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.

Another bone of contention was the inclusion of deferred tax credits in assets. When Jonathan Weil of Bloomberg had suggested that the use of tax credits might produce an unduly rosy balance sheet; some dismissed it, arguing in effect that the tax assets would have value because 1) the GSEs would at some point be profitable, so the tax shield did have value, and in any event, a successor could use the assets were the GSEs reorganized.

The Times addressed some of these issues:

….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 Times also contends:

Freddie has not written down many of its subprime and Alt-A exposures to market value

Both companies appear to be managing earnings by delaying increases in loan loss reserves

As the search for the guilty continues, expect to see more post mortems of strategy (were the GSE’s doomed to run aground due to their conflicted public/private charter?) and management decisions.

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  1. Stuart

    no, really?

    Citicorp, Lehman, WaMu, MER, oh the list would be long and glorious if a similar examination was conducted…

  2. Yves Smith

    Yes, but they aren’t on a supposed short leash as a result of accounting fraud a mere five years ago.

  3. Stuart

    I haven’t seen this anywhere, apologies if it was already discussed. What’s the consensus/thoughts on what this does to Treasuries and the dollar?

  4. doc holiday

    I’m just amazed at this whole conspiracy to defraud, i.e, where were the regulators, the ratings agencies, the accounting firms, the auditors, The SEC, The FED, OFHEO, the FASB and the highly effective: http://www.pcaobus.org/ ??

    — I just don’t buy this: http://www.urbandictionary.com/define.php?term=sack%20of%20shit

    Beneath contempt. Worthless. The term is usually used to describe a contemptably dishonest person.

    Also see: In Dante Alighieri’s Inferno, the lowest circles of Hell are reserved for traitors; Judas, who betrayed Jesus, suffers the worst torments of all. His treachery is in fact so notorious that his name has long been synonymous with traitor, a fate he shares with Benedict Arnold, Marcus Junius Brutus, and Vidkun Quisling. E.g: Don’t be a Paulson or Bernanke you little snark!

  5. mxq

    “….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.”

    The exact same reason that GM has ended up with a book value of -$102 per share.

    The verdict: Syron, Mudd and Raines…4 years re-education through labor. No trial.

  6. Dave

    This looks a bit more like an accounting “accident” as opposed to accounting fraud. I may not be adding anything to the discussion, but when a firm has losses it generates net operating loss carryforwards which are grossed down to deferred tax assets, or taxes that will not need to be paid in the future. This is a legitimate asset… so long as the company earns enough profit to benefit from it. The problem is that most firms have to put up a “valuation allowance” against the gross deferred tax asset (which yields the NET deferred tax asset) until they prove to their auditors (lots of subjectivity here) that they’ll be able to earn enough pre-tax income to use up the deferred tax asset. My issue is not that either firm did anything illegal, but rather why did their auditors allow them to have such a small (or completely absent) valuation allowance given that they hadn’t been earning any money? While deferred tax asset valuation allowances aren’t an exact science, it doesn’t take a rocket surgeon to see that Fannie and Freddie’s profitability was in doubt. Consequently, these firms should have had to keep a full valuation allowance against their gross deferred tax assets until they could show a couple of years of profitability that justified a positive value. And given the recent losses, a full valuation allowance should have been in effect. That’s not so much Fannie or Freddie’s fault – they’re going to lobby for as much GAAP value as they can get. But why did the auditors give in under the circumstances? Bizarre.

  7. Independent Accountant

    To answer your question about the CPAs, not being more forceful with F&F, having seen the S&L crisis first hand: because Uncle Sam didn't want those deferred tax assets written down, that's why. Allan Sloan at Fortune had a recent article explaining what's going on, i.e., delay and pray. Why did the Big 87654 firms fail to find the S&L industry was insolvent in about 1983? Because it does what Uncle Sam wants it to do: conceal financial difficulties in large financial firms.
    Doc Holliday:
    As for the PCAOB, it is a hopeless fraud. I've blogged extensively on the PCAOB.

  8. Anonymous

    Why do you expect a post-mortem? There hasn’t been even talk of a post-mortem of the Bear Stearns fiasco bailout.

  9. Anonymous

    “We have no plans to insert money into either of those two institutions,” Mr. Paulson said in an interview on NBC’s “Meet the Press” broadcast Sunday from Beijing.

  10. Timothy

    “while not necessarily in violation of accounting rules” will go down in history with the Showa Emperor’s famous admission at the end of WW2 “The situation has developed not entirely to Japan’s advantage” as a world class understatement. I would be really surprised if this does not end up costing at least the high end estimates floating around at present. The can-opener has been deployed now count the worms

  11. Matt Dubuque

    A principal reason why I have stated for the last several months that we may well stave off the meltdown until February of next year deals with this very issue.

    Recall the dramatic downdraft we had in January. This is coincident with a little known fact.

    Quarterly earnings reports are not audited. Annual statements, typically issued in January, are.

    AUDITED reports, especially after the Enron scandal, are far more probative of a company’s ACTUAL financial health. This story deals with the difference between an AUDITED and an UNAUDITED view of a company’s balance sheet.

    Under current case law, accounting firms are FULLY LIABLE for ALL of the losses not properly represented on AUDITED statements. This means that just one poorly performed audit of a corporate behemoth can wipe out any of the large accounting firms. Again, recall Enron and Arthur Andersen. This case law has not changed.

    As yet another sign of their central role in intensifying this crisis, the SEC (NOT the FED) is likely to argue in court against this case law. However, it is by no means clear they will prevail.

    Think of Arthur Andersen’s extinction at the hands of Paul Volcker and the courts. They were thought to be “too big to fail”. Their very public dismemberment chastened EVERYONE working for a large accountng firm.

    Because ONLY annual reports are audited, this accounts for why there were so many huge earnings “surprises” in January. Last January, corporate Treasurers were shocked by the intensity and pugnaciousness of the auditing firms, said firms determined not to go the way of their dear friends at Arthur Andersen by failing to include enormous risks posed by asinine derivatives accounting practices in their comprehensive audits.

    The story above is but one example why in this current environment quarterly earnings reports are virtually worthless and the ONLY rational accounting treatment occurs from the AUDITED reports, issued every January.

    Matt Dubuque

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