The NYT reports that the Treasury is acting now to bail out Fannie and Freddie in part because Freddie (FRE) has been overstating its capital cushion. Given the accounting trouble these companies have had over the years, this is appalling.
[L]ast 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, according to people briefed on those findings. The company had made decisions that, while not necessarily in violation of accounting rules, had the effect of overstating the companies’s capital resources and financial stability.
Indeed, one person briefed on the company’s finances said 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, according to other people who have been briefed.
Specifically, the company did not write down the value of some subprime and Alt-A loans, taking the position that–because it planned to hold them to maturity–it didn’t have to. This flies in the face of mark-to-market accounting. Even if legal, it is also a different (and more aggressive) accounting choice than that used throughout the financial services industry:
[W]hile 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.
Both Fannie and Freddie have also been using deferred tax assets to bolster their capital ratios. This is also highly questionable:
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.
The government also believes both companies spiffed up their numbers by 1) under-reserving for losses and 2) lengthening the time loans are delinquent before they take a loss:
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 recognised 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.
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