Friday, July 11, 2008

Fore! Timber! Fire in the Hole!

From today's NYT:

WASHINGTON — Alarmed by the growing financial stress at the nation's two largest mortgage finance companies, senior Bush administration officials are considering a plan to have the government take over one or both of the companies and place them in a conservatorship if their problems worsen, people briefed about the plan said on Thursday.

The companies, Fannie Mae and Freddie Mac, have been hit hard by the mortgage foreclosure crisis. Their shares are plummeting and their borrowing costs are rising as investors worry that the companies will suffer losses far larger than the $11 billion they have already lost in recent months. Now, as housing prices decline further and foreclosures grow, the markets are worried that Fannie and Freddie themselves may default on their debt.

Under a conservatorship, the shares of Fannie and Freddie would be worth little or nothing, and any losses on mortgages they own or guarantee — which could be staggering — would be paid by taxpayers.

Why would the shares be of little or no value in a conservatorship, Spotty?

Because Fannie and Freddie have no real worth. We've talked about this before in Spot's post about level 3 assets:

If you say so grasshopper, but consider this story from Bloomberg (a thump of the tail to reader Jim for the link):

May 14 (Bloomberg) -- Freddie Mac, the second-largest U.S. mortgage-finance company, reported a smaller loss than analysts estimated after accounting changes reduced charges by at least $2.6 billion.

Without the use of two new accounting rules, Freddie Mac would have posted a loss of at least $1.7 billion, analysts said. A change in the way the company values some assets that aren't traded reduced credit losses by $1.3 billion, while a separate rule that lets the company pick and choose which assets to measure contributed an equal amount, Freddie Mac said.

``They put a lot of lipstick on this pig including several accounting changes that have given them a one time step-up,'' said Josh Rosner, an analyst at independent research firm Graham Fisher & Co. in New York.

The article continues:

The new accounting had a ``significant positive effect,'' reducing volatility in the value of the company's $738 billion in mortgage holdings, as well as for securities and derivatives used to hedge against credit and interest-rate risk, Freddie Mac said.

Freddie Mac spokesman Michael Cosgrove said, ``clearly, based on the comments and reports this morning by the real, substantive analysts who follow this company, the Street is comfortable with our accounting and reporting, and encouraged by the results we presented today.''

Exactly what did they do, Spotty?

Again, from the Bloomberg article:

Financial Accounting Standard 157 allows companies to estimate a value on holdings that aren't traded. Freddie Mac used FAS 157 to list $156.7 billion in so-called Level 3 assets, a category that indicates the holdings are so illiquid that they can only be priced using the firm's own valuation models.

The Level 3 holdings represent 23 percent of assets and are up from $31.9 billion as of December.

The first-quarter results also benefited from a change in policy for buying seriously delinquent loans, those at least 120 days past due, out of the mortgage pools Freddie Mac guarantees. The company must book the decline in value on loans bought from pools at the time of purchase. It ended that practice, cutting losses to $51 million from $736 million in the fourth quarter.

In other words grasshopper, they took the sewage that nobody would buy and decided themselves what it was worth.  And changed the way they count. And you know what happened, grasshopper?

The stock went up?

Bingo. This is the genius of the stock market to which our Chief Economics Correspondent [MPR's Chris Farrell] refers. It is also worth noting that Freddie's level 3 assets are within spitting distance of its surplus:

The company said its core regulatory capital rose to $38.3 billion at the end of the quarter, about $6 billion above the 20 percent mandatory surplus.

So, maybe ol' Freddie isn't worth much, huh, Spot?

A conservator would have to wipe all that lipstick off, right Spotty?

That's right grasshopper. Aren't you glad that you aren't one of the investors who helped bid the price of Freddie up after these recent accounting shenanigans?

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