Fannie Mae in Trouble

Todays IHT published a revealing story about mortgage giant Fannie Mae. Their deceitful and worrisome accounting practices are sadly a microcosm of the troubles facing the financial sector.

J

Worries grow over big backers of U.S. mortgages

By Charles Duhigg
Tuesday, May 6, 2008

As home prices continue their free fall and banks shy away from lending, Washington officials have increasingly relied on two giant mortgage companies Fannie Mae and Freddie Mac to keep the housing market afloat.

But with mortgage defaults and foreclosures rising, Bush administration officials, regulators and lawmakers are nervously asking whether these two companies, would-be saviors of the housing market, will soon need saving themselves. The companies, which say fears that they might falter are baseless, have recently received broad new powers and billions of dollars of investing authority from the U.S. government.

As Wall Street all but abandons the mortgage business, Fannie Mae and Freddie Mac now overwhelmingly dominate it, handling more than 80 percent of all mortgages bought by investors in the first quarter of this year. That is more than double their market share in 2006.

But some financial experts worry that the companies are dangerously close to the edge, especially if home prices go through another steep decline. Their combined cushion of $83 billion the capital that their regulator requires them to hold underpins a colossal $5 trillion in debt and other financial commitments.

The companies, which were created by Congress but are owned by investors, suffered more than $9 billion in mortgage-related losses last year, and analysts expect those losses to grow this year. Fannie Mae is to release its latest financial results on Tuesday and Freddie Mac is to report earnings next week.

Concerns over the companies' finances have prompted a fierce behind-the-scenes battle between nervous government officials and the two companies. Bush administration officials, the Federal Reserve and lawmakers all believe that the companies' financial safety cushion is far too thin and have pleaded with them to raise more capital from investors.

Freddie and Fannie, which are enjoying new growth and profits, have largely resisted those pleas, people briefed on the talks say, because selling new shares could dilute the holdings of existing shareholders and drive down their stock prices. Though executives have promised to raise money this year, they refuse to specify how much and when.
Moreover, the companies are using their new found clout to push Congress and their regulator to roll back the limits that were imposed after recent scandals over accounting and executive pay, according to participants in those conversations.

As a result, high-ranking government officials are now quietly threatening to publicly criticize the two companies if they do not soon raise large amounts of capital, people with firsthand knowledge of those threats say. William Poole, a president of a Federal Reserve bank who has since retired, has warned that companies like Fannie Mae and Freddie Mac are "at the top of my list of sources of potentially serious trouble."

A report released last month by the agency overseeing the companies warned that they pose "significant supervisory concerns" and that Freddie Mac suffers "internal control weaknesses." Lawmakers are pushing to rein in the companies with new legislation. Senator Christopher Dodd, the Connecticut Democrat who leads the Banking Committee, will soon take up legislation giving the government broad authority over the companies. Lawmakers say it is likely a bill will pass this year.

"They are on real thin ice financially," said Senator Richard Shelby of Alabama, the senior Republican on the Banking Committee. "And the way the law is written right now, there is very little we can do to correct that." The companies say such criticisms are without merit. Their latest regulatory filings, they note, show a combined financial safety net that exceeds required minimums by $7 billion. The companies raised $13 billion from investors last year and say any future losses will be offset by new revenue and by money they have already set aside.

"The irony is that right now I'm seeing the best opportunities since I've been in this business," said Daniel Mudd, chief executive of Fannie Mae, in an interview conducted last month. The companies also say that they have not demanded anything. Rather, they say, the limitations have been dropped because of the companies' commitment to financial transparency and aiding the housing recovery.

(J's comment: I have a feeling we will be quoting these soon to be ironic and telling statement in a few quarters when Fannie Mae is struggling just like we did for a certain Bear Stern's CEO on the eve of his company's destruction.)

But others remain concerned. Though the companies' main regulator, James Lockhart III, director of the Office of Federal Housing Enterprise Oversight, has voiced strong confidence in the companies, a high-ranking member of his staff said some officials had begun considering the worst. "It's not irrational to be thinking about a bailout," said that person, who requested anonymity, fearing dismissal.

Fannie and Freddie do not lend directly to home buyers. Rather, they buy mortgages from banks and other lenders, and thereby provide fresh capital for home loans. The companies keep some of the mortgages they buy, hoping to profit from them, and sell the rest to investors with a guarantee to pay off the loan if the borrower defaults.

Because of the widespread perception that the government would intervene if either company failed, they can borrow money at lower interest rates than their competitors. As a result, they have earned enormous profits that have enriched shareholders and managers alike: from 1990 to 2000, each company's stock grew more than 500 percent and top executives were paid tens of millions of dollars.
Those profits were threatened earlier this decade, however, when new competitors emerged and after audits revealed that both companies had manipulated their earnings. The companies were forced to replace top executives, pay hundreds of millions in penalties and consent to strict growth limits.

To keep profits aloft and meet affordable-housing goals set by Congress, the companies began buying huge numbers of subprime and Alt-A mortgages, the highly profitable loans often taken out by low-income and riskier borrowers. By the end of last year, the companies had guaranteed or invested in $717 billion of subprime and Alt-A loans, up from almost none in 2000.

Then the housing bubble burst. In February, the companies revealed a $6 billion combined loss in the fourth quarter of 2007, and both companies' stock prices fell more than 25 percent in two weeks. Despite those troubles, however, lawmakers had few alternatives to asking Fannie and Freddie to buy more and riskier mortgages. "I want these companies to help with affordable housing, to help low-income families get loans and to help clean up this subprime mess," said Representative Barney Frank, a Massachusetts Democrat and the chairman of the House Financial Services Committee. "Otherwise, why should they exist?"

But now that the government depends on Fannie and Freddie to keep markets humming, the companies are making demands of their own namely, repealing some of the limits created after the scandals and even some established by law. Last year, in return for buying billions of dollars of subprime mortgages to help stabilize the market, executives won the right to expand their investment portfolios. In March, the companies agreed to raise more capital within the year. In exchange, they received an additional $200 billion in purchasing power.

Last month, the companies promised to pump money into pricier reaches of the housing market. In return, Congress temporarily raised the cap on the size of the mortgages they can buy to almost $730,000 from $417,000. "We have to bow and scrape and haggle each time we need help," said a senior Republican Senate assistant who spoke only on the condition of anonymity.

Each time Congress or regulators have given the companies new room for growth, their stock prices have risen. But so far the companies have balked at raising more capital. That hesitation has lawmakers concerned that when the companies raise money this year, it will not be enough.

In a March meeting, Freddie Mac's chairman, Richard F. Syron, bolstered those fears by saying the company would put shareholders' interests first. Michael Cosgrove, a spokesman for Freddie Mac, said Syron is committed to both satisfying the company's public mission and creating shareholder value. Fannie Mae, which is in a regulatory-imposed quiet period because it will soon release financial information, declined to comment on capital-raising issues.

(J's comment: Mr. Syron will be "putting the interests of his shareholders first", before his government-backed entity created to help make homes affordable for Americans does anything else. The only thing more troubling than Mr. Syron's comments is the statement made by his "spokesperson" Micheal Cosgrove regarding commitment to their public mission and creating shareholder value. That sounds alot like a financial win-win. The telltale signs of trouble: platitudes by spokesmen. How anyone finds these statements assuring is beyond me and Fannie Mae's inflated share price.)

As worrisome as the need for new capital, some analysts say, are the companies' books. A report released earlier this month by Lockhart, the regulator, noted that although Freddie and Fannie had a combined $19.9 billion of "unrealized losses" on mortgage-related investments, neither company had reduced its earnings to reflect those declines. That is because they judged the losses to be temporary in essence wagering that the mortgage market would recover before those assets were sold. Such a wager is permitted by the rules but difficult for outsiders to analyze.

(J's comment: who decides said losses shouldn't count against the books, and who's crystal ball is being used to surmise that the mortgage crisis will be long gone before they decide to sell any troubled assets?)

Fannie Mae declined to discuss unrealized losses. Cosgrove said Freddie Mac's accounting choices had been the best way to reflect financial realities.

(J's comment: There go the spokespeople: ignoring losses reflect a reality to which only the Fannie Mae brass and their PR folks live in)

Both companies have also recently changed their policies on delinquent loans, which they previously recorded as impaired when borrowers were 120 days late. Now, some overdue loans can go two years before the companies record a loss. Fannie Mae declined to discuss the accounting of impaired loans. A representative of Freddie Mac said marking loans as permanently impaired at 120 days does not reflect that many of them avoid foreclosure.

(J's comment: 120 days... 4 months late on mortgage payments and Freddie Mac declined to comment on how this is not considered impaired? Change accounting rules to benefit your company and send in a representative to decline comment other than to suggest 4 month arrears on a mortgage payment doesn't reflect the reality that most don't foreclose. While we're at it lets consider that most people who have heart attacks don't die right away, why bother sending them to the top of triage at emergency rooms!)

But the biggest risk, analysts say, is that both companies are betting that the housing market will rebound by 2010. If the housing malaise lasts longer, unexpected losses could overwhelm their reserves, starting a chain of events that could result in a federal bailout.

A version of those events began in November, when Freddie Mac's capital fell below Congressionally mandated levels. The company stemmed the decline by selling $6 billion in preferred stock. But it might not manage that again if there is another unexpected loss, analysts say.

"The last two years have shown the real need for a stronger regulator," Lockhart said. If his agency did not curb the companies' growth earlier this decade, he added, "they would be part of the problem right now instead of part of the solution."

Nouriel Roubini and the Systemic Meltdown

This piece from Nouriel Roubini's blog http://www.rgemonitor.com/blog/roubini provides an indepth analysis of the current risks facing investors and a great overview of other analysts opinions regarding the growing dramatics in capital markets.

Its long but well worth the read, Mr. Roubini, author of Bailouts or Bail-Ins: Responding to Financial Crises in Emerging Markets made many of his most bearish calls years ago when euphoria was high and such opinions were unpopular:

The Rising Risk of a Financial Meltdown and the Escalating Losses in the Financial
System

Nouriel Roubini Mar 10, 2008

Given the growing turmoil in financial, credit and equity markets my 12 steps scenario to a systemic financial meltdown is becoming more likely by the day; and my estimate that financial losses could end up being at least $1 trillion dollars – considered as an extreme worst case scenario a few weeks ago – is now being endorsed by an increasing number of serious analysts.

Let us consider the details of these seriously worsening financial conditions…

Serious concerns about a systemic financial crisis or a meltdown have been recently expressed by a number of very distinguished observers and analysts. Larry Summers recently warned that “we are facing the most serious combination of macroeconomic and financial stresses that the U.S. has faced in a generation--and possibly, much longer than that"; he then added the country has "never been in more need of serious economic thinking than we are now"; he warned that "the current estimates of mortgage losses are $400 billion…Those estimates are substantially optimistic."; and then argued that "It's a grave mistake to believe in the self-equilibrating properties of economies in the face of large shocks…Markets balance fear and greed. And when fear takes over, the capacity for self-stabilization is not one that can be relied upon."

Similar concerns about a systemic financial crisis/meltdown have also been echoed today – in a series of op-eds – by Clive Crook in the FT (“In the grip of implacable subprime forces”), Paul Krugman in the NYT (“Mr. Geithner came as close as a Fed official can to saying that we’re in the midst of a financial meltdown”), and Wolfgang Munchau in the FT (“Central banks cannot stop this contagion”).

As for the losses from this financial crisis – that I estimated to be at least $1 trillion and possibly much higher – George Magnus of UBS (the wise analyst who coined the “Minsky Moment” term) agrees with the view that they will end up being about $1 trillion. Mortgage losses alone are now estimated – in the excellent paper by Greenlaw, Hatzius, Kayshap and Shin – to be $400 billion rather than original estimates of $100 to $200 billion. And the $400 billion estimate for mortgage losses does not include the losses from commercial real estate loans, from consumer credit (credit cards, auto loans, student loans), losses on muni bonds and ABS instruments from monoline downgrades, losses on leveraged loans, losses on corporate loans and defaulting corporate bonds, losses on credit default swaps, and losses on agency debt. Also, a recent analysis by UBS estimates the losses in the financial system to be at least $600 billion; but it is not clear how much this study includes the potential losses in a variety of non-mortgage credit markets. Also Clive Crook argued in the FT today that “as house prices continue to fall – leaving as many as 20m in negative equity, on some estimates – the lenders’ losses could exceed even Mr Roubini’s estimates”.

The very thoughtful Martin Wolf – who masterly summarized my systemic crisis scenario in a recent column of his in the FT – then went on in his next column to argue that this may be a worse case scenario. But he then acknowledged that a $1 trillion dollar loss – and related potential fiscal bailout cost of rescuing the financial system - is possible but would be manageable as it would represent only a 7% of GDP fiscal bailout cost. Following my extensive reply that losses may be much larger than 7% of GDP and that a financial system that privatizes gains but socializes losses is seriously flawed Martin Wolf replied that “I think Nouriel’s post is so important that I plan to devote a column to it in the not too distant future”. One can thus look forward to another thoughtful and insightful contribution by Martin Wolf to this debate.

In the meanwhile conditions in financial markets have significantly worsened in all dimensions compared to the time I wrote my 12 step scenario a month ago: stock markets are falling day after day; margin calls are hitting hedge funds and highly leveraged institutions; highly leveraged private equity firms are in serious trouble; more large mortgage lenders are going belly up; credit derivatives spreads for corporate bonds are widening even for high grade bonds; even the super safe agency debt spreads are now widening; the muni bonds, TOB and ARS markets are in a seizure; the liquidity crunch is back with a vengeance forcing the Fed to sharply increase the size of its liquidity operations; but since such widening spreads in interbank rates are now representing more credit premia rather than liquidity premia monetary injections are likely to become increasingly impotent in addressing such widening spreads. Market observers are now using terms such as the markets are becoming “utterly unhinged”, the financial system is “broken” and “everybody's in de-levering mode'' to describe the rising panic in financial markets.

The recklessness of a highly leveraged financial system is epitomized by the Carlyle Group bond fund (Carlyle Capital Corp.) that failed this week to meet its margin calls and is now on the verge of bankruptcy. Think of the chutzpah of such a private equity firm that – well into the current financial turmoil – raised about a paltry $600 million of investors’ equity and leveraged it about 32 times to make over $21 billion of investments in agency (GSE) AAA mortgage debt. Of course the only way to make a high and risky return on AAA debt that had originally very low spreads relative to US Treasury was to lever the initial investment by a reckless 32 times. Too bad that the massive losses that even GSEs are experiencing on their portfolios have recently led to a significant widening of such spreads and massive default on this highly risky scheme (or scam?). Only fools would be shocked that such agency debt spreads have widened: in August of 2006 this column warned that the coming housing bust would not spare even Fannie and Freddie as they would experience massive losses on their portfolios of mortgage related assets. At that time – August of 2006 – when the housing and subprime bust had barely started this column warned:

the coming housing bust may lead to a more severe financial and banking crisis than the S&L crisis of the 1980s. The recent increased financial problems of H&R Block and other sub-prime lending institutions may thus be the proverbial canary in the mine – or tip of the iceberg - and signal the more severe financial distress that many housing lenders will face when the current housing slump turns into a broader and uglier housing bust that will be associated with a broader economic recession. You can then have millions of households with falling wealth, reduced real incomes and lost jobs being unable to service their mortgages and defaulting on them; mortgage delinquencies and foreclosures sharply rising; the beginning of a credit crunch as lending standards are suddenly and sharply tightened with the increased probability of defaults; and finally mortgage lending institutions - with increased losses and saddled with foreclosed properties whose value is falling and that are worth much less than the initial mortgages – that increasingly experience financial distress and risk going bust.

One cannot even exclude systemic risk consequences if the housing bust combined with a recession leads to a bust of the mortgage backed securities (MBS) market and triggers severe losses for the two huge GSEs, Fannie Mae and Freddie Mac. Then, the ugly scenario that Greenspan worried about may come true: the implicit moral hazard coming from the activities of GSEs - that are formally private but that act as if they were large too-big-to-fail public institutions given the market perception that the US Treasury would bail them out in case of a systemic housing and financial distress – becomes explicit. Then, the implicit liabilities from implicit GSEs bailout-expectations lead to a financial and fiscal crisis. If this systemic risk scenario were to occur, the $200 billion fiscal cost to the US tax-payer of bailing-out and cleaning-up the S&Ls may look like spare change compared to the trillions of dollars of implicit liabilities that a more severe home lending industry financial crisis and a GSEs crisis would lead to.

The main, still unexplored issue, is where the risk from mortgages is concentrated: among the sub-prime lenders)…or among commercial banks or among hedge funds and other financial intermediaries that purchased mortgage backed securities(MBSs) or among the GSEs (Fannie and Freddie)? Commercial banks claims that they have transferred a lot of their mortgage risk to other financial intermediaries – such as asset managers, hedge funds or insurance companies – who purchased large amounts of MBSs. But banks have still lots of mortgages on their books and, on top of it they have tons of consumer debt exposure (credit cards, auto loans, consumer credit) that may go really bad in a recession. If part of the housing risk has been off-loaded to hedge funds, the risk is not just of some of these hedge funds going bust but also their prime brokers (i.e. large investment banks) getting into trouble; counterparty risk will become serious once the hot potato of mortgage risk is pushed from one counterparty to the other. And finally, a large part of the housing risk is also in the hands of Fannie and Freddie. How much are the GSEs at risk is a complex issue… Either way, a serious housing bust followed by an economy-wide recession implies serious financial risks for the entire financial system, not just risks for the real side of the economy. A systemic risk episode triggered by a housing bust cannot be ruled out”


To repeat: those are words that were written here in August of 2006. And now that the systemic financial crisis that some of us warned about in the summer of 2006 is in full swing the Fed cannot does not seem to be able to do any better than effectively bailing out those reckless investors and private equity firms that levered a paltry equity position 32 times (!) to make the most risky investments in agency debt. This is a bailout as the recent decision by the Fed to increase size of its liquidity injections (via TAF and other operations) to $200 billion will imply that financial institutions will be able to sell to the Fed agency debt (as well as other much more toxic ABS instruments) and get Fed liquidity in exchange for it.

So now the Fed has effectively entered into the business of propping up a market – and reckless investors – whose spreads are widening for good fundamental reasons (as such GSE are now experiencing mounting multi-billion dollar losses on their portfolios). No wonder that some observers are starting to talk about a covert partial nationalization of the US banking system. Then the explicit partial nationalization of this financial system may only become the next step of this financial meltdown.

Tuesday morning update: The just announced new Fed facility - the the Term Securities Lending Facility that will to lend up to $200 billion of Treasury securities in exchange for debt including agency and private mortgage-backed securities - confirms that the Fed has now entered into the business of artificially propping up the agency debt market and the residential MBS market. With credit risk for GSEs recently rising for fundamental reasons the manipulation of this market just increases moral hazard and saddles the Fed with meaningful credit risk.

Washington Mutual ensures top exec's pay protected from sub-prime losses

This story from Reuters highlights how far gone US banks really are, when time and resources are squandered to ensure bonus packages for management are protected from sub-prime fall out.

The board's committee said in light of the challenging business environment and the need to evaluate performance across a wide range of factors it will take a three-step approach to rewarding its executives including subjectively evaluating company performance in credit risk management.

Subjective evaluation of company performance as opposed to objective evaluation of crippling losses related to Wamu's core thrift lending practices in the mortgage markets?

Surprisingly not everyone is suffering from the sub-prime fiasco:

In January, Seattle-based Washington Mutual said it awarded CEO Kerry Killinger 3.2 million stock options for 2008 to provide a "strong incentive to restore shareholder value".
WaMu's share price sank 70 percent in 2007 as mortgage losses soared

What incentive is needed to convince a CEO to restore shareholder value if their rewards may exclude the poor performing aspects of their business... that account for the lion's share of the share price losses to date?

Bankrupcy Filings up 15% in February

here's an interesting report from Reuter's:
Julie Vorman

it highlights the onslaught of bankrupcy filings in February:


WASHINGTON (Reuters) - American consumers' bankruptcy filings jumped 15 percent in February from the previous month and a steeper rise is looming because of the subprime mortgage crisis, the American Bankruptcy Institute said on Monday.

Consumer bankruptcy filings in February totaled 76,120, up from 66,050 recorded in January, the non-partisan bankruptcy research group said. The February number was 37 percent higher than in the same month a year ago, according to the institute.

"February's bankruptcy spike -- the highest single month since the 2005 (bankruptcy) law changes -- forecasts the start of more to come for the balance of 2008," said Samuel Gerdano, ABI executive director.

"It is probably too early to attribute the current trend to the mortgage crisis. But if it continues -- as it is certainly expected to with adjustable rate mortgages resetting -- it could add to the bankruptcy rate," Gerdano said in an interview.

The institute is forecasting more than 1 million consumer bankruptcies in 2008, compared with about 800,000 in 2007, due mostly to household debt. But the 2008 estimate could go even higher "if this contagion affecting the home mortgage market continues," Gerdano said.

Last week, Senate Republicans blocked a Democratic-written bill that would change federal bankruptcy laws to curb rising home foreclosures.

The legislation, which lawmakers said might be reconsidered in coming days, would let bankruptcy judges reduce mortgage amounts to reflect the current fair value of the home in Chapter 13 bankruptcy proceedings. The White House threatened to veto the bill, calling it too costly.

In a Chapter 13 bankruptcy, a consumer typically must budget some future earnings to repay unsecured creditors. However, secured debt -- such as a home mortgage -- cannot be modified under current Chapter 13 law, Gerdano said.

"Here the scenario is a restriction in the flow of credit to troubled businesses," Gerdano said. "In recent years, there was almost excess liquidity, which propped up a number of businesses and let them stave off a day of reckoning."

(Reporting by Julie Vorman; Editing by Jan Paschal)