Capital Measures of Fannie and Freddie

Investors, debtholders, companies use different capital measures to guage the riskness and get different pictures. GAAP capital measure include just equity, regulator look at core capital, such as Tier 1, which omits the loss the of asset. The collapse of shares in Fannie Mae and Freddie Mac came down to investors' fear that the mortgage companies don't have enough capital to weather the housing crisis. Yet the companies, and their regulator, say this isn't so. And even as the stock market panicked, investors were more sanguine when it came to Fannie and Freddie's debt. Sound crazy? Actually, it makes perfect sense. Investors, regulators and the government are looking at different numbers when it comes to capital at Fannie and Freddie. The drubbing of their stock highlights a growing loss of confidence among investors in many measures that regulators use to argue the companies' strength. Until Fannie, Freddie and their regulator acknowledge this, the stocks will rightly keep getting killed. So far, though, that isn't happening. In statements Friday, Fannie and Freddie each said they are adequately capitalized, but in arguing their cases pointed to measures of regulatory capital investors no longer trust. Debt investors, meanwhile, haven't been as worried by the capital conundrum because they remain confident the government will, if necessary, back the companies' liabilities. They are probably right to think that a worst-case scenario would run along the lines of the Bear Stearns bailout: The stock gets creamed, but debtholders are all right. At the heart of the questions over capital are three key measures. The most basic is shareholder equity based on generally accepted accounting principles. Next comes core capital, the regulatory measure. Finally, the companies provide a capital figure using market values for all their assets and liabilities. Regulators and the companies look to core capital, which is similar to gauges used for banks, such as Tier I capital. But Fannie and Freddie's regulatory capital figures omit some potential losses, while giving credit for assets that banks wouldn't be able to count toward Tier 1 capital. When times were good, investors didn't worry too much about this. That changed as investors grew more anxious about potential losses from the more than $5 trillion in mortgages the companies hold or guarantee. Investors began paying closer attention to the GAAP balance sheet and fair-value figures. On that score, Fannie looked decidedly weak; Freddie was a basket case. At the end of the first quarter, Freddie's regulatory capital was about $38 billion. Yet GAAP total shareholders equity was $16 billion and common equity, or book value, was just $2 billion. On a fair-value basis, the company had negative net worth of nearly $17 billion. How could there be such a big difference? Core capital excludes losses on securities that Fannie and Freddie hold but that don't immediately show up in profit. Freddie had about $10 billion in such losses in the first quarter. The company believes such losses are temporary, but many investors aren't so sure. The differing views on capital become especially important because they can influence debt investors' willingness to lend short-term money. Fannie and Freddie each had more than $200 billion in short-term debt outstanding at the end of the first quarter. So far, investors haven't backed away from this debt, although they are demanding slightly higher interest rates. That is in part because of the belief that the U.S. government will ultimately make good on the companies' debts. The companies also can fund themselves for short periods without rolling over short-term debts. But that doesn't solve the capital issue. Investors are in show-me mode. Smoke, mirrors and regulatory capital measures will no longer suffice.