GSEs Overstated Their Financial Positions in Violation of Accounting Rules

GSE has been found or being scrutinized for --Abusing deferred tax assets --Inflating capital cushion by using hold-to-maturity accounting method, instead of traditional mark-to-market method --Managing earnings by delaying reserves --Chaning the method of recognizing mortgage delinquency losses. The government’s planned takeover of Fannie Mae and Freddie Mac, expected to be announced on Sunday, came together after advisers poring over the companies’ books for the Treasury Department concluded that Freddie’s accounting methods had overstated its capital cushion, according to regulatory officials briefed on the matter. The proposal to place both companies, which own or back $5.3 trillion in mortgages, into a government-run conservatorship also grew out of deep concern among foreign investors that the companies’ debt might not be repaid. Falling home prices, which are expected to lead to more defaults among the mortgages held or guaranteed by Fannie and Freddie, contributed to the urgency, regulators said. Investors who own the companies’ common and preferred stock will suffer. Holders of debt, including many foreign central banks, are expected to receive government backing. Top executives of both companies will be pushed out, according to those briefed on the plan. The cost of the government’s intervention could rise into tens of billions of dollars and will probably be among the most expensive rescues ever financed by taxpayers. Both presidential nominees expressed support for the government’s plans. Senator Barack Obama, Democrat of Illinois, said as he campaigned in Indiana that not acting could place the housing market in further distress. Senator John McCain’s running mate, Gov. Sarah Palin, said at a rally in Colorado Springs that Fannie Mae and Freddie Mac have become too big and too expensive. The takeover comes on the heels of a rescue of the investment bank Bear Stearns, which was sold to JPMorgan Chase in a deal backed by taxpayers. Already, the housing crisis has cost investors and consumers hundreds of billions of dollars. The big question now is whether the federal government’s move to take over Fannie and Freddie will restore investor confidence in the nation’s credit markets, help stabilize the stock market and keep loans flowing to creditworthy borrowers. Fannie and Freddie, by buying mortgages, provide banks and other financial institutions with fresh money to make new loans, a vital lubricant for the housing and credit markets. Under the plan, the Treasury Department itself will begin buying mortgage securities, providing crucial market support. As a result of the government’s intervention, the cost of borrowing for Fannie Mae and Freddie Mac should decline, because the government will be insuring their debts. Equally important, because the government is backing the companies, they will continue to buy and sell home loans. But the plan will probably do little to stop home prices from falling further. And foreclosures are almost certain to rise. Just a week ago, Treasury officials were still considering a wide variety of options for Fannie Mae and Freddie Mac, ranging from doing nothing to taking over the companies completely, according to people with knowledge of those discussions. The Treasury secretary, Henry M. Paulson Jr., who won authority from Congress last month to use taxpayer money to bolster the companies, always maintained that he hoped never to use that power. But, as the companies’ stocks continued to languish and their borrowing costs rose, some within the Treasury Department began urging Mr. Paulson to intervene quickly. Then, last 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’ 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. Representatives of both companies did not return calls or declined to comment. But officials who have been briefed on the plans said late Saturday that the companies had agreed to the takeover. On Friday, executives from Fannie Mae and Freddie Mac were ordered to appear in the offices of their regulator, James B. Lockhart, in separate meetings. They were told that regulators were exercising their authority to place Fannie Mae and Freddie Mac in conservatorship, which would allow for uninterrupted operation of the companies but would put them under the control of Mr. Lockhart. The details of those plans continued to be worked out on Saturday, when the Federal Reserve chairman, Ben S. Bernanke, met with Mr. Paulson, Mr. Lockhart and key company executives in Washington. While Freddie Mac’s accounting woes make it easier for regulators to force the company into conservatorship, there was more resistance from Fannie Mae, according to people familiar with the discussions. Once the government took action against Freddie Mac, however, confidence in Fannie Mae would certainly waver. Given Fannie Mae’s declining financial condition, the company has few options but to concede to the government’s demands. Accusations of questionable accounting are not new for either company. Earlier this decade, both companies paid large fines and ousted their top executives after accounting scandals. Freddie Mac’s current chief executive and chairman, Richard F. Syron, joined the company in 2003 after the former managers revealed that they had manipulated earnings by almost $5 billion. The next year, Fannie Mae’s chief executive, Daniel H. Mudd, was promoted to the top spot after that company was accused of accounting errors totaling $6.3 billion. The accounting issues that brought so much urgency to the bailout appear to center on Freddie Mac’s capital cushion, the assets that regulators require them to keep on hand to cover losses. The methods used to bolster that cushion have caused serious concerns among the companies’ regulator, outside auditors and some investors. For example, while 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. 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. Regulators are also said to be scrutinizing whether the companies were trying to manage earnings by waiting to add to their reserves. Both companies have gradually increased their reserves for loan losses — Fannie’s reserves today stand at $8.9 billion, and Freddie’s at $5.8 billion. 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 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. The companies have injected their own capital into pools of securities containing these loans, arguing that their new policies are helping more borrowers. Under conservative accounting methods, changing these policies would not have any impact on the companies’ books. However, people briefed on the accounting inquiry said that Freddie Mac may have delayed losses with the change. “We have just had to nationalize the two largest financial institutions in the world because of policy makers’ inaction,” said Josh Rosner, an analyst at Graham Fisher, an independent research firm in New York, and a longtime critic of the government-sponsored enterprises. “Since 2003, when these companies’ accounting came under question, policy makers have done nothing.”