There should be two distinct entities within Freddie and Fannie. One for the retained, and one for the guaranteed.

Throwing them together just complicates things needlessly.

Do the same capital requirements apply to retained and guaranteed? If not...why the heck not? Are they risk-based requirements?

LEh is down $4 dollars. Guess KDB decided bridge too far. Fuld is toast.

Thanks Tanta! That made sense to me...and while complex, not nearly as crazy making as, for instance, someone describing a derivative to me, or the alternative minimum tax...

as to not offend tanta, how bout a OpenT, leh is going down , Hard today.

Tanta writes:
Do individual loans move from the guaranteed to the retained in the event of default?

I obviously am incapable of explaining this to you, since I just wrote a big honkin' post on the subject and it didn't do anything for you. Maybe someone else can try explaining it again?

You actually expect me to read all of that?

Re: quasi-religious faith in some quarters,

I have unlimited faith in this and see no reason to question it: Sarah Pali

This may be coming to a head. Lehman is "too big to fail" but the fed can't politically bail them out.

Hanging - I suggest you get offline and turn on CNBC. It's better suited to your attention span.

This post is about financial accounting matters. If you are one of those people who drove us insane in the comments to yesterday's post on "assets" versus "liabilities" by arguing that "assets" are "really" "liabilities" because you, like Humpty Dumpty, are The Master, then you will find this post unsatisfactory.

Thank you. Most excellent Lewis Carol reference.

I am, however, willing to sell my liabilities to several people on yesterday's thread, at bargain prices. Just sayin'.

"Do individual loans move from the guaranteed to the retained in the event of default?"

it was an easy reading, thank you tantachka.

We should create a debunking site, a la Snopes, for Tanta's best work. Name? "Dopes" comes to mind, but one of our posters might sue for infringement.

that was apologies on LEH

Thanks Tanta!

The 2 years is simply the end of the option period. During the two years, Freddie can opt to either advance the payments to the investor at the mortgage MBS rate or buy the loan principle if Freddie's cost of funds is cheaper. They are responsible for the foreclosure losses regardless. The only issues are capital cost and cash flow. Until recently cash flow for GSE's had never been a problem.

The issue with Gretchen and other similar reporters is that they are writing about things that neither they nor their readers have any understanding about and they consistently get it wrong. They appear to have an agenda and anything they hear is filtered according to that agenda.

Thank you, Tanta.

This post is a perfect example of why I no longer bother to read any articles in newspapers anymore, except possibly the headlines in order to be aware of what others will say or be thinking on the topic.

Disclosure requirements may discourage entities from violating the intent of the fair-value election. An entity must disclose its reasons for electing the fair-value option. If a partial election is made, an entity must disclose the reasons for the partial election.

“If it is probable that the investor will be unable to collect all amounts due according to the contractual terms of a debt security not impaired at acquisition, an other-than-temporary impairment shall be considered to have occurred.”

(PCAOB) emphasizes the importance of determining an entity’s principal market when pricing services are used for fair-value measurements The alert states that “a pricing service might provide an amount for which a large financial institution could sell the financial instrument. However, a company that owns that financial instrument might not be able to transact in the same market as a large financial institution. If the price available to a large financial institution would not be available to the company, then that price may not be an appropriate measure of fair value under SFAS 157.”

The use of Level 3 inputs is necessary when observable inputs are not available. For MBSs, this could happen when very little or no market activity is observed for identical or similar assets at the measurement date. In using Level 3 inputs, SFAS 157 (para. 30) indicates that “the fair-value measurement objective remains the same, that is, an exit price from the perspective of a market participant that holds the asset.” Assumptions in a model used to measure fair value should take into account assumptions that market participants would make in pricing an asset if the information can be obtained without undue cost and effort.

The current environment of foreclosures, defaults, and uncertain real estate values suggests increased risk and uncertainty of future cash flows for investors holding MBSs. Accordingly, measuring risk for some MBSs may have become more difficult.

As noted, fair-value measurements based on the use of unobservable inputs (Level 3) requires the exercise of significant professional judgment. Consistent with the subjectivity of these measurements, extensive disclosures are required by SFAS 157 (see paras. 32–35). Among other disclosures, entities must disclose the levels (1, 2, or 3) in which inputs to fair-value measurements fall.

Re: Some of our financial instruments, such as our trading and available-for-sale (“AFS”) securities and our derivatives, are measured at fair value on a recurring basis in periods subsequent to initial recognition. We measure some of our other financial instruments at fair value on a non-recurring basis in periods subsequent to initial recognition, such as held-for-sale mortgage loans. Table 1 presents, by balance sheet category, the amount of financial assets carried in our condensed consolidated balance sheets at fair value on a recurring basis and classified as level 3 as of June 30, 2008. We also identify the types of financial instruments within each asset category that are based on level 3 measurements and describe the valuation techniques used for determining the fair value of these financial instruments. The availability of observable market inputs to measure fair value varies based on changes in market conditions, such as liquidity. As a result, we expect the financial instruments carried at fair value on a recurring basis and classified as level 3 to vary each period.

FEDERAL NATIONAL MORTGAGE ASSOCIATION FANNIE MAE - 10-Q - 20080808 - MANAGEMENT_ANALYSIS

Most important, an entity can make the election on the adoption of SFAS 159 for financial assets and liabilities owned or issued before that date (e.g., on January 1, 2008, for calendar year–end companies). Additionally, the election can be made on a security when the security is purchased. Paragraph 9 of SFAS 159 includes a complete list of triggers allowing for an election. Once SFAS 159 is effective for an entity, the effect of the first remeasurement to fair value will be reported as a cumulative-effect adjustment to the opening balance of retained earnings (para. 25).

I t is funny how thousands of banks are fucking up accounting and cant understand this basic accounting shit that average person should be able to understand, like Gretchen, Paulson, Fuld, Dodd, Tanta...

ever underestimate the predictability of stupidity

thanks tanta.

if the millions of people who want to be informed citizens and read the nyt everyday continue to be subjected to this crap we are truly fucked.

you were too nice to Morgenson and Duhigg. virtually every word in the two paragraphs you posted were wrong.

Thanks re capital clarification.

Do you have any comment on the tax asset criticism? This was also mentioned in a Bloomberg article.

Tax assets in my view are equivalent to deferred cash inflows (offsetting future taxes), albeit contingent on future profitability.

What I see in these criticisms is a tendency to associate capital with these specific assets, and an inability to get cash out of them when needed. But this is a false association in that it confuses the aspect of capital and liquidity. Write-offs and lossses don't necessarily generate a requirement for cash directly.

I'm also confused by the comment that financial institutions are not allowed to carry tax assets, which I've also seen in several places. If that's true, how do they square the balance sheet with the income statement when the after-tax cost of losses is less than the pre-tax cost?

Thanks for clarifying, Tanta. Look forward to reading you regularly (including maybe a possible future post on capital requirements?).

There are a handful of people that read your posts like this and continue to tell you that you are right.

The rest of the world doesn't 100% understand what is happening but at least investors are smart enought to understand the common is basically worthless.

Mortgage rates have lower a little bit but in time they will be head higher.

I urge all of you to just pray harder and everything will be fine!

Whyizzit we(U.S.) only take over the loser banks after they hit bottom? I say we take over a few good banks to offset the bad banks and take back the 28 mil we just paid to frannie's ceo's. Where's the accountability?

You have funding costs that can--and apparently have, recently--exceeded the interest rate on the loans, which gives you a negative interest margin and blows a big hole in your income.

what exactly do you mean by "funding costs"?

No pay, no pray?

The accounting issues are a complete red herring -- these 'issues' have been well known, nothing new, and nothing shady. Ditto capital ratios.

After all, Lockhart presided over pledging the books clean, and also presided over lifting the caps and reducing the capital ratios! And just in the last few weeks, Lockhart, Bernanke, et al all said there were no capital adequecy problems at the GSEs.

And yet, now, suddenly, Paulson has to move quickly to place the GSEs into conservatorship -- and he places Lockhart and Lockhart-selected people in direct control of the GSEs! If these new accounting problems were are real issue, why continue with Lockhart?

Obviously, a red herring.

But what I really want to know, is why isn't this aspect being discussed in the (free) press?

Hi Tanta,

An off-topic question: I think I understand correctly that Fannie and Freddie invented mortgage backed securities -- and basically securitization itself. But we they also the founders of CDO style (multi-tranche) securitization or was that an innovation that they adopted from the private sector?

My very profound thanks for your willingness to share your expertise with us on this blog.

I'm afraid I don't understand your question.

I hate to be busted, and Im trying to eat brunch, sorry man!

Does Fannie exchange indexed securities?

Re:hese transactions create what are called mortgage-backed securities (MBS). Fannie and Freddie only guarantee to the holders of MBS that the principal and interest on the mortgages in the trusts will be paid in full and on time. In other words, Fannie and Freddie take only the credit risk on these mortgages; the interest-rate risk--that interest rates will rise and the mortgages will become less valuable, or that interest rates will fall and the mortgages will be prepaid and disappear--is taken by the holders of the MBS. For their guarantee, Fannie and Freddie receive an annual fee as long as the pools remain in existence. In this segment of their business, Fannie and Freddie have guaranteed about $2.2 trillion in mortgages.[1]

In the other part of their business, Fannie and Freddie buy mortgages from originators and hold them in portfolio; they also repurchase for their portfolios some of the MBS that they have already issued. Because they are then the owners of these mortgages and MBS, they have assumed the credit risk, and because they have to borrow the funds to buy the mortgages and MBS, they assume the associated interest-rate risk. Of the two, interest-rate risk is far more significant, and Fannie and Freddie have to enter into large hedging transactions to mitigate it. They assume these substantial risks, and contract for hedging, because their portfolios of mortgages produce by far the greater part of their profits. This is true because, as GSEs, they are accorded favorable rates in the capital markets, and thus can arbitrage between their borrowing costs and the rate they will receive on the mortgages and MBS they hold.

AEI - Regulating Fannie Mae and Freddie Mac

I meant what the Q calls "the expected cost of holding the nonperforming mortgage in our retained portfolio."

i see. i think using the term "funding costs" is somewhat confusing, because it's not really about the cost of issuing agency debt (which is always substantially cheaper than the coupon on MBS) to fund the mortgage, and it doesn't really have anything to do with interest margin.

per Freddie:

Freddie Mac believes that the historical practice of purchasing loans from PC pools at 120 days does not reflect the pattern of recovery for most delinquent loans, which more often cure or prepay rather than result in foreclosure. Allowing the loans to remain in PC pools will provide a presentation of its financial results that better reflects Freddie Mac's expectations for future credit losses. Taking this action will also have the effect of reducing the company's capital costs. The expected reduction in capital costs will be partially offset by, but is expected to outweigh, greater expenses associated with delinquent loans.

Freddie Mac Announces Operational Changes for Purchasing Delinquent Loans From Mortgage PCs. - News Archive - Freddie Mac

Tanta wrote "How MUCH capital would now be needed if they were to take the guarantys onto their investment portfolio, regardless of the relative expense - advantage or disadvantage to funding costs?

So the answer, at the moment, seems to be about $12.5 billion less the fair value adjustment, whatever that is."

No, no, no. The $12.5 billion is the face value of the loans not the capital required. Assuming an 8% capital requirement (generally applicable to banks) that would translate into $1 billion in capital required. However banks (don't know about Freddie or Fanny) usually have a capital charge associated with guaranties or off-balance sheet items. Therefore, the additional capital required to bring the $12.5 billion in loans on-balance sheet could be less than the $1 billion.

"That probably refers to instances where they're using the accrual instead of cash method."

All companies use accruals, except the smallest home businesses.

Fair Value: Forget about it. No one is going to seriously introducing new accounting treatment in the middle of this mess. It is also just another set of estimates. For anon who is crazy about it, fair value includes fair value of liabilities also. Like debt. Look for other financial institutions that are booking increases in capital by reducing the "fair value" of their debts. Find at least one and then report back.

Andreas: Don't bet on International standards being any better. The motivation was to put all financial entities on an equal footing. Banks, insurance companies, etc. And also get rid of arbitrary, legacy capital regulatory requirements. A lot of those rule of thumb, legacy requirements are why the entire system hasn't collapsed yet. I.e. Legacy financial institution wanted lower capital requirements to compete with less regulated competition.

"Andreas writes:
This reminds me of an esteemed Congressman I saw interviewed (CNN?) a month or so ago, making the claim that the GSE's have an advantage as they don't have to mark their portfolio to market "

Banks don't write their portfolio of held mortgages to market either. Among other things, that means their value would change with each 1/8% rise or decline in interest rates. They do have to accrue for expected losses, which is judgmental. It is also disclosed and easy to find and people can make up their own minds regarding how realistic they are. Among other things, that is the theoretical function of security analysts - superimposing their judgment on qualitative aspects of the balance sheet and earnings.

The financial statements of F&F are complicated. Now that they are pretty much out of contention as investments (equity and anything junior of the govt), why bother now?

As far as cost of capital, the "threat" of Freddie to quit buying additional mortgages for their held portfolio, which would have amounted to a reduction of billions a quarter would have been very smart consider the cost of capital associated with holding them. In my opinion, one of the reasons they got taken over.

There are far bigger elephants in the room regarding F&F's accounting and risks then the TIMING of moving impaired loans from one bucket to another.

The problem with the stupid reporting is that stuff either goes up or down, AND the reporters want/need a reason for everything. They have a 50% of being right for the wrong reasons.

Just because their reasoning is faulty doesn't mean they don't have it right, in spite of themselves.

Tanta writes:
"maybe it's that 'double-entry bookkeeping' scam we were talking about yesterday. Everybody knows double-entry means 'lies.'"

Hold on just a minute. I strongly dispute the contention that "everybody knows double-entry means 'lies.'" Double entry bookkeeping is merely a fancy way of saying debits must equal credits. This can be confirmed by anyone with even the most rudimentary knowledge of accounting.

By the way, accounting problems can be roughly sorted into buckets.

Worldcom = They didn't move stuff into different buckets. They just made things up. And wrecked their competition, like ATT, in the process as a result of their lying.

Enron = They went to the trouble of inventing profits using something similar to real accounting. However, very little in real profit.

Almost everyone else -- wrong side of the line. didn't know what they were doing. other other types of things.

"Ed writes:
Thanks, what a mess this is...even people who are not unintelligent have to really think about it, where does that leave the herd?"

Exactly. Take me for instance. I somehow strayed onto this page looking for some cud when I ran into this post. I'm going to have heartburn for a week.

Tanta, DO YOU THINK THAT BECAUSE EVERY ONE HAS A SHORT ATTENTION SPAN AND CANNOT READ A LONG POST ON ACCOUNTING MEANS THAT WE HAVE BEEN COMPLETELY DUMBED DOWN AS A NATION?

Should we try to summarize it in 2 words or less for them? That seems to be the median attention span for the American voting public.

Tony

A second issue in the article that is somewhat deceiving is the comment on the deffered tax assets:

"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."

This is obviously another misunderstanding of what these deffered tax assets are. A deferred tax asset is created when an instrument that is not held in a mark to market through income(ie trading) portfolio but rather a portfolio that is market to market on the balance sheet but not through the income statement (ie available for sale). Since gains or (in this case) losses have no tax impact (as they don't accrue to income) the loss flows through to an other comprehensive income line which offsets equity. Before this happens, the tax impact is recorded as a deffered tax asset so that the full loss does not flow through income.

Net net, it reflects the tax benefit for a loss the company hasn't yet taken and may/probably will never take. If this tax item did not exist, it would also not impact regulatory capital as other comprehensive income (the liability that the tax asset offsets) is added back to book equity to come up with capital.

I think it is clearly poor reporting.