Barron’s Clarifies Obvious and Not-So-Obvious About Fannie & Freddie

Markets were buzzing today about this weekend’s Barron’s story on Fannie Mae and Freddie Mac. Not just buzzing, but trading down as this story kicked off a new wave of negative credit market sentiment. The Dow was down 180 points, and at the time of this writing, Asian and European markets followed suit as we move into the week. It’s not that we haven’t heard plenty about FNMA/FHLMC lately, but the Barron’s piece clarified some of the obvious and not-so-obvious reasons these two institutions may be headed for a fall.

First is the some clarification of the obvious and imminent Treasury intervention. Of all the chatter, this statement from the Barron’s piece perhaps sums it up best:

An equity injection by the government would be tantamount to a quasi-nationalization, without having to put the agencies’ liabilities on the nation’s balance sheet, and thus doubling the U.S. debt. Treasury would install new management and directors at both, curb the GSEs’ sometimes reckless investment and guarantee operations, and liquidate in an orderly fashion the GSEs’ troubled $1.6 billion in on-balance-sheet investments. Then the companies could be resold to the public without their explicit government debt guarantees, or folded into government agencies like Ginnie Mae or the FHA.

We’ve said before that the solution is privatization but that solution isn’t something that can happen immediately. So this is the way to get it done. This will take time, and it will be extraordinarily complex, making the credit crunch run on for longer than many people may think.

The second not so obvious point is about how the GSEs are doing their accounting. Everyone remembers Treasury Secretary’s July 11 statement about the two GSEs: “Their regulator (OFHEO) has made clear that they are adequately capitalized.” Yes, sure. If you do your accounting as follows:

Both GSEs continue to note their so-called core or regulatory capital levels remain comfortably above the minimum required by federal regulation. This ignores what would happen, however, if their balance sheets were marked to fair value — or if their fair-value estimates were hugely inflated, as indeed may be the case. Both balance sheets, for one, contain an entry called deferred tax assets that bulks up Fannie’s fair-value net worth by $36 billion and Freddie’s by $28 billion. These assets don’t represent real cash but tax credits the agencies have built up over the years that can be used to offset future profits. But, since the tax assets can’t be sold to a third party, or disappear in a receivership or sale of the company, they are disallowed in the capital computations of most financial institutions. Ironically, the worse a company does, the more capital cushion this asset creates.

People who own investment property and earn more than $250k per year know how this works. People in this category can’t take their Schedule E deductions on that investment property but rather let the deductions they get accrue over time and get to use them as a credit against capital gains when they sell. But it’s the same concept: they and only they get those credits. They cannot be transferred.

Normally Treasury Secretary Henry Paulson is less political and cuts to the point, but his “adequately capitalized” statement was glaringly political at the time as this information proves. Regardless, he or his successor will have to face up to the accounting facts. The public may have approved of his message at the time, but it’s only a matter of time before he has to reduce this accounting shell game to some new pithy statement.

Limiting the role and/or privatizing FNMA/FHLMC is the right thing to do. It’s just a matter of exactly how, and we will surely find out over the next few years.