The Potential Crisis at Fannie Mae

Market Commentary by Comstock Partners ^ | 8/11/2005 | Staff Writers

[ex-Texan]

We have no proprietary information about Fannie Mae, but what is publicly known is scary enough.

As you may recall, last December the SEC required Fannie to restate prior financial statements while the Office of Federal Oversight (OFHEO) accused the company of widespread accounting regularities that resulted in false and misleading statements. Significantly, the questionable practices included the way Fannie accounted for their huge amount of derivatives. On Tuesday, a company press release gave some alarming hints on how extensive the problem may be.

The press release stated that in order to accomplish the restatements, “we have to obtain and validate market values for a large volume of transactions including all of our derivatives, commitments and securities at multiple points in time over the restatement period. To illustrate the breadth of this undertaking, we estimate we will need to record over one million lines of journal entries, determine hundreds of thousands of commitment prices and securities values, and verify some 20,000 derivative prices…”

“…This year we expect that over 30 percent of our employees will spend over half their time on it, and many more are involved. In addition we are bringing some 1,500 consultants on board by year’s end to help with the restatement…Altogether, we project devoting six to eight million labor hours to the restatement. We are also investing over $100 million in technology projects to enhance or create new systems related to accounting and reporting…we do not believe the restatement will be completed until sometime during the second half of 2006…”

It seems to us that anybody reading that press release should be shocked by what appears to be the paucity of knowledge about what is going on at a company of such great size and importance to the U.S. economy. About 18 months ago Fed Chairman Greenspan stated that problems at both Fannie Mae and Freddie Mac had the potential to bring down the financial system. He stated at the time that, “…Most of the concerns associated with systemic risks stem from the size of the balance sheets that these GSEs (government-sponsored enterprises) maintain…”. He added that the immense size of their holdings and the need to keep growing to satisfy their shareholders made them increasingly vulnerable.

The White House, too, in its 2003 budget report, expressed their concerns. They stated that although both GSEs tries to limit their risks through various risk-management methods, these techniques “do not eliminate all the risk associated with funding long-term, mostly fixed-rate assets that have uncertain payment streams… Furthermore, the hedging transactions transform credit or interest rate risk into counterparty risk (the risk that a counterparty of a hedging transaction fails to honor the contract). Thus the GSEs management of counterparty risk is of increasing importance”.

Now it appears that Fannie Mae’s internal controls have been so weak that no one actually knows what the risks are or what the auditors will find—and we won’t know for at least another year. For a company as important to the U.S. as Fannie Mae, this is a national problem with widespread potential for developing into a dangerous financial crisis.

[ex-Texan]

Fannie and Freddie are bankrupt. Everybody in government is aware of it. The mainstream media are ignoring what may be the 'biggest story' of the past five years. Have you seen a report about Fannie and Freddie on television recently? Read about this scandal in the news papers? Huh? Duh?

How many billions will be required to bail out Fannie and Freddy? 30 Billion? 100 Billion? More? And what will be the effect on the U.S. economy when the mainstream media starts to report the facts? Will people be happy and cheery and optimistic? Or, will they be upset and outraged?

In the meantime, the real estate bubble is nearing its peak. Housing sales are beginning to stall and stumble nationwide. Speculators are grumbling in La La Land, worried they may have to dump and run. Guess Greenspan can keep his mouth shut for another two years? Guess again, people. There is a light at the end of the tunnel. It's a speeding train. Want to learn more?

[Eagles6]

save

[redgolum]

Talked with a few friends last night. Gas prices and rising interest rates have slowed home sales in some areas. People are getting worried about their interest only loans and the adjustable rates. Right now, the long term rates are still very low, but that could change.

Hopefully, it is just a slow cool off of prices, not a crash.

[stefan10]

I make research on risk management systems used by banks to predict bankruptcy mainly for large and middle companies.


While we see here in europe huge and growing problems for companies but also private people to get loans because of the risk management of banks and the new rules of Basel II.

Banks in the US are able to outsource their risk to these two "public" companies. In the end the markets believe that if there will be a problem the tax payer will take the burden to stabilize the financial system. If someone looks at the numbers of mortgages and other loans and the amount of the debt of US households it is clear that if we see a different trend on the real estate market a lot of mortgages and loans will need a devaluation. This could lead to problems of fannie and Fredie and for the hedge fonds and investors that bought their papers.

I am very interested to hear more about that topic

[Inwoodian]

And amidst it all the die-hard Clintonians like Franklin Raines, Jamie Gorelick and Jack Quinn fleece the dying carcass of multi-millions in salary, bonuses and golden parachutes. They should all be fitted for striped jumpsuits.

[Just mythoughts]

"Fannie and Freddie are bankrupt......"


Protected via a gorelick wall.

[Lobbyist]

Thank you for your input.

[ex-Texan]

The hedge funds are having major problems. Visit my FR page and check the links there. What mortgage companies do in the U.S. is package loan portfolios as CMO's and then sell them on Wall Street. The under performing loans may be sold again and again until a potential foreclosure scenario develops. Add to the equation mortgage brokers, mobsters and slicksters trying to get rich quick.
Problems with mortgage fraud, loan servicing schemes and illegal foreclosures are endemic. Check my posts for more details.

[ex-Texan]

I agree 100%. Gorelick would be a prime target for a Justice Department investigation, but for the fact she was
"Wookie's" favorite pet under Clinton. Or, was she on top with Clinton lurking . . . Oh, well, you get the picture.

[DH]

What did I miss in this report? Somehow I didn't read anything about anyone being fired or held responsible for this mess.

Oh, I forgot....no one in government (or managing a government enterprise) is ever held responsible or fired for poor performance or criminal activity.

[WoofDog123]

"“…This year we expect that over 30 percent of our employees will spend over half their time on it, and many more are involved. In addition we are bringing some 1,500 consultants on board by year’s end to help with the restatement…Altogether, we project devoting six to eight million labor hours to the restatement. We are also investing over $100 million in technology projects to enhance or create new systems related to accounting and reporting…we do not believe the restatement will be completed until sometime during the second half of 2006…”"

Some here may think this is embellishment, but working at a firm specializing in CMO's, I know there is a lot of truth to it. The scary part is there are not enough people who can knowledgably price CMO's available to do this work, even if they were willing to give up their own careers.

I bet most of the folks they end up with cannot clearly enunciate the differences between an i/o, an inverse floater, a p/o, or describe how each would be expected to act under various rate scenarios.

[staytrue]

I think freddie is leveraged at about 90 to 1. Fannie is leveraged to about 1000 to 1 and is much bigger too.

Freddie is probably ok. Fannie is the pink elephant in the living room.

[Ann Archy]

Jamie Gorelick MUST g down for this AND Abel Danger!!

[quantfive]

Fannie and Freddie are bankrupt. Everybody in government is aware of it. The mainstream media are ignoring what may be the 'biggest story' of the past five years. Have you seen a report about Fannie and Freddie on television recently? Read about this scandal in the news papers? Huh? Duh?
How many billions will be required to bail out Fannie and Freddy? 30 Billion? 100 Billion? More? And what will be the effect on the U.S. economy when the mainstream media starts to report the facts? Will people be happy and cheery and optimistic? Or, will they be upset and outraged?

In the meantime, the real estate bubble is nearing its peak. Housing sales are beginning to stall and stumble nationwide. Speculators are grumbling in La La Land, worried they may have to dump and run. Guess Greenspan can keep his mouth shut for another two years? Guess again, people. There is a light at the end of the tunnel. It's a speeding train"

I don't know if it is as catastrophic as your making it out to be, however the perfect storm of outrageous energy prices, trickle down effect of energy, surging home prices, brutal health care costs, real-estate bubble and an overseas engagement draining our resources will cause a deep recession in 2007.

A lot can happen between now and then to soften the landing such as a housing correction instead of a bursting bubble, energy prices easing and continued if modest gains in personal wages and business growth, and increased regulation of interest only and other risky loans.

[SierraWasp]

Pingin Grampa Dave and a couple other FRiends

[BOBTHENAILER]

Mae's Fannie is getting buggered.

[Southack]

"Fannie and Freddie are bankrupt. Everybody in government is aware of it. The mainstream media are ignoring what may be the 'biggest story' of the past five years."

No, no, and no.

FNM has some problems, but overstating its problems to such a degree (bankrupt!) is irresponsible.

In the past, FNM has been a cushy place for the reigning political Party of the moment to park their friends in nice jobs. Under the Clinton Administration, this got out of hand. The goons parked in FNM got greedy, and worse, they were smart enough to game the bonus system.

To insure that they got maximum salary bonuses each year, the top FNM execs began sandbagging. Sandbagging is when you **HIDE** excess profits in good years so that you can expose those profits in lean years (in order to make your bonus target each year).

The accounting term for this trick is called "smoothing" because you are rigging the accounting books to show smooth, predictable earnings in an unpredictable business.

One such trick is to expense your derivatives higher than they actually cost. Then, if you later need to show a bigger profit, you restate earnings by showing the actual cost of those derivatives. There are many, many other such tricks.

But hiding profits doesn't mean that you are bankrupt. Restating earnings after such shenanigans have been used, however, will show losses for some years and gains for others, compared to what the cooked books were showing, anyway.

That's not bankruptcy, however. FNM has massive cash flow income, can cut its expenses (e.g. derivatives) at a moment's notice, has liens on massive quantities of assets, has the assets themselves insured by a widely diverse group of insurers, has the notes for the liens insured through a completely different pool of insurers, and has the insurers themselves insured through entities known as "re-insurers," among other financial protections to their business.

It would take a lot to break up all of those levels of protection. We haven't seen a lot.

We've seen some "smoothing" going on; some cooked books that hid profits for some years in order to falsely report those profits in other years.

That's all going to be re-stated. New losses and new profits are going to be reported. Focus on just one (e.g. just on the losses) and you'll miss the true picture. Heck, you'll probably be frightened out of your wits for the very security of our entire economy if you only focus on the one rather than look at both.

[RegulatorCountry]

" the insurers themselves insured through entities known as "re-insurers," among other financial protections to their business."

Shenanigans in re-insurance are not inconceivable. Are you familiar with Maurice Sabbah and Fortress Re?

[staytrue]

I think Freddie is ok. the leverage at freddie is "only" about 100-1 while at fannie it is about 2000-1. further freddie is "only" about 1/10 the size of fannie.

If anything brings down the US economy, it will be fannie, not freddie.

[Just mythoughts]

"I think Freddie is ok. the leverage at freddie is "only" about 100-1 while at fannie it is about 2000-1. further freddie is "only" about 1/10 the size of fannie.

If anything brings down the US economy, it will be fannie, not freddie."


Could well be, I have been watching to see what method and path Hillry could have been talking about when she was squealing to her high dollar rollers in CT talking about a Bush economy was same a a "Hoover economy".