Fannie Mae Warns of Possible $9 Billion Loss

NY Times ^ | Published: November 16, 2004 Filed at 4:55 p.m. ET

[DeaconBenjamin]

Shares of Fannie Mae slipped Tuesday as the mortgage giant's outside auditor KPMG refused to sign off on its third-quarter earnings report, causing the company to miss a regulatory deadline for filing it.

The company's stock fell 80 cents, or 1.1 percent, to close at $69.40 on the New York Stock Exchange.

Fannie Mae, whose accounting is under investigation by the Securities and Exchange Commission, also said Monday that if the agency finds that it has improperly accounted for derivatives -- the financial instruments it uses to hedge against interest-rate swings -- it would show an estimated net loss of $9 billion for the July-September period. And it acknowledged that some of its accounting policies do not comply with generally accepted accounting principles.

Washington-based Fannie Mae, which finances one of every five home loans in the United States, disclosed the SEC investigation on Sept. 22, stunning investors.

The company, recently cited by regulators in the Office of Federal Housing Enterprise Oversight for serious accounting problems and accused of earnings manipulation, notified the SEC Monday that it would not file the third-quarter report on time.

The OFHEO regulators had ordered Fannie Mae to make massive recalculations, and the delay fueled speculation as to whether the company would restate earnings.

SEC spokesman Matt Well declined comment on the filing as did Corinne Russell, a spokeswoman for OFHEO, an independent agency within the Department of Housing and Urban Development. Spokesmen for Big Four accounting firm KPMG could not be reached for comment Monday.

In its filing notifying the SEC, Fannie Mae said it ``is not able to file a timely (quarterly report) that complies with the SEC's rules because it has been advised by its independent auditor that it is unable to complete its review of Fannie Mae's interim unaudited financial statements for the quarter ended September 30, 2004.''

Fannie Mae also acknowledged that some of its accounting policies do not comply with generally accepted accounting principles, apparently contradicting recent public statements by top executives who have defended the company's accounting.

Chief executive Franklin Raines and Chief Financial Officer Timothy Howard insisted in sworn testimony at a congressional hearing last month that the HUD regulators' allegations of accounting improprieties and management misdeeds going back to the late 1990s were a matter of interpreting complex rules.

In its filing Monday, the company said it ``recently determined that its methodology for performing'' some calculations for 2001 and 2002 balance sheets ``was not consistent'' with generally accepted accounting principles. It said it expects the effect of the discrepancies will be an increase in earnings for 2001 and 2002, and a decrease in 2003 profits, ``with the cumulative effect of these changes across the three periods netting to zero.''

The ``catch-up'' calculations in question were related to 1998 expenses that OFHEO had said the company incorrectly put off to future periods so that top executives could collect full annual bonuses.

The stakes are high for Fannie Mae, the second-largest financial institution in the country behind Citigroup, which also faces a criminal investigation by the Justice Department.

The SEC inquiry makes things potentially tricky for Fannie Mae. Also by law, the quarterly financial reports must be certified in writing by Raines and Howard.

If the SEC investigators turn up accounting violations in the quarter, that could expose Fannie Mae and its executives to legal liability with shareholders and others, some analysts say.

A restatement could lead Fannie Mae's board to shuffle the company's executive ranks.

Fannie Mae and its smaller sibling Freddie Mac pump money into the home mortgage market by buying and guaranteeing repayment of billions of dollars of home loans each year from banks and other lenders, then bundling them into securities that are resold to investors. Their stock and debt are widely held by investors worldwide.

[Roy Tucker]

As Warren Buffett says, "It is interesting to see who's swimming naked when the tide goes out."

[rollin]

Definitely time to go short FNM~

[JasonC]

Fannie owns hundreds of billions in loans that it has kept on its own books. It finances them with hundreds of billions in private borrowings, not mortgages, from investors in its own debts. Then in addition, it actively hedges to try to keep the two sides, long and short, roughly even, to reduce exposure to changes in interest rates. When it does so, somebody else takes the other side of every bet (swap agreement, repurchase agreement, etc) that it enters. The notional value of those is well into the trillions. The risk equity that protects all of these operations from default is very thin compared to those figures.

If their books are kept honestly, and they run their derivatives operations correctly, to reduce risk all the time, then their capital may or may not be adequate to cover any losses they are exposed to, but the downside for all the debts would be modest. Mostly, the collateral would match the liabilities. But not exactly, because they are so large if they became a distressed seller of a given class of security, they would sink the price. But none of that is the worry.

The worry is they may have played bubble accounting, counting their winnings differently than their losses and the like. Then their matched book might not be so matched. They might have assets that are only supposed to pay them eventually over 10 or 20 years, that might fall in value due to early refinancings and the like. While they might owe payments on current debts, and on swap agreements, that have to be paid right away.

See, the money Fannie bets on things, leveraged out the wazoo to make the most of its marginally better credit rating, is not its own. Everything is promised someplace else. The horse can easily need to be in two places at once. The ultimate collateral for it all might be a trillion in mortgages, but if they have two trillion in liabilities what good is that?

Land banks have a poor track record for financial soundness. The reason is their assets or the ultimate collateral for their assets tend to be more speculative than people assume in good times, and far less liquid than normal operations lead people to expect, whenever a big player in those markets is in distress.

We have regulators to catch this stuff and stop it from getting out of hand. They can do things like require a company to raise more risk capital, or to sell off both assets and pay down debts, shrinking both sides, to increase their effective cushion. And they can require they count their winnings and losings in conservative ways, etc. That usually works. But it isn't a good sign when the accountants refuse to certify their books. It usually means somebody has been hiding significant losses for some time, and has been caught at it.

The level of attention Fannie gets might mean they've caught things before that, and are just being especially careful. Time will tell. At the very least, the announcement of a refusal of the accountants to certify, will mean a bath for the shareholders and probably a serious management shake up as well.

[Captiva]

MBS are just that. MBS. They are not backed by the equity of Fannie Mae. They are backed by real estate. The only thing FNMA guaranties on their MBS is the timely payment of principle & interest from the mortgages. Worst case scenarios -if/when borrowers stop paying on their loans Fannie owns the home.. Sells the home.. Pays of the MBS investor. It's an over-simplification but I'm tired.

Now you are totally correct about their corporate debentures....

[Captiva]

She probably has no idea of what FNMA does.

[Captiva]

The worry is they may have played bubble accounting, counting their winnings differently than their losses and the like. Then their matched book might not be so matched.

Isn't this all a accounting shell game? When to "recognize" this income or that expense. This is what I can't stand about accounting.

Organized crime handles finances waaaay better than FASB. Cash in. Cash out. You no pay. I break leg.

[JasonC]

No it is not all an accounting shell game, and if they only tracked cash in and cash out that would be a shell game itself. The fact that accounting is non trivial or that you can't stand it does not make it unreal or unimportant.

Cash doesn't tell you anything because the whole point of financial transactions is they involve intratemporal trades. The timing of things matters as much as the amounts. The way in which amounts and times are related is a complex structure of interest rates. Which are a moving target, not something that sits still over the time periods involved.

Mortgages have embedded real options. Anyone is allowed to refinance a mortgage by pre-paying the principle. That means a mortgage involves a kind of downward ratchet on the interest rate - if the rate drops it will be refinanced, if the rate increases it will not be. This makes the total payments that will be received for a mortgage with known terms, an uncertain thing, that depends in a second way on the entire path of interest rates over the term of the loan.

Which is plenty complicated. If someone puts up all the money for a mortgage loan, and holds it until it is refinanced or paid off, then that just shows up in when he gets his money back and what overall rate of interest he will earn. But if he uses somebody else's money, borrowed money, then his position includes the uncertain mortage credit, and an often different loan debit. If the second is more certain than the first, then the uncertain bit is magnified in its importance, for the overall result.

There is no way any institution can hold trillions in such assets, with trillions in debts to others financing those holdings, without knife edge accounting issues mattering. Why do institutions like Fannie lend and borrow trillions? Because they have marginally better credit than banks. They earn maybe 0.1% on the differences, if they do everything right.

Their whole point is to shave tiny bits for huge quantities. There is no way to operate as a shaver of tiny bits of huge quantities, without every minute detail of the huge quantity part of the accounting, mattering for the tiny bit part. Some people (firms) may be able to get away with ignoring or oversimplifying accounting trivia. Fannie is not one of them.

[GeronL]

AGain??? Another multi-billion loss???

PRIVATIZE!!!!!!

PRIVATIZE!!!!!!!

[Roy Tucker]

Yup. I wouldn't be holding any of their paper either.

[Roy Tucker]

GeronL is right. Why is the Government in the business of packaging mortgages. I also think his one word advice is the answer to government deficits at the state and federal level. We should be looking to privatize as many services as possible. The independently financed Government agency route is a recipe for disasters such as Amtrak and Fannie Mae.

[Johnnyboy2000]

Fannie Mae doesn't arrange houses for people. It buys mortgages from lending institutions. You are thinking of HUD and the FHA. You like many people in this thread do not know what Fannie Mae is. All these people on here who think Fannie Mae is setup to help the DNC and poor people do not have a clue what they are talking about. You are thinking of Section 8 Housing.

[Johnnyboy2000]

Fannie Mae is oine of the largest private companies in the world. It is not run by the government. You are thinking of Freddie Mac, and you do not know what you are talking about.

[Johnnyboy2000]

"End of REAL-ESTATE bubble is in sight.

"It's got to end at some point, but Fannie Mae's stock hardly budged on the news. I don't think this will be the catalyst."

Wrong. First of all there is not such thing as a real estate bubble, because it has real value. The real estate market is driven by supply and demand. It is not Yahoo stock. Anyone expecting real estate values to freefall is way off. The values on the east and west coasts will keep going up because there is a limited amount of housing. There is a housing shortage in many areas, and that will continue to drive values up. Interest rates may cause the markets to level, but the values will not go down. Long term the values will keep going up.

[traviskicks]

hmmm... thanks for that information. I'd like to read more about the regulations and 'liabilities' etc.. that surround them. I guess I'll withhold further comment until I know more.

[traviskicks]

ahh.. I went back over the thread and read your 2 long, thoughtful and informative posts. I think I did the same thing someone else did earlier and mixed up freddie mac and fannie may.

thanks again for that info.

[LaGrone]

Take their million dollar bonuses back for starters. Someone or more likely many should go to jail for knowingly cookin the books.

Start with Gorelick and Raines please.

[Joe Hadenuf]

The real estate market is driven by supply and demand. It is not Yahoo stock. Anyone expecting real estate values to freefall is way off. The values on the east and west coasts will keep going up because there is a limited amount of housing.

I couldn't agree more.

[Southack]

"You are forgetting all of those FNMA mortgage-backed securities that are owned by every pension fund in America. Several trillion dollars worth..."

No, I'm not forgetting it. On the contrary, I'm *remembering* that "mortgage-backed" securities are...drum roll...backed by home mortgages.

Every *penny* inside mortgage-backed securities is backed by a tangible asset such as a house, backed by an individual borrower such as a civilian homeowner, further backed by mortgage insurance in case the individual borrower defaults, and then the entire package of mortgages is finally "wrapped" in yet another layer of insurance that by law has to come from a completed unrelated insurance company than the individual default insurance.

Fannie Mae purchases home mortgages, loans money to companies to issue home mortgages, and writes its own home mortgages. FNM then takes groups of those home mortgages, wraps them in another layer of mortgage insurance, and then sells that package of loans to other investors such as pension funds.

So there is nothing to "bail out." Fannie Mae could go bust tomorrow and all of those home mortgages would still be getting monthly mortgage payments from individual home owners. None of that debt is dependent upon FNM surviving.

The investors who purchased those securities are looking to the individual homeowners to repay all of that debt, not to Fannie Mae.

So whether or not Fannie Mae is solvent has little bearing on anything besides who makes a market in buying and issuing brand new home mortgages...hardly something that needs a bailout simply because those new home mortgages haven't even been written yet.

[Rain-maker]

Higher rates and limited loans decrease demand, then prices fall.

Simple supply side economics.


As for coastal areas:

Bay Area Housing Crash Continues
http://freerepublic.com/focus/f-news/1067383/posts?page=81

[Southack]

"If I understand correctly, Fannie Mae simply buys the loans from the bank and sells them out to investors. They don't "back" them from there. They're not going to "go under" and cause a massive bailout. The investors who own the mortgages aren't going to lose their investments just because the broker goes under."

Correct. Well, that's a pretty simplified version, but yes, FNM is buying home mortgages, wrapping them with an extra layer of additional insurance into packages, and then selling those packages of loans to pension funds and other conservative investors.

NOTE: the investors who purchase those packages of loans are getting repaid by the homeowners...that's where your monthly mortgage payment goes. Those investors are *not* being repaid by Fannie Mae. Fannie Mae can go under and everyone is still going to be making their monthly mortgage payments on their homes.

So there isn't anything to "bail out." The investors who purchase those loan packages don't need a bailout because millions of homeowners aren't defaulting. Homeowners don't need a bailout because they've already had someone transfer the money required to purchase their homes.

Who the heck is going to get bailed out, and why? For what?

Fannie Mae simply buys a lot of home mortgages. This article says that they buy 20% of them. Well, if Fannie Mae goes bust then the buyers of the other 80% of all home mortgages will have ample opportunity to expand their marketshare at Fannie Mae's expense.

So what's to be bailed out?!