George M. Mangion | Wednesday, 23 July 2008

Bailing out US mortgages

This month, the shares of mortgage giants Fannie Mae and Freddie Mac fell on news, with the possibility of them facing government bailout. The issue is important to the financial markets and the national economy because both hold more than $5 trillion in mortgages. Fannie Mae and Freddie Mac have awoken to the fact that they own trillions in worthless debt, which will need to be owned (or rather bought) by the U.S government.
Created by the US government, Fannie Mae is a publicly held company that buys home mortgages from banks and other lenders. It keeps some of the mortgages it buys and sells the rest, packaged into securities, to large investors such as mutual, pension and hedge funds. Fannie guarantees the repayment of all mortgages it buys, whether it keeps or sells them. In the past, US government regulators alleged that it has used improper accounting methods that raise serious questions about the quality of its management and the growing spread of its dominance. So in order to create competition, another entity, Freddie Mac was created in 1970 with a similar structure and social mission. Their combined difficulties are of late becoming worse by the minute.
Many sub-prime borrowers unable to meet their mortgage payments had their homes reclaimed by the banks, who sold them off to the highest bidder. When the housing market was rising, this allowed banks to recoup their losses. But with house prices now down between a quarter and a third from their peak – and still falling as the market becomes flooded by bank-owned properties – the markets are not far from full-scale panic mimicking the sub-prime crisis. Fannie Mae may be one of the most ill-fated welfare creations ever on the part of the United States government. Fannie and Freddie were created to specifically address the problem of liquidity in the mortgage market. Traditionally, banks would write mortgages to borrowers on a regional or local level. The amount of loans were limited by the funding that the specific bank could raise and the profitability that it could raise it at. Naturally, the higher funding, the more you can raise mortgages. It goes without saying that pressure on regulators in various countries is mounting. They are more than ever expected to improve public perception of how mega businesses are being regulated. Besides, what safeguards are in place to avoid repeating the recent bad image that the commercial community received after Shell overstated its oil reserves in 2003?
Back to Fannie and Freddie, the two companies borrow heavily to finance their operations, deriving revenue from payments made by homeowners whose mortgages they hold. Together, they stand behind more than $4 trillion of home mortgages. They circulate 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 converting them into securities that are resold to investors. They are the largest source of housing finance in the United States. They are considered to be “government sponsored” because Congress authorised their creation and established their public purposes. The controversy started some years back when Freddie Mac made public an accounting scandal that led to a $5 billion earnings restatement in its accounting period 2000 to 2002, together with a $125 million civil penalty, and the departure of five top executives. Office of Federal Housing Enterprise Oversight investigation revealed that the company had understated profits to the tune of $4.5 billion for 2000-2002 to smooth earnings and meet Wall Street expectations. Regulators found that the company failed to apply generally accepted accounting principles, manipulated earnings to lessen the appearance of volatility and aimed to meet Wall Street’s profit expectations and hand out generous bonuses to executives. The company made generous gains simply by working on the spread by arbitraging the interest rates, from which it generates its net interest income.
At the time of the controversy, Fannie’s executives believed they could run the business on the basis of core business results, which relies on historical cost accounting for assets and liabilities. Now that house values started to tumble, a big gaping hole appeared in the valuations. Contrary to the above-mentioned accounting conventions, Fannie preferred a traditional approach to accounting as in times of stable property prices it then provided the best representation of how the mortgage business operates. But IFRS rules stress that mark-to-market valuation takes a snapshot of the market value of an asset or liability at a specific moment in time. This would be useful for certain investors such as hedge funds that trade securities in the market every day, because that’s how they would determine the net value of their business on a given day. But for portfolio investors like Fannie Mae, some may argue that to hold assets and liabilities to maturity, marking to market is not a very meaningful way to measure how they are doing. Indeed, it might be misleading for management, and investors, to value its performance solely on a mark-to-market basis, during a stable economic environment. Critics of mark-to-market accounting retort that in a rising economy it produces paper gains and losses that a held-to-maturity enterprise may never realise. During the 2002-2003 accounting scandal, auditors detailed numerous transactions over several years where it said Fannie Mae management intentionally smoothed out gyrations in its earnings to show investors it was a low-risk company. Fannie Mae “maintained a corporate culture that emphasised stable earnings at the expense of accurate financial disclosures,” regulators said in a letter to the company. For their part, Fannie Mae executives conveniently replied they believed they were properly applying complex accounting standards that can be interpreted differently. To its defense, Fannie Mae is recognised to maintain stability in the market. During stressful times, such as the global credit crunch of 1998 and post-9/11, Fannie served to stabilise the financial system by keeping housing capital flowing smoothly. But what happens if it were to lose its implied government backing? It has all its eggs in the mortgage basket. In fact 90 per cent of its balance value is mortgage–based activity and suffers from lack of diversification. Can the unexpected happen? Such as the scenario of a system risk of a rapid increase in inflation rates and the collapse of the sub-prime rates that would cause housing prices to decline abruptly. This will increase volatility of its earnings and boost the probability of default as has been stated earlier in this article. To conclude the credit squeeze is threatening to engulf Freddie Mac and Fannie Mae, both of which halved in value recently. Can superman Hank Paulson, the US Treasury Secretary, succeed in negotiating a Congressional bail-out? I think the sooner the better. One never knows what is in store for Fannie and Freddie‘s economic and political future. This may well depend on the decision of the electorate on who is better suited to run the US economy in the coming November presidential election.

George Mangion
Partner at PKF – an audit and business advisory firm
[email protected]