The
news yesterday was not pretty.
The investigation showed executives embellished the company's earnings over the years by overvaluing its assets, underreporting credit losses, and misusing tax credits, the sources said.
Several of these people examining Fannie's books also said evidence indicates the company purchased so-called finite insurance policies to hide earnings losses after they were incurred.
[...]
This is only the latest in a
long line of financial irregularities from the mortage giant.
Fannie Mae chief executive Franklin Raines and chief financial officer J. Timothy Howard left the company in December 2004 after two federal agencies accused Fannie Mae of improper accounting amounting to $9 billion (the SEC's top accountant said that Fannie misstated earnings for 3 and a half years). Investors are still waiting for Fannie Mae to restate earnings going back to 2001.
Freddie Mac was involved in another accounting controversy in 2003.
All these scandals are starting to
hurt their stock prices.
First of all, a little background:
Fannie Mae was created in 1938 as part of the Reconstruction Finance Corporation, during the Franklin D. Roosevelt administration, to purchase Federal Housing Administration loans. As a Government Sponsored Enterprise (GSE) together with Freddie Mac, it is exempt from SEC registration while being listed on stock exchanges. It is subsidised by being exempt from many state and local taxes, which gives it a distinct advantage over other normal participants in the free market.
Fannie Mae and Freddie Mac support about three quarters of all American home mortgages, to the tune of about $4 trillion.
Here's how they work:
- Home buyers take out mortgages from lenders, e.g. banks.
- Lenders sell mortgages to GSEs, or exhange them for mortgage-backed securities which they can then sell.
- GSEs repackage mortgages into mortgage-backed securities and sell them to investors.
- Lenders offer new loans to home buyers fuelled with the funding for previous mortgages from the GSEs.
Fannie Mae has over $700 billion of obligations in bonded debt, and in total combined with mortgage-backed securities and derivatives, obligations amount to trillions of dollars. A default on Fannie Mae's bonds would dwarf Worldcom ($23.2 billion), Quest Capital ($12.9 billion), Enron ($9.9 billion), Parmalat ($7.2 billion), Conesco ($5.1 billion) and Argentina in 2001 ($76.7 billion) all put together - many times over! To say this would pose a systemic risk to the financial system might be an understatement.
Now the federal government hasn't underwritten these $4 Trillion in mortgages, but there has always been an "unspoken understanding" that the federal government wouldn't let the GSE's fail. With that "understanding", the GSE's have always been able to borrow at much lower interest rates than truly private entities.
Because of their size and complexity, there was already a
great deal of worry out there.
Republican Representative Richard Baker of Louisiana was reported in the August 2002 issue of Washingtonian magazine as having said this about the GSEs:
"The taxpayers are living under an enormous rock suspended by a single rope. Once it breaks, there's no recovery."
The Economist has described Fannie and Freddie as "arguably the most worrying concentrations of risk in the global financial system."
St. Louis Federal Reserve Bank President William Poole gave this warning in 2003, which caused the GSE stock to immediately fall 6%:
"Today, the housing finance system is heavily concentrated. Just three firms- Fannie Mae, Freddie Mac and Ginnie Mae- account for over 40 percent of the residential mortgage market. Ginnie Mae is backed by the full faith and credit of the U.S. Government Fannie Mae and Freddie Mac are not so backed, and hold capital far below that required of regulated banking institutions. Should either firm be rocked by a mistake or by an unforecastable shock, in the absence of robust contingency arrangements the result could be a crisis in U.S. financial markets that would inflict considerable damage"
In 2003, Fannie and Freddie had a leverage ratio (defined as total assets divided by total equity) of 63.1 and 38 respectively, whereas the average bank in the S&P banking index had one of 11.3.
Assets, to a bank, is often another word for "liability".
So what does this all mean? Well, for starters, a crisis at FNM means that mortage rates would shoot through the roof. But that would only be the start. A bond crisis would go right along with it, which means a drying up of liquidity (for the consumer, this means credit).
It then depends on how bad things get. Fannie Mae kind of lands in the "too big to fail" catagory. But it is so big that it borders on the "too big to save" catagory. It's hard to see Fannie Mae going under without effecting Freddie Mac as well (and Freddie Mac isn't without it's own financial scandals).
Would the federal government try to borrow the hundreds of billions required to bail out the GSE's? And if they did, could they actually be able to borrow all that without it driving the interest rates for treasuries through the roof?
Would the federal government simply print dollars to bail out Fannie Mae? Things like that have been done before.
Stay tuned.