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In the end, the U.S. government takeover of housing giants Fannie Mae and Freddie Mac was inevitable.
The two companies were seized Sunday morning, Sept. 7, as Treasury Secretary Henry Paulson placed Fannie Mae and Freddie Mac under a conservatorship, giving the reins for their future management to the Federal Housing Finance Agency (FHFA).
The government intervention marks a watershed moment in U.S. history. It is the largest financial bailout the country has witnessed to date, following on the heels of another government rescue in March: Investment bank Bear Stearns, which was sold to JPMorgan Chase in a deal engineered and backed by nearly $30 billion in government financing.
Combined, Fannie Mae and Freddie Mac own or back half of the nation’s mortgage debt, more than $5 trillion. Now, these liabilities rest firmly with the American taxpayer.
For years, the monolithic structure of Fannie Mae and Freddie Mac has been cause for concern, with critics calling for tighter regulatory standards and stronger risk management measures to minimize risks to country’s larger financial system and taxpayers.
That didn’t happen. Instead, both companies enjoyed a host of privileges, including special lines of credit, because of their government-sponsored status. Flawed business models, conflicts of interest, inadequate capital reserves, continued exposure to risky loans and major accounting errors became the norm.
Last month, Treasury Secretary Paulson - the former chairman of Goldman Sachs - hired investment bank Morgan Stanley to investigate the financial books of Fannie Mae and Freddie Mac. Findings from the probe showed that the accounting methods of the two companies, though legal, overstated the true value of their capital reserves.
The use of questionable accounting methods to pump up the financial cushion of a business is the subject of Gretchen Morgenson’s Sept. 7 column in the New York Times, in which she writes that Fannie Mae and Freddie Mac relied on deferred-tax assets - credits accumulated over the years that can be used to offset future profits - to inflate their financial positions. Using this method, Morgenson concludes that Fannie Mae increased its worth by $36 billion, and Freddie Mac, $28 billion. The problem is these credits have no value unless the companies generate profits.
In the past year, shares in Fannie Mae and Freddie Mac have plummeted, dropping more than 90% in value.
As Morgenson notes, the majority of financial institutions are not allowed to count deferred-tax credits as assets. The credits themselves cannot be sold and disappear in the event of receivership.
Moreover, it appears that both Fannie Mae and Freddie Mac added to the illusion of stable financial health by taking a lax approach on when to recognize losses on defaulted loans. According to the New York Times article, Fannie Mae and Freddie Mac extended a 90-day past-due loan to two years.
This means thousands of loans that previously would have been marked down were in essence allowed to maintain their value.
As early as 2003,
