Fannie Mae, Freddie `House of Cards’ Prompts Takeover

By Dawn Kopecki

Sept. 9 (Bloomberg) — Fannie Mae and Freddie Mac used accounting rules that created a “house of cards” as the housing market descended into its worst slump since the Great Depression.

While the two largest mortgage-finance companies met regulatory requirements for their capital, reviews by the Treasury, the Federal Housing Finance Agency and the Federal Reserve found they probably wouldn’t weather the highest delinquency rates on record, lawmakers and regulators said.

“Once they got someone looking closely at Fannie and Freddie’s books, they realized there just wasn’t adequate capital there,” U.S. Senator Richard Shelby of Alabama, the ranking Republican on the Senate Banking Committee, said after a briefing by Treasury officials. “They found out they had a house of cards.”

Treasury Secretary Henry Paulson and FHFA Director James Lockhart seized control of Fannie and Freddie less than a month after Lockhart, whose job is to oversee the companies, declared them “adequately capitalized” under law. The discrepancy highlights the flaws in legislation and in the regulatory oversight of Fannie and Freddie that didn’t demand they keep more assets as a cushion against losses, according to Joshua Rosner, an analyst with Graham Fisher & Co. in New York.

“Fannie and Freddie’s accounting during the housing crisis appears to have been more fantasy than reality,” said Rosner, who first highlighted problems in 2003, before the two companies were forced to restate about $11.3 billion in earnings.

`Not Adequate’

Washington-based Fannie had $47 billion of regulatory capital as of June 30, about $9.5 billion above what FHFA required, according to company filings. McLean, Virginia-based Freddie’s capital stood at $37.1 billion, a cushion of about $2.6 billion over FHFA’s standard, filings show.

“They met the legal definition,” Lockhart said in an interview with Bloomberg Television yesterday. “As I have been telling lawmakers for a long time, that legal definition was not adequate.”

As their stock prices declined and yields on their debt rose to the highest in at least 10 years above benchmark rates, the FHFA saw “big questions out there,” Lockhart said.

“The issue is that the exposures are continuing and continuing to grow and it looked like in the future there were going to be significant issues and they were going to have capital problems,” Lockhart said.

Lockhart said he brought in financial examiners for the Federal Reserve and the Office of the Comptroller of the Currency to help with a review of the companies’ finances. Treasury also sought help from Morgan Stanley officials, who prepared a report after trawling through the accounts.

`Too Low’

After looking through the finances, Fed examiners deemed their capital reserves too low, Dallas Fed President Richard Fisher said yesterday.

“We concluded that the capital of these institutions was too low relative to their exposure,” Fisher said in response to an audience question after a speech in Austin, Texas. Further, “that capital in and of itself was of low quality.”

Fannie counted $20.6 billion in so-called deferred tax credits toward its $47 billion of regulatory capital as of June 30, according to company disclosures. Freddie applied $18.4 billion in deferred-tax assets toward its $37.1 billion in regulatory capital in the second quarter.

Fannie and Freddie have posted four straight quarterly net losses totaling a combined $14.9 billion and have said they anticipate more. The tax credits don’t have any value unless the companies are generating profit.

`Not Even Real’

“That’s not even real money,” Shelby said.

Senator Christopher Dodd, a Connecticut Democrat and chairman of the Senate Banking Committee responsible for oversight of the companies, said yesterday he plans to hold hearings on why the Bush administration didn’t act sooner.

“Why weren’t we doing more, why did we wait almost a year before there were any significant steps taken to try to deal with this problem?” Dodd said in a Bloomberg Television interview. “I have a lot of questions about where was the administration over the last eight years.”

Market Value

After more than eight years of debate, Congress passed a law in July expanding Lockhart’s authority to raise capital requirements, curb growth and to take over the companies’ operations in a conservatorship or liquidate their assets under receivership. The legislation also gave Paulson temporary power to inject unlimited sums of taxpayer money into the companies.

The companies just four years ago admitted to $11.3 billion in earnings misstatements that led to $525 million in federal fines, tighter regulatory controls and the ouster of the CEOs.

Paulson said he stepped in to prevent a collapse of the companies, protecting investors owning more than $5 trillion of Fannie and Freddie corporate debt and mortgage-backed securities while potentially sacrificing holders of the common and preferred stocks.

The companies yesterday lost the majority of their market value, with Fannie falling 90 percent to 73 cents in New York Stock Exchange composite trading, its lowest level since 1982. Freddie dropped 83 percent to 88 cents, the lowest since the regular common stock began trading 20 years ago.

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