Fannie/Freddie – Massive Fraud Breakdown

Posted on September 7th, 2008 in Daily Mortgage/Housing News - The Real Story, Mr Mortgage's Personal Opinions/Research

So, the tax payers get stuck with this mess!  Phonie and Fraudie got busted cooking the books.  We will see if Paulson does the right thing here. He has a chance. Bill Ackman laid out a great plan two months ago that would work fine.

I believe Gretchen Morganson’s story out late yesterday changes the game here. This bailout is not some sort of a proactive, warm and fuzzy, well-thought out move as its being portrayed.  As it turns out, this looks like the largest two business failures in history due to absolute fraud.  Freddie Mac was the primary target and Fannie had to give in due to it. But Fannie would have likely suffered the same fate anyhow so they threw her in the mix.

I have been a complete advocate of nationalization and ‘explicit’ loan guarantees going forward. This will promote healthy buying of Fannie/Freddie debt and makes it so nationalization does not interrupt the healing of the mortgage and housing sectors.  But it is not some magic bullet by any means. For all intents and purposes nothing changes with respect to mortgage lending to consumers from Friday.  Perhaps rates will come down a bit but for all intents and purposes they are ‘historically low’ already so they say.

This is exactly the reason they were taken over this weekend. Things were about to change in a very bad way. Due to massive fraud within these companies, they were about to implode.  Deloitte and Morgan Stanley discovered this.  As you can imagine, an outright implosion of the two would have done bad things to the financial markets. 

What I am still most freightened of and what I believe will do bad things to US Treasuries, the Gov’t and the tax payers balance sheets is the retroactive, open-ended backing of the $5.2 trillion in total loan guarantees, much made during the worst years of mortgage finance. I believe Congress would have to approve this anyway but Paulson could do much to get it going in that direction.

The GSE’s have a total combined $1.2 TRILLION in Subprime and Alt-A exposure that they have told us about. But, we know now that they covered up many other things so exposure is likely greater. On top of this, they likely have several hundred billion in higher grade guarantees that will act much closer to Subprime and Alt-A in the future.  This is due to their faulty automated underwriting systems, DU and LP respectively, set to ‘way too easy’ mode during the bubble years.

Lets pretend they have $2.25 trillion in ‘at-risk’ mortgage exposure. If 33% lose thier home (less than private lebal final estimates) at a 50%-60% loss, which is about typical now but should increase in the future, then we are talking about $450 billion in losses.  Those of you who tell me ‘it won’t be that high’ obviously did not watch underwriters put the exact same loan through DU or LP 25 times until they got the approval results and conditions they wanted. Or, watch all appraisers find the most expensive comparable  vs the ‘closest comparable properties’.

Let’s go through Gretchen Morganson’s story and pull out the good stuff.

Loan Giant Overstated the Size of Its Capital Base By GRETCHEN MORGENSON and CHARLES DUHIGG Published: September 6, 2008

As a result of the government’s intervention, the cost of borrowing for Fannie Mae and Freddie Mac should decline, because the government will be insuring their debts. Equally important, because the government is backing the companies, they will continue to buy and selling home loans. (I agree. If they ‘explicit guaranty loans going forward, their MBS will sell just fine. But how much lower can rates fall with most thinking the ‘implicit’ was ‘explicit’ anyway. I do not think this will have much impact. As a matter of fact, saddling the US Treasury and US tax payer with open-ended, retroactive backing of the $5.2 trillion in past guarantees could tear apart US Treasuries increasing borrowing costs for everyone)

But the plan will probably do little to stop home prices from falling further. And foreclosures are almost certain to rise.

(Funny – the words ‘last month’ and ‘always used here) The Treasury secretary, Henry M. Paulson Jr., who won authority from Congress last month to use taxpayer money to bolster the companies, always maintained that he hoped never to use that power.


last week, advisers from Morgan Stanley hired by the Treasury Department to scrutinize the companies came to a troubling conclusion: Freddie Mac’s capital position was worse than initially imagined.

Freddie Mac had made accounting decisions that pushed losses into the future and postponed a capital shortfall until the fourth quarter of this year, which would not need to be disclosed until early 2009. Fannie Mae has used similar methods, but to a lesser degree,

While Freddie Mac’s accounting woes make it easier for regulators to force the company into conservatorship, there was more resistance from Fannie Mae, according to people familiar with the discussions. Once the government took action against Freddie Mac, however, confidence in Fannie Mae would certainly waver. Given Fannie Mae’s declining financial condition, the company has few options but to concede to the government’s demands.

(the former CEO’s look like super-stars) Accusations of questionable accounting are not new for either company. Earlier this decade, both companies paid large fines and ousted their top executives after accounting scandals.  Freddie Mac’s current chief executive and chairman, Richard F. Syron, joined the company in 2003 after the former managers revealed they had manipulated earnings by almost $5 billion. The following year Fannie Mae’s chief executive, Daniel H. Mudd, was promoted to the top spot after that company was accused of accounting errors totaling $6.3 billion. People familiar with Treasury’s plan say that both men, as well as other executives, will be forced to leave the companies.

Capital Cushion, Alt-A/Subprime, Accounting ‘Irregularities’ and Outright Bulls***

For example, while Freddie Mac’s portfolio contains many securities backed by subprime loans, made to the riskiest borrowers, and alt-A loans, one step up on the risk ladder, the company has not written down the value of many of those loans to reflect current market prices. Executives have said that they intend to hold the loans to maturity, meaning they will be worth more, and they need not write down their value. But other financial institutions have written down similar securities, to comply with “mark-to-market” accounting rules. Freddie Mac holds roughly twice as many of those securities as Fannie Mae.

(they) have also inflated their financial positions by relying on deferred-tax assets — credits accumulated over the years that can be used to offset future profits. Fannie maintains that its worth is increased by $36 billion through such credits, and Freddie argues that it has a $28 billion benefit.  But such credits have no value unless the companies generate profits. They have failed to do so over the last four quarters and seem increasingly unlikely to the next year. Moreover, even when the companies had soaring profits, such credits often could not be used. That is because the companies were already able to offset taxes with other credits for affordable housing. Most financial institutions are not allowed to count such credits as assets. The credits cannot be sold and would disappear in a receivership. Removing those credits from assets would probably push both companies’ capital below the regulatory requirements.

Regulators are also said to be scrutinizing whether the companies were trying to manage their earnings by waiting to add to their reserves. Both companies have gradually increased their reserves for loan losses — Fannie’s reserves today stand at $8.9 billion, and Freddie’s at $5.8 billion.  Other companies, like private mortgage insurers, have been quicker to identify large losses and have set aside much greater amounts. Fannie and Freddie have dribbled out bad news with each quarterly announcement, suggesting they may be trying to manage this process.

(classic, sounds just like Wells Fargo last quarter) Finally, regulators are concerned that the companies may have mischaracterized their financial health by relaxing their accounting policies on losses, according to people familiar with the review. For years, both companies have effectively recognized losses whenever payments on a loan are 90 days past due. But, in recent months, the companies said they would wait until payments were two years late. As a result, tens of thousands of loans have not been marked down in value. The companies have injected their own capital into pools of securities containing these loans, arguing that their new policies are helping more borrowers…people briefed on the accounting inquiry said that Freddie Mac may have delayed losses with the change.

“We have just had to nationalize the two largest financial institutions in the world because of policy makers’ inaction,” said Josh Rosner, an analyst at Graham Fisher, an independent research firm in New York, and a longtime critic of the government-sponsored enterprises. “Since 2003, when these companies’ accounting came under question, policy makers have done nothing. Even though they had every reason to know that the housing market’s problems would not be contained to subprime and would bring down the houses of Fannie and Freddie.”


34 Responses to “Fannie/Freddie – Massive Fraud Breakdown”

  1. The US Justice department should consider prosecuting all of the fraudulent lenders and their former EMPLOYEES under RICO statutes. This would allow the FED to recover some of the losses by freezing lenders’ EMPLOYEES real property and bank accounts until a determination is made if the EMPLOYEE was a party to fraud. If they were, then the EMPLOYEES should be prosecuted just like any other potential FELON. Why should white collar crime like this go unpunished? Why should some of the EMPLOYEES be able to keep their millions in ill-gotten gains. If the Justice Dept. does not clean these guys out of the system, they will resurface again and again. How many Fannie-Freddie collapses can the US taxpayer stand?

  2. HERE IS THE FRAUD, which I, as someone who has passed the Bar, am convinced that any Attorney General of any state could easily obtain an indictment against any person connected with or who ratified the decision below.

    THERE IS NO RATIONAL REASON for this accounting change described below OTHER than to intentionally deceive the investing public for this accounting change. That’s a felony.

    From Today’s NYT:

    “Finally, regulators are concerned that the companies may have mischaracterized their financial health by relaxing their accounting policies on losses, according to people familiar with the review. For years, both companies have effectively recognized losses whenever payments on a loan are 90 days past due. But, in recent months, the companies said they would wait until payments were TWO YEARS late. As a result, tens of thousands of loans have not been marked down in value.

    Tony Buzan

  3. Mr Wiz – they all do each others sisters. Aint gonna happen.

  4. You are missing the point.

    ANY attorney general in ANY state can bring this indictment, because every pension fund is an investor.

    You should be less smug.

    Tony Buzan

  5. THIS IS ANOTHER reason why I have said in this forum that QUARTERLY accounting statements can be ignored, but annual AUDITED statements are a different matter.

    Tony Buzan

  6. so if treasuries shoot up as in previous blog post, will the dollar go up further? and this will lead to possibly a rate cut in 2 weeks?

  7. RE- “ANY attorney general in ANY state can bring this indictment, because every pension fund is an investor.”

    How can the general public motivate an Attorney General to pursue the GSE’s in their state to not allow GSE’s to wait 2 years to foreclose?

    If the GSE’s can pencil whip receivables for two years, then Pension Funds should be barred from holding GSE securities by the AG or State Pension Fund Supervisor because the security valuations are suspect.

  8. Changing the subject for a moment, what will this do to the housing market.

    1) The cost of these mortgages will fall significantly for borrowers.
    2) There will be a temporary expansion.

    Open question. Will the terms be a generous or will Frannie tighten up loan conditions accepted.

    Views please?

  9. I think the only thing that could support the existing home prices would be an interest rate which is fixed at 1 or 2% for 30 years. This would probably bring the payments down to a level that wages could sustain and motivate people to buy homes. But who will lend at this rate? I doubt private enterprise would… who wants to lock into the high probability of 30 years of negative return? So it would be the govt. and would essentially socialize housing. Since it would take over the mortgage market.
    I’m probably missing something. But it looks like credit’s been destroyed and will take to time to stabilize. Until that time, the only generous lender will be the govt…which is already at historic debt levels.

  10. This is going to end up being a lot bigger than anyone anticipates. We may never know the full scope of the dollars involved. Look at this quote from an article today:

    “The bailout involves total assets that would dwarf the savings and loan rescue in the 1980s that shook the banking sector to its core. Fannie and Freddie hold roughly US$1.5 trillion in direct debt, guarantees on what could be as large as US$5 trillion and possibly off-balance sheet obligations that could reach $3 trillion, according to recent estimates from Ladenburg Thalmann & Co.”

  11. > So, the tax payers get stuck with this mess!

    You’re assuming that I still care about fixing this government and paying taxes.

    Burn Rome burn.

  12. Gov’t got a 10% preferred coupon payable before anyone else and owns 80%. That’s a good deal for the gov’t. It’s like the mafia coming in and taking over.

    It’s good for taxpayers and will help the prices stay somewhat higher.

  13. Lets pretend they have $2.25 trillion in ‘at-risk’ mortgage exposure. If 50% lose thier home at a 60% loss

    We know from their public disclosures that their current delinquency rates are around 1%. To see 50% defaults in $2.25 trillion of their mortgage exposure, their delinquency rates would have to rise TWENTY TIMES.

    The assumption of 60% losses is also extremely flawed; the bulk of their delinquent mortgages is credit-enhanced (protected by PMI); the ones not protected were up to 80% LTV at the time of issuance; and, finally, FNM/FRE had very limited exposure to bubble markets. Much of the losses they are suffering comes not from Los Angeles and San Diego but from Cleveland and Detroit.

    Sorry, you’re way way off in your doomsday projections. Govt $25 billion projections are far more realistic.

  14. As Americans, aren’t we all just entitled to the govt. paying for our houses, you know, mortgage free? So, what’s the fuss?
    I want a Mercedes, too, because, well, I just do, and I’m a taxpaying voter.

  15. The pay for book-cooking chefs is not too bad, it seems…

    WTF is going on here? These guys should go to jail, not be rewarded in the tens of millions of dollars:

    “Mr. Syron may walk away with an exit package that could total as much as $15 million, says David Schmidt, a senior consultant at James F. Reda & Associates LLC, a compensation consulting concern in New York. That includes a pension and deferred compensation, about $3.7 million in severance pay, and a possible payment of $8.8 million to compensate for forfeiting certain equity grants.

    Mr. Mudd’s exit package, including stock he already owns, could total $14 million, Mr. Schmidt estimates. That includes $5 million in pension and deferred compensation, $4.2 million in severance pay and $3.4 million of restricted stock, based on Friday’s closing price. That value of that stock could fall sharply, however.”

  16. Anonymous – yes, I did make that assumption. Rock on.

    Rick – we are doomed.

    GCox – nothing in the mortgage industry changes unless you bring back interest only, stated income, 100% seconds and pay option arms. Rates dropping 25bps means nothing. This will not bring about increased lending flexibility.

  17. I think this still does not change what’s going on with defaults. Home values dropping and more borrowers going upside down. Am I wrong?

  18. NEWS OUT. This is becomming more realistic. Now double it because he is paid to be conservative and you come very close to my figures.

    U.S. Losses on Fannie, Freddie May Be $300 Billion, Poole Says
    By Christopher Swann and Pimm Fox
    Sept. 7 (Bloomberg) — William Poole, former president of the Federal Reserve Bank of St. Louis, said taxpayers may face a $300 billion bill to revive Fannie Mae and Freddie Mac, the mortgage giants being taken over by the Federal government.

    “I would not be surprised if their total losses aggregate about 5 percent of their obligations” of about $6 trillion, Poole said today in an interview on Bloomberg Radio. “Five percent does not seem to me to be an outrageous guess.”

    Poole welcomed the decision to put the companies into conservatorship by the Federal Housing Finance Agency, calling it preferable to action by the Federal Reserve. He said financial fallout from Fannie and Freddie was likely to be a long-term drain on the Treasury.

    “It’s extremely healthy that it’s now the Congress and the Treasury and not the Federal Reserve putting funds in,” he said. “It’s not the purpose of a central bank to put funds in to save or bail out failing companies.”

    Treasury Secretary Henry Paulson said today he would replace the chief executives of Washington-based Fannie Mae and McLean, Virginia-based Freddie Mac and eliminate their dividends. The Treasury will purchase up to $100 billion of senior-preferred stock in each company as needed to maintain a positive net worth.

    The Treasury said it would reduce the portfolios of both companies by 10 percent a year starting in 2010. “I think that’s a good way to go, and I just hope that the government can complete that course,” Poole said.

    To contact the reporters on this story: Christopher Swann in Washington at; Pimm Fox in New York at;

    Last Updated: September 7, 2008 16:39 EDT

  19. The markets will be up tomorrow and the insiders will dump more of their shares. Thus the average American will not only have the wealth gutted from their home equity, they will also have more losses from the market as they are fooled by this and bubblevision as the “bottom”.

  20. Oh yeah, and I think about 70 million of them are nearing retirement age as well. Nice!!!

  21. MM – May I make a suggestion, might we be able to shift our focus a bit, away from what the losses that will be occuring, and whether we will have a depression ….., and brainstorm for ways to take advantage of what the new “fix” is presenting us with.

  22. Buy gold for your long-term savings. The dollar is going to hell. The financials should short-squeeze rally big tomorrow. Anybody long stocks next year is going to have problems. All this money is only going to bolster financials, but it won’t keep them up for long, not with HELOCs pushing them down. This is it! The US gov’t only has inflation left in its quiver. Inflation will destroy capital, pricing, debt, creditors, savers and landlords.

  23. Total loss 5% of their obligations? What if it’s 10, 15 or 20%? Why should 95% hang on when they see what the 5% is getting away with?

  24. Note that Paulson–in his bailout statement–specifically removed blame for the GSE’s collapse from both ex-CEOs and boards, helping insure that the CEO’s severance packages remain intact (perhaps the boards, too). Second, note below Syron’s raising the awareness of Paulson’s “gift” in his “retirement” letter to Freddie Mac’s employees:

    Message From Dick Syron: “Treasury Secretary Paulson today said, “I attribute the need for today’s action primarily to the inherent conflict and flawed business model embedded in the GSE structure, and to the ongoing housing correction. GSE managements and their Boards are responsible for neither.””

    So, in Paulson’s words, the GSE’s problems were caused by the “inherent conflict and flawed business model embedded in the GSE structure, and to the ongoing housing correction,” not the GSE managements and their Boards, yet he is replacing GSE managements and their Boards in their entirety–while doing all he can to guarantee their “retirement” packages.

  25. Here ya go Housing Reaslist:

    A big winner from the boost to Fannie and Freddie debt will be real estate investment trusts that invest in their mortgage-backed securities, says Doug Kass, the head of Seabreeze Partners. The mortgage REITs will step in as MBS buyers, using substantial leverage, while Fannie and Freddie reduce their issuance of MBS over time, he says. “These could become market darlings,” Kass says

  26. Jaybee – I totally agree that is where in a perfect world going forward it should go. However, it just may not happen that way especially if over the next few weeks this plan does not work. The biggest tthreat is that large GSE senior mortgage debt holders use this potentially one and only pop to unload their holders. Remember, Treasury is only buying new GSE senior debt. There is still the little problem with the $5 trillion out there that could be dumped on the market beginning this morning that would significantly depress prices.

    This was a last ditch effort. If it does not work, we come out of this 10x worse.

  27. TM – ‘the profits made me do it’ is not a great defense.

  28. In a nutshell, watch those MBS speads. If there are sellers in size then this thing falls apart fast.

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  31. I think if the spread narrows by Treasuries going up, the govt will have stop the process to save itself. This may well be a stalling tactic to allow the foriegn owners of this debt to get out and into Treasuries in the coming months. The govt will not save F/F if it’s debt costs rise because of it. That’s too imortant, and why they really did the bail out in the first place. OTOH, it’s probably a good week to stock up in SKF’s as they are down due to the problem being “over”. HAHAHAHA

  32. One item to remember regarding the S&L bailout, I keep hearing the 150 bil to 200bil amount the taxpayers picked up. For comparison purposes, double that figure to 300-400bil just based upon inflation adjustment. Even if losses get to 600-700bil we will survive. With those of you who do not want the backstop, I have a question or two for you, 1.) Do you have a job in the private sector?
    2.) Do you own any financial assets (home, stocks, etc) 3.) Does your family fall into Q1 or Q2. Once again I hate the moral hazard issue as much as anyone, but I’m not looking at “cutting my nose off to spite my face”!

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  34. […] Fannie/Freddie – Massive Fraud Breakdown (32) Posted on September 7, 2008 10:59 AM […]

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