Fannie Mae: FHFA/Treasury Attorney’s Claim “Potential Future Profits” Belong on Balance Sheet

Fannie Mae: FHFA/Treasury Attorney’s Claim “Potential Future Profits” Belong on Balance Sheet by Todd Sullivan, ValuePlays

You have to read this and then think about the ramifications of what they claim. The scope of this is staggering……

HT to Peter Chapman at Bankrupt.com for alerting me to it.

From the  FHFA Motion to Dismiss before Judge Lamberth

From the filing:

HERA authorizes the Conservator to “transfer or sell any asset” of the Enterprises “without any approval, assignment, or consent.” 12 U.S.C. Sec. 4617(b)(2)(G).  By executing the Third Amendment,  the Conservator agreed to transfer an Enterprise asset ——— potential future profits ——— to Treasury in exchange for relief from an obligation ——— 10% dividends ——— in order to minimize the  possibility that the Enterprises would exhaust the Treasury  commitment and thereby maximize the possibility that the  Enterprises would survive and avoid receivership.  Section 4617(f)  thus precludes judicial review of that agreement and prevents the Court from taking any action to “restrain or affect” that agreement.

Fannie Mae and Freddie Mac’s balance sheet under “assets”

Sit back now and think about that.  Is it just me missing things or is there a line on corporate balance sheets under “assets” for “potential future profits” ?

Now, Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC) did have an “asset” related to earnings on the balance sheet, the DTA’s (deferred tax assets) and some may be inclined to infer this is indeed what FHFA lawyers were referring to when they wrote that.  They weren’t.

For proof we need only reference their own words:

FHFA and Treasury have maintained that they never considered—and need not have considered—the tens of billions of dollars in deferred tax assets held by the Companies, even though those assets were recognized immediately after the Sweep Amendment and resulted in a dividend to Treasury of more than $50 billion. See Treasury Reply 47; FHFA Reply 56; see also APA Opening Br. 17 & n.6, 72-73, 77-78; APA Reply 41-42. Indeed, FHFA’s litigating declaration asserts that the agency never “discuss[ed]” the deferred tax assets while considering the Sweep Amendment and that neither FHFA nor Treasury “envision[ed]” the quick recognition of those assets. FHFA 0009-0010.

So, we can definitively state that the “potential future profits” mentioned above had nothing to do with the DTA’s but the future net income of Fannie Mae and Freddie Mac’s.

Consider this:

Banks across the US are subject to leverage ratios based on their level of assets. What happens to those ratios if it is now ok to add a balance sheet entry for “potential future profits”.  I’d dare say every bank in the US becomes immediately excessively capitalized….leverage that up baby!!!! Ditto that for every insurance company..

Any struggling company that might be in violation of debt covenants due to debt ratios simply need to just ratchet up this “asset” and presto, everything is just fine.

Take it a step further, how many frauds will be committed by people using “potential future profits” to dress up a balance sheet for secondary offerings to unsophisticated investors?  We see it all the time now under GAAP rules, imagine this wholly arbitrary “asset” being introduced into the mix?

US GAAP accounting rules forbid “potential profits” being declared an asset on financial statements simply because the future is unknowable and the very ambiguity of it is ripe with fraud and a massive range of errors.  But FHFA says it is one…

HERA states that:

Fannie Mae, Freddie Mac financial statement misses potential future profits as an asset

Nowhere in any financial statement prepared by Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC)’s am I able to find “potential future profits” as an asset. If, as Treasury/FHFA claim “potential future profits” is indeed an asset and FHFA considered them as such all along, they are in violation of HERA by not disclosing it. Since that undisclosed “asset” was then used as justification for the 3rd amendment, isn’t the 3rd amendment then in violation of HERA?

Further, how is FHFA supposed conduct “asset” sales. Since FHFA claims this was an “asset” that was sold, the selling of it must then conform to the “asset sales” guidelines in HERA. It is no idfferent than if they were selling MSR’s. This is what it says:

From HERA::

I’d submit here that the “sale” of this particular “asset” (potential future profits) in this case violates all three of these rules. Violating any one of them is enough to be in violation of HERA:

(i)  Selling “potential” profits makes it impossible to calculate the NPV of the assets being sold so  in no way can FHFA claim its value was “maximized”

(ii) Fannie Mae and Freddie Mac’s lost all future profits in this transaction, in no way does this coincide with the mandate to “minimize losses”. Had they agreed to ship 98% of them to treasury it was a better deal.

(iii) To date Treasury has reaped over $200B in exchange for the elimination of the 10% dividend and that number will increase annually indefinitely.  If we assume 10% on $188B that means the annual dividend was $18B for both Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC)’s. From ’12-’13 that meant $36B in dividends.  Further, Fannie Mae and Freddie Mac’s are under no obligation to repay the Treasury in cash. they could have paid it with additional stock. So, far from an “adequate” return for the sale of the asset, in this case the offerors received a windfall to say the least.

Fannie Mae, Freddie Mac: HERA only authorized FHFA to dispose of “assets”

So, why go through this exercise? HERA only authorized FHFA to dispose of “assets”. Nowhere in the document does it state they can commit the net income of the entities in perpetuity to a creditor. Only by classifying them as an “asset” could they justify the action.   So I ask, where in GAAP rules or bankruptcy  law are “potential future profits” declared as an asset?

The government’s reply to all this (and other arguments) is HERA essentially granted them “the right to what we want when we want and how we want”.  This isn’t true. The reason HERA is as long as it is can only be because FHFA must act within the guidelines spelled out within it.  When they deviate (as they have here and other occasions) they open themselves up to judicial review.  If Congress had intended to grant FHFA absolute and all encompassing powers, they could have easily done that on 1 page, not the 261 HERA entails.

Further the FHFA/Treasury constantly fall back on “congress passed the law so everything we did is ok” theory. This also fails. Those laws must conform to the constitution and legal precedent.  Typically it is the courts that lead the charge in this area (just look at civil rights legislation for evidence). The courts will review this and plaintiff will prevail.