Fannie Mae: FHFA Accounting Fraud Chorus Deepens by Glen Bradford
The federal takeover of Fannie Mae and Freddie Mac refers to the placing into conservatorship of government-sponsored enterprises Fannie Mae and Freddie Mac by the U.S. Treasury in September 2008. It was one of the financial events among many in the ongoing subprime mortgage crisis.
Federal takeover of Fannie Mae and Freddie Mac
On September 6, 2008, the director of the Federal Housing Finance Agency (FHFA), James B. Lockhart III, announced his decision to place two Government-sponsored enterprises (GSEs), Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation), into conservatorship run by the FHFA.
Early Reports of Accounting Fraud Resurface
Bethany McLean wrote a book Shaky Ground where she dives into the strange saga of the U.S. mortgage giants that were created by Congress to serve the American Dream of homeownership. According to her, her quest begins with her own desire to better understand why the government seems to want them dead. She highlights in her book where the calls for this new type of accounting fraud surfaced.
Normally accounting fraud involves the overstatement of assets. In this case, however, the fraud is in understating assets in order to prevent non-governmental stakeholders from participating in the good business that Fannie and Freddie facilitate in capital markets. Bethany’s research suggests Fannie and Freddie needed much less than they were forced to take:
$10B is a lot less than $187.5B that they are on the hook for or the $132.2B that they actually were forced to borrow. Meanwhile another accounting analysis suggests that Fannie and Freddie Mac didn’t need a dime, but the government did.
HousingWire’s Trey Garrison – A FannieGate Hero
Apparently Trey Garrison is the go to guy for GSE accounting fraud analysis when it needs to be spread like wildfire. Mike Ciklin and Adam Spittler put together the first real forensic accounting fraud analysis that demonstrated that the firms were making massive cash profits while the government was forcing them to report massive losses and a new report that has just come out suggests that this was done solely to disenfranchise non-government stakeholders. The original report can be found here. My coverage of it can be found here. My explanation for how accounting fraud like this gets discovered can be found here. Specifically, here’s the rub:
On September 10, Trey Garrison broke news of a new GSE accountingfraud supplementary report by D. Larry Crumbley, CFD, Cr.FA, CPA, CFF, FCPA whose primary teaching and research interest is Forensic Accounting with two additional research interests including Expert Witnessing and Control Systems/Lying. If that isn’t authoritative enough, he is the author of more than 55 books, including Forensic and Investigative Accounting. He’s even written an Accounting Action Adventure, The Big R. My favorite sentence:
In this situation the majority shareholder, the Treasury Department, enjoyed a 9% borrowing premium by purchasing senior preferred stock instead of allowing Fannie Mae to draw on the GSE credit facility.
D. Larry Crumbley’s Accounting Fraud Report Analysis
The first and most alarming thing the accounting fraud report reveals is management’s willingness to pay more than they had to during a time when they were reportedly financially distressed:
It’s no surprise that given that the firms decided to pay a premium to borrow the findings of this report were that management was motivated to engage in balance sheet management for the benefit of the government at the expense of minority shareholders:
My favorite part of the fraud report:
Since management was competent, they should have explored all financing options, especially ones that had a 9% difference in financing rates. Myers and Majluf’s (1984) Pecking Order theory suggests that managers prefer to finance operations from the lowest cost of capital. Typically the pecking order of financing options results in management using internally generated capital first, then debt, and finally equity issuance.
This isn’t a surprise to me because I was personally let go from a position where I was the Director of Financial Planning & Analysis because I wasn’t willing to put down the numbers that those in charge wanted to see. In other words, the people that have been able to keep their jobs at Fannie and Freddie are the ones that have been willing to at least play along with those in charge. If you don’t do what your boss says you must find a new one, as the saying goes.
Crumbley conclues his analysis with the following remark:
I do wonder, however, why the SEC has not brought abusive balance sheet management charges against Fannie Mae.
The SEC, the FHFA, and US Treasury are all parts of the government and their interests are aligned.
Investors Unite & Politico Pro Breaks Mulvaney Bill
Legislation being drafted in the U.S. House by Rep. Mick Mulvaney (R-S.C.) would let Fannie Mae and Freddie Mac “once again build up their capital cushions,” reports Politico Pro. This is a great development. IU’s own Tim Pagliara says he’s extremely pleased this is being undertaken, and that the Third Amendment Sweep continues to put taxpayers at risk by depriving the GSEs of capital that would be a buffer against another economic downturn. The legislation would be a good partner with Rep. Marsha Blackburn’s legislation to put the money siphoned off under the Sweep into a separate holding account instead of getting lost in the U.S. Treasury’s general fund.
Summary and Conclusion
If you asked me point blank if there was accounting fraud committed by FHFA to ensure that the GSEs profits were as government owned as they are government run I would simply point to where all the money is going and say that if you can’t see what’s going on then you might want to take a step back. This is an unprecedented situation where the government has forcibly put in $132.2B and taken out $239B during a period of time when independent forensic audit reports demonstrate that the GSEs didn’t need any money at all because they were making so much money the whole time that was merely being hidden by the government dictated accounting practices.
Will the accounting be reversed in time to save the day for shareholders? I’m not betting on it. I’m betting that we see a politically oriented recapitalization and release in order to minimize the quantity of the 11,292 documents that currently no one is able to see that are in hot dispute in Judge Sweeney’s Court of Federal Claims. In the event the accounting fraud is revealed and the warrants are cancelled, the companies are way overcapitalized and worth over $100. Although that’s the right thing to do, I’m not expecting it to happen and I’m expecting a play through that involves increased capital requirements and increased funding going to affordable housing that achieves several purposes for the administration:
- Prevent a massive windfall for non-government investors.
- Fund affordable housing.
- Lock in GSE takings and continue to partake above what investors might expect in a 35% tax rate environment.
- Extend the illusion of a government backstop.
At the end of the day, I figure that the people who have been forcing the GSEs to make themselves look bad so that they look good don’t want the tables reversed and have a vested interest in seeing this come to a happy conclusion where they look like heroes. The common shares are likely worth more than they are today in such a scenario. How much more remains to be seen in the next independent GSE accounting fraud report declaring accounting fraud coming later this year.
Disclosure: The author of this article owns shares of Fannie Mae and Freddie Mac, Preferred and Commons.
Glen Bradford is the author of My first or second: I’m about who you’re about.