A Forensic Look At The Fannie Mae Bailout: Scrubbing the Tricky Accounting of Conservatorship via Housing Wire
Adam Spittler CPA, MS
Mike Ciklin JD, MBA, MRE
As readers of interest in Fannie Mae and Freddie Mac are aware, the circumstances surrounding the Conservatorship on September 7, 2008 are often fuzzy with little factual data to support the vast claims of insolvency and failure of business model by various politicians and interest groups. As such, the debate rages on seven years later with little resolution in sight. We have heard many GSE investors claim that the bailout was never necessary and the Conservatorship was illegal to begin with. The purpose of this article is to attempt to prove the true financial condition of the entities at both 1) the time of Conservatorship and 2) in subsequent years leading up to the massive windfall to the US Treasury in 2013.
The ExodusPoint Partners International Fund returned 0.36% for May, bringing its year-to-date return to 3.31% in a year that's been particularly challenging for most hedge funds, pushing many into the red. Macroeconomic factors continued to weigh on the market, resulting in significant intra-month volatility for May, although risk assets generally ended the month flat. Macro Read More
The first item that we need to address is: what exactly is a bailout? From our friends at Wikipedia, a Bailout is a colloquial term for “giving financial support to a Company or Country that faces serious financial difficulty or bankruptcy.” What piqued our interest in this project is the question: “What company facing serious financial difficulty borrows 116b from 2008 to 2012, losing supposedly billions of dollars in the process, is then able to pay more than everything back in 2013 and 2014?” Wouldn’t a failing company burn through all that cash that it “needed” to ensure continued operations? Let’s examine what really happened using a key lesson that I was fortunate enough to learn towards the beginning of my career.
Soon after finishing grad school, I was discussing stocks with my boss, in particular the EPS of one of the companies that I had been following closely. When I stated my case for the Company’s financial strength based on its seemingly robust EPS, he sarcastically rolled his eyes and laughed. Surprised by his reaction, I asked him what he thought was funny; we were having a serious conversation after all. He responded: “One day you will realize that Net Income doesn’t matter. The fact is; you can make it whatever you want it to be. If you want to understand the Company, you need to follow the other side of the transaction…to the balance sheet.” My career has taken me from KPMG to the private world at both financially healthy and struggling entities; all along the way, those words have critically guided my day-to-day work. As a result, I’ve become quite skilled in understanding the mechanics of balance sheet manipulation…and undoubtedly, Fannie Mae deserves such an analysis.
First, however, we must define two very important non cash expenses: 1) Deferred Tax Asset and 2) Loan Loss/FMV Reserves.
Per Investopedia, a Deferred Tax Asset “is created due to taxes paid or carried forward but not yet recognized in the income statement. For example, deferred tax assets can be created due to the tax authority recognizing revenue or expenses at different times than that of an accounting standard….lt is important to note that a deferred tax asset will only be recognized when there is expectation of future profit.” The second item, a Loan Loss/FMV Reserve, is defined as an expense set aside as an allowance for bad loans or assumption of reduction in near term fair value of an asset. As a quick example, in the case of Fannie Mae, a Loan Loss Reserve would be the expected total of losses over its entire 30 year portfolio or alternatively, an estimate of 30 years of expected losses estimated at a single point in time. Please note that neither of these expenses is a use of cash. In fact, you can find them on the Statement of Cashflows under cash flow from operations as a “source” of cash. The reason for this classification is that an increase in reserve results in a net loss…with the offset being a reduction of the corresponding asset on the balance sheet (where it stays until it is either used to write off bad loans or reversed if subsequently proven to be unnecessary). Finally, a related item which will come into play is valuation losses. These reflect an estimated adjustment for current market value, independent of intention to liquidate.
What is the function of these accounting items? In the academic world, we use reserves to quantify as accurately as possible the estimated losses on an asset or collection of assets at a point in time. The reason they are classified as non cash is simply because we haven’t sold the asset and may not have any intention of selling the asset so the impairment is not realized. To that extent, the breadth and duration of a reserve is nothing more than a guesstimate. In practice, all management teams know the final number they want or need often working towards that goal. Reserves are a simple means of achieving a certain result within the reasonable confines of GAAP. Also, supportable audit evidence can always be produced due to the level of subjectivity involved.
See full PDF below.