GSEs and Other Financial Institutions Overstate Capital Base

By: Mike_Shedlock

In an easily believable story the New York Times is reporting Loan Giant Overstated the Size of Its Capital Base .
The government's planned takeover of Fannie Mae and Freddie Mac, expected to be announced on Sunday, came together after advisers poring over the companies' books for the Treasury Department concluded that Freddie's accounting methods had overstated its capital cushion, according to regulatory officials briefed on the matter.

The proposal to place both companies, which own or back $5.3 trillion in mortgages, into a government-run conservatorship also grew out of deep concern among foreign investors that the companies' debt might not be repaid.

My Comment : It's called "investing" for a reason. If there was no risk of loss it would not be called investing but rather "winning" or something similar.

Investors who own the companies' common and preferred stock will suffer. Holders of debt, including many foreign central banks, are expected to receive government backing. Top executives of both companies will be pushed out, according to those briefed on the plan.

The cost of the government's intervention could rise into tens of billions of dollars and will probably be among the most expensive rescues ever financed by taxpayers.

My Comment : This is just a guess and I could be wildly off base but my range of taxpayer losses is $50 billion to $250 billion. The vast majority of Fannie and Freddie loans are not at risk.

The takeover comes on the heels of a rescue of the investment bank Bear Stearns, which was sold to JPMorgan Chase in a deal backed by taxpayers. Already, the housing crisis has cost investors and consumers hundreds of billions of dollars.

The big question now is whether the federal government's move to take over Fannie and Freddie will restore investor confidence in the nation's credit markets, help stabilize the stock market and keep loans flowing to creditworthy borrowers.

My Comment : The only question is how badly this will blow up. Government bailouts are never confidence inspiring regardless of whatever short term reaction we may see on Monday.

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 worst debts. Equally important, because the government is backing the companies, they will continue to buy and sell home loans.

My Comment : Don't count on it. We might easily see lending restrictions that could drive mortgage rates up. Alternatively, there is no guarantee this will restore any faith. But if there are no lending restrictions, then I may need to raise the upper end of my taxpayer loss estimate stated above.

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

My Comment : That statement makes perfect sense.

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. But, as the companies' stocks continued to languish and their borrowing costs rose, some within the Treasury Department began urging Mr. Paulson to intervene quickly.

My Comment : That is not what he said at all. What he said was that he did not believe he would have to use it. I cannot prove it, but I believe Paulson's statement to be a blatant lie.

Then, 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, according to people briefed on those findings. The company had made decisions that, while not necessarily in violation of accounting rules, had the effect of overstating the companies' capital resources and financial stability.

My Comment : This is certainly believable. Now if Morgan Stanley would only make the same statement about its own books.

Indeed, one person briefed on the company's finances said 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, according to other people who have been briefed.

FASB Postpones Truth In Reporting

There is lots more to the article but let's stop right there because that is the critical issue. I do not think there is a major financial company that has properly stated its financial base. That is what's behind the decision by the FASB to postpone rules on off-balance-sheet accounting for a year.

Inquiring minds should consider Not Practical To Tell The Truth for further analysis of actions taken to suppress the truth. Those looking for manipulations and conspiracies can find fertile ground in that article.

Now, Morgan Stanley hired by the Treasury Department to scrutinize the companies came to a troubling but perfectly believable conclusion: Freddie Mac's capital position was worse than initially imagined. Morgan Stanley also concluded this was "not necessarily in violation of accounting rules".

What a difference things would make right now if off balance sheet assets had to be brought back on balance sheets, and banks and brokerages made a better attempt to bring forward losses and to properly value level three assets.

Partial List Of Overstated Capital Bases

• Citigroup (C)
• Bank of America (BAC)
• JPMorgan (JPM)
• Wachovia (WB)
• Wells Fargo (WFC)
• Washington Mutual (WM)
• Fannie Mae (FNM)
• Freddie Mac (FRE)
• Morgan Stanley (MS)
• Goldman Sachs (GS)
• Merrill Lynch (MER)
• Lehman (LEH)

That list is incomplete and in random order. Add to it every bank and broker dealer in the country.

By Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com

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Mike Shedlock / Mish is a registered investment advisor representative for SitkaPacific Capital Management . Sitka Pacific is an asset management firm whose goal is strong performance and low volatility, regardless of market direction.

Visit Sitka Pacific's Account Management Page to learn more about wealth management and capital preservation strategies of Sitka Pacific.

I do weekly podcasts every Thursday on HoweStreet and a brief 7 minute segment on Saturday on CKNW AM 980 in Vancouver.

When not writing about stocks or the economy I spends a great deal of time on photography and in the garden. I have over 80 magazine and book cover credits. Some of my Wisconsin and gardening images can be seen at MichaelShedlock.com .

© 2008 Mike Shedlock, All Rights Reserved

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