The rumble of distant thunder
After a very quiet fall for Fannie Mae, a recent Washington Post article reported a sound of distant thunder:
Fannie Mae Finds More Errors, Names New CFO
Fannie Mae yesterday disclosed additional accounting errors, adding to the list of problems the mortgage finance company must sort through as it tries to untangle a nearly $11 billion financial scandal that came to light last year.
Fannie Mae chief executive Daniel H. Mudd said of disclosing his company’s accounting errors: “This is not an easy road to take.”
It had also made mistakes in accounting for some investments in low-income housing, for which it also received tax credits, the company said in a filing with the Securities and Exchange Commission.
Properly accounting for the investments in low-income housing, meanwhile, could change the timing of when losses from those projects were recognized.
Up until now, after a terrible spring, the fall has been kind to Fannie Mae. Despite ten-plus billion in writedowns, Congress has not (yet) enacted new restrictive GSE legislation, and every day that passes lowers the legislation’s expected-teeth ratio.
The House last month passed legislation to create a new independent regulator for Fannie Mae and its rival, Freddie Mac, with the ability to place them in receivership if they run into financial trouble and to adjust the size of their investment holdings. A similar bill in the Senate has not reached the floor for a vote.
The White House has long asserted that the House bill is unacceptable in two ways: not tough enough on balance sheet, and inappropriate in its half-tithing to create an affordable housing trust fund.
Meanwhile, new crises and issues have intruded on the newspapers’ front pages (it is ever thus). With the political calculus shifting, Fannie Mae executives might well have been feeling relieved that the worst was behind them. Certainly the capital markets apparently think so. The stock, which was battered this spring, has leveled out:
News of further accounting problems had little effect on Fannie Mae’s share price, which fell nearly 2% early in the day, then rebounded to close at $46.39, down 1 cent.
[…]
While that figure may change because of the new mistakes, analysts who follow the company were not concerned. They noted that most of the new information was in hand when the company’s chief regulator declared recently that Fannie Mae had enough capital on hand to cover any costs that may result from its accounting review.
In the same thunder, there came a quieter delayed coda:
The accounting errors revealed yesterday concerned mortgage insurance, investments in synthetic fuel partnerships and investments in low-income housing. Fannie Mae did not estimate the extent to which the additional errors will affect its bottom line.
“Tax credits, maybe?”
The company said it expects that the accounting error on the insurance policy … will have “no cumulative impact.”
The company said it does not think the errors related to synthetic fuel investments will have a “significant impact,” either.
Properly accounting for the investments in low-income housing, meanwhile, could change the timing of when losses from those projects were recognized.
This last phrase, and its absence of insignificance, that causes the trained ear to perk up.
“Changing impairment schedules?”
Explaining why takes a moment, so make yourself comfortable
Not that comfortable.
As I’ve posted many times, “investments in low-income housing” mean tax credits, a form of soft equity whose benefits are delivered over ten years and subject to recapture over fifteen years. (Comprehensive review available here.) How does the investment’s value change over the delivery and recapture periods?
These investments are illiquid; they trade infrequently and they are not listed in stock exchanges. So we have no real-time measurements of fair market value. Instead the asset — that is, the investment interest (not the property itself) is in a ‘value tunnel’ — a long interval where its value is not externally observable, only inferable. In cash terms, we know the asset’s value for certain at only two points:
When we buy, it is worth what we paid for it, because that is indeed the definition of fair market value.
“Right now it’s worth what I’m paying for it!”
When we sell, usually after the recapture period, it’s worth what the next buyer pays for it
“Older, wiser, and less valuable?”
Meanwhile, although not certain, we have a working presumption that the investment interest’s value declines over the interval, most simply because the investor (in this case, Fannie Mae) bought the interest for its ability to generate a yield (LIHTCs) that is consumed ratably over ten year.
A tax-motivated investment is thus like a returnable bottle of Coke. You buy it for the contents (the tax benefits), which you consume with great satisfaction, and at the end you have the bottle (the ownership shares) which has some value, but that value is based on fundamentally different considerations than what motivated you to buy it in the first place.
What’s this worth as a fraction of its original purchase price?
At year zero, the asset is worth 100%. At year fifteen, it’s worth R%, where R% is probably less than 100% but greater than or equal to zero. You won’t know R% until you get there. So what’s the investment worth in year 4? Year 8? Year 12? In accounting terms, what has been the impairment in value (GAAP accounting generally precludes marking an asset up)?
This is a Schrodinger’s-cat valuation problem — the only way to prove the value is to sell the asset, something you are not going to do. What then can you do?
You estimate. And you need a basis for your estimate.
The estimate can be asset-by-asset (I think this one is worth R1, and this one R2), or algorithmic (next year it’ll be worth D% less than it was last year). Depreciation, a long-time staple of real estate investment, began its storied career modestly as GAAP accounting algorithms to measure impairments.
Algorithms are nice — when you have thousands of assets, they’re virtually essential — but they’re to some degree arbitrary (independent of context). Thus you can ask your regulator — in this case, the Emerging Issues Task Force (EITF) of the Financial Accounting Standards Board (FASB) — to establish guidelines.
“O solons of double-entry, wilt thou bless mine formula?”
Full disclosure: back in 1995, in partnership with Ernst & Young, Recap Advisors prepared a comprehensive study that various tax credit sponsors did submit to the EITF. That 1995 study demonstrated — to my satisfaction and more importantly to the EITF’s — that there would be some residual in most LIHTC investments. As the EITF reported at the time:
The following consensus was reached regarding investments accounted for under the cost method:
Any excess of the carrying amount of the investment over its estimated residual value (calculated at the end of the last period in which tax credits are allocated to the investor without reflecting anticipated inflation) should be amortized during the periods in which tax credits are allocated to the investor. Annual amortization should be based on the proportion of tax credits received in the current year to total estimated tax credits to be allocated to the investor.
So you write the value down from initial cost to estimated residual. That is the proposition we successfully established. But how to estimate residual we did not address, nor did we offer an algorithmic approach. Sponsors and investors were left free to use their own good judgment.
Fannie Mae stands accused of manipulating earnings, one technique for which is turning up and down the dials by which non-cash events are recognized: changes in portfolio values, say, or impairment in long-term assets. Tax credit equity investments (speculation alert!) appear fertile ground — a very complex asset with no external value moment – no sales, few refinancings, no third-party property appraisals — to challenge management’s judgment.
An organization under pressure from senior management to show high earnings that would trigger vast incentive compensation payments to said senior executives might tarry by the roadside long enough to rethink its previously-too-conservative algorithms for measuring these impairments.
The company’s third quarter Form 12b-25 says:
Fannie Mae has determined that it has made errors in the accounting for its Low Income Housing Tax Credit (”LIHTC”) investments. Fannie Mae incorrectly accounted for certain of its LIHTC investments using the effective yield method instead of the equity method of accounting. Restating the accounting of these investments using the equity method will affect the timing of recognition of losses during the restatement period and will result in more variability from period to period.
Here’s the EITF’s description of effective yield as applied to affordable housing investments:
The principle underlying the effective yield method is that the investor recognizes tax credits as they are allocated and amortizes the initial cost of the investment to provide a constant effective yield over the period that tax credits are allocated to the investor. Further information about this method is discussed in EITF Abstracts.
So the previous (now discredited) method had the effect of decreasing earnings volatility.
Were tax credit equity investment values used to smooth out Fannie Mae’s earnings?
Back to Fannie Mae’s 12b-25:
Fannie Mae also determined that it has made certain errors in the calculation of impairment on these LIHTC investments. Previously reported impairment amounts also will need to be restated as a result of the impact of the errors described above on the carrying value of the company’s investment.
Fannie Mae has a vast portfolio of LIHTC assets. In the first half of 2005 alone, the company invested more than $550 million in equity; in 1994, Fannie Mae invested $1.7 billion. Total Fannie Mae LIHTC purchased probably exceed $10 billion. Will there be a further writedown of their carrying value?
Fannie Mae expects to complete its accounting restatement by the second half of 2006.
