GSE’s: Welcome to turbulence

May 8, 2007 | Fannie Mae, Freddie Mac, GSEs, Lending


“Hello, Washington, we’re coming into some turbulence.”


As I am being periodically made aware on the London-to-Boston flight where I am writing this post, turbulence is uncomfortable and unsettling, as revealed by three stories, each of them a nasty bump, starting with this March 24 Washington Post piece about the lumbar jolts suffered when the shock absorbers are removed:



That’s going to take some absorbing


Freddie Mac, still fixing weaknesses that came to light in 2003, yesterday issued its first timely annual report in five years


Inability to file financial reports timely is an embarrassment and then some.  Financial reporting is a great leading indicator of management competence: I have never known a company to be well run if it cannot produce financial reports.


So this recent development should be cause for celebration:



“Everything’s coming up roses, coming up roses”


Shouldn’t it?



“Ti finite returns — and beyond!


which showed that the giant mortgage funding company lost $480 million in the fourth quarter. That compared with a profit of $684 million in the comparable period a year earlier.


With their awfully big advantages, GSE’s aren’t supposed to lose money.  They just aren’t.  What happened?


The loss was largely a reflection of declines in the value of financial instruments known as derivatives that Freddie Mac uses to hedge against movements in interest rates.



“We’re relying on our financial instruments.”


If a lender/ securitizer uses match funding — issuing bonds with the same maturity as the loans it is making — then it needn’t hedge against interest rates.  Hedging arises when maturities are mismatched, turbocharging the balance sheet, which as I’ve previously posted OFHEO demonstrated was used by Fannie Mae to smooth earnings with financial tricks, with the goal (says OFHEO) of maximizing executive bonuses.  But as a truism, one cannot remove all the volatility from a system, so even if the derivatives dampened volatility,  they did not eliminate it.  But playing with derivatives, as numerous commentators have observed and very smart people like Long-Term Capital found out the hard way, is dangerous: earnings oscillate.



Up, down, up, down


Last year Freddie Mac earned $2.2 billion ($2.84 a share), up 3.8% from $2.1 billion ($2.75) in 2005 — largely the result of increases in the value of derivatives during the first half of the year. Revenue declined to $5.2 billion from $5.6 billion in 2005.


Got that?  Revenues declined but earnings went up, because of derivatives.  Makes the derivatives look big rather than small, doesn’t it?  If the derivatives portfolio is bouncing up and down, how do you know how well the core business is doing?  Or, for that matter, how risky the derivatives portfolio is?


Unless you study really hard, you don’t.  That’s why the GSEs had such an incentive to suppress criticism in the Bad Old Days.  In fact, as we get more timely and more transparent financial information, the number of accounting judgments multiplies:



Mickey mouse

And every entry begets two more entries


Last year, Freddie experienced a slight deterioration in the creditworthiness of loans “as more loans transitioned through delinquency to foreclosure” and as “the expected severity of losses” on individual homes increased, the company said.


The company increased its reserves for potential loan losses to $420 million as of Dec. 31, from $414 million the year before.


The hike would have been greater if Freddie Mac had not reduced reserves for damage related to Hurricane Katrina. After putting $128 million in reserve in 2005 to cover anticipated losses from Katrina, the company reduced that reserve last year to $46 million.


Was $128 million the right number in 2005?  Is $46 million the right number in 2006?  Are we $79 million safer than a year ago?



“Don’t worry, you’re in good hands with me.”


For these answers, we ask auditors — but this might not be the moment to ask them, as revealed in the second bump, from the April 21 Washington Post:


[Fannie Mae’s former] auditor KPMG this week sued its former client Fannie Mae, alleging that the giant mortgage funding company deceived it for years, damaging KPMG‘s reputation and exposing it to the threat of substantial liability.


Both firms have been sued by investors since Fannie Mae was revealed to have overstated profits by billions of dollars.  For years, KPMG put its stamp of approval on financial statements that Fannie Mae now acknowledges were flawed.


A normal reader might be forgiven for presuming that an auditor would conduct credibility checks seeking to detect client fraud.  Not so, claims KPMG:



Say it ain’t so, bro


The accounting firm says it was relying on Fannie Mae to tell the truth about its finances when KPMG issued clean audit reports year after year “in the absence of further analysis, review procedures, and/or modifications to the financial statements.”


“Fannie Mae repeatedly, deliberately, and recklessly provided misleading information to KPMG,” the lawsuit says.


The fees KPMG charged Fannie Mae were “significantly lower than the fees that would have been charged had Fannie Mae disclosed all material information,” KPMG added in the lawsuit.


Translation: “If you’d lied to me, I’d’ve had to charge you a lot more to correct your lies.”



“You’re not lying, are you Roger?”


Under chutzpah in your dictionary, you will find the image of a litigator.



Usually worn atop a litigator’s head


But then, you knew that this lawsuit had to be coming from KPMG:


[KPMG] was countering a lawsuit Fannie Mae filed in December, which alleged that the audit firm committed malpractice when it signed off on financial statements that were riddled with errors. KPMG’s counterclaims were reported yesterday by Bloomberg News.


Though KPMG didn’t quantify the damages it is seeking, Fannie Mae is trying to recoup more than $2 billion from the accounting firm, including the more than $1 billion Fannie Mae has spent redoing its books.


You get sued for two billion, you put everything including the kitchen sink into the countersuit.



We’re adding this to the claim


Among the alleged false representations are letters to KPMG signed by members of Fannie Mae management, including former chief executive Franklin D. Raines, former chief financial officer J. Timothy Howard, former president Lawrence M. Small — who recently resigned as head of the Smithsonian Institutionand current chief executive Daniel H. Mudd. Those men are not named as defendants in KPMG’s suit.


So far the well-paid ($14 million in 2006!) and favorably-profiled Mr. Mudd has escaped any allegations of impropriety, even as claims surfaced of ‘false signatures’,



“Surely you’re not suggesting anything about Mr. Mudd.”

“Don’t call me Shirley.”


 but now that his signature has been revealed on a certification letter, Mr. Mudd will most likely be offering the reliance defense — that others assured him of the veracity of the statements to which he was attesting.


KPMG cited findings of an investigation by the Office of Federal Housing Enterprise Oversight, including the agency’s assertion last year that Fannie “worked strenuously to hide” its “improper earnings management” from KPMG.



The auditors will never find me


Job cuts scything through the organization, earnings bouncing around, litigation flying around.  The GSE boss’s job just isn’t as much fun as it used to be, as revealed by this May 2 Washington Post story:


Freddie Mac president and chief operating officer Eugene M. McQuade has turned down the board’s offer to make him chief executive this summer, dashing the federally chartered mortgage funding company’s long-standing succession plan.


McQuade was part of a leadership team brought in to straighten out the company after a multibillion-dollar accounting scandal.


After Hercules cleaned the Augean stables, he slew the man who had set him the task.



“This is gonna cost ya, Augeas.”


“The whole political environment around the GSEs is one that no one would like to deal with,” McQuade said in an interview yesterday, using the abbreviation for government-sponsored enterprises. “It is very difficult as an executive to be strategic and provide … leadership to the employees when there is this continued uncertainty.”


In saying No to the job, Mr. McQuade walked away from a very large executive compensation package:



“You just try and make me CEO, tough guy”


McQuade’s 2004 employment contract gave him the potential to receive a substantial payout if anyone else was named to succeed Syron or if he were not offered the job by Sept. 1 of this year. The board recently followed through as planned by offering him the job. Syron, 63, who became chief executive in 2003, would have remained chairman.


Evidently Mr. McQuade has done his difficult task well:


The work to fix Freddie Mac’s financial systems has taken more time and money than either the company or its regulators expected, a federal oversight agency said in a recent report. Freddie Mac’s efforts “suffered during 2006 from ineffective planning and inconsistent execution,” the Office of Federal Housing Enterprise Oversight reported.


However, the agency had no objection to McQuade’s becoming chief executive, OFHEO spokeswoman Corinne Russell said yesterday.


It’s one thing to pilot a smooth-sailing ship.  It’s quite another to take it over when it’s floundering and beset by storms.



“We’re all right behind you, Stryker.”


The board has formed a committee to work on a new succession plan.



“Look, somebody up there must be willing to fly this thing!”


It may take a while.



“No worries, we’re on auto pilot.”