Fannie: $100 billion ain’t enough

Fannie reported a $29 billion loss for the third quarter, a staggering number any way you slice it. It’s important to note that $21 billion of that was a simple write-down for deferred tax assets, while their credit losses on mortgages were over $9 billion.  Understanding the role played by those DTAs is fascinating, but before I get to that, a summary of Fannie’s recent news. According to the NYT:

…Fannie Mae said that it was bracing for billions of dollars in additional losses and that it may need more than the $100 billion that the Treasury Department has pledged to keep the company afloat. The hole at Fannie could get even worse if the economy confronts a deep, prolonged recession…

Of particular concern is the hostile reception the company is getting in the capital markets. Since the government guaranteed certain kinds of debt issued by banks last month, investors have shunned Fannie and Freddie debt that comes due in more than a year because those debts do not have an explicit federal guarantee.

The $100 billion figure is hugely significant, and it has a lot to do with why investors aren’t buying Fannie’s debt.  Here are James Lockhart’s comments from Oct 23rd, when he backed away from using the word “explicit” regarding Treasury’s guarantee of Fannie/Freddie debt:

“What we did say is [there is] an effective guarantee because there’s $100 billion backing their equity provided by the U.S. Treasury,” Lockhart said after the hearing. “That does give them effectively a guarantee of the U.S. government.”

No it doesn’t!  Not if Fannie’s (and Freddie’s) losses are going to greatly exceed $100 billion.  What are bondholders supposed to make of a guarantee that isn’t large enough to protect them?  Probably nothing, which is why they won’t buy Fannie and Freddie bonds, driving up mortgage interest rates for everyone.

More interesting may be the story of those deferred tax assets that were written down…

The deferred tax assets Fannie wrote down made up 40% of their regulatory capital.  Regulatory capital, remember, is the cash the company is supposed to have on hand to protect against losses.  Freddie’s DTAs are fully half of their capital.  A deferred tax asset isn’t cash and never will be; it’s just a coupon to reduce your future tax bill.

If you do your own taxes, and trade stocks, you know that a capital loss can be used to offset taxable income ($3000 per year).  But if you lose more than $3000 in a year, you can keep the remainder as a “tax loss carryforward” to offset income in future years.  Wouldn’t it be great if you could use that “asset” as collateral to borrow money from the bank?  That’s precisely what Fan and Fred did.

Corporations that believe they’ll generate taxable income in future years count their carryforwards as “assets” on the balance sheet.  That’s perfectly legal and makes sense under accrual accounting conventions.  But counting deferred tax assets as “regulatory capital” is totally foolish.  The regulatory capital of a financial institution is supposed to be the reserves it has on hand to pay off liabilities in case of default.

Imagine if an individual who’d lost hundreds of thousands in the stock market ended up in bankruptcy.  The tax credits he has against future income aren’t worth anything to his credit card company, to his mortgage lender or to the bank that has his car loan.

Writing off these deferred tax assets is an acknowledgment that Fannie isn’t going to make money for years.  They have no prospect of generating taxable income against which to use their tax credits.  So those credits are worthless.

And yet their chief regulator allowed them to count these deferred tax credits as part of their capital base.

The upshot is that Fan and Fred each have close to zero capital to protect against losses.  Taxpayers will have to make up the difference.  Their portfolios are chock full of toxic mortgage paper that will likely decline in value by 30-50%.  That means hundreds of billions of writedowns over the next few years as the credit crisis and housing collapse worsen.

And while Treasury has *promised* $100 billion to each company, they haven’t actually injected any capital yet.  The Feds haven’t actually borrowed the money they’ll need to bail these two out.

This is how the U.S. turns into Iceland. When Uncle Sam’s losses start to run into the trillions—from Fan and Fred, from failed banks that carry deposit insurance, from the busted collateral backstopping Federal loans, etc.—it will become clear that we can’t borrow enough to plug every hole in the dam.  We’ll try to borrow a ton, but interest rates will spike as Treasury floods the market with new debt issues.  Scarier still is the prospect of capital flight from the dollar when our financial losses overwhelm the government’s balance sheet.

What happens when there is a run on the world’s reserve currency?  I don’t know, but it won’t be pretty.

…

I would be remiss if I didn’t call out David Brooks for a particularly ill-conceived column in late Sept.  On politics he’s very good.  But here he tried to peddle the conservative line that Fan and Fred were “highly regulated” and we shouldn’t overreach on regulation going forward.  Let’s get this straight:  Capital adequacy rules are the only financial regulations that count. Having a government bureaucrat look over a financial institution’s shoulder doesn’t mean anything unless you force the institution to keep enough money in REAL RESERVES to protect depositors, bondholders and others to whom it would owe money in the case of default.  In their continuing idiocy, both Democrats and Republicans (but especially Dems) encouraged Fannie and Freddie to lend hundreds of billions without making any additions to their capital base.

And even though our biggest banks are themselves WAY overlevered (think 100:1 when you back out faux reserves and include off-balance sheet liabilities) Congress is telling them to lend more to keep the economy going!  This is beyond foolish. Our banks are on fire and Congress wants them to pour gasoline on themselves.

Posted in Economy, Fed, Interest Rates, accounting, bailout, banking, bankruptcy, credit crunch, politics, taxpayer issues |