Gov't. "Watchdog" Bamboozles Press About Fannie and Freddie

(Article changed on August 25, 2013 at 15:58)

(Article changed on August 22, 2013 at 18:25)

If Steve Linick, Inspector General of the Federal Housing Finance Agency, set out to bamboozle the press and the public, he succeeded beautifully.

With the notable exception of  Nick Timiraos at The Wall Street Journal, just about every other major news outlet was tricked into believing that Fannie Mae and Freddie Mac were less than scrupulous about posting credit losses on their books. Check out these headlines:

None of those claims is true. The issue under discussion would have a de minimis impact on the GSEs' reported earnings, probably something close to zero. But, given the false and misleading insinuations set forth in the IG's report, it's easy to see how reporters, always burdened by tight deadlines, were tricked.   

If I weren't familiar with banking and accounting terminology, and with Fannie and Freddie's financials, I might have fallen for the IG's obfuscatory rhetoric as well. Here's a key passage of the IG report, which, for the most part, is BS. An explanation and translation into plain English follows:

FHFA examination staff identified no later than January 2012 a significant risk management issues relating to loan loss reserves, with potentially significant consequences for Fannie Mae and Freddie Mac, concerning the treatment of loans delinquent for more than 180 days.

Appropriately classifying assets according to risk characteristics is a key safety and soundness practice that could have an impact on loan loss reserves. The loan loss reserve is a critical/significant accounting estimate for both Fannie Mae and Freddie Mac.

FHFA recognized the issue's significance when it issued the advisory bulletin in April 2012, directing the enterprises to classify loans delinquent for more than 180 days as a "Loss." The bulletin notes that it is consistent with the system for loan classification followed by federal banking regulators.

The bulletin states that it "embodies a basic principle in GAAP that losses should be recognized on loans that are deemed uncollectible and that there should be no delay in loss recognition of probable incurred losses."  (Emphasis added). Yet, it will not be fully implemented until January 2015, three years after the issue was first raised.

 How Credit Losses Are Booked

First of all, here's how Fannie and Freddie recognize credit losses, in really simple terms. They look at their delinquent loans and then estimate a default rate (based on recent default rates) and a loss per property (based on the expected sale proceeds and mortgage insurance proceeds versus the loan balance). That estimated credit loss is expensed on the income statement for the current period. On the balance sheet, the loan amounts are not reduced, but the new loan loss reserve reduces total assets by the amount of the loss expense on the income statement.

Later, when foreclosure proceedings are actually initiated, a GSE will write down the face amount of the loan by the amount of the loss reserve, which is then extinguished. All of this is fully compliant with GAAP, and, if you parse the IG report carefully, no one is saying--as opposed to suggesting and insinuating--that the GSEs' financial accounting is not entirely proper.

A Simple Example: Here's a very simple example, which assumes that a GSE has only one loan on the books:

In the 1^st quarter, a GSE estimates a 20% loss on a $100 loan. So current income is reduced by $20, and a $20 loan loss reserve is netted against the loan on the balance sheet, so that total loan assets, which were previously $100, now equal $80.

Then, in the 4^th quarter, foreclosure proceedings are initiated, at which point the loan, which was previously $100, is now valued at $80, but the offsetting entry is the elimination of the $20 reserve. Total loans on the balance sheet, which were $80 before, are still $80.

Again, the initial loss provision in the 1^st quarter affects income and net worth; the loan write-off in the 4^th quarter is a wash, because assets are simply shifted from one account to another.

So WTF is the Inspector General talking about? Nothing subtstantive.

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