Freddie Mac Suffers Bout of Temporary Insanity
May 21 (Bloomberg) — How long does the word “temporary” mean? The accountant who wants to stay employed knows the right answer: “How long do you want it to mean?” That new twist on an old joke goes a long way toward explaining Freddie Mac’s net loss last quarter of $151 million, which was smaller than analysts’ estimates. In reality, Freddie is gushing much more red ink than that. Yet hardly any of it is showing up on the company’s income statement. That’s mainly because the government-chartered mortgage financier has deemed $32.4 billion of paper losses from mortgage- related securities as “temporary.” Freddie’s big sister, Fannie Mae, is in a similar, though less extreme, position with $9.3 billion of such losses.
To ordinary folks, temporary means something of limited duration. Under the accounting rules, the word means almost nothing.
The designation means the losses don’t have to be counted in Freddie’s calculations of net income or capital, which is supposed to be the company’s financial cushion against losses.
Most of these losses are on securities backed by subprime mortgages. About $13.2 billion of them are on securities that have been valued below Freddie’s cost for a year or longer. Some of the losses stretch back more than two years. All this has occurred under the tolerant eyes of Freddie’s feeble regulator, the Office of Federal Housing Enterprise Oversight.
To put this in perspective, $32.4 billion is more than double Freddie’s $16 billion of shareholder equity under generally accepted accounting principles. It’s almost twice as much as the company’s $17 billion stock-market value. And it’s infinitely greater than the fair value of Freddie’s net assets, which at March 31 was negative $5.2 billion.
Arbitrary Label
Freddie can get away with this because it has hung the label “available for sale” on these investments. The rules say it still must reflect the losses on its balance sheet. Yet the for- sale label is an arbitrary one.
Had Freddie classified the same holdings as “trading” securities, it would have been required to recognize the losses in its earnings and capital already. Instead, Freddie gets to wait until it decides the losses no longer are temporary. At that point it would have to record a charge against net income.
Freddie, based in McLean, Virginia, has never recorded such a charge to earnings on any of its subprime or “Alt-A” mortgage-related securities. (Alt-A loans also fall short of prime.) It strains credulity to posit that every one of these investments’ values will rebound shortly, whatever that means, much less in their entirety.
FASB Rules
Freddie’s subprime and Alt-A portfolios were responsible for $28.1 billion, or 86 percent, of the company’s total unrealized losses on available-for-sale securities at March 31. With a combined fair value of $114.8 billion, these holdings finished the first quarter 20 percent below their cost. Presumably, some of Freddie’s securities had declined much more than that.
The Financial Accounting Standards Board’s rules don’t define the word temporary, and that is a big part of the problem. The Securities and Exchange Commission’s staff has said that when a security’s value has been below cost for more than six months, that is “a strong indication” the decline isn’t temporary.
There is no hard-and-fast rule, though. Companies must consider the length of time and the severity of the drop in a security’s value when deciding whether to record a charge. They also must have the intent and ability to hold the security for as long as they believe it will take for the investment to recover its value.
See No Losses
When asked to comment, Freddie spokeswoman Sharon McHale referred me to the company’s public disclosures. While Freddie says charges are possible, it says it hasn’t identified any securities in its available-for-sale portfolio where a loss is probable, based on its own cash-flow projections. Amazing — not one.
The company’s disclosures don’t say how long Freddie is estimating it will take for these securities’ values to recover. Doing that, of course, would give the public a benchmark to hold the company’s management accountable.
This notion that the subprime meltdown will reverse into a total meltup for Freddie might be comical if taxpayers weren’t on the hook. There remains the implied promise that the government will cover Freddie’s debts should the company fail. Perhaps Freddie can keep plugging its capital holes for a while longer by raising cash from investors. Nothing lasts forever, though.
While the accounting-rule makers can’t fix Freddie, they can fix the rules, by treating all securities the same and counting all gains and losses in net income. That would render the meaning of the word “temporary” irrelevant, eliminating the opportunity to abuse it.
Until then, we’re left with a system in which the only reason Freddie Mac is now solvent is that everyone who matters has agreed to believe it’s true. That can’t last forever, either.
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