Were They Or Weren't They?

Staff writer Zachary A. Goldfarb reports on the interesting contortions federal regulators went through to describe the capital condition of mortgage finance giants Fannie Mae and Freddie Mac just before they were taken over by the government.

Here's his full story; you decide if there aren't some contradictions here:

By Zachary A. Goldfarb

Reading the latest report from the federal regulator running mortgage finance giants Fannie Mae and Freddie Mac could give you whiplash.

Fannie Mae and Freddie Mac had said at the end of June that they had billions of dollars more of a financial cushion than required by their regulator. The report by the Federal Housing Finance Agency Thursday reaffirmed that, saying Fannie Mae had $9.4 billion and Freddie Mac had $2.7 billion more capital than required.

But, even though the companies were adequately capitalized, the regulator Thursday declared them undercapitalized. How did it square that circle?

The regulator, in essence, said capital wasn't a good enough barometer of the companies' financial footing. The law gives the regulator the authority to designate the companies undercapitalized even if they technically have enough capital. In its report, the FHFA said that the sharp downturn in the mortgage market over the summer "raised significant questions about the sufficiency of capital."

The report listed six points supporting the regulator's determination, citing concerns about the companies' overall "safety and soundness."

For the first time, the regulator expressed concerns about whether too much of the capital was made up of what it called "intangible assets." Analysts raised questions about these assets, which included tax credits due the companies, in the weeks leading up to the takeover. In the case of the tax credits, they were useful as capital only if the companies had profits; instead, the companies were posting big losses.

The regulator's conclusion comes after it used the companies' capital position to bolster confidence in the firms over the summer.

"They had a bunch of safety and soundness issues in the second quarter, but at that point [the regulator] was putting the sunniest possible face on it," said Karen Shaw Petrou, an analyst at Washington-based Federal Financial Analytics.

Some believe that the government's actions in the weeks leading up to the takeover put the companies in a worsened capital position by making it difficult to raise money by issuing new stock.

"I believe the conservatorship of Fannie and Freddie became almost necessary because secretary of Treasury [Henry M.] Paulson Jr.] was indicating that if the government had to intervene, they would be sure to wipe out the shareholders," said Dwight Jaffee, a finance professor at the University of California at Berkeley. "This made it impossible for Fannie and Freddie to raise any more capital."

The companies' third quarter closed at the end of September. Financial results will not be released for another month. But the decision to declare them undercapitalized suggests the numbers won't be pretty.

"One has to believe that the government came to understand that the financial situation of Fannie and Freddie was much more distressed than the reports of June 30 had indicated," Jaffee said.

Usually, being declared undercapitalized would subject the companies to modest penalties, but none will be exacted while they are under government control. The FHFA also has suspended the capital requirements, though the companies will continue to disclose capital figures in their quarterly reports. The government set up a program to lend money or inject capital if the companies falter.

"As a practical matter, the government is now running Fannie and Freddie to bail out a sinking economy and a sinking housing market," Jaffee said. "And they're going to do everything reasonable to achieve those goals, and that may involve taking more risks than they would ordinarily do and accepting a lower return on the assets than they normally do."

A report from Federal Financial Analytics, called "Don't Ask, Don't Tell," noted that ambiguities still surround the firms. For instance, their debt is backed fully by the U.S. government, but the cost of their debt is much greater than government debt such as Treasury bills. That suggests investors don't have full confidence in the companies.

By Dan Beyers  |  October 10, 2008; 8:51 AM ET  | Category:  Fannie Mae , Freddie Mac
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