Poor, beleaguered Fannie Mae and Freddie Mac seem to have embodied all the fears surrounding Financials over the last two weeks—write-downs, possible collapses, and bailouts. And they're back as headline fodder, as Treasury Secretary Henry Paulson's proposal to extend a lifeline to Fannie and Freddie is getting the green light.
Paulson's proposal, attached to a housing bill, now looks set to pass after President Bush withdrew his veto threat. While Fannie and Freddie seem to have become a proxy for Financials' recent woes, they also help illustrate how the popular view of that sector is a bit detached from reality, particularly when it comes to the vast asset write-downs we've seen in recent quarters. As covered in past cover stories ("Of Whipsaws and Rumors," 07/9/08, and "About Fannie and Freddie…" 7/14/08), Fannie and Freddie currently keep their mortgage-backed securities (MBS) off their balance sheets—up until now a perfectly acceptable accounting maneuver for these two. But new accounting rules might change this, possibly dealing Fan and Fred a big balance sheet whack.
The problems they'll face are the same many Financials firms have dealt with over the past year. MBSs rarely trade in open markets, so their values are based on model-driven assumptions about the underlying assets' value. The purpose of recent write-downs was to adjust for the increasing discrepancy between the market value and model value of MBSs. As such, if one MBS's underlying assets are worth $X, but the MBS would only fetch $Y on the open market, the company would have to list $Y as the current value—even if the underlying assets together were worth vastly more!
This is called "mark-to-market" accounting and was widely adapted in the 1980s with the intention of increasing transparency. But it seems to be distorting the view of overall Financials health today. The underlying MBS assets are likely in better shape than the market perceives; the magnitude of write-downs is the result of general investor aversion to the securities themselves—the packaging, if you will, and not what's inside. This is key: Despite paper losses companies have taken through write-downs, most haven't sold the MBSs, so they haven't incurred actual losses. If MBS pricing recovers, companies may write-up the values in the future.
Which means Fannie and Freddie may be getting a government bailout for a problem that's an accounting fiction—a fiction being imposed by the same body offering the bailout! It'd be rather like the government injecting you with the flu and telling you, "Don't worry, we'll give you the vaccine for free." Though Paulson has repeatedly said both companies remain well-capitalized—their assets' underlying values are fine. Moreover, the housing bill doesn't mandate a bailout or government intervention—it's just a failsafe, licensing the government to act if necessary.
But Fanny and Freddie's fate provides a good reminder that Financials, though undoubtedly in a tough spot, are not helped out by the distortions of mark-to-market accounting and other arbitrary capital requirements. And it's still more evidence that reality remains decidedly better than current sour sentiment.
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