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Freddie Mac, Fannie Mae Deja Vu?: Part II

Posted by Larry Doyle on April 8, 2010 11:51 AM |

On Christmas Eve 2009, the Obama administration provided a blank check to the wards of the state known as Freddie Mac and Fannie Mae. (“Fannie and Freddie’s Huge Christmas Bonus”)

What other quasi-government institutions have a very similar business profile as Freddie and Fannie? The Federal Home Loan Bank system, acronym FHLBs, commonly referred to within the financial industry as FLUBs. I will reserve comment on that moniker. Ten months ago, I questioned whether the dynamics at work within the FHLB system would be the equivalent of what has transpired at Freddie and Fannie. I wrote “Freddie Mac, Fannie Mae Deja Vu?” and highlighted:

Can our economy absorb another financial hit of the magnitude of Freddie Mac and Fannie Mae?

In the process of digging for some data on Uncle Sam’s TARP commitments, I came across a compelling story at Subsidyscope, a Financial Primer link (right sidebar) here at Sense on Cents. The lead story at Subsidyscope, dated May 26, 2009: Concerns Grow Over Federal Home Loan Bank Investments. They write:

The Federal Home Loan Banks, or FHLBs, may be the biggest financial players you’ve never heard of. Collectively, they hold $1.3 trillion in assets and are the largest U.S. borrower after the federal government.

For readers here at Sense on Cents, I have raised warnings about the FHLB system both on April 3rd (“Putting Perfume on a Pig!!”) and just this past Monday, May 25th (“FHLBs: Red Sea, Dead Sea, or Both?”). In my opinion, there is little doubt that the FHLB system was the greatest beneficiary of the FASB’s relaxation of the mark-to-market. Subsidyscope says as much:

A Subsidyscope review of the FHLBs’ financial statements has found that several of the banks are carrying substantial “unrealized losses” on their investments in mortgage-backed securities. Because the banks believe these losses are temporary, they don’t have to be recognized on the banks’ accounting statements.

What’s potentially worrisome is the sheer size of the losses. For the Federal Home Loan Bank of Seattle, they are substantially larger than the capital the bank holds to protect itself against such declines. If its mortgage-backed securities don’t regain their value, the bank will have to write them down, which could wipe out its capital buffer and raise risks for taxpayers.

Fast forward ten months and let’s quickly review how the felonious accounting within the FHLB system has played out. Major high five to our Sense on Cents Hall of Famer Bloomberg’s Jonathan Weil for laying it out today as he writes, How $1 Trillion Time Bomb Posts a Phony Profit:

Last week, the FHLBs, which is pronounced “flubs,” published their combined audited financial statements for 2009. And at first glance, it might seem like they had a profitable year. Net income was about $1.9 billion, the banks said, up 54 percent from the year before.

The most striking part about that dollar figure was what it didn’t include: About $8.8 billion of paper losses from their portfolios of mortgage-backed securities. By the banks’ own description, these losses were “other than temporary,” meaning the values of the investments aren’t expected to recover soon.

The reason those losses weren’t included in earnings? The Financial Accounting Standards Board rewrote its rules a year ago so they wouldn’t have to count, following an intense campaign by the banking industry and its friends in Congress. One thing the rule change couldn’t do, though, was make those losses go away in real life.

With more than $1 trillion of assets and about $973 billion of liabilities, the FHLB system is among the largest U.S. borrowers after the federal government, bigger even than Fannie Mae or Freddie Mac. Operating independently, the FHLBs make low- cost loans to about 8,000 member banks and finance companies. They also sport AAA credit ratings from Moody’s Investors Service and Standard & Poor’s, which keeps their borrowing costs low, because their debt has an implicit federal guarantee.

Thanks to the FASB rule change, the banks got a new way to report phony profits, too.

If you listen hard you can hear the bomb inside the FHLB system tick, tick, ticking. Where are we going with this? As Weil concludes:

The only thing that bond investors care about, of course, is whether the U.S. Treasury would ever bail out these banks if needed. Undoubtedly, it would.

The bull market in moral hazard rages onward.

On the street, it is called a shell game.


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