House of cards

I just read this article. After passing Level I in December and sitting for Level II unsuccessfully in June, I have some perspective on the accounting methods used by Fannie and Freddie. I'm almost tempted to crack open the Schweser notes and look up the accounting warning signs.
First of all, let me just say this. Perhaps my naivete is an asset here; because this just sounds ridiculous to me having only been in the industry two years, but to others I guess they must have been so used to it. I can't believe how levered the balance sheet was. The Bloomberg article I attached talks about the firms capital. See, when banks or lenders like Fannie and Freddie operate, they make money by borrowing at one interest rate and lending at a slightly higher rate. This is called the "spread" they earn. Also, banks and lenders need to have sufficient capital. That means that any bank has to have a certain amount of money in deposits at all times to comply with law. This prevents panic if people start going nuts withdrawing money. This is A and B of Banking ABCs. A) Borrow short term, lend long term, earn the spread and B) have sufficient capital. Well, FNM and FRE's capital got pretty low because they started losing mad money on all the mortgages people are walking away from. Then people started getting worried. Thus, the market ceased giving the agencies favorable rates. This compressed the spread they earned. When you can't borrow at a low interest rate, the business model is kaputz. And things collapse like a house of cards.

Now here is the kicker, if you have hopefully read this far. Fannie most recently stated $47BB in capital. $20.6BB of this was in DEFERRED TAX ASSETS. Are you kidding me? Is this new information? DFAs are tax credits and you can treat them as an asset because you will reduce your taxes in the future. But when your business model is broken, you don't make money, and when you have no income you don't pay income tax so nearly 50% of their capital was in assets that could more than likely be taken off the balance sheet. At $47BB, they were about $9.5BB above the requirement, but as it turns out when the Feds starting looking at the books, $20.6BB was in deferred tax assets. So for some time up to this point, best accounting practices would have calculated both companies as severely undercapitalized. This just blows my mind. I have a lot of questions. Who audited their financials? How was this acceptable in the past?

That's the macro blog.
Here's the micro blog.

Today was crazy at work. Our Investment Committee worked through the entire weekend. I went into a meeting at 7:30am with the client servicing group and we got debriefed on the situation. We are lucky to be so well positioned across most of our portfolios. That makes our job easier for sure, but I really admire how our firm has been able to focus and concentrate on understanding the recent developments in FNM and FRE so we can properly convey it to our clients. I was just stacked with work all day but I felt fulfilled by my job today. I'm really glad I believe in what we do at our firm and I think we do good work for the world.

I'm also worried about the banking system. The government took the companies into conservatorship, and in the process the common shareholders get nearly wiped out, the bond holders and mortgage holders get made whole (get their money back), and the preferred shareholders unfortunately, like the common holders, don't get made whole. I think this could change. Here's why. A lot of banks hold this preferred paper. It's trading down over 50% from where most owners got in at. A lot of banks hold this in huge quantities. I saw some reports that this is over 20% of some bank's capital. That's not good. The Treasury might have to step in and prop up the preferreds to.

That's all I have for tonight. Again I can't emphasize how impressed I am by my colleagues. Some groups worked all weekend to brief us this morning on the situation. Other groups came in at 5am to prepare for a volatile trading day. I was in the office today for 11 hours getting information out to clients. These are exciting and turbulent times in the bond market. So much has changed from start to now in my two years of working.