The Fannie Mae Freddie Mac Takeover – Now We’re Holding The Bag

…And let me make clear what today’s actions mean for Americans and their families. Fannie Mae and Freddie Mac are so large and so interwoven in our financial system that a failure of either of them would cause great turmoil in our financial markets here at home and around the globe. This turmoil would directly and negatively impact household wealth: from family budgets, to home values, to savings for college and retirement. A failure would affect the ability of Americans to get home loans, auto loans and other consumer credit and business finance. And a failure would be harmful to economic growth and job creation. That is why we have taken these actions today…

That quote comes from Treasury Secretary Henry Paulson’s statement on September 7th announcing the takeover.

And he also says:

…because the GSEs are Congressionally-chartered, only Congress can address the inherent conflict of attempting to serve both shareholders and a public mission. The new Congress and the next Administration must decide what role government in general, and these entities in particular, should play in the housing market. There is a consensus today that these enterprises pose a systemic risk and they cannot continue in their current form…

I find it interesting that he uses the term, “inherent conflict,” to describe the dual role of the GSE’s to serve both shareholder’s interests and a public mission. Fannie Mae and Freddie Mac were also publicly traded entities, charged with making a profit and creating wealth for shareholders and bondholders while also serving the public interest of providing liquidity to those who originate mortgages..

It’s not much different in my eyes from the inherent conflict which exists in the public accounting firms and, in particular, the Big 4 firms. They are paid to produce an audit opinion on behalf of the shareholders and serve the public mission of providing this assurance in order to add predictability, stability, verifiability of financial information to the global capital markets.

They are also profit-making private partnerships, with the business purpose of creating wealth for their owners, the partners of the firms. How much longer can we tolerate this inherent conflict of interest, especially given the fact that it is serving no one well except the owners of the firms?  That is, as long as the firms don’t fail, like Arthur Andersen, where partner owners who had no real control over the destiny of their firm were wiped out. If another audit firm fails, and it will, the current firms’ partners, the majority of whom also have no real control over their investment in equity in the firms,  lose their equity.  In the meantime, given the desire of the firms to maintain high levels of profits for their partners, some of them may lose their jobs, along with their staff.

Getting back to Fannie and Freddie… It was extremely frustrating to see the NYT take a namby-pamby diplomatic approach to excusing the audit firms from any responsibility for the near catastrophe which is the failure of Fannie and Freddie.

Then, last week, advisers from Morgan Stanley hired by the Treasury Department to scrutinize the companies came to a troubling conclusion: Freddie Mac’s capital position was worse than initially imagined, according to people briefed on those findings. The company had made decisions that, while not necessarily in violation of accounting rules, had the effect of overstating the firm’s capital resources and financial stability.

Indeed, one person briefed on the company’s finances said F
reddie Mac had made accounting decisions that pushed losses into the future and postponed a capital shortfall until the fourth quarter of this year, which would not need to be disclosed until early 2009. Fannie Mae has used similar methods, but to a lesser degree, according to other people who have been briefed.

And it’s also frustrating to see that Paulson is letting the CEOs off the hook (From the FEI Blog):

He added, “GSE managements and their Boards are responsible for neither.” The tone of his remarks was slightly different from that of President George W. Bush’s remarks on the situation. The “conflict of interest’ situation regarding the GSEs is the focus of Floyd Norris’ article in the NYT today, “The Dilemna of Fannie and Freddie.”

And it’s extremely frustrating to see everyone act as if the problems have been recent, occurring only as a result of the housing crisis. These companies have been incorrigible for a while. And their auditors have been part of the problem, not part of the solution.

Fannie Ma
e and Freddie Mac have had accounting problems for a while, multiple restatements, adverse opinions on their internal controls, suits against them and have filed suit against their auditors. But neither of them ever received a qualified or going concern opinion from their auditors. The auditors didn’t warn of the issues. If you read the audit reports, you saw that there were issues, but were led to believe all would improve at some point.

On the contrary.  The audit firms enabled the Fannie and Freddie problems.

When will the capital markets demand Congressional action such as was needed for Fannie/Freddie to resolve “the inherent conflict and flawed business model embedded in the GSE structure,” and resolve the inherent conflict and flawed business model of the public accounting firms that audit publicly owned companies – beyond giving the audit firms an impotent, sewn-up, filled with insiders regulator like the PCAOB?

For a great summary and index of all relevant documents, go to Edith Orenstein’s blog at FEI.

12 replies
  1. Anonymous
    Anonymous says:

    Fannie Mae is audited by Deloitte, previously KPMG. Freddie Mac is audited by PwC. Coincidentally, Francine has a number of blogs regarding Deloitte and PwC audit layoffs. As more audited clients fail, there will be more layoffs. Since the audit, tax, and consulting functions within these firms are so intertwined, it could affect all the employees.

  2. Independent Accountant
    Independent Accountant says:

    Amen! Why did FRE need Morgan Stanley anyway? What did its CPAs do? How could it have accounting problems?

  3. Anonymous
    Anonymous says:

    Does anyone else have the sense that the U.S. economy is going down the drain? As embarrassing collapses of U.S. companies abound, our Asian counterparts (China and India) are thriving. We are exporting manufacturing jobs to China and services jobs to India and laying off the higher paid U.S work force. What’s worse than the job export is the export of intellectual technology/know how offshore. What will stop the Tienamen Square government from siezing and displacing its U.S. partners when it does not need them any more? Sadly, there is no stopping the train wreck that is waiting to happen. All driven by greed.

  4. Content
    Content says:

    What will stop China from deciding all of a sudden that they no longer need to play nice with the United States? Probably the $500 billion in US debt that China holds.

    You know the old adage, owe the bank $1,000 and they own you, owe them $1,000,000 and you own the bank. Perhaps the figures are dated bur the sentiment stands. Not to mention the fact that the US is a huge source of the capital that is funding China’s growth.

  5. Anonymous
    Anonymous says:

    Although China has modernized its economy — partly by letting foreign firms pay the tab — its politics are still stuck in the past, with no democracy in sight. Chairman Mao’s degenerating politic views (forcing starving Chinese peasants to resort to cannabalism in the the most extreme case) are still upheld by the current political party. Despite U.S. jobs being exported to China and the increase in the average Chinese wage, the poor Chinese workers are still being taken advantage of, because they still have no rights. Its interesting that the U.S. can pretend to support human rights, but look the other way when it comes to laborers in other countries.

  6. Anonymous
    Anonymous says:

    I am seasoned external auditor with over 20 years external audit experience (8 with the Big 4) and couldn't agree more with your article! I totally agree that "Fannie Mae and Freddie Mac have had accounting problems for a while, multiple restatements, adverse opinions on their internal controls, suits against them and have filed suit against their auditors. But neither of them ever received a qualified or going concern opinion from their auditors. The auditors didn't warn of the issues. If you read the audit reports, you saw that there were issues, but were led to believe all would improve at some point.

    On the contrary. The audit firms enabled the Fannie and Freddie problems."

    Here is the smoking gun…I personally know of Deloitte & EY Consultants from all over the world who were sent in like an army of ants to eat on fees whatever they could…often these high priced consultants who who could barely speak or write English we told by their Deloitte Partners to redo the same work over and over again even if it had been done previously and to bill "Freddie for the work" as there was no oversight on any of their internal controls consulting work…they were told not to address and "waste time" on any controversial issues as well…The current managment at these companies should all be fired and not getting retention bonuses for not blowing the whistle and the only ones who should remain are the ones that cooperate with investigators.

  7. Anonymous
    Anonymous says:

    Well said, 20 year external auditor. It is time that the partners of the accounting firms be held accountable. Let’s not bring down an entire firm like Andersen, because it is the innocent staff who suffer.

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  1. […] for a while. The US government took over Fannie Mae and Freddie Mac in September of 2008. Then Secretary of the Treasury Henry Paulson admitted the fatal flaw that foils attempts to successfully, and conclusively, untangle the GSE […]

  2. […] the hardest to repurchase poorly or fraudulently documented loans they sold to the GSEs – Fannie Mae, Freddie Mac, and the Federal Home Loan […]

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