‘Confidential’ Memo in the Hedge Fund Battle for Freddie and Fannie Comes Out of Hiding

By Pam Martens and Russ Martens: May 25, 2016 

Hedge Fund Titan, John Paulson

Hedge Fund Titan, John Paulson

There’s a lurking memo among government documents concerning the government takeover of Fannie Mae and Freddie Mac during the 2008 financial collapse on Wall Street that undermines the raging media propaganda wars now taking place. But first some necessary background. 

Similar to Judith Miller’s shilling for the Iraq war in the pages of the New York Times, which spread like an uncontrolled virus to other media, hedge funds that hope to reap billions of dollars in windfall profits in the preferred and common stock of Fannie Mae and Freddie Mac, which has continued to trade despite the government takeover, have set up a Machiavellian plot to get high-priced media real estate on board their scheme. Mainstream media as well as alternative media (that should know better) have taken the bait — hook, line and sinker.

Two writers at the Wall Street Journal have functioned as Diogenes in this churning sea of propaganda: John Carney and Joe Light. Carney has brilliantly and cogently explained why it “would take decades” to build adequate capital at Fannie and Freddie and set them free from the September 2008 conservatorship under which the U.S. government placed them in an effort to save the rest of the financial system. Joe Light has done yeoman’s work in laying bare the lengths to which hedge fund titans like John Paulson (already bathed in shame for his scurrilous acts with the vampire squid) are willing to go to push their greed agenda with Fannie and Freddie’s stock. See here and here.

Wall Street On Parade has also attempted to open the public’s eyes to the continuing dangerous exposure to derivatives at Fannie and Freddie and the Wall Street mega bank beneficiaries that continue to gorge on billions of dollars of payouts on these derivatives.

Yes, there are plenty of secrets the U.S. government is keeping from the public about Freddie and Fannie, just not the ones the hedge funds are trying to sell to the courts and an increasingly gullible media. Many of the hedge funds and other investors who have taken arguments to court that they are being treated unfairly by the government bought the Fannie and Freddie stocks after the share prices had collapsed and simply want to boost the stock prices with a propaganda war that offers hope they might achieve a court victory. That’s worked out pretty well so far.

Two days ago, Glen Bradford at Seeking Alpha wrote this:

“Fannie Mae and Freddie Mac had their highest levels of capital in history as they were placed into conservatorship,” with the inference that they didn’t really need to be taken over by the government.

That statement compares with this finding from the official Financial Crisis Inquiry Commission report, which refers to Freddie and Fannie as “GSEs,” that is, Government Sponsored Enterprises:

“The GSEs were highly leveraged—owning and guaranteeing $5.3 trillion of mortgages with capital of less than 2%…

“The value of risky loans and securities was swamping their reported capital. By the end of 2007, guaranteed and portfolio mortgages with FICO scores less than 660 exceeded reported capital at Fannie Mae by more than seven to one; Alt-A loans and securities, by more than six to one. Loans for which borrowers did not provide full documentation amounted to more than ten times reported capital…

“At the end of December 2007, Fannie reported that it had $44 billion of capital to absorb potential losses on $879 billion of assets and $2.2 trillion of guarantees on mortgage-backed securities; if losses exceeded 1.45%, it would be insolvent. Freddie would be insolvent if losses exceeded 1.7%. Moreover, there were serious questions about the validity of their ‘reported’ capital.”

Then there is the bombshell “confidential” memo which has been resting quietly in the exhibits of the Financial Crisis Inquiry Commission (FCIC). On Saturday, March 8, 2008, White House economist Jason Thomas sent U.S. Treasury Undersecretary, Robert Steel, a 12-page bombshell memorandum explaining in copious detail why Fannie Mae was engaging in “accounting fraud.”

Why is this memo a bombshell? Because Fannie Mae, precisely two months after this memo, issued billions of dollars of new preferred and common stock to the marketplace. We’re pretty sure there was no mention of “accounting fraud” in the offering memorandum. According to the press release at the time of the capital raising, Lehman Brothers, JPMorgan Securities and Citigroup Global Markets were joint book-running managers for the common stock while Goldman Sachs and Morgan Stanley acted as co-managers. JPMorgan Securities, Lehman Brothers and Banc of America Securities were joint book-running managers on the preferred stock.

Very likely, some or all of these banks needed to infuse additional capital into Fannie Mae to protect their own status as derivative counterparties to Fannie Mae.

Thomas makes the following points in his memo:

“Any realistic assessment of Fannie Mae’s capital position would show the company is currently insolvent. Accounting fraud has resulted in several asset categories (non-agency securities, deferred tax assets, low-income partnership investments) being overstated, while the guarantee obligation liability is understated. These accounting shenanigans add up to tens of billions of exaggerated net worth. Yet, the impact of a tsunami of mortgage defaults has yet to run through Fannie’s income statement and further annihilate its capital. Such grim results are a logical consequence of Fannie’s dual mandate to serve the housing market while maximizing shareholder returns. In trying to do both, Fannie has done neither well. With shareholder capital depleted, a government seizure of the company is inevitable…

“For shareholders, the company has failed to deliver despite the inherent advantages of a lower cost of funds and having larger market share in an impenetrable duopoly. Under Franklin Raines, the company developed an appetite for growth and imprudent speculation. Such risky behavior led to large losses on interest rate bets gone bad and accounting fraud to cover them up. After this was exposed, Fannie undertook a massive multi-year restatement under current CEO Mudd, a Raines protege. Just as the company has finally caught up with its financial reporting, details are emerging about the tremendous increase in credit risk that the company undertook in recent years. Fannie Mae fully participated in the mortgage industry’s fascination with exotic products, from subprime to Alt-A, interest only to negative amortization. What is all the more striking is that this dramatic deterioration in credit standards occurred even while the company was under the watchful eye of its regulator as it worked toward remediating its appalling business controls. Once again, the company is faced with large losses. Once again, the Fannie Mae management team, led by Dan Mudd, Michael Williams, Robert Levin, and Peter Niculescu, all veterans of the Raines era, has resorted to accounting fraud to delay loss recognition and dance around capital requirements.

“Lucrative executive compensation with no accountability to shareholders, it goes without saying, continues at Fannie Mae.”

 (See Wall Street On Parade’s saved copy of the Jason Thomas memo or the FCIC’s official copy of the memo here.)

Prior to the U.S. government takeover in 2008, both Fannie Mae and Freddie Mac had experienced accounting scandals. Without the implied backing of the U.S. government, the GSE bonds which were sitting on the books of mega Wall Street banks, insurance companies, and pension plans across the nation, would have cratered in price, toppling more dominoes in a cascading financial crisis.

The same thing would happen today if Congress were crazy enough to recapitalize Fannie and Freddie and set them lose again as the hedge funds would like.

There is also the propaganda floating around that the government promised it would return Freddie and Fannie to health, thus dangling a carrot that common stock holders might be made whole in the future. Here’s the actual press statement that then U.S. Treasury Secretary Hank Paulson released in announcing the conservatorship. Note carefully this statement:

“Because the GSEs are in conservatorship, they will no longer be managed with a strategy to maximize common shareholder returns, a strategy which historically encouraged risk-taking.”

When hedge funds are allowed to pull levers behind a dark curtain to effectuate housing policy in the United States, we’re all in danger. Mainstream media that’s been shilling for this gang needs to take a sober, serious examination of its reporting, not after all the damage is done as in the Judith Miller case.

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