As I was researching work on a forthcoming blog post, I reviewed the following exchange between Representative Alan Grayson (D, FL) and FHFA Director James Lockhart. The conversation occurred on June 3, 2009 during a congressional hearing:
SUBCOMMITTEE ON CAPITAL MARKETS, INSURANCE, AND GOVERNMENT SPONSORED ENTERPRISES OF THE COMMITTEE ON FINANCIAL SERVICES: THE PRESENT CONDITION AND FUTURE STATUS OF FANNIE MAE AND FREDDIE MAC
There are many interesting points to review during this hearing. However, the questioning by Congressman Grayson asks what many others have asked over the years — was the government takeover necessary? Recall that the conservatorship began on September 6, 2008. Grayson states that he reviewed FNMA’s then-current (at the time of the takeover) 10-Q and asks how a $192 million loss created a $100 billion takeover. Lockhart’s response was the answer could be found in 10-Q’s that were published after the takeover — September 2008, December 2008 and March 2009. So, if you listen to Lockhart’s response, he basically says “we used clairvoyance as a part of our decision process to seize the company.” What it actually suggests is the future losses were accounting manipulations to serve the government’s other goals.
Further, Lockhart described the post-conservative losses as private label securities credit losses — the losses related to the bank settlements, i.e. not Fannie’s fault. In fact, earlier in the hearing Lockhart said, “I do not think Fannie and Freddie were the cause.”
Mr. Grayson. Thank you, Mr. Chairman.
I have here the Form 10-Q filed by Fannie Mae the month before it went broke. I actually went through it and read it myself personally, and I had some questions I want to ask you about that to try to get a sense of how this happened and what we can learn from it.
Specifically, on page 112, it says, “Risk Management Derivatives,” and there is a table there, and it indicates that between December 1, 2007, and June 30, 2008, Fannie Mae increased its notional balances for derivatives by $255 billion.
Can you give me some idea of the justification for a company like Fannie Mae increasing its exposure to derivatives at seemingly the worst possible time by a quarter of a trillion dollars?
Mr. Lockhart. Fannie and Freddie had many problems that surfaced over the last year. Certainly, in their June 10-K of last year, they mentioned many issues.
The derivatives have not been an issue that actually caused any significant problems at the two firms. The derivatives were used to hedge their mortgage portfolios.
What they do oftentimes as the market changes, is they add a derivative. Then rather than closing it out, they just buy one to counter the one that they had before. And so you get this piling up of derivatives. It is an issue that we have talked to them over the years about. Could they close these derivatives out rather than just buying a counter one?
Oftentimes, they buy it with the same counterparty, and so the actual exposure is not that large. It is an issue that we have been talking to them about before the conservatorship and after the conservatorship. As I think Congressman Garrett asked earlier, there are ways to lessen the exposure through exchanges and clearinghouses. And that is something we are looking at, at the moment.
Mr. Grayson. I wonder if it is really true that this had no effect on them. I mean, logically, having an exposure that as of June 30, 2008, totaled $1,141,000,000,000 is something that could conceivably have some effect on your operations, particularly since we are talking about a time just 2 months before it went broke.
Mr. Lockhart. Right.
Mr. Grayson. Why would they have such an exposure like that unless it were for a purpose? And for that purpose, couldn’t it easily have been something that went wrong?
The reason I am asking this question is because if you look at page 78 of this same 10-Q, what you see is that for nonperforming single family and multi-family loans together in their portfolio, which was almost a trillion dollars by itself, the amount of interest income that they lost because of nonperforming loans was only $192 million and going down–$192 million versus $255 billion—isn’t it more likely that they got into trouble over the $255 billion than they did over the $197 million?
Mr. Lockhart. I can tell you, in retrospect, they haven’t lost significant money in the derivatives area. They are using derivatives to hedge their mortgage-backed exposure.
The vast majority of those losses, the over $100 billion in combined losses in the two companies, has been not on their interest rate risk and their interest rate risk management, although there has been some there. Most of it has been in credit losses. And it is credit losses related to the private label securities, and credit losses related to their books.
When we did a very extensive look at the two companies in August, we worked with the OCC and the Fed. Also, Treasury had hired an investment bank as an advisor.
As we looked through all the issues in these two companies, the derivatives was an issue but nowhere near the top. The key issues really were they had a deferred tax asset and they had credit exposures in their private label securities. The three quarterly reports since then have shown that is where the big losses were.
Mr. Grayson. Well, again, let’s look at the information I just provided to you. If in fact the interest income that was lost—and interest income is defined in the 10-Q as, “the amount of interest income that would have been recorded during the period for on-balance sheet nonperforming loans had the loans performed according to their contractual terms.”
If those losses are only $192 million, how could a $192 million loss result in a $100-billion-plus loss to the taxpayers? How is that possible?
Mr. Lockhart. What has happened since then is they have had to put up reserves for loans that are in default. And they have also had to take other-than-temporary impairments on their private label securities. And they booked a lot of losses related to the credit.
The interest give-up is a very small issue. Under proper GAAP accounting, if you think you cannot recover, you have to take an other-than-temporary impairment. Or if it is a loan, you have to write it down to the value that you expect to recover. And that is what has happened.
Mr. Grayson. Well, I see my time is up. But let me just ask you this last follow-up question, and thank you, Mr. Chairman, for your indulgence.
I still don’t have a clear understanding from you about how a relatively tiny amount, like $192 million in unpaid mortgage interest on what is a trillion-dollar portfolio, how that possibly lead to the taxpayers having to shell out $100 billion plus.
Mr. Lockhart. They have had a lot more missed payments since then. It has spread throughout not only their lower quality book, but even to some of their prime loans. They have had to put up reserves. They have built the reserves very dramatically since June because of the deterioration in the mortgage market and the deterioration in the economy.
We would be happy to go through those numbers with you, and meet with you and show you what really happened, and go through not only the June numbers but the September, December, and March numbers, and how these losses have unfortunately marched through their financial statements.
Mr. Grayson. Well, that would be great. Thank you very much for doing that because, as we know, those who don’t understand history are doomed to repeat it.