A forensic look at the complex legerdemain that was federal government putting the GSEs in conservatorship reveals some head-scratching accounting and some three-card Monte-style mathematics.

Serving as a guide in all this is a new report that, admittedly, comes from a source with skin in the game. But they’re willing to put their names and professional reputations to it, and if whole and accurate, is pretty damning for the Treasury Department.

The full 27-page report, which can be read here, is from two activist investors involved in the FannieGate controversy with extensive legal and business backgrounds, Adam Spittler CPA, MS and Mike Ciklin JD, MBA, MRE.

Here’s what they say they’ve found.

For starters, they say, Treasury justified the conservatorship of the GSEs via accounting gimmicks since they faced no liquidity issue at the time of the crisis and recession. They note that Fannie Mae’s Cash Net Income, adjusted for non-cash items, was positive throughout entire crisis and recession.

In the third quarter of 2008, the financials should have looked like an abattoir floor. But it didn’t.

Accounting net loss for the quarter was $29b. Loan loss reserve for the quarter was $8.7b and FHFA forced Fannie to write off $21.4b of Deferred Tax Asset.[1]

The manufactured $29b loss “wow” factor was an attempt to overcompensate for the shaky legal justification for the conservatorship.

Deduct the two massive – and unnecessary as proven in later years – non cash expenses of $21.4b and $8.7b, Fannie’s Cash Net Income = 1.1b. Fannie, in the quarter it was taken into conservatorship, generated $1.1b of cash.

Okay, you say, but what about liquidity?

Fannie Mae disclosed they held $36.3 billion cash in the bank on September 30, 2008 with a maximum exposure of roughly $6 billion per quarter. That was enough liquidity to survive over 18 months, assuming it didn’t bring in another dime.

Then there’s the Treasury Draw Trigger.

Treasury Draw Trigger =  “Net Assets” instead of cash, or fair market value, or even current or quick ratio. Why?

Net Assets is by far the easiest measure to manipulate. With it, Treasury can push reserves onto the balance sheet to impair assets while liabilities remain untouched. In effect, it gives Treasury the power to force the GSE’s to take funding via aggressive reserve assumptions.  If Treasury had picked a true cash or liquidity measure to serve as the draw trigger, none of the draws would ever have been required.

All of which leads to a number of questions the report poses.

Q: “What company requires 116b [sic] of a bailout but then pays it back in full within a 2 year period of ‘returning; to profitability?”

A:  “One that non-cash based accounting gimmicks made it seem like it needed in the first place; in terms of operations and cash, it needed nothing.”

In other words, these accounting gimmicks would made it seem that HERA conservatorship criteria had been met, but it looks like, if the authors are right, none of them were.

In fact, they argue quite compellingly that the Treasury could have provided GSEs with line of credit and they never would have had to borrow a penny.

President Bush despised the GSEs (as did HP & TG) and they wanted GSE balance sheets to help TBTF banks and support housing.

Federal Accounting Standards Advisory Board (FASAB) Meeting held from December 17-18 2008 [2]

Treasury’s Deputy CFO, Director of Accounting, and a rep from the Office of the Inspector General all appeared. No one from FHFA.

Then they offer this bombshell – the GSE bailout number of $200 billion “was not an accounting estimate…figure developed from a public policy perspective… not developed based on any type of analysis of future (i.e. cash flow) needs.”

Buried in Fannie’s 2009 10k was this:

“On April 1, 2009, we adopted (management [Treasury/FHFA] elected) the FASB modified standard on the model for assessing other-than-temporary impairments, applicable to existing and new debt securities held by us as of April 1, 2009.”

Prior accounting (Q1 09 and before) provided for exclusion of a reserve if the Enterprise intended to hold the security until it recovered.

The capital markets retained portfolio of Fannie Mae on December 31, 2008 was $765.1 billion. (Not a typo. Three-quarters of a trillion dollars.)

The US Treasury has required Fannie Mae to liquidate 100% of its retained portfolio by 2018.

By changing this accounting method, Treasury created an unbelievably powerful mechanism to mercilessly write down the retained portfolio. Treasury, racing to the scene, then forces the GSEs to draw down funds to repair the phantom accounting damage it engineered.

Then there’s this.

“Within 15 business days following the determination of the deficiency amount, if any, as of the end of each fiscal quarter of Seller which ends on or before the Liquidation End Date….Purchaser shall provide such funds within 60 days of its receipt of such request.”

Ponder that one.

The quarter end close in a normal company takes about three weeks, right?

At day 21, the GSEs are able to determine if there is a deficiency (negative net assets).  At which point they have 15 days to request funds.  At this point, they are 5 weeks into the process, paying payables every single day.

Then, Treasury has a full 60 days or 8 and a half weeks to fund. At this point, the Bailout Funds are now available 13 ½ weeks after the date of determination for the supposed cash needs.

If, the authors argue, the GSEs were on the verge of diabetic coma and they needed their insulin from Treasury, they’d be stone cold dead.

So how did Fannie or Freddie keep operations going while they were supposedly insolvent?

The answer is simple: they were never insolvent…the smoke and mirrors of accounting reserves were used to make them appear that way.

Loan loss and FMV reserves were materially overstated in 2008 and 2009 then reversed in 2013 and beyond.

Rep and Warrant accounting was incorrect.  Never recorded any receivable from the banks, only impaired the defaulted loan

If everything in the whole report – and I urge you to look the full thing, with its extensive research and footnoting – then there’s an amazing amount of gymnastics you have to go through to get to where the Treasury stands today.

The Deferred Tax Asset Reserve should have never been booked in the first place.  Using the uncertainty of conservatorship as a reason to impair while ignoring the previous 18 years of profitability is unreasonable and incorrect.  On the flip side, ignoring the uncertainty of conservatorship in 2013 to reverse the reserve is cherry picking and also incorrect.

What they’re saying – and I can’t find a good counterargument otherwise – is that the Treasury can’t use the argument to its advantage on the front end and ignore its existence on the back end.

Deloitte knew or should have known better…and they should be on the hook for the cost of a full restatement. In addition, all non-cash inflated reserves that were historically unnecessary must be reversed and pushed back into Net Income. Deloitte simply has no margin for error based on Treasury’s imposed “Net Asset” trigger for borrowing funds.

R&W estimate was $50b, 41.5b above settlements to date, yet another back door bailout of banks]

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