Fed, Comptroller of the Currency Due Diligence Sham for Fannie, Freddie

The political theater continues. The New York Times reports in “Bush Prods Congress, as Financiers Are Inspected,” that the Fed and the OCC are giving Fannie and Freddie the once-over:

Bank examiners from the Federal Reserve and the Comptroller of the Currency are inspecting the books of the nation’s two largest mortgage finance companies, Fannie Mae and Freddie Mac, as the Bush administration prods Congress to approve a plan that would enable it to inject billions of dollars into the companies.

Treasury Secretary Henry M. Paulson Jr., in a meeting on Monday with reporters and editors of The New York Times, said the Fed and the comptroller’s office began combing the books of the two companies after their declining stock prices caused widespread anxiety in the market. The two companies guarantee or own almost half of the home mortgages in the United States.

There are three simple reasons why this supposed review is certain to be a sham.

First, do you think that it would be acceptable for the examiners to come back and say the GSEs were in trouble, or merely undercapitalized? Never. So the outcome of this exercise is predetermined. The most we might see is some recommendations for improvement and/or mention of some minor problem area, nothing threatening. to make the process look legitimate.

Indeed, Paulson’s own comments confirm that this is a PR effort:

“Ofheo has told us one thing and the markets have told us another,” Mr. Paulson said. “I’d like as much input as possible.”

He added that the examination would “make the markets more comfortable” about the financial health of the companies.

That comment presupposes a clean bill of health.

Second, the manpower is certain to be insufficient. When Citigroup was in serious trouble in the early 1990s, it took 160 examiners to go over their portfolio. And the troubled loans were junior/senior debt deals, where Citi was holding junior debt on what turned out to be see-through office buildings in Texas and the Southwest. That meant it was a specific number of deals (I have no idea how many, but exactly how many bad commercial RE deals could a large bank do?) that were inspected intensely.

Now this is a completely different sort of exercise, but I strongly suspect it would take more than 160 people per GSE to perform this review in enough depth to make most readers happy, and it’s a pretty safe bet there are not that many people dedicated to this task.

Third, not even remotely enough time. Paulson wants the rescue package approved by Congress this week and wants the inspection to bolster confidence:

Mr. Paulson repeated his earlier comments that Congress should provide the administration with open-ended authority to make investments and loans to the two giant companies to send a strong signal to the markets that they have plenty of financial muscle behind them.

“The more flexibility we have on the credit facility, the more confidence you have in the market and the greater protection to the taxpayer because the less likely it will be used,” Mr. Paulson said. “Something like that shouldn’t have to be used. It’s like the Fed’s lender of last resort facility.”

He said it would be unfair to describe any possible loan to either institution as a bailout because, he said, they would have to post “strong collateral” that would protect taxpayers from losses.

“These entities have good collateral,” he said. “There are mortgages being made today.”

In response to a question about how confident he could be that the collateral would be adequately valued considering the sharp and continuing decline in the housing markets, he said that the two companies were being examined by officials from the Fed and the comptroller’s office.

So pray tell, how are the OCC and the Fed going to verify that the collateral is any good? Get appraisals? Review recent (and I mean very recent, since conditions are changing) sales in the area? On what sample? In what detail?

Getting appraisals and comps takes time. There isn’t sufficient a long enough runway for the examiners to verify the value of even a teeny sample of the collateral in anything but the most cursory fashion (assuming they can even do that).

Oh, but we don’t have to worry. Paulson told us the collateral is good and he worked at Goldman, so he must know.

Now the Freddie/Fannie situation is different, but ultimately, you need to understand, at least in the most at-risk markets (California, Arizona. Florida) how well capitalized the most problemmatic loans are (however you define that).