Deloitte & Touche As Part Of A Conspiracy To Destroy Fannie Mae

March 7, 2016 at 10:00 pm, 2 comments

Fannie Mae shareholders filed a lawsuit in Florida District Court that alleges that Deloitte & Touche's public stance, that it acted with professional independence in its capacity as the company's outside auditor, is a joke. Rather, plaintiffs allege, the accounting firm took illegal actions, at the behest of the Federal Housing Finance Agency and the Department of Treasury, to present a false and misleading picture of the company's financial health to investors and to the public.

The accounting firm purportedly signed off on wildly over-inflated loss provisions and writedowns, which were posted in late 2008 through 2011. Those illusory losses were used to create the false impression that Fannie Mae's management and business model created a financial disaster at the center of the mortgage crisis. The bogus numbers also served as the pretext for a $117 billion taxpayer "bailout," which would encumber the company with an annual obligation to pay out $11.7 billion per annum in senior preferred dividends in perpetuity.

Of course, those illusory "losses" would inevitably be reversed. But Deloitte delayed recognition of such non-cash "income" until 2013, when, under the Third Amendment to the Senior Preferred Stock Purchase Agreement, all earnings would be swept out of the company in the form of cash dividend distributions.

Yep, it was a conspiracy: Plaintiffs allege that Deloitte was a chief enabler of a broad-based conspiracy--involving high ranking officials at FHFA, Treasury and The White House--to drain the private company of all financial resources. (The word conspiracy is never used in the complaint, which focuses on Deloitte's professional malfeasance. But the accounting firm's actions can only be understood in the context of the government's broader, highly coordinated, agenda.)

The clear implication of the lawsuit's narrative is that, during the conservatorship, nobody with a legal mandate to act on behalf of the corporation--none of the corporate officers, directors, government regulators--acted with the requisite level of professional independence. It's hard for a lot of people to get their head around this idea. As we will see below, this phenomenon did not suddenly emerge out of nowhere in September 2008.

The missing restated financials: Irrespective of whether the initial provisions and writedowns were patently fraudulent, or whether the timing of the subsequent reversals was fraudulent, plaintiffs allege that Fannie had a legal obligation to restate its financials for the 2008 -2013 period, so that investors and the public could obtain a proper picture of the company's financial standing during those years. Such a restatement would strike a blow against the Treasury Department's party line, which is that both government sponsored enterprises, Fannie and Freddie Mac, are irredeemable failures that must be put out of business. For purposes of this lawsuit, Deloitte had an obligation to withdraw its opinion on Fannie's financials in the absence of an effort to restate them for the prior fiscal years.

The burden of proof: The facts underlying the allegations are not set forth in the complaint with great specificity. This is not like a complaint alleging securities fraud in Federal Court, where the plaintiff must essentially prove his case before he is given the opportunity to pursue discovery. If I knew nothing of Fannie or the government conservatorship when I read the complaint, I would be skeptical of the plaintiffs chances at success. (Then again, if I knew nothing of Fannie Mae, I never would have imagined that a large corporation in conservatorship would pay out cash dividends.)

The numbers always looked highly suspicious, as I wrote in December 2013 and in November 2014. But it's very difficult to prove that loan loss provisions were calculated in a fraudulent manner, because the process, which involves subjective assessments and professional judgement, can be complicated by many moving parts.

To the uninitiated, the timing differences that drive bank earnings and equity may seem difficult to grasp. Accrual accounting for lending institutions was neatly summed up by William Faulkner. "The past is never dead," he wrote. "In fact, it's never really past." Bank accounting is all about the continual reconciliation of the past, measured as loan loss provisions in prior quarters, with the present, measured as the cash proceeds from loans taken off the books. Moreover new loan loss provisions are continually updated, based extrapolations of backward-looking data.

Defense counsel would hope to sow confusion that works in favor of the defendants. But the plaintiffs should prevail if the data is really is very lopsided, if it is clear that the process for arriving at the numbers was a sham.

Plaintiffs' counsel know what they are doing. Thomas, Alexander, Forrester & Sorensen specializes in going after accounting firms, and won a $112 million settlement against Ernst & Young in connection with its negligence in the Bernie Madoff Ponzi scheme.

My understanding is that plaintiffs' counsel have spoken with knowledgeable corporate insiders, who have described in detail how the process of corporate governance was continually short-circuited.

It didn't start in September 2008

At first blush, it is difficult to get one’s head around the allegations of an ongoing pattern of accounting fraud, directed by high ranking corporate and government officials, at Fannie Mae. So it may be worthwhile to step back and review the government’s oversight of the GSEs over the past dozen years or so. Because there’s a lot of cognitive dissonance to overcome.

To make sense of it all, one must remember Wall Street’s favorite rhyme:

Money talks, bullshit walks.

(From here on in, I’ll use a more descriptive and less vulgar synonym for BS, doublespeak.) More specifically, any analysis of the GSEs and their role in our financial system must address three basic questions, which all focus on money. They are:

1. Where do debits and credits go?

2. Which loans are repaid with interest?

3. What is the flow of funds?

Unless you address these three questions, it is all but impossible to excavate the Himalayan mountain range of doublespeak— thousands of pages of garbage analysis in books, articles and “academic studies” — used to obscure the truth about the GSEs. Once you make a good faith effort to grapple with those three questions, you arrive at certain uncomfortable conclusions:

Where do debits and credits go? The answer leads to the conclusion that the Fannie Mae accounting scandal was an elaborate scam invented by corrupt government officials who lied to Congress and the investing public. This phony scandal was the foundation of the myth that Fannie’s portfolio business was dangerous and mismanaged and must be downsized into oblivion.

Which loans are repaid with interest? The answer leads to the conclusion that those who argued that GSE underwriting standards led to the mortgage crisis are Intellectual frauds who pander to class bigotry.

What is the flow of funds? The answer leads to the conclusion that those who say the GSEs “collapsed” in a manner comparable to the collapse of the Wall Street banks are intent on perverting the history of the financial crisis. The GSEs never ever faced any difficulty in accessing the unsecured debt markets. By tracing the flow of funds, we see that the “necessity” of a $187 billion GSE bailout was highly dubious. The evidence to be presented in the Deloitte lawsuit may very well prove that the “losses necessitating a bailout” were fabricated of a team of corrupt government officials at FHFA, Treasury, and the Federal Reserve.

Fannie Mae Accounting Scandal Presages The Deloitte Lawsuit

Today I’ll focus on the Fannie Mae “accounting scandal” because it is so clear cut and obvious.

The scandal is one of the most remarkable Emperor's New Clothes phenomena of the 21st century. The story had been subjected to intense media scrutiny for six years before I stumbled on to it in November 2010, when, being without sin, I cast the first stone in the Huffington Post. (That piece and about 25 others by me were scrubbed from the site a few months later, after the American Enterprise Institute complained that I libeled Peter Wallison. Given how, five years ago, my assertions seemed so far out in left field, I have no hard feelings toward HuffIPo.)

It’s always the debits and credits: I’m no CPA or accounting expert; but I knew the basics. I knew that every accountant on planet earth would back me up on this point. Whenever you accuse somebody of violating accounting rules, you must address three questions upfront:

1. Where are the debits and credits supposed to go?

2. Where, if anywhere, did the debits and credits show up instead?

3. How were people deceived by the misplacement of the debits and credits?

If the accuser does not have a clear and cogent response to those three questions, you know, with absolute certainty, that he is clueless. And if you read a report that waxes profane about generally accepted accounting principles and FAS 133 and highly effective hedges, it’s all blah, blah, blah nonsense until you know where the debits and credits are supposed to go.

This isn’t just my opinion or my personal interpretation of accounting rules. This is a simple cut-and-dry fact. You can’t edit a story for The New York Times if you don’t know the alphabet, and you cannot identify an accounting violation if you don’t know where the debits and credits are supposed to go.

Let me spell it out because a small army of lawyers spent eight years spinning their wheels on this point.

Debits and Credits For Interest Rate Derivatives: Fannie Mae buys interest rate derivatives that swap the 90-day rate into the 10-year fixed rate. Virtually all 10-year derivatives have mark-to-market values that go up and down over time. When the mark-to-market value goes down, Fannie posts a negative debit to show the reduced value of its assets. And it posts a negative credit to show a mark-to-market loss, which reduces total corporate equity.

FHFA, called the Office of Federal Housing Enterprise Oversight in its previous incarnation, contended that the credits should be posted on Fannie’s Income Statement. But Fannie made a practice of posting the debits on its Statement of Changes in Shareholder Equity, as a category called Other Comprehensive Income.

Which brings us to the third question above. Who was deceived by the posting of credits in the

Changes in Shareholder Equity? Nobody. If somebody were confused by the placement, he was also incapable of understanding almost everything else in one of Fannie’s 10-Qs or 10-Ks.

A tale told by an idiot, full of sound and fury signifying nothing: So what was all the fuss about? OFHEO created a lot of fuss because it used this substance-free “infraction” as a pretext for telling a bunch of wild inflammatory lies to Congress. OFHEO and the SEC said that they had conducted a multi-year investigation and discovered that Fannie had concealed $10.6 billion in mark-to-market derivative losses. The truth was that Fannie had always disclosed $10 billion in mark-to-market derivative losses as Accumulated Other Comprehensive Income on the Statement of Changes in Shareholder Equity.

Why did this obvious lie go unnoticed for years? Because nobody would believe that the Chairman of the SEC, Christopher Cox, the Director of OFHEO, James Lockhart, and a small cadre of other high ranking government officials would all engage in criminal conspiracy to deceive Congress and the public about the nature of Fannie’s financial position. This criminal conspiracy was initiated and spearheaded by Steven Blumenthal of OFHEO, who hired a mendacious bank examiner, Christopher Dickerson, to fabricate two tombs of doublespeak intended to create the false impression that Fannie Mae mismanaged its derivative exposures the same way that Enron did.

The debits and credits reveal both the truth and the mendacity of the situation. They prove, beyond all reasonable doubt, that Lockhart and Cox knew they were lying to Congress when they testified that Fannie had “understated” losses by $11 billion. Again, no one can testify before Congress, accuse a company of egregious accounting violations and not know where the debits and credits were supposed to go, where they were misplaced, and how people were deceived. Can you imagine a prosecutor handing down an indictment for murder without bothering to ask if somebody died?

Following the OFHEO and SEC investigations, Fannie issued restated financials and the $11 billion “understatement” suddenly disappeared. But the spurious lawsuits charging Fannie’s CEO, CFO and controller with malfeasance and accounting fraud lingered on for another six years. Why? Because it was politically incorrect for the high powered defense lawyers to say: Judge, look at where the debits go and where the credits go and you can figure out that James Lockhart and Christopher Cox were lying through their teeth.

For more details on the travesty known as the Fannie Mae accounting scandal, see this, this, this, and this. And in case you doubted that past is prologue, consider this gentle rebuke by Judge Richard Leon, “The discovery process was unnecessarily prolonged by OFHEO’s repeated and stubborn assertion of privileges that had to be litigated up to the Court of Appeals.”

And a primary motivation for placing Fannie in conservatorship may very well have been that, in September 2008, the five year statue of limitatiions for the crime of lying to a Federal official had not yet passed with regard to the false statements made by a small cadre of officials at OFHEO and the SEC.

[Modified from the original to reflect the allegation that Fannie, not Deloitte, had the direct obligation to restate its financials and that Deloitte failed in its duty as a public watchdog to withdraw its opinions on the original, misleading statements.]

2 comments - Deloitte & Touche As Part Of A Conspiracy To Destroy Fannie Mae

19thstreet - March 8, 2016 at 8:10 pm

IMO accounting got sucked into the affair just as the BOD did.. Remember Hank never told the board what the deal was,. It was IMO a slow burn. I don't think accountants new anything more than what they were told. Until now!

Cliff - March 9, 2016 at 8:30 am

I've really enjoyed your reports. Concise, to the point and full of facts not found elsewhere.

Thank you for what you are doing.

Deloitte & Touche As Part Of A Conspiracy To Destroy Fannie Mae

It didn't start in September 2008

Fannie Mae Accounting Scandal Presages The Deloitte Lawsuit

2 comments - Deloitte & Touche As Part Of A Conspiracy To Destroy Fannie Mae

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