Freddie Mac's Latest Earnings Report Made Suckers of Us All

My friends, over the last month or so it has been truly tempting to tell you that the bull market has begun anew. Truth be told, my popularity, not to mention my portfolio, would have fared better had I thrown caution to the wind and joined the perma-bulls in saying that the Bear Stearns (BSC) collapse was the end of trouble for US markets. After all, the markets have rallied nearly 10% in one month's time.

Stocks continue to rally despite economic data that is clearly fraudulent or flat out horrific. And many financial heavy hitters, among them Alan Greenspan and various Wall Street CEOs, have stated that the "worst is over."

The reality, however, is that we are all engaged in a giant poker game. The players are the Federal Reserve, the Wall Street banks, the Credit Rating agencies, the US Government, and ordinary investors like you and me. Guess who the patsy is? Warren Buffett, once wrote, "As they say in poker, 'If you've been in the game 30 minutes and don't know who the patsy is, you're the patsy.'" Well, this current rally has now cleared the one-month mark, and Joe America still hasn't figured it out. So I'm going to come out and say it… The patsies are ordinary investors like you and me.

Nowhere is this more evident that Freddie Mac's (FRE) 1Q08 earnings. Freddie Mac is the second largest mortgage originator after Fannie Mae (FNM). The company's primary business is to securitize mortgages into mortgage-backed securities to be sold on the secondary market. As such, Freddie is the 'Father of All Mortgage Packaging'.

On Wednesday, Freddie announced a lower than expected 1Q loss of $151 million. The company beat estimates not by generating real profits, but through Wall Street's favorite new gimmick: accounting changes. Without the changes Freddie made to its accounting principles it would have reported a 1Q loss of over $1.7 billion. Amazingly, you didn't have to dig into the financials to find this out: It was right in the headlines! Freddie told investors right to their faces, "We manipulated the numbers," and investors applauded like a bunch of idiots, pushing Freddie Mac shares up more than 9%. I wish this was the end to the tragic comedy, but Freddie's conference call was even more ridiculous.

Below is a brief transcription:

Analyst: There is a headline out there that you have level 3 assets of $157 billion. I was just wondering is that true and is that related at all to the markups of the 1.2 billion gain?

Freddie Mac: No, it is not Paul. We made a determination in the first quarter that given how widely the pricing we were getting on the ABS portfolio [varied] that it no longer made sense to leave that into level two. So we essentially moved the entire abs portfolio into level three.

Those of you who are familiar with accounting principles in the US know what this means. For those of you who are not, I'll give a quick explanation. Accounting for financial firms break assets into three categories: Level 1, Level 2, and Level 3. Level 1 pertains to assets that are extremely liquid and thus are easy to price: stocks, bonds, etc. Level 2 are for assets that are slightly more illiquid, but still have regular market pricing: municipal bonds. Level 3 assets are so illiquid that they have no market pricing and thus are valued using the firm's own models.

Put another way, Level 3 offers the greatest potential for accounting fraud. There is no oversight of these assets. The company can simply value them at whatever it pleases. And Freddie Mac just moved its entire Asset-Backed Security [ABS] portfolio to Level 3.

As a result, its Level 3 assets ballooned from $39 billion to over $157 billion in the first quarter. Its reasoning? The pricing the market was giving these securities varied too much. In other words, when the market was responsible for figuring out how much these assets were worth, the price fluctuated dramatically, providing the potential for major losses. So Freddie moved these assets to Level 3, where the market no longer has any say in their value. It's yet another nail hammered into the coffin of what was supposed to be a capitalist free market.

Amazingly, in spite of both the phony "smaller than expected" loss and the shift of a $100+ billion portfolio to Level 3, investors pushed Freddie Mac's stock up 9% on Wednesday. It's simply incredible. Not too long ago, the powers that be⎯ Wall Street, the Fed, Credit Rating Agencies⎯ used to tell us it was raining while they pissed on our backs. Now they don't even bother with the weather pronouncements. And investors don't seem to care. It's truly unbelievable.

Anyone buying into the idea that the credit crisis is over is a patsy. That's all there is to it. Wall Street doesn't even need to dress up its lies anymore, the perma-bulls are more than happy to believe whatever the Street wants them to believe. Please, do not be one of them. This is a sucker's game. And the ones buying into financials and others companies exposed to the credit crunch are going to find out who the sucker's are before the end of the year.

Disclosure: None

Comments

[adamstuartrand]

T'is better to keep our heads in the sand while the Emperor's parade goes by.

Looks like everyone, the Fed, Ofheo, etc. is trying to buy time for the Emperor to get to a clothing store.

[nmau]

I guess we'll find out who is right in time. The permabears who seem the mainstream in Alpha,or the permabulls. I believe the worst is over and that quite a few Level III assets will work out fine.

[Chuck]

Billions in the Level III column.
and if just Millions survive, then 'nmau' is correct, and 'quite a few Level III assets will work out fine.'

I'm on the side worried about the Emperor's judgement.

[GeorgeBurdell]

Terrible news... But an excellent post pointing out the truth. I couldn't agree with the author more that something is amiss in the quick move of assets to level 3. My question is "what next?" The external auditors, OFHEO, et al have allowed / are allowing accounting manipulations to go on... at what point does it hit the fan, and can no longer be supported? What event is the tipping point? How far are we from it?

[sivere]

Of course we are the patsy. We allowed congress to give the resonsibility to create a currency and maintain na system iof credits to Wall Street (through the Fed).

Do you want to survive? You have 3 choices, pick one:

TakeBackThe Fed.com

TakeBackThe Fed.com

TakeBackThe Fed.com

[monday1929]

The level of denial, and the instant willingness to believe corrupted statistics and massaged numbers, indicates to me that when reality dawns the markets will lose 50-80 per cent very fast.

[DaveW]

I am with the author that this is a sucker's rally. I've read so many great article here on SA pointing out all the market's realities. All the fundamentals point toward holding cash and waiting for the bottom to fall out. But..., reason doesn't always make the markets move, and reason won't be at the wheel in this market anytime soon. We'll see only a modest 5-8% correction in the near future and proceed from there yet higher. Be very careful shorting this foolish market, I did via SRS and am deeply buried in that position, am doing okay in my SKF position and will capture those gains after the coming correction. Also, be very careful holding on to cash positions for too long.

[DaveW]

By the way, anyone see the interesting article from Bespoke yesterday?

seekingalpha.com/artic...

It is food for thought for sure. Many a wise and realistic investor was crushed by the subsequent bull (fools?) rally. The rally may be foolish fundamentally but your cash does not know the difference.

[jimmy46]

If FRE keeps the level 3 assets to maturity, what does it matter if the daily price changes?
Marking to market assets that will be held to maturity has caused a lot of the problems of the last 9 months and IMO doesn't help investors.

Instead of running mtm gains/losses thru the income statement,
there should just be a footnote in the financial statement.

[User 194258]

If company's can move assets to Level III to the tune of $151 billion because they don't like the pricing model the free market gives, then what is the point of even reporting earnings?

That's like saying to your tax broker, I bought $50,000 of stock but I don't like the way the market is pricing it at $30,000, so I'm going to move it to fantasy land and not report that loss because I feel that one day it will be worth $50,000...

WTF??? That is corruption...