Estimates Are Key at Financial Firms

The troubled housing market has already weakened major financial institutions, and additional vulnerabilities can be found in the fine print and between the lines of their financial reports.

Crucial figures, such as the size of reserves that Fannie Mae, Freddie Mac and major lenders are holding to cover expected losses, are often based on subjective estimates and choices of accounting methods. The current environment has made those predictions even more difficult.

For investors, "the decision fundamentally becomes, do I trust this management team to get these numbers right?" said Zach Gast, an analyst at RiskMetrics Group who studies corporate finances for institutional investors.

Freddie Mac of McLean and Fannie Mae of the District, federally chartered pillars of the housing economy, are a case study. Whether they get the numbers right can have weighty consequences for the economy, because the meltdown in the mortgage-funding business has left them responsible for 75 percent or more of new mortgage-backed securities. Those are instruments through which investors funnel money to lenders, enabling them to make more loans and keep the mortgage business functioning.

If Fannie or Freddie weakened further, mortgages could become harder to get, making it tougher for people to buy and sell homes and adding to the downward pressure on home prices.

Both companies have paid penalties for misstating earnings years ago. In a recent report, a federal regulator raised new questions about Freddie Mac's accounting, saying it warrants further study. One risk the regulator noted is that at the end of last year, Freddie Mac had $15.1 billion of "unrealized losses" on mortgage-related investments. At Fannie Mae, the total was $4.8 billion.

The unrealized losses represent declines in the value of assets that the companies hold. The companies have not counted those losses against earnings because they consider the declines in value to be temporary.

"We have not recognized other-than-temporary impairment with respect to these securities because we believe it is probable we will collect all of the contractual amounts due and we currently have the intent and ability to hold these securities until they recover their value or until maturity," Fannie Mae said in its annual report for 2007.

To put the unrealized losses in perspective, Freddie Mac reported a loss of $2.5 billion in the fourth quarter of last year, while Fannie Mae reported a loss of $3.56 billion.

If the companies had determined that the investments would not regain their value, the resulting charges would have eaten into their capital, the financial cushion they are required to maintain to reduce the risk of their becoming insolvent. Fannie Mae's capital exceeded the government requirement by $3.9 billion as of Dec. 31. Freddie Mac had a capital surplus of $3.5 billion.

Though the government makes no such promise, investors generally assume that taxpayers would have to bail out the companies if either faltered.

Representatives for Fannie Mae and Freddie Mac declined to comment for this article.