Fannie, Freddie Take Massive Noncash Charges

They use "valuation allowance" against deferred tax asset balances to produce Q3 amounts of $21.4b and $14.3b, respectively.
Robert WillensNovember 17, 2008

The third quarter earnings reports for both Fannie Mae and Freddie Mac embody massive noncash charges resulting, primarily, from the each entity’s establishment of a substantial “valuation allowance” against its deferred tax asset balance.

A deferred tax asset represents the tax effect of “deductible temporary differences” — the amount by which the tax basis of an asset exceeds its book carrying amount. Here, deductible temporary differences arise from the writedown or writeoff of loans and securities for book purposes in advance of the time these charges are taken for tax purposes.

An entity is required to establish a valuation allowance against its deferred tax assets where, based on the weight of available evidence, it is more likely than not that all or a portion of the deferred tax asset will not be realized. Here, that weight is decidedly negative, and the fact that these entities have been reporting losses for the past 12 quarters provides irrefutable evidence that a valuation allowance is necessary.

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When a valuation allowance is established, or an existing valuation allowance is “enhanced,” earnings are penalized because the entity’s provision for income taxes is correspondingly increased. Fannie Mae and Freddie Mac are government-sponsored mortgage entities.

In Fannie’s case, a valuation allowance amounting to $21.4 billion was established in the third quarter. In the case of Freddie, a valuation allowance amounting to $14.3 was so established. In each case, however, the company still has an unencumbered (by a valuation allowance) balance of net deferred tax assets.

In Fannie’s case the unencumbered amount is $4.6 billion; in Freddie’s case, it is just shy of $12 billion. A valuation allowance was not established for the deferred tax asset related to unrealized losses recorded in “other comprehensive income” with respect to “available for sale” securities.

The companies believe that these amounts will be recoverable because they each have the “intent and ability” to hold these securities until recovery of the unrealized losses. Accordingly, if this belief is later demonstrated to be overly optimistic, the valuation allowances established by each entity may have to be enhanced, with the result that additional noncash charges (which, nevertheless, impair capital) may be incurred.

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