Monday, September 8, 2008

This blog’s evolving view on Fannie Mae

I was once short Fannie Mae understanding (well before their regulator) of the extent of the scam in their derivative accounting. I even managed to quantify it. [Funnily enough executives who I thought up to their neck in that scam are still in senior positions at Fannie. Will the conservator please sack them for cause. If they leave with big packages I will be disappointed.]

The stock however didn’t fall out of bed – and whilst we made money – it was hardly worth the stress.

When I first looked at Fannie for this blog my predisposition was to go long. However I would not do that without analysis – so I had a go at doing the analysis.

The first post – Fannie Mae Part I – detailed the revenue and pre-provision profit potential of the company. That was really the “upside case” and it was considerable. I got quite a lot of emails from short sellers who thought I was insane. They were right I might add.

Fannie Mae Part IA detailed my views about the way Fannie was feeding business to insolvent mortgage insurers to keep them solvent. It was bearish because the mortgage insurers provide protection for Fannie on a large number of high loan-to-valuation mortgages and if the mortgage insurers were rubbery then Fannie also was.

The next post was a plea to help model Fannie Mae’s losses. The range of numbers in the marketplace was huge – and the analysis behind those numbers was thin. It was however thin for a reason as the modelling post makes clear. My plea for help fell on deaf ears. This blog has 1000 daily visits but nobody could provide me a decent model of Fannie’s losses.

Fannie Mae Part II discussed whether Fannie Mae was insolvent or profoundly insolvent. I thought that mattered then and it matters now. If Fannie Mae is correctly reserved now I figure the stock is worth more than $8 even after the bail out. It is however not correctly reserved – and the extent of shortfall is the critical factor for the value of Fannie Mae and for the risk to Federal Government from this bailout. I figured if the shortfall were 80 billion then Fannie Mae was “borderline profoundly insolvent”.

Fannie Mae Part III gave up altogether and produced what I think remains a rubbery estimate of Fannie Mae losses above trend. The number was $64 billion – but there is some Alt-A and I should include trend losses. If you do that you get something close to $80 billion. I concluded – much to my surprise as follows:

My a-priori expectation was that Fannie was going to be better than that. If you had put a gun at my head and asked me would I prefer be long or short I would have said long.

Now I would say short.

I have no position and it is likely to stay that way. But for once I do not think the shorts are grotesquely overstating their case.
That call was good – but not strong enough. I should have shorted the stock.

After the fix was in and the legislation was in place to guarantee Fannie Mae I was perplexed that Fannie Mae spreads did not drop. In this post I made one of the best observations I have made on this blog – but I did not hammer it home because I thought the spreads were so irrational they would drop shortly. I said:

Monday, August 18, 2008
Foreigners selling Fannie and Freddie debt
I wrote here about what seemed to be the irrationally wide spread on Fannie and Freddie debt. We are after the Paulson plan. The US Government has promised it stands behind these entities. But the spreads still widen.
Widening spreads will cause the end - because Fannie and Freddie need to borrow humungous piles of money.
Now Naked Capitalism has a nice post on foreigners selling Fannie and Freddie debt. That seems irrational to me - but it is still happening - and that is not good news for the GSEs.
I expressed my opinion about the irrationality here.

Even then I did not think that the Bush administration would step in and socialise the problem.
The Bush administration is hardly characterised by decisive well considered action. There is an election coming – why not just palm it off on the next guy?

I "missunderestimated" them. Paulson is his own man and whilst George Bush didn’t think it was a bailout Paulson knew better.

I think the bailout was the right thing to do – expressed here. And I am surprised it is so generous (expressed here).

The question will now come down entirely to the “known unknown” – which is how big are the credit losses. I think my estimate here is the best so far anywhere in the market – and I barely think it worth the place in the Blogger computer server. Nobody knows. If they are bigger than about 80 billion the Government will probably wear some losses. If they are less than 80 billion the preferred will probably retain some value. If they are less than 40 billion the common will be a good buy. Unfotunately I come out about 80 billion. That will make the government whole but leave everyone else very distressed. Freddie Mac being worse than Fannie Mae will wind up costing the government money.

I hope this series has helped people. It helped me to write it.

Finally - this bail-out is only worth doing if the spreads on agency debt falls. Funnily enough it still is not - see this post from Naked Capitalism. That looks strange to me. But I have given up disbelieving things because they look strange.

John Hempton


Toby Douglass said...

John -

I'm not in any way involved in finance so the things I'm about to say may well be completely wrong.

Firstly, about the spread not coming down. This makes sense. If the implicit guarantee didn't lower spreads, then the market was indicating the Government money wasn't going to help. The fact that the implicit guarantee it now explicit still doesn't mean Government money is going to help.

Secondly, we then have to ask - why is this so? and the answer is - could it be that the market is indicating the scale of loss is going to be MUCH larger than 80 billion? to the extent the Government isn't going to be able to solve the problem.

Toby Douglass said...

In fact, thinking about it, what it might be is that the market simply doesn't believe the Government will support Frannie to the extent that may prove necessary - that if things really do go pear-shaped, it will simply be too expensive, and the Government won't do a proper job, e.g. the guarnatee is all bark and no bite.

Roger Bigod said...

I've read several stories and blog postings about this, and your discussion is the clearest, best organized and most approachable of the lot. Thanks for the effort.

One point I couldn't follow was the relation of political ideology to the question of whether the Feds or private holders should have seniority of debt. My impression is that both parties are such a mishmash of interests that it could go either way, depending on the last lobbyist who talked to Paulson before the decision.

John Hempton said...

Roger - I thin Paulson would have liked to kill the subordinate as well as the preferred. I believe that is where his ideology is - and it would have been the right decision if it were practical. Unfortunately it was not.

The preferred can suspent its dividend for five years without an event of default.

The subordinate cannot.

An event of default would accelerate the swaps Fannie and Freddie have on their books and do other nasty things in the derivative market.

The line of the bailout was not determined by lobbying or ideological factors. It was determined by this practical reality.


alex said...

I agree with you . Spreads should have narrowed PRIOR to the takeover. THis seemed like a wonderful investment opportunity.
If spreads do not narrow significantly at this point it implies that the investing community does not believe the explicit guarantee by the US Govt.
It also implies that Treasuries are in trouble. For that matter, we're all in serious trouble.

Roger Bigod said...

Thanks for the explanation. I'm not sure what Paulson's ideology is, or how strong. Obviously he wouldn't occupy his position in this administration if he were a flaming liberal. OTOH, he got there via a successful career at Goldman, which implies a certain flixibility.

I've considered shorting one or more of the walking-wounded US regional banks, but it looks like there's a provision allowing them to repackage bad mortgage debt and sell it on to Fannie or Freddie. Paulson may have intended that as a rescue for the ones that hold a lot of GSE preferred. Lot of moving parts here.

Anonymous said...

Why did the Bush administration act now instead of waiting for the next administration? First of all, the next administration doesn't take office until next January (not November), and that's a long time in the context of an ongoing crisis. But more importantly, Fannie and Freddie had $225 billion of debt to roll over before the end of September, and it was looking increasingly unlikely that they'd be able to do so (see WSJ and Brad Setser). This buyers' strike forced the government's hand.

David Merkel said...

Two notes: 1) This is being treated as an event of default in the senior debt markets for FNM and FRE. 2) The Government's preferred class is cumulative, whereas other preferreds (as you have noted) are not.

StockStudent said...

Hey, this is probably my favourite post on the subject on all the blogs I follow...I also like the one Ian Campbell wrote at

It discusses more the overall economy...Personally I don't know what to think og the economy, I am just going to stand aside and wait till this roller coaster passes...

Toby Douglass said...

There's a comment quoted on naked capitalism;

"as you did in Sweden, so there can be no real confidence in the government bailout, because the government is actively perpetuating subterfuge and offering no segregation of the good assets vis a vis the bad assets."

That's a great point. The problem is okay - you've got a bailout - but you *still* don't know how bad the problem is. So how can you rely on the bailout?

If you knew the scope of the losses, and you knew the scope of the bailout, you'd know where you stand.

Right now, *even with the bailout*, you *still don't know where you stand*.

You can't rely on the bailout till you know the Fed knows how much it'll have to bailout - and then when you know they know, and you see them going for it, *then* you can breath more easily.

Anonymous said...

as always the "obvious" trade (eg short FNM, long coal in the spring) is plainly obvious in hindsight.

I too kick myself for missing the retrospectively obvious moves this year but I take solace that only 13% of FNM was short in mid-August (so it wasn't that obvious to the Street) and that I lots of dry powder to put to work when the carnage is over.

Better to be a surviving wimp than a broke hero.


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The content contained in this blog represents the opinions of Mr. Hempton. Mr. Hempton may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Hempton's recommendations. The commentary in this blog in no way constitutes a solicitation of business or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author.  In particular this blog is not directed for investment purposes at US Persons.