From the comments - believing in Magic

Bondinvestor (whoever they may be) left a reasoned piece in the comments. It disagreed with my position on Magic outlined in this post.

I like people that disagree with me and I would love BondInvestor to get in contact...

bondinvestor said...

MTG, PMI, RDN and even ORI and GNW are all buys.

the best way to think about MI conceptually is as a bridge loan. if home prices collapse or the borrower loses a job in the first 3 yrs, the loan goes bad. otherwise, it's a solid investment.

the critical question to getting these stocks right is the level of cumulative defaults on 06/07 flow business. 05 is bad, but not catastrophic. the bulk business has already been written off. therefore, the only lingering uncertainty is what the level of defaults on 06/07 will be.

here is how to answer the question. MGIC's total claims paying resources (investments + collateralized reinsurance recoverable + the present value of installment premiums) is roughly $13B. that is 24% of the total risk in force. the subprime debacle (for which you were right to short the stock) will end up costing them about 8% of risk in force on a cash basis. that leaves 16% of risk in force (roughly $9B) available to satisfy claims on 06/07 business.

that leaves roughly 2/3rds of the claims paying ability ($9B) available to satisfy losses on flow business. the problems are concentrated in 06/07. the total risk in force on 06/07 is roughly $20B (may be high). so in order for MGIC to go bust, roughly 4/10 06/07 vintage loans must go belly up.

so how likely is that? well, if you obtain copies of MI annual statements, you can recreate loss triangles by accident year. they will show you that, over time, the cumulative default rate on a flow book is around 2%. it also demonstrates that by year 3, somewhere between 30 and 50% of lifetime defaults have been recognized.

you can use the loss triangles and historical seasoning curves to develop a rough model of what lifetime defaults will be on the 06/07 books, given the experience to date. they suggest cum defaults in the range of 10-15%. now, 06/07 only accounts for 40% of the flow book, so the total contribution to loss frequencies will probably by somewhere in the 4-6% range.

this analysis suggests that, far from being insolvent, there is actually tremendous value here that has been unrecognized by the market. the stocks are 10-20 baggers over a 5 year time frame.

that being said, i think all parts of the capital structure of these companies are interesting. for those who are intrigued by the analysis, but scared to own the equities, i'd point to RDN and PMI holding company debt. you are getting 13-25% YTM (face value 55-80% of par) for a senior interest in the holding company that owns the regulated MI subsidiary.

August 29, 2008 10:54 AM

My objections to this are that I am not sure that the bulk book is fully written off, nor am I sure that the book in 2007 will look anything like any previous year - as the last refinance of my rolling loans was onto Magic's book.

My further objection is that statutory capital deficiency happens way earlier than this - and stat capital deficiency will close the business as per TGIC.

But I remain to be convinced otherwise - and I have had a go at reconstructing Magic's loss triangles (with help from a reader) and we got not very far (probably because we gave up early).

If Bond Investor would like to share with me I would much appreciate it.

Thanks.

John

Ripping off two charts – Moodys mid year residential mortgage backed security performance update

Moodys has published a short report entitled U.S. RMBS Mid-Year Performance Update: H1 2008. This post will shamelessly rip off a two charts from it. The entire report is absolutely consistent with the data summary that I have been giving on this blog. Its really annoying to do all this work eyeballing hundreds of MBS pools and then find a really neat 8 page paper that does it all for you…

I would quote the report more broadly except that I do believe that they have some copyright issues. You might find someone to kindly send you it. Or you can buy it on the web here at an outrageous price. [If the price were one tenth the price listed here I would recommend it…]

But given that I do not own the research I will limit myself to a review.

The review goes through different types of collateral and different loss curves. I will not go through all of them for copyright reasons.

The first picture I will extract is cumulative losses on Subprime RMBS by year of origination. This is one of those “no hope” charts because losses are trending upwards fast with no obvious signs of stopping.

The picture makes it look like 2005 looked nasty and stabilised (something I have been saying for a while) but that the 2006 and 2007 pools have no hope. The 2007 pool is worse than the 2006 pool. [This should sound familiar to regular readers of this blog.]

The second chart I think makes the story a little clearer:

The 2005 pool had a delinquency hiccup – but is now back in the fold. I think we can safely estimate losses on 2005 subprime pools now and they are not that bad. The 2006 pools looked like they were stabilizing – and I blogged to that effect. The data in the last month however has given me some pause – hence my depressing thoughts post. Any light at the end of the tunnel in the 2007 pool looks like an oncoming train.

The same trends exist for Alt-A generally – but I am not going to extract all the data from the Moody’s report as I respect their copyright. I should say with Alt A the 2007 pools are not modestly worse then 2006 pools they are immodestly worse.

This is consistent with my rolling loans thesis. The loans could never be repaid but they could be refinanced. They kept getting refinanced to later pools and the last pool contained the detritus.

The 2006 Alt A delinquencies also looked to be stabilising but with a hiccup in the last month. The hiccup in the last month was worse than the subprime pools. 2005 is right back in the fold as with subprime.

Moodys then break the Alt-A into conventional adjustable rate mortgages (ARMs) and Option Arms. It seems there is almost no last-month kick up in delinquency for conventional arms but a big kick-up for option ARMS. This suggests the problem is Option ARM resets and confirms the analysis of many of the people who have commented on my blog. [Dear readers – a lot of you are very smart - indeed the great joy of this blog is what it delivers to my inbox.]

They then do cumulative losses on jumbos. Similar trends – but there is a kick down in last month delinquency. Does anyone know why jumbo credit looks to have got better very quickly. I have no idea.

They then do subprime Closed End Seconds and HELOCs (something I have studied at great detail). There is MUCH more stabilisation in CES – even the 2007 pools appear to be stabilising, however HELOCs, which are generally more prime than CES are not showing the same stabilisation.

Also with PRIME CES the 2005 pools look awful, with subprime CES the 2005 pools look good. In general 2005 mortgages are only bad if they are prime. [That should confuse most of you - but I think its because in bad poosl the really bad loans rolled out into 2006 and 2007 pools but prime people did not roll their loans.]

I would go further than the Moodys report and note that more generally the better the credit the worse the trend, or the worse the credit the better the trend. But nonetheless the Moody’s report is accurate, neat, short and should be got by anyone with decent access. The expensive source I link to is probably too expensive – but that is your choice.

If you are really maniac you can take this data and recalibrate Bill Ackman's open-source model of the bond insurers. I have done that - but my estimates are probably not much better than anyone else who does it with some integrity.

J

Reducing post frequency

I started doing this blog with the idea of two posts per week, but it somehow morphed into one per day. I had a lot to say and somehow had found an outlet.

I was however chewing considerable human capital - having developed ideas over a long period of time. [I do not generate ideas as fast as I have put out posts.]

So it is time to face reality and drop the post frequency to one per week - somewhere near the level that I consider sustainable.

If given a choice between quantity and quality I will chose quality. I hope my readers are not too disappointed.

J

Counting and double counting – a comment on losses and accounting standards esp FAS 159

Warning: Wonky accounting alert. Don’t bother reading this if you are not interested in wonky accounting issues

Last post I asked if anyone had a decent list of the losses so far realised. The problem was double counting – which is pervasive if you do this sort of thing. Aaron of the HF implode meter (who is usually acute about these things) made a comment which misses the point entirely – but it required a little thinking – and I admit I missed it at first. Here is his comment –

Then again, some gains aren't really gains, like the gains counted on the financial co's own collapsing bonds. Sure, they could buy those back, if of course they weren't already in hock for cash...

I will get back to Aaron’s comment later…

The gains from debt forgiveness in tax

In the US if you have a debt forgiven that is income for ordinary tax purposes. It sounds quirky – but its not.

If a bank lends company A $100 and they haven’t paid it back then the bank has clearly lost $100. Company A has lost $100 too – but that loss ultimately did not come out of Company A’s pocket – it came out of the bank’s pocket.

Unless you are very careful though the tax law is going to allow both company A and the bank to claim $100 in tax losses. That is a good way for the tax system to collapse because Company A could lend to Company B who could lend to Company C and so on and a single $100 loss could theoretically produce thousands of dollars in tax losses. Those losses could wipe out the tax base of any respectable country.

Fortunately (or unfortunately depending on your point of view) the people who draft tax law in most countries are not that stupid. [I started my career doing this stuff at the Australian Treasury – so it was once an area of expertise for me. We had terrible trouble in those days with cascading tax losses in trusts…]

What most countries do is that they have provisions against “loss cascading” or the like. They fix this up ultimately by taxing gains from debt forgiveness.

When it is finally clear that Company A in my above example will not have to pay back the said $100 it gets assessed on a “gain from debt forgiveness”. The idea is that if you borrow $100 and don’t have to pay it back that is a gain of $100. It offsets the loss of $100 above.

Gains from debt forgiveness in GAAP

The accounting rules do the same thing. When Conseco (a company I knew extremely well) completed its bankruptcy it compromised a few billion in debt (mostly preferred shares). The $2 billion or so it did not have to repay was a gain for accounting purposes – and the “New Conseco” published accounts reflecting that gain.

There were similar adjustments for the removal of Conseco Finance from the balance sheet.

Done properly these gains will remove double counting of losses from the accounting system. If you add up the losses made by Conseco and the losses made by the preferred stockholders without assessing the gain from debt forgiveness you get double counting.

Accountants rightly get concerned about double counting. But the accounting answers questions in a way that might be misleading to investors.

Typical question:

How much did company X lose doing that stupid lending:

Two possible answers:

(a). $2 billion dollars

(b). $500 million dollars [but we have ignored the $1.5 billion more borne by debt holders but ultimately forgiven].

The accounting answer is technically correct but doesn’t really get to the guts of why the lending was so stupid.

Now accountants are often pedants and investors should be practical people. And I have never seen a place of more vociferous disagreement than the disagreement over FAS 159.

FAS 159 says (roughly and in this context) that if a company is using mark-to-market accounting on its assets and its liabilities it should also use mark-to-market accounting on liabilities whose market value is affected by their own credit worthiness.

To take a real example, Ambac is a bond insurer which is showing in its accounts about 7 billion in derivative losses. During the last quarter they booked about a billion in gains because the market assessment of their credit worthiness went down and so the market value of Ambac’s derivative liabilities went down. Had the accounts been measured a month later Ambac would have booked over a billion in losses on the same transactions. The result was that during the last quarter Ambac’s profit was approximately equal to its market cap. It will reverse that profit this quarter.

That profit of course was meaningless for an investor assessing Ambac stock. [I own Ambac stock - purchased at $1.30.] I don’t think the FAS159 movements make any difference in assessing Ambac. I ignore them. I think Ambac’s results were not great but they showed stabilisation which was enough given the stock price.

David Einhorn – a man considerably smarter than me - put it this way in a speech (“FAS 159: Profiting From Your Own Demise”)

If your own credit spread widening counts as revenue...

... and you pay compensation as a percent of revenue ...

... the most profitable and lucrative day in the history of your firm will be...

THE DAY YOU GO BANKRUPT!

Ok – so let’s ignore FAS 159 assessing Ambac, investment banks and the like. And the results are much worse than the headlines. The underlying of the investment banking industry sucks.

When you shouldn’t ignore FAS159

In once sense what FAS159 does is it brings forward the gains from debt forgiveness. If the price of repurchasing Lehman’s debt falls then Lehman has made a gain which it is hard for shareholders to profit from. If Lehman goes bust and has its debts forgiven Lehman has also made a gain – but it’s the same gain recognised on a mark-to-market basis as its credit worthiness collapses. [Its also hard for the shareholders to benefit from this gain.]

This is of course a problem with mark-to-market accounting generally. Mark to market accounting brings forward profits. It also brings forward losses. It’s a darn stupid way to run an investment bank when you pay cash on profits that are not realised but just bought forward. It’s a darn stupid way to invest when the profits being bought forward are the profits from total collapse and debt forgiveness.

But if you are adding up losses then the gains from debt forgiveness are a necessary part of ensuring that you don’t double count.

Likewise – in a mark-to-market world if you are adding up losses then the gains on FAS159 are a good thing to include.

Now let me bring back Aaron’s comment:

Then again, some gains aren't really gains, like the gains counted on the financial co's own collapsing bonds. Sure, they could buy those back, if of course they weren't already in hock for cash...

Aaron bought this up in the context of double counting. But this is the one context when those gains really are gains. Aaron is thinking like an investor – and I love him for it. But just for once I wanted someone thinking like an accountant.

J

Does anyone have a good estimate of losses recognised to date?

In this post I talked about the Bloomberg list of losses recognised to date. I even gave a spreadsheet here.

The problem with the Bloomberg list is that it doesn't include lots of entities that have booked losses. It excludes for instance insurance companies (AIG does not appear and they are almost exhibit A in big companies gone mad). It also excludes GSEs, mortgage insurers, bond insurers, hedge funds that have lost money and the like. It does not include Residential Finanial Corp (GMAC), or any of the imploded subprime issuers.

Even then recognised losses come in above 500 billion.

Does anyone have a complete list?

Even better - does anyone have a complete list with spreadsheets speculating on obvious problems of double-counting. For instance if someone is mark-to-market on a bond insured by MBIA then they are probably showing a loss. MBIA is showing losses. There is of necessity some double-counting here. [Such an adjustment will be rough...]

Hoping for help.

---

The reason is that I want to work out how far down this credit crisis really is. The Bloomberg list is misleading for that task.


Thanks.


John Hempton

This week's bank collapse

FDIC Friday - and another bank was taken over by the FDIC. The number so far is relatively small - because the bad mortgages are not in the banks. (The bad mortgages were sold to the securitisation market as this blog has made clear several times.)

Anyway this bank collapsed due to commercial real estate. That matters as the CR loans are in regional banks.

Calculated risk has a nice post observing that this collapse - whilst small - is probably going to be representative of this cycle. I have short positions in a few CRE exposed banks.


J

Berkshire risk aversion - a follow up

Thanks for all the people who followed up on this. I think we can safely conclude that the factual background in the original post was correct. Mostly GEICO sells household insurance as an AGENT for Travelers. It may or may not take on umbrella policies through other Berkshire subsidiaries.

I really appreciate the confirm from my readers. Disagreements about facts should be easily sorted [provided of course I remain adequately circumspect about what constitutes knowledge]. I expect disagreements about interpretation to be much more difficult.

This is a follow up from my Berkshire risk aversion post.

I have received an email from a finance guy who has a homeowners insurance policy attached to his GEICO auto policy. In some states (notably Florida but also possibly other states) this policy may actually be written by Berkshire - but mostly it is a policy whereby GEICO acts as an agent.

Can people with umbrella and homeowners insurance policies from GEICO tell me who the underwriters are for the homeowners component - and what State they are in. Also useful would be the number of years that they were policy holders.

Thanks.


J

Some depressing thoughts

The position of this blog has been stated several times. Subprime credit is a pig-in-the-python. It got bad very quickly – and it will get better very quickly. The losses on some pools (particularly loans originated in early 2007) will look implausibly large – but 2005 pools will be much tamer.

Prime credit by contrast is deteriorating at an increasing rate and there is no obvious end in sight. It is not able to be modelled. It is very scary.

The thinking behind that is detailed here and here.

Wish it were so simple. The prime credit is looking every bit as bad as all that. But the trend in subprime credit is also less clear than a month ago. In some pools (not all) the trends are less good. Short dated delinquency is rising in some places. Losses look a little larger than they might have looked a month ago. The improvement trend was three months old. And one month does not a cycle make – but my level of comfort is falling.

Risk aversion – Berkshire style

Chatting with a well known blogger yesterday who made the (common) assertion that all insurance companies eventually go to zero. The world – it is argued – is full of surprises – and if you take even a small chance of blowing up then eventually your number will be up and you will blow up.

Then our protagonist argues all insurance companies take a small chance of blowing up – and eventually there number is up.

This I think is too simplistic. I think some types of insurance have realistic (albeit small chances) of blowing up. Others (rarer) do not.

Take for example household versus auto insurance.

Household insurance is subject to super-catastrophes. Big earthquakes are theoretically possible anywhere (although vanishingly unlikely in some locations). Hurricanes happen as well and the 250 year storm seems to happen fairly regularly.

But auto insurance is not generally subject to super-catastrophes – cars drive away from hurricanes and bounce around in earthquakes. The only catastrophes that regularly affect cars are hailstorms – and the biggest hailstorm claim in insurance history happened in my home town (check this out about 3 inch hailstones).

Has anyone noticed that Berkshire does auto insurance (GEICO) but does next to no household insurance (it writes a few policies in Florida which it tries regularly to cancel – but regulatory rules force it to renew).

If you write household insurance there is the mega-storm that could bankrupt you. Buffett has said that storms substantially bigger than Katrina are possible. Buffett won’t do it even though GEICO could probably – if it chose to be – become the most profitable household insurer in the US.

Also take life insurance

Any student of human history knows that plagues – real devastating plagues which wipe out very large numbers of young healthy people happen irregularly but often enough to be a real risk.

The insurance industry have gotten quite complacent about them – because the only new plague of our lifetime did not affect life insurance companies. HIV is – within the West anyway – primarily a disease of gay men, IV drug users and haemophiliacs. None of these people were regular buyers of life insurance. Had HIV been a disease of middle age men who visit prostitutes because they don’t get it at home it would have selectively targeted the core market for life insurance companies – and every life insurance company in the Western World would have gone bust. In Thailand HIV morphed into such a disease – but surprisingly or not life companies have not been heavily impacted in the West.

Note that if you think plagues are inevitably going to happen then most life insurance companies have a finite life.

Notice that Berkshire does not insure mortality at a primary level and does almost no mortality reinsurance. Swiss Re is the dominant player in that business. Buffett has the capital and the expertise and he does not play.

By contrast annuities are not subject to plagues or shock risk – they can cost you money as life extends due to medicine – but that looks like a continuous process – not a shock process like plagues. Berkshire will write you an annuity online (see http://www.brkdirect.com/)

Again a small risk of blow-up and Buffett will not play.

The Gen Re debacle

The terrorist attacks of 2001 were a true shock to Buffett. General Re was taking a chance of complete wipe-out and had the attack been nuclear there is a fair chance that Gen Re would have folded. Buffett wrote about that in a special letter to shareholders – see this quarterly report which differs from other Berkshire quarterlies as it contains a shareholder letter...

Buffett criticises Gen Re for writing risks that could have been lethal. His company broke the first Buffett rule of risk aversion. [Despite the joke that the rule is don’t lose money – the rule really is don’t blow up. Buffett is quite prepared to lose 5 billion on a single policy.]

Note that almost none of this involves mathematical models. It involves stress tests. And the stress is not a selected 99% probability stress test – it’s a complete implausible debacle stress test.

And when most people do stress tests the process is “well what happens if property prices drop 30%?” and someone says “what if they drop 40%?” and the response is – they can’t go that far.

The Buffett question for a risk manager is “what if they drop 70%?” You might say it can’t happen. One word: Japan.

I know how you live by the Buffett stress test with a diversified portfolio – when I open a fund it will live by that test. (No intolerable concentrations of long only banks or life insurance companies.) But I have no idea how you run a life company by the Buffett stress test. I don’t think you can. That doesn’t mean the businesses shouldn’t exist – but they probably never be considered completely safe. And a portfolio investor should never be totally weighted there even if that is their field of expertise.

John

Market puzzles - Fannie Mae and Freddie Mac

Crank your mind back to 2006. You are a run-of-the-mill hyper bear (as I appeared at the time). Someone told you that in 2008 there would be a crisis at Fannie Mae and Freddie Mac. The Secretary Treasury would ask for and get an essentially unlimited pool of government money to ensure that the senior debt of those institutions did not fail. [He said nothing about the preference shares or common.]

What would you have thought would happen?

To me it seemed obvious. The senior debt would now be as safe as Treasuries and the spread on the senior debt would come in to maybe 30bps from crisis levels.

But the whole scenario would be very bad for the US dollar because the implied debt of the Federal Government just rose an awful lot.

So what did happen?

Well the spread on Fannie and Freddie securities widened not narrowed, and the US dollar got strong.

The widening of the spreads on Fannie is either irrational or a rational bet that the US Government cannot be trusted to honour its promises. But if it is the latter why is the USD strong?

What is happening now is every bit as weird as what happened in the bubble.

I blame the one child policy: explaining the brokers part II

This is going to look very tangential – but I know someone who is a demographer. And just as I think everything in the world comes down to banks (because that is what I understand) he think that everything in the world comes down to demographics.

He has a better chance of being right than me.

And the biggest thing going on demographically in the world is the one-child policy.

Asian style industrialisation and current account deficits

Pretty well every Asian tiger economy has gone into large current account deficit whilst it industrialises. Savings rates may have been 20-25 percent of GDP but the investment rates were higher. The high levels of current account deficits have left those countries vulnerable to current account crises – and they got their crisis in 1997.

China is different. The investment rate is higher in China then elsewhere. Chinese statistics are abnormally patchy – but Chinese investment may have got has high as 40 percent of GDP. (You can see this in the performance of various capital equipment exporters in the West.)

And yet China never managed to get a current account deficit. That is really strange.

We have investment of 40% of GDP and a large current account surplus. This means that the average Chinese person is saving maybe 46 percent of their income. Now once when I had a very high income I saved that much. But we have poor people saving half their income.

I ran this idea past a Chinese friend of mine (now resolutely middle class). He remembers his family saving money furiously whilst he was hungry for lack of food.

Question: what is it that makes them save so much?

Answer: fear.

In most poor jurisdictions there is a simple method of saving for old age. Have six kids. They will have a few each and if you survive there will be lots of grandkids trained to respect their elders who will look after you.

This does not work in China. Indeed if everyone has only one child there will potentially be four grandparents per grandchild. You can’t expect to get supported.

In most developed countries people trust the system to look after them. Mutual funds are well developed, there is often a social security savings net, and a lot of people (perhaps falsely) expect to sell their house and live in clover.

But in China you can’t trust that either. So you save. And save. And save…

Chinese families save because they have a gun at their head. They save an amount that is almost incomprehensible by Western standards.

I point this all out because there is a lot about excessive spending in the west (and the spending has been excessive). But for all this excessive spending there has to be an area with excessive savings. Japan has it. Petrodollars have it – but the big incremental excess savings of the last five years has been China.

And for that I blame the one child policy.

I am going to give Mr Bernanke a plug here. Before the crisis started Ben used to talk about excess savings in the world. He figured the bad lending in the US happened not because people were venal or stupid in the US – but that there was just an endless supply of investable funds because the world had excess savings.

I think he was right. Go look at a Japanese bank now and you still see excess savings. We discovered that we can’t lend them endlessly in America without substantial credit losses. But that doesn’t mean the excess savings aren’t there.

It is a strange reversal to blame bad lending on the people in China who wanted to take no risk with their savings – but it is the reversal that interfluidity made in one of the best blog posts of recent times. It’s a reversal I believe in too.

My thesis - which will be expanded in future posts is that the brokers have become the intermediaries between this endless demand for products to save in (China, Petrodollars etc) and the endless willingness of the profligate in the West to spend. What they do is - through their trading, their securitisation and through other things they turn the complex financial instruments of the West (mostly but not entirely debt) into vanilla instruments that the Chinese and petrodollars want to buy.

How they did that intermediation will be the subject of the next couple of posts – but it begins to explain why they got so big. This is the biggest demographic feature of the world and the brokers made themselves front-and-centre. (They may not have even understood what they were doing - but that is also subject of another post.)

Indeed how they did it altogether and its implications are for later in this series.

John Hempton

Rick's rats on its clients

I gather the kiss-of-death for any brothel owner is to blow confidentiality. You do that once - and nobody much has any incentive to keep you in business.

The kiss of death for a "adult entertainment venue" is much the same. So it is with great interest I read this extract from the 3Q earnings release for Ricks - a listed consolidator of strip joints:

Eric Langan, President and CEO, said: "Both our internal growth and expansion by acquisition programs continue on course and we are looking forward to a strong performance at Rick's Cabaret Minneapolis in our fourth quarter, which should benefit from the Republican National Convention in early September." He noted that the company's cash position increased to approximately $13 million at the end of the quarter due to strong cash flow and a recent capital raise.

Are RICK's executives ratting on the Grand Old Party? Is this sensible?

In the mode of Fox News: "We report - you decide".

I might turn up at the next conference call to ask the poisonous question: how much did turnover in Minneapolis go up around the convention? But only after the obligatory congratulations for a great quarter guys...

John

Rick’s Cabaret – a Gentlemen’s Establishment with a private jet

This blog does not usually comment on small caps – but following Jeff Matthews I couldn’t resist. Ricks Cabaret is a listed consolidator of strip joints. Yeah – you read that right. The business consists of renting crappily constructed barns on the edge of towns (Houston, Vegas etc) and getting gals to jiggle their silicon around. They do own a fine-dining strip joint in NYC.

Despite having compiled an index of the price of hookers in various Eastern European locations I don’t usually hang around these businesses. I had never heard of Rick’s before Jeff’s post.

The stated premise for Rick’s Cabaret is that being a listed company gives Ricks (RICK:NASDAQ) access to capital and hence provides an exit for the thousands of strip club operators throughout the land. This of course ignores the other exits that Jeff Matthews points out (busted for prostitution, non payment of taxes etc).

But let’s take them at their word and look at the accounts as given. Here is the balance sheet:

CURRENT ASSETS:
Cash and cash equivalents	13,191,087
Accounts receivable
Trade	1,339,413
Other, net	722,868
Marketable securities	2,225
Inventories	1,706,544
Prepaid expenses and other current assets	975,067
Total current assets	17,937,204
PROPERTY AND EQUIPMENT:
Buildings, land and leasehold improvements	44,031,599
Furniture and equipment	11,463,950
	55,495,549
Accumulated depreciation	-7,288,117
Total property and equipment, net	48,207,432
OTHER ASSETS:
Goodwill and indefinite lived intangibles	60,272,095
Definite lived intangibles, net	1,322,111
Other	761,753
Total other assets	62,355,959
Total assets	128,500,595
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable – trade	912,190
Accrued liabilities	4,390,849
Current portion of long-term debt	1,561,244
Total current liabilities	6,864,283
Deferred tax liability	16,278,165
Other long-term liabilities	508,579
Long-term debt, less current portion	28,877,816
Long-term debt-related parties	1,260,000
Total liabilities	53,788,843
COMMITMENTS AND CONTINGENCIES
MINORITY INTERESTS	3,359,595
TEMPORARY EQUITY – Common stock, subject to put rights (461,740 and 215,000 shares, respectively)	10,935,020
PERMANENT STOCKHOLDERS' EQUITY:
Preferred stock, $.10 par, 1,000,000 shares authorized; none issued and outstanding	--
Common stock, $.01 par, 15,000,000 shares authorized; 9,272,237 and 6,903,354 shares issued, respectively	92,722
Additional paid-in capital	52,807,479
Accumulated other comprehensive income (loss)	-11,123
Retained earnings	8,821,839
Less 908,530 shares of common stock held in treasury, at cost	-1,293,780
Total permanent stockholders’ equity	60,417,137
Total liabilities and stockholders’ equity	128,500,595

Now I am a dopey sort of guy – more used to bank balance sheets than strip joints. But there are a few things that are odd about this one.

The first is that there is over 60 million in goodwill on the balance sheet. That is 60 million paid to owners in excess of the value of couches and other fittings. That is a lot of goodwill for strip joints and leads you to the conclusion that if you want to be a multi-millionaire forget hedge funds – start a strip joint and sell it to RICK.

Indeed despite selling considerable common stock in unregistered sales to institutional investors the company manages to have almost no net tangible net worth. [The cash flow statement shows 27 million raised from sale of equity in the quarter – but I can find only one SEC 8K for about half that amount.]

The second thing that jumped out at me was the large deferred tax liability. The deferred tax liability of 16.2 million.

My first reaction was whoa – a deferred tax liability happens usually because profit for GAAP purposes is substantially higher than profit for tax purposes. This could be accelerated depreciation or some other tax incentive (though why the IRS/congress might give tax incentives for strip joints is beyond me) or it might just be that the company is declaring income for accounting purposes but not for tax purposes. There is of course a problem with faking your income up – which is that you tend to have to pay tax on the phoney income – unless you tell something different to the IRS.

In the quarter the prima facie tax was over a million but the payments were just over half a million. There is no large current tax liability to note – so there is prima-facie suggestion of overstating GAAP vis taxable income. Indeed the cash flow statement benefits from 632 thousand being added to the deferred taxes during the quarter… This does not surprise me – but it is not the main reason that that there is a large deferred tax liability. This company peculiarly tax effects the goodwill purchased – a treatment I have not seen elsewhere – but then I am used to looking at financials. [Anyone known why you would do this?] To quote:

Included in the Company’s deferred tax liabilities at June 30, 2008 is approximately $14,400,000 representing the tax effect of indefinite lived intangible assets from club acquisitions which are not deductible for tax purposes. These deferred tax liabilities will remain in the Company’s balance sheet until the related clubs are sold or impaired.

This led me to think that the company might be doing something very strange like buying the clubs and not the corporate structures that the clubs reside in. That indeed would be sensible because it would absolve the acquirer from unpaid taxes and penalties (criminal and otherwise) that might live with the old owners. That might give a peculiar GAAP treatment of goodwill. And indeed they are – as this 8K shows . If there is any accounting expert here – can you explain this.

But this still gives us a residual of 1.8 million of deferred tax liability that comes from another purpose. This implies GAAP income of about 5 million more than cumulative taxable income over the history of the firm. I will make the point that this is roughly the half cumulative profit of RICKS. When in doubt (and where I can’t see a good explanation for deferred tax liabilities) I tend to prefer the income people report to the IRS than their stated income. (Maybe that is something I just learnt in the mortgage market!)

Now the premise for listing this thing is – I presume – access to capital. But you got to wonder the extent to which a bank or for that matter typical financial market type might lend money to a strip joint whose tax accounts don’t match their GAAP accounts. Well for the most part they don’t lend that way. Indeed almost every strip club they consolidate they do with high interest vendor finance. This is typical:

On November 30, 2007, in connection with the acquisition of Miami Gardens Square One, Inc., (see Note 9), the Company entered into two secured promissory notes in the amount of $5,000,000 each to the sellers (the "Notes"). The Notes bear interest at the rate of 14% per annum with the principal payable in one lump sum payment on November 30, 2010. Interest on the Notes is payable monthly, in arrears, with the first payment due thirty (30) days after the closing of the transaction, which occurred on November 30, 2007. The Company cannot pre-pay the Notes during the first twelve (12) months; thereafter, the Company may prepay the Notes, in whole or in part, provided that (i) any prepayment by the Company from December 1, 2008 through November 30, 2009, shall be paid at a rate of 110% of the original principal amount and (ii) any prepayment by the Company after November 30, 2009, may be prepaid without penalty at a rate of 100% of the original principal amount.

Most the long term debt is pretty short term – 30 November 2010 won’t get them to a time when bank lending standards drop enough. So they better have the cash when they get there. And that is not the only "long term debt" on the books.

Indeed access to capital looks questionable when the CEO has to personally guarantee corporate debt:

In connection with the acquisition of the real estate in Dallas related to the acquisition of Hotel Development Ltd., on April 11, 2008 (Note 9), the Company issued a $3,640,000 five-year promissory note (the "Promissory Note"). The Promissory Note bears interest at a varying rate at the greater of (i) two percent (2%) above the Prime Rate or (ii) seven and one-half percent (7.5%), and is guaranteed by the Company and Eric Langan, the Company’s Chief Executive Officer, individually.

Come to think of it – this company also purchased its private jet on hock:

In February 2008, the Company borrowed $1,561,500 from a lender. The funds were used to purchase an aircraft. The debt bears interest at 6.15% with monthly principal and interest payments of $11,323 beginning March 12, 2008. The note matures on February 12, 2028.

Hey – the interest rate on a private jet (presumably secured by the jet) is almost 8 percentage points better than the interest rate on a strip joint secured by the strip joint. Impressive.

Summary

So what have we got?

• A company in a seedy business usually infiltrated with the sort of people who you would not want to have marry your daughter.
• A company whose tax returns do not match their GAAP accounts
• A company with no obvious access to capital and with a lot of debts that mature quite shortly and pay high interest rates,
• A company who has no reason to be listed but manages to buy a private jet

People own this stock? Search me as to why…

That this is listed and retains a market cap over $100 million tells me that this market has a long way to fall. I shorted a token number last night.

A positive: the company has a code of ethics

I can’t be all negative.

Rick’s must be the only strip joint with a public stated code of ethics. You can find it here. However at Rick’s ethics tend only to apply to financial matters. The code is also only applicable to the following persons:

1. The Company's principal executive officers; 2. The Company's principal financial officers; 3. The Company's principal accounting officer or controller; and 4. Persons performing similar functions.

I will leave it to your imagination what other unethical behaviours might happen at a strip joint and who might perform them.

I wonder if you can think of any ethical violations that might involve the private jet.

I thought you could.

John

Explaining the brokers Part I

Don’t read this series if you expect clear tradeable answers. I don’t have them (yet?) and really this is just the beginning of another intellectual journey. It may be a dead-end.

For someone that might open a fund I am about to do something profoundly stupid. I am going to have a peek at the broker balance sheets in public without being entirely sure what I will find. This series might go nowhere – or it might wind up being very interesting. I am trying to get readers to help me pick apart the brokers.

I have to say that I got a lot of email on Fannie Mae when I did the series there – almost all expressing religious belief on whether Fannie is OK or not. Not much counted as analysis and less contained methods which are testable..

I hope my readers are better this time – but I am not counting on it.

Before I start my instinct on Wall Street Brokers is hyper-bearish. It is not that I think they have solvency problems (on that I have no opinion). It is just that I think that their stated business and their actual business differ substantially. When companies can’t explain clearly what they are doing then I get bearish – and nobody seems to explain brokers clearly.

With Fannie at least I could explain how the business was meant to work. With Goldman Sachs I don’t even start with that.

Part I is just going to leave everyone with a puzzle. Why are the broker balance sheets so big – and what business inflated their size to such grotesque levels? I think this is the key issue wit the brokers – but for the moment I will just give you some numbers.

The FED flow of funds data gives type of debt outstanding in the US at any time. At the last release (Q1 2008) there was 30.8 trillion of non-financial sector debt outstanding. [You don’t want to count financial sector debt because you are double counting though I have known a few reputable people who have done just that.]

Of this “only” 14.0 trillion was to households and “only” 10.6 trillion was mortgages. The mortgage growth rate had slowed to 3 percent. The fastest growing category was the Federal Government (up at over a 9% annual rate). That hardly bodes well for the US. 5.2 trillion of Federal Government debt outstanding. Private sector debt was 24 trillion. I want you to keep that number in head for the reason I am about to bold

• 24 trillion – total private sector debt – is the maximum about of debt that it possibly makes sense in any way for financial institutions to intermediate. Brokers can’t make money intermediating government debt.

The second set of statistics is about the sheer size of broker balance sheets:

• The Goldman Sachs balance sheet is 1.09 trillion in size at the last quarter (admittedly a slightly different date to the Fed Flow of Funds data).
• Lehman is 0.639 trillion – and that was after some questionable moving of items off balance sheet.
• Merrill Lynch is 1.04 trillion at the closest quarter
• Morgan Stanley is 1.03 trillion.

On top of this there is probably almost a trillion of investment banking assets at Citigroup, over a trillion at JPM (including Bear Stearns) and another trillion at Barclays Global Capital.

Somewhere investment banks got on their balance sheet maybe 7 trillion in assets which is very large compared to the total assets that could theoretically be intermediated in the US.

Goldman Sachs has a balance sheet the same size as a smaller Japanese megabank.

One thing is for sure – you don’t hold all these assets because you are facilitating trades on behalf of your customers. I have seriously been told my investor relations at investment banks that the reason they hold so many assets is to facilitate client transactions.

I might be young and naïve – but I am not sure I was ever that naïve…

The investment banks are full of people considerably smarter than me. But the shareholder letters are not very explanatory. (These companies fail Warren Buffett’s test of clear shareholder letters.)

They don’t do what they say they do. So what are they? We all deal with them so we think we have some idea – but the places that I deal with don’t produce balance sheets that look anything like Wall Street. I have some answers – but I know before I start that they are not complete answers – moreover my answers are hard to test.

Some exploration (but probably few answers) coming in Parts II, III etc…

If people have suggestions I will include those (with some analysis) in later parts. Email me please.

John

Weekend edition: the somewhat cooler Hempton

My cousin got the movie star looks and the saxophone. I got the penchant for reading accounts of banks. I think he got the better deal!

I suppose he got the girls too! And he got the MySpace page with the cool jazz soundtrack.

For my NYC readers - he is back in NY -

22 Sep 2008, 07:30 PM
183 W10th st @7th Ave, New York, New York
Cost : $20 incl. a drink!

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.

J

Extra credit Jeff Matthews: great blog posts of yesteryear

Someone complained the other day that my posts are too detailed. Sorry. That is me.

But I got to admire someone who can keep it shorter than that – and so I present one of the best investing blog posts ever – Jeff Matthews wonderful call when Highfield tried to buy Circuit City. Jeff screamed SELL (at $17).

I think he got that right. The stock is below $2.

You should buy his book when it comes out too!

Estonians trash their flash cars: can't make the lease payments

The most read post ever on this blog was "Hookers that cost too much, flash German cars and insolvent banks".

In it I predicted a future for the Baltic States where the middle class rioted and Swedbank (the Swedish bank most responsible for funding the bubble) was trashed either by depreciation caused default or just by default.

Anyway I love this story. An insurance company in Estonia is having troubles with customers trashing their flash cars because they can't make the lease payments.

It gets worse and worse and worse from here.



J

PS. I mentioned the geopolitics in the first post on this subject... I said I was "loudly calling the likely collapse of a politically sensitive country". Well now the Estonian press is actively speculating about a Russian takeover. I think it is unlikely - but do not forget the Bronze Soldier.

For those with a real interest I know enough history to be dangerous. My version comes from the perspective of some Jewish relatives who were holocaust survivors. My relatives saw the Baltic States as containing particularly enthusiastic Nazis. (They tend to site Lithuania over the others but I think that was bitter experience. Lithuania had a gruesomely effective holocaust). Whether the Balts were more enthusiastic Nazis than some other Europeans is something I have no real knowledge of. Indeed the initial Russian-Nazi treaties gave Lithuania to the Germans but the Lithuanians refused to participate in the invasion of Poland and passed to Rusian influence until the Nazis reinvaded...

The Russians still look on the march into the Baltic States as a liberation from Nazism. They revere their Bronze Soldier. Many Baltic people see the same Bronze Soldier as a symbol of Russian oppression.

When the Estonians moved the statute there were deadly riots. These wounds are still open.

My Jewish relatives however wound up living in an apartment building in Bondi Australia one floor above some post-war Lithuanian immigrants. They became firm friends . And both could see the other's point of view...

Article in Portfolio magazine on British banking

I haven't written much on UK banking - an article about Barclays, one on Alliance and Leicester and one on Northern Rock.

But I got quoted in this neat and accurate story in Portfolio magazine.

All I noted was that the UK had taken Maggie's philosophy to heart and decided that if financial institutions didn't have much capital the market wouldn't deal with them. The result is that UK institutions got to run with much less capital than their American counterparts and that left them vulnerable.

That is clearly true. But the journo found a better story about why wholesale financing arrangements shouldn't be regulated... that lovely cliche about "consenting adults".

Hey you know what happens to "consenting adults"...

I thought you did...

Things that make you go hmmm...

Fannie Mae conducted one of its regular "benchmark note" auctions today. Here is the relatively non-descript Reuters report.

The spread over Treasuries was 122bps.

In the old days when Fannie debt was explicitly not backed by Treasury it was about 60bps or less.

The US Government has made it clear that it backs Fannie - so this extra-wide spread is surprising...

Unless people no longer trust the US Government.




John

PS. The investment implications are not good. The only plausible buy case for Fannie at the moment is that its not much to pay for a franchise with a US Government guarantee. If nobody trusts the guarantee there is no franchise...

The crudest of models for Fannie Mae cumulative losses – (Fannie Mae Part III)

As explained in the “modelling post” there is very good reason why you cannot sensibly estimate prime mortgage losses. They are getting worse at an increasing rate.

I didn’t want to make it up. So I asked my readers for guidance. Nobody much helped me – but several people pointed to Jamie Dimon’s various statements on the subject. Those statements come down to Dimon’s broad guess that losses will triple.

We know the trends look awful.

But I have a model. Its crude – but in the face of radical uncertainty it is about the best I can do. So I will present it.

Below is a chart of the type that most thrill me as a bank analyst. It’s a cumulative loss chart as presented in Fannie’s last quarterly results.

What this chart shows is the cumulative loss on loans versus the time the loan was originated. It’s a sort-of-generalisation of the securitisation cum-loss charts with which I am so familiar.

This chart contains several trends that are representative of the whole mortgage industry. The 2007 pools are radically worse than the 2006 pools which are in turn radically worse than the 2005 pool. The 2004 pool is OK but turning a little sour at the edge…

I have a pet theory as to why the 2007 pools are so much worse than 2006. Its not that the lending was any more stupid in 2007 or that property prices had gone one step too far. It was that there were many bad loans made in all years after 2002 however the bad loans didn’t default – they were refinanced. They all thus wound up in the later pools and hence the later pools preferentially contained the bad loans. They are thus awful.

Anyway Fannie Mae doesn’t give us this data in tabular form – but here is my simple model.

Data:

• The 2006 pool is currently behaving about 3 times worse than the 2000 pool.
• The 2007 pool is currently behaving about 6 times worse than the 2000 pool
• The rate of deterioration of prime delinquency is increasing
• Fannie Mae took credit risk on 615 billion of mortgages in 2006 and 746 billion of mortgages in 2007. We do not know how many of those mortgages are still outstanding – but total mortgages outstanding are a bit over 3 trillion.
• The baseline 2005 pool wound up with cumulative loss of 1.25% plus a trivial amount in the out-years.

Assumptions

• That the outstanding mortgages from 2006 are 450 billion reflecting some repayment to date. (This is a good educated guess – if Fannie publishes the data somewhere I have no memory of it…)
• That the outstanding mortgages from 2007 are 650 billion reflecting some repayment to date (another educated guess…)
• That the relative performance of the 2006 and 2007 pool vis the 2000 pool remains the same – which means if it starts 3 times worse it ends 3 times worse.

Calculations

• The 450 billion outstanding from 2006 will wind up a further 2 times 1.25% worse than the baseline 2000 year. That is 3 percent of 450 billion – say 15 billion.
• The 650 billion outstanding from the 2007 year will wind up a further 5*1.25 worse than the baseline 2000 year. That is 7.5% of 650 billion – or 49 billion.
• That totals 64 billion.

Some notes on the model

There will be a few losses from 2005 and other years – but they are small.

The numbers could be MUCH worse than this – because as I have noted the rate of deterioration is accelerating – which tends to indicate much worse.

They could also be worse than this if the mortgage insurers who are the frontline protection on the high LTV loans fail. [Mortgage insurance is already built into the base line losses.]

There are also a few things that Fannie is currently doing in loan modifications that look like loss deferral and that could further mean my numbers are conservative.

Against this, losses could be better than these calculations because there could be a pig-through-the-python effect in the conventional mortgage market just as I believe there has been in subprime. [Indeed there is some evidence that the 2007 pool is so bad precisely because a lot of bad loans did one last refinance into Fannie Mae. That is proof that Fannie’s management is incompetent. But it would cause a pig-in-python effect and mean my loss estimate for the 2007 pool is overstated.]

But – in the absence of a better model based on better data (something I think the world cannot provide us at the moment) I suspect that there is about 64 billion in excess losses coming through at Fannie Mae.

That is enough to render Fannie Mae insolvent. Indeed it is nearly enough to render Fannie Mae as “profoundly insolvent”. Not quite – but close.

I am not buying the stock here. If given a guess I would be on the short side – but I can find plenty more to short that I think is easier and more likely to be right than this.

Personal conclusion

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.

To my readers

Thank you for coming on this intellectual ride. Its caused me some grief as I have promised you a model which I could barely deliver. And it scares me to pretend I know more about the future than I do about the past and present.

But I have learnt something – and I hope you have too.

To the several people out there (including friends) who just knew in their gut what the answer would be - all I can say is your gut is more knowing than mine...

John

Losses recognised to date - and where to look for more

I was somebody who believed in 2006 that most the risks were outside the US banking system. I knew very risky loans were being made - but most were being securitised.

A lot of them wound up in the European banking system - witness Natixis and UBS.

I did however underestimate the losses that would wind up in the US banking system - and Tanta is now saying that it was a little more complicated than my 2006 view. (See this Tanta post I mildly disagree with.)

But data is what I tend to crave. Bloomberg publishes a list of total losses recognised in this crisis so far. The number just passed 500 billion - which means I think it is about half-way there...

Here is the list - but I have done something else - I have divided it into US Investment Banks (Lehman, Bear etc), US Banks dominated by investment banks (Citicorp, JPM), and conventional US banks (Fifth Third, Keycorp).




The conclusion - conventional US banks are only about a sixth of the losses. The Europeans have hurt MUCH more. What Tanta derides as conventional wisdom of 2006 was mostly correct.

What is interesting about this list is the absence of one core type of financial which is loaded with long term assets, CDOs, mortgages and other potentially toxic stuff. Where are all the life insurance companies?

I have a few shorts in that pile. There are probably plenty more - but I don't see anyone publicly berating those incomprehensible piles of mediocrity.

If you are looking at conventional banks you might find some credit losses. Indeed I am short a few conventional banks in anticipation. But they are not where I think the really good ideas are.

Thoughts anyone.



J

Post script: my classification of institutions seems fair enough in most cases - though JPM has made a fair few of its losses outside the investment bank. I also classified Barclays as a US investment bank. That seems fair enough to me...

The Bloomberg list does not include other culprits such as the GSEs, mortgage insurers and bond insurers. If anyone has a more complete list please forward it to me...




John

I was considered a scaremonger with my Swedbank post

Along with those other scaremongers at the IMF who essentially repeated the story yesterday...

See this story about the IMF warning Swedbank and SEB off their Baltic investments and the Swedish Central Bank having to down-play the risk.

I guess the IMF is scared that they will have to bail out the Baltics less the Ruskies do it for them...

J

PS - if you are interested in Russian-Baltic relations see this Wikipedia article about the Bronze Soldier in Estonia... or this BBC version...

Insolvent versus profoundly insolvent – Fannie Mae Part II

The origin of this post came about because of a blog post about Freddie Mac being “profoundly insolvent”. Infectious Greed thought it too fine a distinction between “insolvent” and “profoundly insolvent”. As this post shows I think there is such a distinction.

Fannie Mae and Freddie Mac right now have vast books of prime mortgages for which the credit is deteriorating at an increasing rate. I gave some delinquency sequences in this post and asked people to estimate where the losses peaked.

Nobody was prepared to take a guess but several people quoted back JP Morgan. If JP Morgan is right (and I will guess they probably are) delinquency is more than doubling from here and losses are more than tripling. But it is a blind guess as explained in the modelling post. It remains very bad for US domestic financials – and the more prime your business the more your credit losses will deteriorate. That does not bode well at all for the GSEs.

Fannie Mae and Freddie Mac came into this crisis with a bad history because of stuff-ups in interest rate risk management. This was explained in Part I.

Fannie Mae’s shareholder equity includes a massive tax asset – reflecting that their past sucks. [I was asked whether sucks was a technical term the other day...]

There is no question that the situation is difficult. Moreover given the thin equity they start with and the large books of Alt-A business (even if it is higher quality than average Alt A business) it is likely that the companies are insolvent.

There I said it. But that still doesn’t mean it makes sense to short them.

In my Fannie Mae Part 1 post I suggested that pre-tax, pre-provision income of an unimpaired Fannie Mae is about 10.5 billion dollars. Call it 6 billion post tax and some minimal normal provisions. If someone were to waive a wand and give you a well capitalised and well managed Fannie Mae tomorrow you might pay 13 times earnings for it – say 78 billion. [A government guarantee - implicit or otherwise - has a lot of value...]

The problem is that Fannie Mae is not well capitalised (or well managed) now. If you buy it you are almost certainly going to have to chip in equity, perhaps a lot of equity.

Under no circumstances is it profitable to chip in more than 78 billion in equity because at the end you are left with something that is worth 78 billion in total. If the shortfall at Fannie is more than 78 billion then Fannie is “profoundly insolvent”. It is so insolvent it is not worth saving. That doesn’t mean it won’t be saved. More than a few financial institutions have solved their problems by leaking out the bad news over time and doing more capital raising than their end net worth. But if the losses are more than 78 billion the first capital injection is not going to be sensible and Fannie can only survive if the capital market is prepared to throw good money after bad.

However if you “only” have to throw in 10 billion dollars then Fannie is a steal right now. The market cap is only 8.6 billion – and you would only be paying 18.6 billion for something worth 78. You would get a 4.5 bagger out of the stock. That I think is the upper limit for Fannie Mae stockholders now.

I am beginning to find a way of modelling this – subject to the radical uncertainty in the modelling post.

But that is for Part III.

John

Recollections of Alt-A

There has been a lot of chat in the blogosphere about the real nature of Alt-A loans. Tanta has a brilliant post – and his recollection is at least as valid as mine – but different. He wants to focus on the bad bits of this market (and there were many) but for today I will focus on the good.

My take on this has a very big impact on Freddie Mac – so it is market topical.

Anyway – just as there are many takes on what constitutes subprime there are a few takes on what constitutes Alt-A and here is one.

Once upon a time (as long ago as the mid 1980s) there was a well run mutual thrift in Brooklyn called Greenpoint. It had a very nice – but somewhat risqué lending business. Greenpoint is no more. It was merged into North Fork Bancorp and then into Capital One Financial – so here I am talking about ancient history.

Essentially there are a lot of people in NYC who have done pretty well for themselves despite being illegal immigrants. They have all the characteristics of good borrowers – a family, a sizeable amount of equity, a desire to maintain the lifestyle the wife and kid have got used to, and a genuine ability and intent to pay the loan. They look like the super-prime borrowers of my modelling post – with delinquency well under 1 percent.

However they were illegals. And to get a “qualifying” mortgage from Fannie or Freddie you needed to give over a lot of documentation and these people were not that happy to do that.

Enter Greenpoint. Greenpoint lent on a limited or no documentation basis but a smell test and most importantly used its own valuers who were trained by the company and paid on salary not commission. Their lending was 35% down – but the deposit wasn’t the 35 percent (real though that was) it was the smell test conducted on the borrower.

This was a very good business – but hard to scale and hard to reproduce - it made good loans by properly training staff and by using all-in-house valuers. That didn’t stop others trying using outsourced brokers. It ended in tears the first time – when Citicorp lost 500 million and Dime Bancorp lost two thirds its capital. A lot has changed since then: Citicorp has become Citigroup and Dime Bancorp has become another spoke of Washington Mutual. The quality of Greenpoint was shown when they got through this crisis essentially unscathed… They had many defaults – but the loss given default averaged three percent.

Anyway this business was fundamentally limited because Greenpoint was a mutual which always had a limited deposit base. It demutualised, purchased some branches on Manhattan for the deposit base and moved itself to a more salubrious Manhattan address (the address where the CFO told me this story which I am repeating from memory). I believe (but could be persuaded otherwise) that the term Alt-A was coined by Greenpoint to explain what they were doing. And it really was an alterative to other A grade mortgages – to distinguish it from B&C business that was the then fashionable term for non-prime mortgages.

From here Greenpoint really hit the big time. Freddie Mac agreed to buy Greenpoint mortgages on a risk sharing basis. This meant that Greenpoint had access to the GSE/quasi-government guarantee spigot and was no longer limited by its deposit base. [I always wondered about the politics of using the GSE subsidy to support illegal immigrants given the xenophobia sometimes on exhibit in Washington but…]

This allowed Greenpoint to grow – which they did sensibly at first – keeping their culture of in-house valuers and their smell test. The growth rate became more rapid - and if I had to guess - I would think the standards fell as the growth rate rose. Standards are hard to maintain at a growing institution.

They merged with a mortgage company on the West Coast doing roughly the same thing – but getting some access to wholesale funding. That company was Headlands Mortgage founded and run by Peter Paul. Mr Paul became the largest shareholder in Greenpoint.

Anyway the scene in LA probably wasn’t that much different to NYC – with a bunch of illegals made good. The merger of Headlands with Greenpoint looked like a fit despite being on opposite sides of the country. (My direct knowledge here is limited.)

Greenpoint and Headland both grew with help from their friends at Freddie Mac. This was the bi-coastal non-standard mortgage lender – and as far as I can tell it kept moderately high standards for some time - although my ability to confirm that was low and I never purchased the stock.

I followed Greenpoint for another reason. Long time readers of this blog will know I was once short a lot of Conseco. Conseco had a truly dreadful business in manufactured housing lending. It eventually cost them the company and was the first place where widespread non-fraudulent defaults of AAA securitisation paper took place. The manufactured housing market in the period until 2002 is a pretty good indicator of how a non-prime mortgage crunch works.

Anyway thinking it could do one type of non-prime mortgage with better-than-average legwork it decided it could do another. It purchased Nations Bank’s manufactured housing lending business and became instantly the number 2 manufactured housing lender in the country. They called this business Greenpoint Credit. [For those without memory Nations Bank purchased the West Coast based Bank of America and changed its name – but kept its HQ in Charlotte.] This was an unmitigated disaster with Greenpoint eventually closing the business after losses that from memory were about a billion dollars. Peter Paul was called back to run Greenpoint Credit – and when it failed he eventually resigned his position on the board. Peter Paul retreated to charity and a mortgage company on the West Coast called Paul Financial. He services mortgages and as this entry at the Mortgage Implode site shows – he has not come out entirely unscathed.

As I was searching for links on this story I found a slightly different take on it here. They mention for instance a 75% loan to valuation threshold and a business helping tax evaders buy houses. The core part of the story – being the use of in-house trained valuers however does not change between my memory and this variant.

The point I make is that this was non-standard lending but was essentially sound because the collateral was essentially sound. But it also passed capacity and character tests as well. It really was an Alternative to A lending. Alt-A as a term used by Greenpoint was not misused.

Things changed

Just as Greenpoint was copied by people with lower standards in the lead-up to 1992 it was copied by people with lower standards again. The Alt-A business had made Greenpoint rich – but – given the manic competition – it became no longer possible to do the lending at the standard which Greenpoint expected.

The last I spoke with Greenpoint management (late 2003 I think but I have no notes) they were getting pretty down on the market - very early – pointing out then the insanity of some other lenders. [Note to readers: every bank during the boom will point to declining standards elsewhere but claim that they have maintained standards. Insurance companies do the same thing – and it is not collectively possible. The correct thing for management to do when all about them are losing their heads is either put themselves up for sale or stop writing business. Both of these are however career limiting.]

They did what a sensible management team will do when the game is up. They put themselves up for sale and North Fork purchased them at a good price.

North Fork tried unsuccessfully to get a good price for Greenpoint Mortgage. Nobody purchased even though this was once the best shop on the block. I didn't follow why - but my guess is that the business just wasn't that special any more becasue everyone had access to funds. What made Greenpoint special when it was good was (a) access to Freddie Mac, and (b) the in-house valuers. By 2004 none of this mattered.

North Fork eventually sold itself to Capital One – and I have lost all contact with or knowledge of the Greenpoint mortgage business.

I mention all this for two purposes. Firstly there has been a debate about what the Alt-A market really is. I agree with Tanta that at the end (and with the ridiculous levels of risk-layering) the loans made no sense. Indeed many were probably fraudulent.

But I am not sure that this sort of lender doesn’t come back.

The second reason I mention is that there is a lot of alarmism about the Alt-A book held by Freddie Mac. Mish for example is sure that Freddie is massively under-reserved for this. I suspect Mish is right – but if the book looks like the old Greenpoint book Mish will be wrong.

There were once good things in Freddie’s Alt-A book. The delinquency of that book says it is not all bad still – but it is certainly not the quality of Greenpoint in 1995. There was an extensive discussion of Alt-A in the last (disastrous) Freddie conference call – and whilst it is clear Freddie’s Alt-A is better than industry Alt-A, it is hardly pristine. The quality of Freddie's book declines massively by year of origination - leaving open the possibility that they were once snow-white - but they drifted. [This is an industry wide trend - but it is particularly pronounced at Freddie Mac.]

If anyone has a real feel for Freddie Mac’s Alt A business now could they share it. With a hundred billion in Alt-A and one billion in provisions this is the issue in analysing Freddie Mac.

But for the moment I just wanted an anti-dote to Tanta.

J

As a further link - this post on Blown Mortgage essentially argues that Alt-A was (or became) an excuse to do lending without underwriting.

I think that is right - but it is not necessarily the case. In the days when Greenpoint had limited access to funds it lent those funds very well. As access to funding increased the quality of the lending for the whole industry deteriorated. In the end it was comically low.

J

From the comments - property prices on the California beach

In the comments someone was wondering if they were mad paying $450 a square foot for a house a few blocks from their favourite California surf beach. I noted that I can't tell as I paid well over double that for a house a few hundred yards from my favourite surf beach (Bronte). [My decision was mad... but then I have a wife who is rather happy here...]

But I think we can all agree that apartments in Estonia at multiples of this price are mad. Check out this article. And we shouldn't be that surprised they have halved.

J

Estimating losses for prime mortgage books

I am struggling here with the modelling of prime and conventional mortgage losses. It matters because I am short Magic (see post). But it also matters to Fannie Mae et al.

Anyway think about a pool of mortgages which is following historical seasoning patters. For very high quality mortgages loss would be peaking (at low levels) at about year three. Subprime mortgages which are following historic seasoning patterns have losses that peak earlier.

Anyway – everything is tracking just fine – and then – for some reason the losses start ticking higher than predicted. Now you have to project what the ultimate losses will be.

By definition here you do not know. The losses are higher than expected – and they are diverging from projection. I am going to use the fashionable baseball analogy to talk about stages of the credit crisis from the perspective of bank-uncertainty.

• First base: loans are turning sour at an increasing rate. They won’t get worse for ever (nothing does) – but they will get worse for an indeterminate amount of time. You have no real basis for estimating how long they are going to get worse for. You might remember the last credit cycle and (for your business) the deterioration lasted 15 months. So you model the losses assuming a “burn out period” of fifteen months. This is highly speculative and the confidence around your estimate will be low. You might think you know what is causing the sudden deterioration of credit vis trend. But you generally don’t. Your guess will be highly speculative too – though that will not stop media and pundits from speculating. If you were going to put an honest confident interval around your estimate it would be high. You can make investments on this basis – but you are shooting in the dark.
  
• Second base: the loans are getting worse still – but they are getting worse at a lower rate. The new entrants into the 30-59 day delinquency bucket are falling and the serious delinquency buckets are rising – albeit at a much reduced rate. At this point you begin to get some confidence about the end losses. Your estimate should get more accurate because you can now see the “burn-out” rather than just having to guess it. You might get one or two write-backs but they are rare and they look desperate.
• Third base: delinquency is falling across the board. The foreclosures are humming along – the courts have caught up with the reality on the ground for foreclosures and your estimates will be pretty accurate. You can still be wrong – but it is getting obvious by now what is going on. You even have enough loan files to work out what has gone wrong. [In stage one and two nobody really knows how much is fraud and how much is ordinary credit cycle.] Write-backs of losses are regularly occurring though are less frequent than further write-downs.
• Home: the economy has caught up – some buckets are actually improving. There is still a backlog of real estate owned, but the property price has stabilised. Your estimates should be pretty good now. Write backs are more frequent than write downs.

And here is where the baseball analogy breaks down. Like baseball a lot of companies will be caught out (even insolvent) between bases. But unlike baseball you are never really home in this game. The economy could have a “double dip” recession – the so called W shaped recession. Certainty is not available.

Anyway in this schema I am fairly capable of modelling the credit losses once we get to the second base – and I am totally incompetent to model the credit losses on the first base. That is just reality. We have no real idea what is going on yet.

And at the moment we are clearly in the second base (or further) with respect to everything that was marketed as subprime 2006 and prior. If it is second lien marketed 2006 and prior we are probably in the third base because we know the loss severity too. (Loss severity = 100 percent!) And I feel pretty confident modelling it. I have even purchased a few stocks on that basis (notably Ambac which I have retained despite originally planning to sell some into the short squeeze).

But with prime mortgages we are at the first base. They are getting worse in every bucket at an increasing rate. It won’t happen forever – but if someone tells you about a model of these loans you know they are just making the key assumptions up. Maybe they are making it up with an educated guess (such as my 15 month burn out period). But they are still making it up.

And this is a problem for me because I have promised you an analysis of Fannie Mae’s credit losses – and I have also promised you that (at least on this blog) I will not make it up.

And I am not sure I can keep both promises.

I am short at least one stock because I guess the better part of their book will kill them. That stock is Magic. I think their subprime estimates are reasonable (though light) … but I sure that they do not have a handle on how the good parts of their book will behave and I am guessing the assumptions are optimistic.

However as I promised you an analysis of Fannie’s credit losses and I promised you that I wouldn’t make it up I have to come to a solution. The solution: get you to make it up!

So here are a few data series just for delinquency:

The two sequences all below 1% are Fannie and Freddie’s core book respectively. They are entirely mortgages below 80LTV and below the GSE threshold. This is the very best of the mortgage market. The books with secondary mortgage insurance are given in columns 2 and 4.

It should be observed that the good end of the credit market did not deteriorate at all until August last year. This is clear across a lot of the data I look at.

In August a lot of banks were “surprised” that the subprime crisis was spreading to their books. Well – give the management credit – if they had a true prime book and they were watching the data carefully – in other words if the management were everything you would hope they were – then they were surprised. Lesson to investors: do not call for the sacking of management who were surprised in August. [Be a little less forgiving of management who chose another month to be surprised.]

But it is pretty clear that this good stuff is getting worse at an accelerating rate. The last two months in particular have been bad.

And for the reasons explained that makes it very difficult to estimate where this deterioration is going to finish.

So – as I am not happy making it up can my readers have a go. What will be the delinquency for the insured and uninsured Fannie and Freddie books in twelve months? How about the Magic book?

Guesses anyone? Email or (preferably) in the comments.

John

Some corrections on statutory capital requirements

With one reader I have started modelling the statutory capital requirements of Magic. In the process I discovered that my understanding of the stat-capital rules was faulty - and hence some assertions made about them in this post and this post are incorrect.

If anyone is truly expert in the stat capital rules for mortgage insurers I would love an email.


John

Another blog milestone

This is the 101st post on Bronte Capital. I missed the hundredth.

On the fiftieth post I noted blog milestones. Here I will update them:

Number of large corrected mistakes was one and is now three. Correcting my own errors is one of the goals of this blog - but I would prefer not make them. [There are numerous small errors and probably some large errors I have not found...]

At post 50 cumulative visits were 3788. In the past month it has been 10848 and I have now had over 5000 unique visitors (up from about 2000). These numbers have taken off recently and I am now getting about 800 visits a day.

The subscribers have taken off - they were running at about 80 and are now about 430.

In the past the most popular posts were the first post about Barclays, and the first post about the fraudulent hedge fund in Santa Fe. They are now running at number 8 and 10 respectively.

The most popular post (surprise) is the post on Swedbank. At least that is partly because it turns up high on Google searches for the price of Eastern block hookers.

Funnily enough the throw-away on Wachovia comes in at number 2. I don't think it is amongst the most interesting things I have said.

The comments were almost non-existent at post 50 - but I was getting a small but loyal email following. The comments are now much more frequent - and for the first time getting annoying. I don't like being asked in a comment for instance how much a stock has fallen. [It is very easy to look up...] So far I have not edited or deleted any comment except when the author has emailed me and asked me to. [They emailed me because they made a mistake...]

Keep the emails coming.

J

From the comments: more on Magic

One of the reasons why I love doing this blog is that smart people disagree with me and send me emails.

And I am not wedded to any position. I change my mind.

Here from the comments is a comment that is accurate enough as per Magic now:

John...Thanks for your thoughts on Magic. We too were short the stock for some of its fall but have now gone long in significant size. Yes they underwrote a lot of crap, but the premium deficiency reserve which assumed a51% loss rate compensated for that. Now the remaining bulk RIF is only $3.5 billion per page 13 of the recent supplement. Total reserves are $4 billion or $34,000 per delinquent loan at June 30. If the cure rate is 50% (which is way below the historic number) then the reserve per real delinquent loan is more like $68,000. You are right to mention how Magic is cash flow neutral and thats important. We see Magic as generating $1.5 billion in pre provision pre tax earnings per year. Just take revenues minus operating expenses. That is alot of cash at $1.5 billion a year plus $4 billion of reserves to pay future claims. Recent book value was just below $23 per share and based on expected losses over next 6 quarters this should not get below $18 per share at year end 2009. At this point the real earnings power of Magic will shine through remember $1.5 billion pre provision pre tax earnings divided by 150 million shares = $10.00 per share. I guess you could say that makes us believe in Magic.

The Anon Guy is right in one key respect. The business is now cash flow neutral. It is however running very substantially statutory capital negative. They will run out of stat capital if the new business shows any substantial losses.

I do not believe that the deficiency reserve is adequate – but the level to which it is inadequate is not large enough to make me want to be short the stock. It exacerbates the stat capital problem but it is not lethal.

The question is whether you believe that the business they wrote in 2007 and early 2008 is sensible.

If the new business is sensible you believe in Magic. I am afraid that I do not believe but my data for that view is thin.

The trend on losses for mortgages originated in 2007 is not good. Indeed it is positively sick. The trend on Fannie Mae and Freddie Mac insured mortgages is looking not good.

In other words the core business is looking worse. However if it is only a little bit worse then my friend above is correct – and you should be be long Magic. I need the core business to deteriorate markedly to get paid on this short.

I think that happens – but any help in modelling would be much appreciated. Dear reders – send me your emails.

John

Postscript: My explanation of statutory capital requirements for Magic is slightly faulty. I have blogged about that here.

One email comment - about reserving at MTG

The GAAP reserving rules for mortgage insurers are very strange - almost prohibiting them taking reserves for anticipated defaults (except the premium deficiency reserve).

I might be harsh saying that they are under-reserved in a GAAP sense. I do not think I am harsh saying MTG is under-reserved according to common sense accounting. But I am open to being convinced otherwise.

J

Do you believe in Magic? [Fannie Mae part IA.]

This post has a couple of purposes. Firstly it is interesting in its own right – but more importantly it is key to understanding Fannie Mae’s credit profile. Consider it as Fannie Mae Part IA to go with my Fannie Mae Part I.

Mortgage Guarantee Insurance Corporation (MGIC or NYSE:MTG) is a mortgage insurance company. It was the mortgage company I hated most. I despised it. MGIC was always known as Magic – and almost whatever they said I didn’t believe. I would rather believe in witches and other black magic than almost anything the CEO of this company said.

You need a little background to know why I hated this company so much.

The changing role of mortgage insurance

There is a traditional role for mortgage insurance. The GSEs (Fannie and Freddie) were not allowed to underwrite mortgages with a loan to valuation ratio of greater than 80% without secondary mortgage insurance.

However realistically most first home buyers have never been able to put 20% down. So secondary mortgage insurance was required. This would bring the loan within Fannie Mae criteria. The traditional book of mortgage insurance companies was thus enormous piles of loans originated with 80-95 percent loan to valuation ratio – almost all loans to young couples for their first home where the total mortgage was somewhere between 100K and 200K. These loans were diversified by geography and time of origination – but not much else. They were also pretty safe.

Then a few things happened. By far the most important was that banks and the securitisation market started offering closed end seconds (CES). The idea was that you took a standard Fannie or Freddie mortgage (ie a GSE qualifying mortgage) and a second mortgage (or even two second mortgages) above that. This was the so called 80-10 product meaning an 80% GSE mortgage and a 10% second above that. There was also 80-20 product and 80-10-10 product describing different sizes of secondary mortgage.

The result was banks undercut mortgage insurers and the core product of the mortgage insurers looked obsolete. The mortgage insurers looked in a quandary – and several of the mortgage insurers had a hard time growing in the domestic market. According to the mortgage insurers association (MICA) the total mortgage insurance in force was 668 billion in December 2006 and 619 billion in December 03. That is not much growth in the most wild-ass mortgage market in the history of the USA. During that period premium rates actually fell – so revenue went nowhere to backwards.

The mortgage insurers compensated by doing other things – mostly riskier things – and that blew them apart.

• PMI went to Australia and purchased a stake in FGIC. FGIC is a bond guarantor that has been smashed.
• Radian funded a bond guarantor (Radian Guarantee – formerly Enhance Re) and blew up on it. They also invested in a fraudulent securitisation company (CBASS) I blogged about here.
• General Electric just decided it wanted to exit the space and wrapped its mortgage insurer in Genworth Financial and spun some out and sold the rest.
• Magic went subprime – and owned a stake in CBASS.

What Magic did

Magic went deep and scummy subprime. It started guaranteeing mortgages in the pools produced by the most dodgy of producers – it was particularly big into Novastar and ResCap (the GMAC mortgage business). Novastar were about as questionable as subprime mortgage providers got (and the money they owe Wachovia is a case-in-point about questionable exposures at Wachovia). ResCap by comparison were Vestal Virgins (and we know how f—ked about ResCap is). Herb Greenberg wrote more-or-less continuously about Novastar. He got a lot of flack – but he was right.

Anyway – insuring mortgages written by Novastar was a pretty quick way to the poorhouse if you asked me. Novastar also got PMI to ensure mortgages but quite quickly PMI realised what Novastar was it stopped doing business with them. Herb Greenberg also wrote about that.

Anyway Magic were the ugliest of the ugly in subprime securitisation. They insured pure crap. I couldn’t imagine how they would wind up solvent.

They then pretended it was OK by using the most absurd definition of subprime, Alt-A and prime I have ever seen. I blogged about that here. Their definition of subprime was so weak that it was possible to not be considered subprime if you had:

• A 95 percent loan to valuation in a low-end housing estate
• Where the valuation was taken by a broker-friendly appraiser at the third cash-out refinance
• Where there was no evidence that the person was able to repay principal and – to the contrary where they needed to refinance their mortgage every few years to make it current, and
• Where the customer had in the past seven years defaulted on a credit card costing the issuer money

And that was the guts of the reason why I hated Magic. It was the company with the most subprime book – but they pretended it was mostly not subprime by defining subprime in such a way that only serial credit card fraudsters seemed to meet the definition.

They also owned half of CBASS – which owned a very nasty loan servicing business (Litton). You can find out just how nasty Litton is here. I blogged about it here.

Magic were the scum of the mortgage boom.

And if you had asked me if there was any realistic proposition of magic surviving a proper crisis I would have answered no. I always said it was a $5 stock – which was just so I didn’t sound nutty saying it was a zip. [I was considered a hyper-bear in those days…]

Anyway I was wrong. Magic is sort of surviving. It is not an easy situation – but it is not completely diabolical. And sometimes I am stunned when institutions with OK management (Fifth Third) or really rich institutions (Natixis) get into trouble. But this stuns me the other way – these guys are haven’t filed the Chapter 11 they so richly deserve.

Do I have to add that they compounded these errors by repurchasing billions of dollars worth of their shares at absurd prices? No – I can thank them for it – their repurchases provided a counterparty to my short sales!

So where is Magic today?

Well – obviously they have given up doing the real dumb business. CBASS has been written off and the company has retreated to doing the traditional business of first home buyers…

I doubt I can say it any better than the Management discussion in the last annual report:

Premium Deficiency

Historically a significant portion of the mortgage insurance we provided through the bulk channel was used as a credit enhancement for mortgage loans included in home equity (or “private label”) securitizations, which are the terms the market uses to refer to securitizations sponsored by firms besides the GSEs or Ginnie Mae, such as Wall Street investment banks. We refer to the portfolios of loans we insured through the bulk channel that we knew would serve as collateral in a home equity securitization as “Wall Street bulk transactions”. During the fourth quarter of 2007, the performance of loans included in Wall Street bulk transactions deteriorated materially and this deterioration was materially worse than we experienced for loans insured through the flow channel or loans insured through the remainder of our bulk channel. Therefore, during the fourth quarter, we decided to stop writing insurance on Wall Street bulk transactions. In general, loans included in Wall Street bulk transactions had lower average FICO scores and a higher percentage of ARMs, compared to our remaining business.

In the fourth quarter of 2007, we recorded premium deficiency reserves of $1,211 million relating to Wall Street bulk transactions remaining in our insurance in force. This amount is the present value of expected future losses and expenses that exceeded the present value of expected future premium and already established loss reserves on these bulk transactions. See further discussion under “— Results of Operations —Losses— Premium Deficiency.”

C-BASS Impairment

C-BASS, a limited liability company, is an unconsolidated, less than 50%-owned joint venture investment of ours that is not controlled by us. Historically, C-BASS was principally engaged in the business of investing in the credit risk of subprime single-family residential mortgages. Beginning in February 2007 and continuing through approximately the end of March 2007, the subprime mortgage market experienced significant turmoil. After a period of relative stability that persisted during April, May and through approximately late June, market dislocations recurred and then accelerated to unprecedented levels beginning in approximately mid-July 2007. As a result of margin calls from lenders that C-BASS was unable to meet, C-BASS’s purchases of mortgages and mortgage securities and its securitization activities ceased. On July 30, 2007, we announced that we had concluded that the value of our investment in C-BASS had been materially impaired and that the amount of the impairment could be our entire investment.

In connection with the determination of our results of operations for the quarter ended September 30, 2007, we wrote down our entire equity investment in C-BASS through an impairment charge of $466 million. This impairment charge is reflected in our results of operations for 2007. For additional information about this impairment charge, see Note 8 to our consolidated financial statements. In mid-July 2007 we lent C-BASS $50 million under an unsecured credit facility. At September 30, 2007 this note was carried at face value on our consolidated balance sheet. During the fourth quarter of 2007 C-BASS incurred additional losses that caused us to reduce the carrying value of the note to zero under equity method accounting. The equity method reduction in carrying value is not necessarily indicative of a change in our view of collectability.

Well apart from not disclosing just how scummy C-BASS was all along this seems a fair disclosure. But here are the critical things for the future:

• That the excess of future claims over revenue (a premium deficiency reserve) was a bit over a billion dollars.
• That the flow business – the traditional first home business – was not showing undesirable credit characteristics as of year end.

Now, as you imagine, I never thought this company had much credibility (they continued to lie about the nature of C-BASS) and they were as close to scum as anyone I have come across in this industry. (Surprisingly the CEO has not changed.) But if the losses on the closed block of business are larger than this or the traditional business of first home buyers goes pear shaped then there is not going to be much left.

So here is the sticky question: do you believe in Magic?

The company gave us one marker that I guess you could use to test whether you believe… that marker is that they predicted paid losses this year to be just under two billion dollars.

And if you want a bull case – the margins are very much improved

Premium revenue is going up massively and they are no longer having to write business for Novastar to get that premium. Net premium written in the second quarter were 372 million compared to 321 million last year – and the total par insured has fallen from 19 billion to 14 billion.

372 million for accepting credit risk on 14 billion of mortgages is still not stunning business – it is still less than 3 percent. But it is an awful lot better than it was. However with this premium the company is still going to get into diabolical trouble if the conventional first-home owner/Fannie insured mortgage market goes pear shaped.

But current margins are not the story – the back-book and the quality of the new business is

Magic gave us a criteria by which we can judge - they told us that premium income was going to be rising and claims paid would be under 2 billion dollars this year. Surprisingly they are beating this by a very comfortable margin.

The claims paid are running at 385 million for the last quarter – about what the written premium is. The company is barely bleeding cash at all. If you had asked me whether it was possible that this – the most scuzzy of mortgage companies – could be essentially cash-flow neutral this far into a mortgage crisis this big I would have laughed and not answered. But they are essentially cash flow neutral (with a caveat that I will explain below about statutory capital). Still it is pretty hard for a company that is not bleeding cash to go insolvent. It is not impossible – but on these numbers you would have to say that you do believe in magic.

The problem with this analysis is that there is a bad reason claims paid are running below projections. It is just that the courts are jammed up, the servicers of the mortgages totally swamped and foreclosure is running much slower than anticipated.

You can see that. The delinquency on their super-scummy subprime loans is over 36 percent and rising very fast. This is serious delinquency – the company does not bother reporting 30 day delinquency (probably because its servicers do not tell it).

The company’s reserves smell very light if you adjust for this problem. They have insurance over 34 billion of bulk loans in force and they have serious delinquency on the bulk loans of is over 25 percent. They are coming in at a few billion of losses – not just the billion or so in the reserve kitty. This company looks and smells under-reserved still. And given that I probably wouldn’t buy insurance from it. Whether it is solvent or not – that is another question.

But people do buy insurance from it and in quantity – and if that insurance doesn’t blow up in their face then the company will be just fine.

Is the new business any good?

This whole thing is contingent on the new business being OK. This is a company keeping up with old losses by writing lots of new business – and to date it is working.

The new business is mostly flow business being written for Fannie Mae and Freddie Mac. It may be good business (the jury is out). But it is pretty clear why Fannie and Freddie want to support Magic. It is in the interest of Fannie and Freddie to keep this company alive. If it dies then Fannie and Freddie are on the hock for the insured business. And if Fannie and Freddie stop trusting it for insurance then the company will die.

This is a bad dynamic. Magic gets to write lots of business at today’s much improved margins at terms which might keep it alive – and it gets to do it because Fannie and Freddie refuse to face reality.

But here I think the magic is very black indeed.

Look at the delinquency rate on the flow business. It has doubled and it is running I the table above just over 6 percent. That number has me really puzzled. Indeed I needed a good lie down and think.

Why is six percent so high? Well Fannie Mae publishes the delinquency on its credit enhanced book every month – you can find it in the monthly statistics. It’s a pretty good indication of the average of the mortgage insurance industry. You can find the table in the bottom right corner of the second page of this pdf.

The Fannie Mae number is running at 3.56 percent. The Magic number is almost twice as high. Come to think of it – the Magic number is almost twice as high as the delinquencies on the 100 odd billion of Alt-A stuff at Freddie Mac which makes everyone sure that Freddie is going to fold.

This suggests to me that Magic is doing something considerably riskier than the Fannie Mae average to get the higher delinquency.

We are meant to believe that this is good business – but it doesn’t look like America. Fannie Mae’ average delinquency of under 1.5 percent looks like America. I do not get it and I have fast come to the conclusion that Magic are just unreformed and unrepentant river-boat gamblers who still operate in the risky end of what is left of the mortgage market.

It might be just the general trend that I have blogged about – that 2007 business just looks sick (see here and here). But if it is the oncoming train of 2007 business then I wouldn’t want to stand in front of it.

So in summary: I do not believe in Magic. I have covered my short – unfortunately several dollars higher than this. But something remains not quite right here.

John

Postscript: Can you go bust whilst being cash flow positive?

I asserted in my post that it was pretty difficult for Magic to go bust whilst being cash flow positive. That assertion was a gross simplification.

Magic is a holding company with considerable debt holding a regulated insurance company. When the insurance company writes premium it needs to make reserves (the so-called contingency reserve). These reserves reduce distributable capital. The losses also reserve distributable capital. The cash flow and the ability to distribute from the regulated insurance company to the holding company are not correlated.

The holding company needs to receive distribution as it has debt – and if it fails to pay that debt it will fold.

In other words it is possible for the holding company to go bust whilst the whole entity is cash flow positive. [Holders of Conseco once found that out.]

I would love it if someone has modelled the statutory accounts of this company – or could help me with that task.

John

Note: I put my MTG:NYSE short back on "last night". This is unusual for me - I originally shorted this stock above 50 and covered at 20 and 12. I put it back on below 8. For those that don't know I am in Australia - so it really was last night.

Covered bonds as a panacea – or a recipe for the FDIC to kick in more taxpayer money

I am getting jaundiced in the banks pushing covered bonds as the panacea for the housing market and the journalists who buy it. This story really got my goat because it is so one-sided.

All a covered bond is is a guaranteed securitisation.

• Currently a bank can borrow money unsecured or subordinated to buy mortgages. In which case the borrowed money carries a bank guarantee, is generally subordinate to depositors, and hits the bank’s capital ratios. In insolvency the assets are there and that helps pay depositors.
• Alternatively a bank can securitize, in which case the funding is secured, but there is no bank guarantee and hence there is no impact on the bank’s capital ratios. Ideally there is no effective guarantee at all on the assets in which case problems with those assets cannot hurt depositors.

What the investment banks want to sell is funding which is secured and carries a bank guarantee.

When a bank sells covered bonds problems with the assets hurt depositors but the assets are not available to help pay off depositors if the bank gets into trouble.

In other words it downgrades the claim of the depositors whilst not reducing the risk to deposits.

Deposits generally carry a Federal Government guarantee. Covered bonds will increase the cost of honouring those guarantees and hence increase the cost to tax payers of bank bail outs.

Paulson wants to allow this. Advice to the Senate: you will be there in 12 months. Paulson will not. Think of it that way.

J

Update

A couple of people (notably Mish) have pointed out the limitations on covered bonds will make them less useful than they might otherwise be and hence reduce the systematic risk. The Aleph Blog also made that point here.

I still think this is very dangerous. Imagine a bank in some trouble selling covered bonds. When the loans go bad they need to replace them. When the insolvency happens the bond holders wind up owning the good assets and the bad assets get left preferentially to the depositors (read the taxpayers). But the limitations which are extensive both reduce this risk and reduce the effectiveness of the bonds as a capital raising tool...

From the comments:

Paul left a comment on my “what if it was fraud” post:

I live in California and work in finance. I took on a pro-bono "client" recently who was up against the wall thanks to mortgage/housing costs that were extremely large: 90% of his gross wages - before the ARM reset. His poor decision to buy near the peak was based on speculation, but the surprising thing I discovered when I looked at the paperwork is that he did not have to commit fraud to obtain the mortgage. Countrywide originated the 0% down ARM loan with full knowledge of my client's financial status.

My client is an immigrant, and Countrywide had reps fluent in spanish who penetrated this community.

I have a retired friend who works full time with a non-profit group focusing on individuals with high debt loads. He has had over 200 "clients" in recent years who got themselves into a very similar situation to my client. Zero money down mortgages, rising house prices, and financially unsophisticated clients all contributed to the situation.

I hear variants on this story regularly. There was a fraud committed. It may not have been by the borrower – it was probably committed by Countrywide (and my guess is that Countrywide offered representations when they securitised the loan and so Countrywide will need to make good). That could be unpleasant for Bank of America.

But the issue I have is about working out what is going on in the market as a whole. Losses like the one you describe are (a) not redeemable by forbearance, (b) large and rapid. They fit the “pig through the python”.

I wish I knew how much of the market was “pig through the python” and how much was ordinary mortgage stress. If it is pig through the python there are plenty of stocks to buy right now. If the “fraud” cases are the first wave of a much broader mortgage stress then there are stocks to short right now.

The thing about the case Paul describes is that there will be no more losses from such cases in a few years. They will have all been incurred.

I would love a way to quantify this. It’s the trillion dollar question.

John

PS. Paul – thanks – can you send me an email. Much appreciated.

A correction on mortgage trends

I posted the general view that the worse your credit the faster it is improving and the better it is the faster it is deteriorating. (See this post in response to Felix Salmon.)

Again there is a gross simplication. This is true for business written in 2006 and prior. 2007 business just looks sick everywhere. I also blogged about that here where I noted that if you did 2005 and 2006 non-prime business you are seeing light at the end of the tunnel. If you did 2007 business that light is an oncoming train.

J

Jamie Dimon – it is time to pay up

Yesterday I wrote about fraud in the mortgage market.

Today I will write about a single deal – the Bear Stearns 2007-1 closed end second deal insured by Ambac.

This deal is a stinker. Ambac has provisioned for an 82 percent cumulative loss rate on this deal. I have looked at the raw securitisation data and I don’t think it will be quite that bad – but it is awful.

For this to happen 85 plus percent of the loans in the deal need to default.

That doesn’t happen to normal loans. Even in the worst of crises diversified and honestly assembled pools of loans don’t default at that rate.

It only happens when there is mass fraud involved.

Bear Stearns assembled those loans fraudulently or knew the loans were fraudulent when assembled.

But it is worse. They warranted the loans would be OK.

You will find the serving agreement here. I am not a total masochist so I haven’t read all of it… however the document contains the usual clause requiring Bear Stearns to buy back and replace loans that breached the mortgage loan purchase agreement…

Jamie Dimon didn’t create this problem. Them lying scoundrels at Bear Stearns did. They misrepresented the loans – not Jamie Dimon.

But Jamie bought this problem and it is now his.

Jamie – it is time to pay up. Hope you have provisioned for it.

John

PS. Not to be too hard on Mr Dimon I have spent some time looking at securitisation created by JPM. They perform better than average at least in the areas I have looked.

Post script: I have just listed to Ambac's conference call. I said in this post that my estimate for loss on this deal is somewhat less than Ambac's estimate. In the quarter Ambac reversed some of their reserve and the reserves look much closer to my estimate. So Jamie doesn't have to pay quite as much. But he is going to have to pay...

Felix Salmon steals my thunder

Felix has the response to my "is it fraud" post. Read it.

There was plenty of fraud - unknowable amounts. And there is an awful big pig in the python.

But there is something coming after the fraud - which is plain vanilla losses.

Now here is something that I was hoping to tease out as part of the Fannie Mae story - which is what I am working to. Its what the mortgage data says:

· If the pool of mortgages is really bad it is getting better.

· The worse it is the faster it is getting better.

The deals in the ABX – which are truly awful – are improving at a rapid rate. This is indicative of a pig in the python. The loss rate for those deals is awful but the direction is good.

· If the pool of mortgages is fairly good it is getting worse.

· The better it is the faster it is getting worse.

The loss rate might not be very bad (yet?) – but the direction is horrible.

It is not like "we are all subprime now" – just that ordinary credit is getting worse – which means what was a fraud problem is morphing into an economic problem.

There are non-prime pools with 85% defaults. There is no way that is going to morph across America. So the line “we are all subprime now” is just wrong. But the there is plenty coming and it has a different profile to what has been.

John

What if the problem was mainly fraud?

Warning: This is a post that stereotypes people to make a point. The world is more complicated than this post – and the stereotypes are precisely that. I would love complex and real examples in the comments that question my stereotypes. I am a finance junkie – and you forget when you are looking at numbers that they embody the dreams, aspirations and failures of real people. What I seek is things beyond the stereotype… so I have different ways of reading the numbers…

There are all sorts of causes of the mortgage crisis and all sorts of results. However I want to pose a question about various types of borrowers and what their loss curves are. I am really seeking anecdotal industry evidence – hopefully from people who were once mortgage brokers or similar.

Imagine a few types of stereotypical borrower:

• Jack and Jane are a typical first-home buyer. They have saved $10000 (which was hard) because Jack does contract work and sometimes his income is good and sometimes it is not-so-good. They have purchased their first home in suburbia. Its small – but property prices were high so they paid too much. Like almost all American young couples they aspire to a nicer second home. Contract work is getting thin at the moment and Jane might fall pregnant reducing the household income further. They are people of good character suffering mortgage stress.
• Margaret is a divorcee. When Patrick walked out he left her with debt against the house (but some equity) and a lifestyle she couldn’t afford. However the credit card offers came in the mail and Margaret maintained her lifestyle. Eventually she had to repay the mortgage. She did so easily by refinancing the house – and even refinanced the house three times on a stated income loan. She now has a debt that she can never afford even if she adjusts her lifestyle. And she has shown no ability to adjust. Indeed she has got fatter and sorry for herself. She smokes 40 a day. [The NYT profiled such a case.]
• Tom is a flipper. He has deliberately borrowed more than he can afford on a stated income loan. He hopes to sell the house to the next flipper. The loan would not have been granted on his real income – stable though it is – because he can’t afford it.
• Jaylin and Ebony are a lower income black couple of good character. They were victims of predatory lending. Some unscrupulous broker sold them a loan with five points up front (hidden in the fine print) and a low initial monthly and a balloon payment so they could consolidate their car loan. The car is necessary because it is how Jaylin gets to work. I am deliberately racially stereotyping here because there is plenty of evidence that predatory loans were targeted at predominantly black neighbourhoods. This couple was just defrauded by the system. They would be willing and able to repay a decent their loan on original schedule – but the balloon payment and the five points ripped off them by an unscrupulous broker puts them over the edge. They too are distressed and angry – and their willingness to work with or trust financial institutions is also low.
• Frank and Helen aspire to the upper middle class. He has a good job and she works part time and looks after the kids. The marriage is about as stable as the average American marriage – which means that when its good it is very good – but financial stress does strain the marriage (and marriage strain potentially strains the finances). They wanted to get the kids into a better school and hence purchased in a better neighbourhood. Keeping up with the Jones they purchased a better car on an incentive payment. It’s a big car (SUVs were fashionable) and the gas price and the lack of overtime is stretching Frank’s budget. But they want to keep the kids at the good school. They have fallen behind on the mortgage payments – but they make payments occasionally –and they can afford to make lesser payments without catastrophically adjusting their lifestyle.

Everyone who has followed this industry has seen borrowers that fit these stereotypes. However people are varied and complex and if you limit yourself to such stereotypes you are going to miss out on the richness of the world. The press articles tend to follow one stereotype or another - and hence also miss the richness of the world. As I am in Australia (reading bank account statements) and many of my readers are in the "real world" I seek comment.

That said – my guess is that these stereotypes have very different default profiles even in a diabolical real estate market.

On the stereotypes I have given you two of the buyers are essentially irredeemable – and three of the buyers could work the loan out with a little bit of forbearance, some modification of loan terms and a little bit of flexibility. The lenders will still take losses – but they won’t be catastrophic losses.

Think what happens if you modify the loans to Margaret, the debt ridden divorcee, or Tom the Flipper. You tell them you can keep the house if only you make 70 percent of the payment you originally promised.

• Margaret got herself into this position because there was no way that she could afford her lifestyle. She borrowed by fraudulently overstating her income. She has no hope of repaying even on modified terms. The best hope for the lender is to close her up. If she gets her act together she won’t be homeless for long. But life is about to get much worse for her.
• Tom the flipper can’t repay either (but he might be able to make 80% of scheduled payment). The problem is that Tom the flipper has no incentive to pay. He is seriously upside down [negative equity] on the loan and he only wanted to flip the house for what is now a very unlikely profit. Tom’s best strategy is to walk - and he was gaming the system in the first place - so he will walk... Again he got there through fraudulently overstating his income. The bank has the property and Tom’s lifestyle won’t change much.

Compare this to the other borrowers:

• The typical first home owners Jack and Jane are going to be very reluctant to default. They have a proven ability to save (witnessed by the deposit that they saved). They want to join the middle class. They still see homeownership as the way there. If the lender modifies their loan they will get paid most of it. Indeed you might receive all of it. It is unlikely that a well modified loan will cost more than 10% of outstandings. Jack and Jane still have a high chance of default in a recession - and there can be a tragedy underlying this - but they will fight not to default.
  
• The couple who were victims of a predatory loan are a bit more difficult. Unscrupulous brokers working for Novastar and similar companies have ripped 10 thousand plus dollars out of these people. That ten grand has gone – it has been spent. Our borrowers have paid interest at say 4 percent but accrued it at 10 percent. They now owe much more than the house is worth. They could reasonably pay the loan on the original terms – and an omniscient owner of the mortgage might restructure their loan that way. But the mortgage is now owned by a defaulted subprime pool and it is not obvious who has the power or incentive to restructure the loan. The restructure will also change the value of different classes of the mortgage securitisation. So they are going to default in my view. The loan might be able to be restructured in a perfect world – but this is not a perfect world. They will default quite rapidly when hit with increased coupon on their loan. There is an out for the lender –just the lender doesn’t know how to take it.
• My last couple will pay (almost?) all the loan and all their loan under modified terms because they want to keep their kids in that school. But they need the loan to be modified because they are at the edge of being able to pay. Still they will cut entertainment, holidays and shrink the car to stay in the house because they want their kids in that school. If there is a recession and the husband's hours get cut - well you should probably modify the loan as that is a better outcome for the bank than foreclosure.
  

Note that some of these are fast defaults and some are slow defaults. If you stop rolling loans the flipper and the divorcee default almost immediately. The victims of the predatory loan default after the low-coupon period expires. The other two loans might not default at all – but whatever happens they will default slowly. They are going to try and hang on.

My point: the fraudulent loans here (stated income, predatory) have fast defaults. The non-fraudulent loans here (typical first home buyer, middle American aspirant family) have slow defaults if they default. One group can’t or won’t hold on. The other group tries desperately to hold on and might succeed.

Or in summary: fraudulent lending leads to incredibly massive and very rapid defaults with little chance of cure. There is no point offering forbearance – it won’t work.

However once the pig (a pile of fraudulent loans) has worked through the python (the mortgage market) then the bulge (defaults) will decline just as rapidly as it rose.

Non-fraudulent but stressed loans take time and if we are seeing increasing defaults now we can expect to see them for another five years. Loan forbearance programs make sense – but they can’t stop the rise in defaults over the next three to five years.

This is where having readers around the world is really useful. To what extent is it fraud – and to what extent is it old-fashioned bad lending. Does this differ by State or even area within States?

If you look at the loss curves for companies (shooting straight up) and extend them then pretty well every institution is insolvent.

Arguing from the stereotypes – if it is fraud is the dominant problem in the mortgage industry then extending these loss curves is wrong – and the losses will drop sharply once the “pig is through the python”. Many institutions that look difficult will turn out OK.

By contrast: if the problems spread to non fraudulent loans then extending the loss curve for many years is the correct analysis – and all sorts of institutions (including the GSEs) are insolvent.

You see why I am looking for comments. This is the Sixty Four billion dollar question – or – more accurately – the trillion dollar question.

I have my views – but data on fraud is particularly hard to obtain because when you survey people they don’t volunteer that they have been fraudulent. So – as the usual data-driven guy that I am I find this one difficult to nut out.

Thanks for the help

John

Just some comments on the email I am getting

I have received a few comments on the Fannie article – which I was going to include in the parts II and III – but as the comments in the email just keep coming I will put something up now:

• The first comment is that I can’t possibly believe that they are solvent given that they are 130 times levered to a really bad housing market.
• I make no such suggestion at all. I simply have not got an answer until I do the credit analysis. However I can say that the inventory and delinquency numbers that they have right now do not indicate insolvency – for them to be insolvent a lot more bad loans have to come through the system than have already come through the system.
• The second – and more sophisticated comment is that all insurers raise rates when times are bad – but it doesn’t save many of them – so why should I spend so much time exploring this effect with Fannie?
• Well – the pricing effect does save some insurers. It only saves them if they can continue to write business – so I don’t ever talk about the pricing effect with MBI or ABK who are effectively in runoff. But I still want to work the numbers.
• That the repo inventory at Fannie is 20 percent in Michigan – even though only 3 percent of their exposure is there.
• That is a real issue which I hadn’t picked up on but should have. When you are as levered as Fannie if a single large state economically falls into the ocean then you can die. I have blogged several times about how bad the housing market is in Michigan (see here and here). It is entirely possible that Fannie loses a very much larger proportion of its inventory. However the point remains that losing 100% on the current inventory is not a problem – for Fannie to be insolvent an awful lot more loans need to pass through the inventory.

As it currently stands very few of Fannie’s losses are in California. Simple logic suggest losses are going higher – much higher. I haven’t worked out any estimate of how much higher – but please keep those emails coming.

Also – my first substantive dig didn’t point out just how exposed to catastrophe risk Fannie is. Fannie has a lot of exposure in LA. The house price in LA currently sucks – and if a major earthquake were to flatten the Inland Empire not only would it be a human tragedy – but I doubt anyone would want to rebuild a large number of the houses. What is a bad situation there for Fannie could turn suddenly diabolical. Warren Buffett once said that he thought Fannie Mae had more super-catastrophe risk than Berkshire. That is a big call by a man who should know…

On the price of hookers in Bulgaria – someone suggested that I could get my readership way up if I were to publish a price index for hookers by jurisdiction.

Well I tried…

No seriously – in the comments was the astounding observation that people in the Baltic States travel internationally to buy food. They suggested pretty well every jurisdiction – but Poland appears to be the consistent answer. This story suggests that food is more expensive in Tallinn than New York or even Finland. I can assure you that not much is cheap in Finland and that this is just another measure of an overpriced currency. Driving to Poland for big shops makes some sense…

But if you wish to confirm that Poland is cheaper than the Baltic States you can do so other ways. The immigrant population of London (who send remittances) will do that for you. Or get on the web and look at the prices of escorts. It will probably do that for you to.

On the last method of research – there is a company in India called “Escorts”. I once worked at a global fund where one staff member legitimately trolled the web for stories about Escorts in India…

How people find my blog

I use Google Analytics to track things like how people find my blog.

Sometimes it surprises me - but yesterday I had not one - but two visitors from the Google search "how much does a hooker cost in Bulgaria".

Oddly Google ranks me as the authority to answer that question. I suspect they will fix that rank soon - as I am a happily married bloke living in Australia who has never been to Bulgaria or owned or shorted a Bulgarian stock. For that reason I have preserved this page:



Well dear readers, I don't much care how you got here. Welcome anyway.



John

Picking apart Fannie Mae – PART ONE

Warning: This post in this form contains NO conclusions. I do not express a position on whether the stock is a long or short. I hope to get there by Part III - at the moment I am just conducting an intellectual exercise for me and my readers.

I have had hostile email suggesting that I couldn't possibly suggesting that the stock is a long. I am not. And I will not without a close examination. And I won't suggest its a short without a similar examination. That is the way I want this blog to work...

There has been an awful lot said about Fannie Mae and Freddie Mac of late. Almost none of it contained numbers. If they contained numbers they were just off-the-bat (ie analysis free) estimates of what a bailout might cost.

I can understand why. I had a go at picking apart Fannie Mae. The deleted post can be found here. It was one of the more embarrassing mistakes I have made. I just left a zero off a calculation and produced nonsense. Moreover I ran the calculation past one of the best known hedge fund managers in the world – and he never noticed the missing zero either. (One of my precious readers pointed it out – keep those emails coming.) My hedge fund manager friend doesn’t publish a blog – so you don’t see his mistakes… I assure you he makes them…

Picking apart the numbers is fraught with difficulty. Very few of us are used to thinking in trillions – and the rules of thumb we develop (is that a big number or a little number) become useless. I left off a zero and because the number was so big it didn’t seem too small…

This is the first part of an attempt at picking apart Fannie Mae. I started writing this without any preconception as to whether you want to be long or short. I might wind up at a conclusion – but forgive me if I sound vague or indecisive. That truly reflects my state of mind. You will find out the conclusions the way that I am finding them out – by actually running through the numbers.

Disclosure: I once knew an awful lot about Fannie Mae. I fully understood their accounting fraud before it was disclosed. Indeed I could accurately count the size of the fraud (and I was correct within a couple of billion dollars). I never understood why OFHEO with 200 staff could not (or would not) see it. I was short a lot of Fannie Mae and – whilst I made some coin – I was genuinely shocked at how little interest the market took in Fannie’s misdeeds. Having not made much money when I was right I went on to work out other ways to be right not make money – and I let my detailed knowledge of Fannie Mae lapse.

The range of outcomes to this project is enormous. It could be that

• Fannie is shockingly insolvent – and hence to be avoided like plague or
• The problems are overstated and Fannie is solvent – moreover because the competition has been removed it is likely to be far more profitable in the future than it ever has been in the past – and you should buy it because its best days are in front of it.

I am trying to start this project with no opinion.

I apologise to bond market experts who might read this post. The first bit assumes you don’t know what “negative convexity” means or how to measure it. I am going to try do this without much bond market jargon.

How Fannie Mae makes money

Fannie Mae is in two businesses.

• The guarantee business: Fannie Mae bundles up mortgages, guarantees them and sells them as “pass-through certificates”. In this business it takes only credit and fraud risk and it earns only guarantee fees.
• The portfolio business: Fannie Mae also buys mortgages for its own balance sheet and funds them using wholesale borrowings. It borrows money fairly cheaply because of a quasi-government guarantee. This allows it to make a reasonable spread by owning mortgages. However in this business it takes funding risk and interest rate risk. Because it owns the mortgages and will suffer if they default it also takes credit risk.

Now for those that are not familiar with the inner-workings of Fannie Mae I will surprise you. By far the most important business is the portfolio business. The spreads are much larger in that business and the business usually generates the bulk of Fannie’s revenue. It is also where the accounting frauds were found.

Mismanagement of the portfolio business has – over the years – cost Fannie tens of billions of dollars. The reason why Fannie has so little capital and credibility going into this cycle is that it stuffed this business up comprehensively.

The guarantee business is what is causing Fannie a lot of trouble now has – for most of Fannie’s history been trouble free. [Standard mortgages had a very low default rate until this cycle.]

This table gives from p.46 of the last annual report details Fannie’s total exposures. [Warning – head for large numbers needed as the numbers are in millions.]

year end data	2007	2006	2005	2004	2003
Mortgage portfolio	727,903	728,932	737,889	917,209	908,868
Fannie Mae MBS held by third parties	2,118,909	1,777,550	1,598,918	1,408,047	1,300,520
Other guarantees	41,588	19,747	19,152	14,825	13,168
Mortgage credit book of business	2,888,400	2,526,229	2,355,959	2,340,081	2,222,556

Since Fannie got into trouble on interest rate risk it has shrunk the portfolio business from 917 billion to 727 billion. It however sharply increased the guarantee book of business.

The credit guarantee fees are low – but are rising. The credit costs have been very low until recently (a single basis point). They were easily manageable last year. Here are the average fees and credit costs for the past five full years.

	2007	2006	2005	2004	2003
Average effective guarantee fee (in points)	23.7	22.2	22.3	21.8	21.9
Credit loss ratio (in points)	5.3	2.2	1.1	1.0	1.0

These tables are not strictly comparable because one table is year end and the other is year average. However ignoring this complication we can see that the guarantee business would have been very profitable in all years (but almost certainly loss making in 2008 and 2009).

The thing that is startling is how low the guarantee fees are. In 2003 Fannie Mae had 2.2 trillion of credit exposure. If you take 21.9 bps on this the total guarantee revenue would have been well under 5 billion. Indeed the annual report gives them as 3.4 billion – but it does not classify the profit from some credit exposure in on-balance sheet mortgages as guarantee income.

5 billion sounds a lot – but the post tax profit of Fannie Mae in 2003 on the restated accounts available to shareholders is almost 8 billion. The money wasn’t made on the guarantee business – it was made on the portfolio business.

Given that the profits historically came from the portfolio business we need to understand the portfolio business to see how it really makes its money.

The portfolio business

Fannie Mae buys mortgages. It finances them by issuing debt – “reference notes” and the like with a quasi-guarantee from the US Treasury – and makes a spread. This is old-fashioned banking business – but Fannie doesn’t take deposits.

There are a few problems with this. The first problem is that Fannie actually has to borrow the money and be able to ensure that it can always borrow the money. If Fannie can’t borrow it will fail. That almost happened recently – but since the Feds have made it clear that they stand behind Fannie it is unlikely to happen again. It’s a real risk though. I have made it clear many times (here, here) that the biggest risk faced by many banks is the ability to finance themselves. Government guarantees help a lot though.

The second problem is more continual. Fannie Mae has no idea what the duration of the mortgages it owns is. This was a very big problem indeed in the period 1999 to 2004 when there were massive waves of mortgage refinance in America. The mortgages might last ten years – or they might refinance next week. This could (and did) cause massive problems for Fannie.

The logic is as follows.

Imagine rates were to rise a lot – so that people were very reluctant to refinance and the lifespan of the mortgages were to extend to ten years. Then Fannie would want to have its financing fixed for ten years. Otherwise there could be a real problem. If the financing wasn’t fixed then the funding cost would rise and Fannie’s spread would go negative. If you are levered as many times as Fannie a large negative spread will make you insolvent quite rapidly. So when rates rose Fannie wanted to have its financing fixed.

However if rates were to fall everyone would run off to their broker (this was 2004 remember) and refinance at a lower rate. If Fannie had fixed its finance it would now have ten year finance for ten years it would now own low-yielding mortgages with old high-cost finance. The spread would be negative again. Of course it would be alright if Fannie were floating-rate financed because as rates fell the finance cost would also fall.

So Fannie had to perform the neat trick of having fixed cost financing whenever rates rose and floating rate financing whenever rates fell.

This is of course impossible.

But you can come pretty close using derivatives. What you would do is have finance of a mix of durations and buy “interest rate swaptions”. The “swaption” would give you an option to enter an interest rate swap (ie to fix or unfix your finance) at various times. That way Fannie could fix its finance when rates were rising or have floating finance when rates were falling. The swaptions were of course expensive.

Fannie could (and did) also hedge its interest rate risk by other methods including:

· issuing callable debt (which is clean but expensive and was favoured by Freddie Mac), and

· delta hedging (which is a trick of high finance that involves selling things when they fall in price and buying them back when they rise in price and hence losing money which is expensive).

You will notice that all these hedging methods are expensive and Fannie thus continuously lost money on derivatives. Derivative fair value losses at Fannie have over the past five years totalled 28 billion. (You need a lot of spread to make that up and make a profit – and Fannie made a profit in those five years.)

The frauds at Fannie were in the derivative accounting. The accounting is also a mess because Fannie accounts for the derivatives on a mark-to-market basis but accounts the spread on a yield to maturity basis. This mismatch makes the accounts incomprehensible to almost everyone (including myself most the time).

I won’t tell you how I worked out the fraud and quantified it – but Peter Eavis (a fine journalist if there ever was one) worked out a fair bit of it and put it here.

One thing that made the portfolio business hard was that the mortgage market was huge relative to the treasury market. To hedge risk Fannie needed to trade in the treasury market or buy swaptions from people who traded in the treasury market. The size of this trading moved treasury prices – and the resulting changes in interest rates were always to the detriment of Fannie. The size of Fannie and Freddie relative to the market for US Treasuries made it difficult for Fannie to hedge.

The decline of the portfolio business

Before the mortgage crisis hit the Fannie Mae portfolio business went into very sharp decline. The profitability of Fannie Mae shows this – dropping from 8 billion in 2003 to 3.5 billion in 2006 even though the book of guaranteed business continued to rise. Even a tick-up in guarantee fees could not offset the profit decline.

There are a few reasons for this. I haven’t quantified these in order of importance but I suspect (with limited evidence) that the last one is probably the single biggest factor:

• Yield curves got less steep – and so Fannie lost the option of financing at close to 1 percent and lending at 5 percent.
• Fannie shrank the “owned balance sheet” under regulatory pressure – from over 900 billion to just over 700 billion.
• Fannie reduced the amount of risk it carried – by buying more swaptions and issuing more callable debt. Lowering risk lowered profit. You can see the lowered risk because the “effective duration gap” that Fannie is running has fallen sharply over the years. [The duration gap is published in Fannie’s monthly data. A duration gap that jumps around a lot indicates that a lot of interest rate risk is being taken. At ones stage the published duration gap got over a year – which is an awful lot when you are levered as much as Fannie Mae. On a trillion dollars of mortgages a one percentage adverse movement in rates across the curve will cost you 10 billion dollars if you have a one year duration gap. The duration gap is now normally less than a month.]
• Fannie let the book run off resulting in a natural decline of spread.

The natural decline in spread as you run the book off is second nature to anyone who deals with mortgages but is not obvious to outsiders. It’s as follows:

In any pool of mortgages there are a few that will last a long time and a few that will refinance next year. If you “match” finance them you will have some finance that matures in a long time and some that matures next year.

The short dated finance is cheaper because the “yield curve” generally slopes upward. So the mortgages that don’t last very long have more spread in them than the mortgages that last a long time. As the book runs off you are left only with the low-spread business.

Anyway – however you count it Fannie Mae’s spread based portfolio business ran off – and its credit guarantee business expanded – just in time for the credit losses to hit them hard. Expanding credit risk into a crunch can’t be much fun!

A possible re-emergence of the portfolio business

Fannie’s reduced reliance on portfolio business is a pity – because if you haven’t noticed the yield curve is quite steep at the moment, interest rates are not massively volatile (reducing the cost of the hedging), and Fannie’s funding advantages are intact courtesy of Paulson et al.

Moreover Fannie can hedge far more easily now in the Treasury market because the Treasury market has grown so massively courtesy of 43s incessant government deficits.

If Fannie were to grow the spread business now it would do so at high spreads. If it were to chose to (or be allowed to) run considerable interest rate risk it could easily get the spread to 120bps (an old level). All treasuries under ten years yield under 4.2 percent. Some shorter dates yield under 2 percent. Fannie should be able to finance at 50-70bps more than Treasuries especially with explicit Treasury guarantees.

The yield on an on-the-run wholesale mortgage with a Fannie guarantee is about 6 percent. [See this graph.] Depending on where on the yield curve Fannie finances it will pick up something like one and a bit to three and a bit percentage points of spread. The “swaptions” will reduce this – but it should be possible to earn 140bps spread on 700 billion of owned mortgages if Fannie whilst hedging a fair bit – but by no means all of their interest rate risk. [They could go bust on that risk – so this is a non-trivial caveat.] 140bps annually on 700 billion is over 10 billion per annum.

Rising revenue on guarantee business

It is also entirely possible for Fannie to raise the guarantee charge on new mortgages to well over 30 bps – and the fee on the whole book will continue to rise. My guess is that the guarantee fee will rapidly go to 30bps - but 25 is a gimme. [The quasi government guarantee is worth a lot in this time of uncertainty.]

The Treasury guarantee and lack of competition will allow the guaranteed amount to go to 3 trillion. 25bps on 3 trillion is 7.5 billion. Guarantee fees were over 5 billion last year and rising rapidly – so this is not a stretch.

This looks very like 17.5 billion in revenue.

Sanity check on revenue numbers

I am back working out what the revenue numbers might be not what they are. They are considerably lower primarily because Fannie has spent the last three years shedding interest rate risk. [One of those funny things – Fannie made the same mistake as me – being petrified about interest rate risk when the right thing was to be petrified about credit risk.]

The guarantee figure estimate (7.5 billion per annum) is probably low. The last quarter the number was 1.7 billion up from just over 1 billion. At this rate of change we are very likely to get to guarantee fee income of 10 billion at some stage. Certainly the credit crisis is driving guarantee fee revenue skyward. The average effective guarantee fee is now 29.5 bps. This has risen about 50 percent since the early parts of this century.

Interest rate income is much harder to estimate. The accounting for this always sucked because you never knew what the right level of derivative expense to include was.

Net interest income was over 1600 million for the quarter – but there was over 4000 million in “fair value losses”. On that front it was not a good quarter. But the “fair value losses” are a mark-to-market concept and the interest income is a yield to maturity concept. Still if the revenue pre-derivative cost is 1.6 billion per quarter I ain’t getting to 17.5 billion per year. I am not even getting to 10 billion. Sure the 1600 is up from 1000 million quarterly as the situation gets better in the portfolio business. But unless Fannie again takes some serious interest rate risk the portfolio business is going to be stuck earning less than 6-8 billion annually.

My sanity check fails. But the possibility exists that Fannie will surreptitiously up the interest rate risk again. In which case we can get big revenue numbers. The problem is that it wasn’t very nice last time they tried it!

So let us take the low-ball numbers. The low ball numbers are revenue for guarantee business if 7.5 billion per annum, and revenue for the portfolio business of 6 billion per annum – total revenue of 13.5 billion.

Expenses other than credit losses and mark-to-market expenses

Fannie is just a big financial machine with very few staff which makes money on guarantee fees and interest rate spreads and loses it on credit and derivative hedging costs. Staff costs are close to irrelevant. Administrative expenses are about 500 million per quarter and falling. [There are half a billion of other non-interest expenses in the first quarter – but they are minorities and debt extinguishment costs and shouldn’t really concern this analysis.]

So pre-credit cost profits of Fannie are about 2 billion per annum. They will rise as credit remediation costs rise – but let’s be nasty and call it 3 billion per annum.

Pre-credit costs profits of Fannie

On this calculation the pre-tax, pre-credit cost profits of Fannie Mae will be about 10.5 billion per annum. It will be wildly volatile because the accounts of Fannie are wildly volatile due to mismatches between the portfolio and the portfolio hedges. But that – I believe – is about the underlying run-rate.

Credit costs – the problem of the moment

To date Fannie’s big problems – the ones that caused them to raise capital last time and restate – were interest rate hedging losses. Now it has credit problems. And nobody really has any good idea of how bad the situation is.

But let’s dismiss some alarmist stuff. There were plenty of alarmist pieces about how much housing stock Fannie Mae owns right now. This article suggests that Fannie and Freddie combined owned 6.9 billion of forclosed real estate – less than 5 billion of which is at Fannie Mae. They might lose 30% on it (though even that is not clear).

Well let me say at the outset that those losses are irrelevant. If they had a loss after foreclosure of 50 percent they wipe out about three months of earnings. That would be no threat.

The real estate inventory that Fannie is currently sitting on – being many thousands of houses and many thousands of families in personal tragedy – is irrelevant financially to Fannie Mae. So steer clear of the alarmist stuff. If Fannie only winds up with say 15 billion of foreclosed real estate it will skate through this crisis just fine.

What we need to really hurt is 50 billion of losses over three years – maybe 20 times Fannie’s current inventory or real-estate-owned (REO) needs to pass through Fannie’s ownership. That would wipe out three years’ profit, plus 20 billion in capital and cause all sorts of social and regulatory stress. [We could also blow up on interest rate risk!]

In summary: if the losses are less than 20 billion you will do OK buying Fannie on any of the panics. If the losses are say 50 billion the financial and regulatory stress will be such that Fannie is problematic.

If the losses are 70 billion – say seven year pre-tax earnings – then Fannie sucks as investment and the best you can hope for is a number of dilutionary capital raises. That is if the Feds don’t just confiscate it from you.

But to want to be short Fannie on the fundamentals you need the real estate owned to wind up more than ten times the current (horrific) level of inventory.

Does that happen? My instinct is no – but I would prefer examine the numbers.

I would love help modelling this – but I think it waits for Part Two.

John Hempton

Fixed currency and bankrupt states - Estonia next

One of the things about fixing your currency is that you can’t print whatever you are fixed to.

Indeed that is the advantage of fixing your currency. Fixing your currency forces and monetary credibility because it effectively removes the printing press as an option. But if you don't respect that force you pay a nasty price.

Its iconic – but when a country with weak economic credentials fixes its currency it tends to have an economic boom. The fixed currency in Argentina last time round was very popular because of this.

But – if you don’t maintain discipline on fiscal and monetary policy you hit the wall very hard indeed. The usual response to a downturn (just loosen monetary policy) becomes unavailable. As a result you get smashed.

So it is with this in mind that I report two stories from the Baltic Business News. The first one might have been triggered by my blog (which has been somewhat controversial in the Baltic States):

Hansabank Estonia CEO: devaluation would bankrupt Estonian economy

The Estonian CEO of Hansabank, Priit Perens, told aripaev.ee that in case loans have been handed out in EEK, devaluation would make the situation easier, but as loans are based on EUR, devaluation would bankrupt Estonian economy.

“Traditionally, ca 70-80 pct of loans in Estonia are based on EUR, so devaluating would make the situation worse. Devaluation would mean that in order to repay the loan, you’d need more EEK than before. It would, in essence, bankrupt Estonian economy,” Perens said and added: “No one is interested in devaluation right now – everyone would loose from it. In a situation, where loans were based on EEK, devaluation would help to ease the loan burden.”

To the question, whether Swedbank has been adding addition pressure to Hansabank lately, Perens responded with a curt: “No.”

Followed quite literally by the second article:

State doesn’t have money to pay pensions in 2009

Gertrud Levit

In 2009, pensions are growing by EEK 2.7 billion when compared to this year, taking up 21 pct of state budget. The state, however, can’t cover the growing pensions from social tax.

Pension index is recalculated every year and it depends on the yearly growth of consumer price index and accruing of social tax. That is why in the coming year a fifth of the planned state budget (EEK 20.4 bln) is taken up by pensions. The state can’t cover all of it from social tax, the Ministry of Finance shed light to the state budget, writes aripaev.ee.

Both inflation and the growth of social tax have been higher than expected, which is why pensions will be growing more than usual in the coming year as well.

The Ministry of Finance isn’t worried about only pensions. The capacity of foreign investments, co-investments and setting aside money for health insurance fund are jumping higher as well, but most of the money accrued to the state budget has a certain goal. Meaning that the funds can’t be used to cover holes, even if the state treasury has the needed amount of money.

You can’t make this stuff up but the last article is a little strong. Estonian politicians still hope to balance the budget.

The State is bankrupt and it can’t print money because the currency is fixed.

It can’t borrow because people expect it to devalue. They are about to have pretty severe austerity measures right into a recession...

The interest rate in Kroon is much higher than the interest rate in Euro – so the domestic population borrow in Euro.

What can I say other than so long and thanks for all the fish.

This is too familiar…

New Fannie - just like the old Fannie

I am a data driven kind of guy.

And every now and again I like to play with numbers in spreadsheets and the like.

I figure I am not alone in capital markets being a little like that.

And I like it when companies make it easier for me. Its part of being “transparent”.

I would like to comment on Fannie Mae’s new commitment to transparency.

I sent Investor Relations and email:

Do you release sets of financial data in spreadsheets - for instance the data in your quarterlies and annual reports and the data in your monthly reports?

I am finding it VERY frustrating not being able to get spreadsheets to do my calculations.

John Hempton

And the new open Fannie Mae replied:

Mr. Hempton,

We do not provide financial data in spreadsheet format on our website. However, using the Word version of any of our quarterly filings, you might be able to "cut and paste" any of the tables into Excel. The Word version of the documents is available from our web site at:

http://phx.corporate-ir.net/phoenix.zhtml?c=108360&p=irol-sec&secCat02.1_rs=26&secCat02.1_rc=25

Hope this helps.

Fannie Mae

Investor Relations

New Fannie – just like the old Fannie.

From the comments section - Latvian bank deposits

Hi! I am from Latvia. What do you think, what happens to people deposits in EUR at worst scenario? We have legislation, that government guarantees about 10 000 EUR for deposits. Where will they get this money?

Thanks

I have no idea how Latvia plays out and no useful knowledge of Latvian politics. But in Argentina they just converted everything to pesos at the old exchange rate:

http://www.commondreams.org/headlines02/0104-03.htm

If Argentina is a model your guarantee will be in Lats in the end...

However it has worked differently in some crisis situations.

--

One person (someone who thinks I am wrong) in the comments section points to a Hansa Bank executive pointing out that Estonia goes bankrupt if the Kroon devalues:

http://www.balticbusinessnews.com/Print.aspx?ArticleID=ba4449d7-bd41-4fe2-b7ba-bbf713312f8c

No. Estonia is bankrupt right now. The Kroon devaluing is just Estonia hitting the rock of reality.

And the Estonian CEO of Hansa is right. There is no pressure from Swedbank. Its head-in-the-sand stuff there.

Wachovia will walk-over-you

I get about two emails a day seeking my views on Wachovia. I am going to disappoint people who want a really detailed examination.

But I will give my quick views before I get to the real point of this post:

Wachovia is a bank with a credibility problem and a funding problem. Whereas I think a smash-em-up insolvency is unlikely at WaMu because WaMu has enough core deposits the same is not true at Wachovia. Core deposits at Wachovia are 390 billion and falling slightly. Total deposits (including hot-money deposits) are 435 and rising. [The deposit trends at Wachovia are worse than at WaMu - though as you will see later the research for this post is giving me some concern at WaMu.]

Loans are 476 billion and rising. The reasons for the rising loan balance are not entirely apparent (and leaves me suspicious). But whatever the reason, rising loans represent rising need for funding.

There is a lot of wholesale funding (especially loans pledged with the FHLB and the Federal Reserve). Bluntly is a shortage of ready funding at Wachovia and Wachovia needs more.

And as the loan problems at Wachovia look a lot worse than average it’s unlikely the capital markets will be generous. They might lend to Wachovia – but they will demand collateral, high rates or both.

So what does a bank in that position do?

It pays up for deposits. Big time.

I got this email – which, so far, I have not confirmed:

Wachovia, in two markets I do business in as a financial planner, has begun offering special rate CD way higher than any other market participants. 5% for three years! Non jumbo btw regular deposits and they claim they can offer double insurance protection by using their bank of Delaware Sub.!

What I can confirm however is that Wachovia is trying very hard to get deposits. Here is the featured deposit advert if you go look on their website. It varies a little by zip code – but they appear to have this high-rate offer in most states.

They are offering an APY of 4.25% on a 12 month CD, minimum deposit 5 grand.

And here are the high rate CDs as listed on BankRate.com.

Wachovia – through its many branches – is offering a rate as high as all but a few diabolical brokered bank CDs. It is paying top dollar.

Now I got to observe something here. The only banks that have a higher rate than Wachovia are Amtrust Direct, Heritage Bank and Corus. Even GMAC bank has a lower rate.

But when I did this survey yesterday WaMu wasn't on the list. Now it is. Comment to come... but this weakens my case for WaMu preferred...

I guess 4.25 percent for deposits is not top dollar when your credit default swap is where it is at the moment. But if you have to pay that much over the odds for money then it rather eats into your margin.

If you are not convinced that Wachovia really is paying over the odds – then have a look at Wells Fargo CD rates (choosing California as jurisdiction). The advantage of not having a funding problem is large at the moment. [I have no opinion as to whether Wells is a good stock or not – but it does have a funding advantage!]

Moral

Banks that are highly dependent on hot-money CDs for their funding have a problem. If Wachovia is competing with you for those large branch CDs then Wachovia will walk-over-you.

Or, tempted by high rates, maybe your customers will just walk-over-to-them. Either way – if your funding is “non core” your margins will be under pressure.

A request

I used to look at bankrate.com to find out which banks were “keen” for funds. But the Wachovia rate is not advertised on bankrate.com. [I used to look for short candidates amongst the banks that were prepared to pay up – and I wasn’t alone – so maybe banks are not reporting to bankrate.com any more.]

If my precious readers scattered all over the world now notice banks that are advertising very high rates locally could they email me. I would really appreciate it. I am very interested in Norway - but I have only a few readers there. Please!

John