This will be the first on a series of posts about Fannie Mae and Freddie Mac. I expect my conclusions to be controversial. One reason I have been quieter than normal on the Bronte Capital blog it is because I am working on this series.
The lack of analysis in the public domain
The discussions about the future of these two institutions (and indeed discussions about the whole shape of the government budget) are taking place in a vacuum – where there are no decent public analyses of the government’s contingent liabilities with the two GSEs. The main part of this series will be to remedy that oversight.
I write this series in the face of genuine press and public surprise at the relatively good results of Freddie Mac. I am not meaning to sound boastful, but I privately predicted those results quite accurately. This series will explain how I got to that prediction – and where Fannie and Freddie losses go from here.*
Where the losses do not come from – losses on traditional Fannie and Freddie business
Fannie and Freddie traditionally insure qualifying mortgages. These are mortgages with:
- loan to valuation ratios of less than 80 percent (or with supplementary mortgage insurance for higher loan to value ratios)
- principal amounts owing lower than the qualifying mortgage limit (which used to be below $300 thousand but has been increased several times and sharply during this crisis)
- with income, employment and assets verified
These mortgages were never very risky – and to date have caused very few problems (although Fannie and Freddie are provisioning for enormous problems that will come).
I can demonstrate this.
At the end of 2007 Freddie Mac had $26.7 billion in common stockholders’ equity and 14.1 billion in preference shares outstanding – a total of $41.1 billion in capital.
By the end of the first quarter all of that capital had been wiped out – and in addition the Freddie Mac needed a capital injection of $51 billion from the Government to maintain positive net worth. Over $91 billion in capital evaporated.
But the losses in Freddie Mac’s traditional book of business to the end of the recent quarter were simply not that large. Here are the losses to the end of the second quarter – with the 5.8 billion being the total realised losses (ie where they foreclosed and realised a loss) and 25.2 billion being the provisions for future losses.
(Click for a larger picture)
Cumulative losses actually realised to date are simply not large enough to have caused problems. $5.8 billion was well within the previous common shareholder equity. If that were all the losses it would have been lower than the operating profit of Freddie - the company would have never been loss making. Whatever, it is nowhere near the $91 billion of capital that has evaporated.
Even provisions – whilst large at 25.2 billion do not come close to explaining the total losses.
I point this out to observe something obvious – but hardly commented on in the public debate. The traditional role for Fannie and Freddie – guaranteeing traditional qualifying mortgages - did not (or at least has not to date) caused losses that are in any sense unmanageable for the system.
If this situation continues it strongly supports the view that Fannie and Freddie can be bought back in their traditional role with relatively few risks to the public purse.
That is a big “if”. There are plenty of people including some journalists I respect a great deal such as Peter Eavis who are convinced that these losses will wind up being enormous. Peter is however working in the same “model-free” environment everyone else is. In a later post I will model losses in the traditional business. In other words I will try to predict the future…
But the next post however has a much more modest task – which is to explain the past – and hence inform as to where the huge losses that have already been realised have come from. Note that the next post does not discuss where future losses will come from - instead I just limit myself to the losses that have been booked already...
That should be easier – it is almost always easier to explain the past than predict the future, but even then the conclusions will be controversial.
*I was not the only person to predict this. I have only once censored a comment on on the Bronte Capital blog because it was too close to what I was thinking and stole my thunder. The last post in this series will reveal that comment and explain why I censored it.
Post script: Peter Eavis has replied in the comments to this blog suggesting that I ammisrepresenting him. He does not necessarily think the losses will be enormous - but he does think it unlikely that they will repay the government senior preferreds.
This post is reproduced on Talking Points Memo. The TPM readers can find Peter's comments on my blog by clicking this link...