Saturday, August 15, 2009

Modelling Fannie Mae and Freddie Mac – Part IV

This blog is reprinted on Talking Point Memo. In that format the post is unreadable unless you click the permalink. The tables are too wide – and have prompted a reformat of my home blog.

In the last post I introduced readers to cumulative default curves. In this post I am going to create a naïve (but surprisingly robust) model of end losses using those cumulative default curves. Later posts are going to detail the limitations of this model and what (if anything) allows me to attest to the model’s accuracy...

Also I am going to use only the cumulative default curves up until December 2008. There are a couple of reasons for doing this. Firstly I am lazy and at Bronte Capital we originally did this analysis in March and I can cut and paste the internal note we wrote at our fund. More pertinently though the default curve past December gets distorted by the foreclosure moratorium which meant that some individual cumulative default curves are quite kinked. For instance the sequential default for the last four quarters on the Fannie Mae 2007 vintage is 1.1 billion, 1.5 billion, 1.0 billion and 1.5 billion. If you used the 1.0 billion default recorded in the first quarter of this year you would underestimate the end defaults by presuming the foreclosure moratorium was a continuing part of the sequence and not a distorted data-point. So whilst it appears lazy to use analysis I wrote in March not updated for new results, there is some method in that.

Here is the default curve – as published by Freddie Mac – until the end of 2008. This curve does not include the kinks caused by foreclosure moratoriums.

image

It has the usual “to the sky” character for the 2006 and 2007 books of business, however the kinks a the end of the curve are not present. (Compare to 2003 curve to the most recent 2003 curve which you can find in the last post – and which has a notable kink at the end of it.)

I would have loved the data points on this curve as actual numbers to run through the model. I wrote to Freddie Mac (and to Fannie Mae) and asked for that data and they refused to give it to me. So I did the best I could and printed the curves on graph paper and read the numbers off the graph paper. [If you are a policy analyst at the National Economic Council looking at this issue perhaps the company will give you actual data points!]

The last six quarters of the 2006 pool for Freddie had cumulative defaults in the following table. I have also included the cumulative defaults of the 2000 series as a comparison – and the ratio to the 2000 vintage as follows:

Last six data points

cumulative default 2006 originations (bps)

cumulative default 2000 originations (bps)

Ratio of cumulative defaults 2006/2000

Y3, q4

115

41

2.8

Y3, q3

90

35

2.6

Y3, q2

64

29

2.2

Y3, q1

42

22

1.9

Y3, q4

24

15

1.6

Y2, q3

13

8

1.6

If the ratio were constant (it is not) then we would have a really good method of projection. Instead the 2006 pool is getting worse relative to the 2000 pool quarter by quarter. My guess is that the end cumulative defaults will not be 2.8 times the 2000 pool (the current ratio) but 4.5 times (substantially worse than the current ratio). This is an educated guess looking at the charts – nothing else. I have tried testing this guess with (former) senior finance execs at Fannie. They said they would like to measure they rate at which the curves are diverging (preferably by state or market character) against rates at which house prices are falling. They want to test how much of the expansion of defaults is induced by falling house prices. They are after a sounder end-default estimate.

That said – I am stuck with the educated guess made above.

We can make a similar educated guess for other years of origination. Here it is:

Current cumulative default (bps)

Guessed end default ratio

End cumulative default

Base year 2000

104

110

2001

74

0.8

88

2002

62

0.75

83

2003

32

0.7

77

2004

52

1.1

121

2005

81

2.5

275

2006

115

4.5

495

2007

63

6

660

2008

negligible

400

Obviously the big problem years are the 2005, 06, 07 and 08. Previous years have largely played out. That is to be expected because if you had a mortgage you couldn’t afford originated in 2004 then you either refinanced it in the boom into a later year or you have defaulted already. I have only guessed the end default in 2008 – there is simply not enough public data to make anything other than an informed guess – however gossip suggests that 2008 is a bad year but not as bad as 06 or 07 for defaults.

From here – with data about how many mortgages were originated each year – you should be able to work out how many defaults are yet to occur. This is done below. The originations for the years 2000-2003 are made up because I can’t find the data any more – but the action is not there anyway. What matters is the later year.

Year

current cumulative default (bps)

end cumulative default (bps)

Defaults still to come (bps)

Originations in year (billions)

Defaults still to come (billions)

2000

104

110

6

450

0.3

2001

74

88

14

450

0.6

2002

62

83

21

450

0.9

2003

32

77

45

450

2.0

2004

52

121

69

495

3.4

2005

81

275

194

501

9.7

2006

115

495

380

577

21.9

2007

63

660

597

460

27.5

2008

400

400

358

14.3

Total defaults still to come

80.7

This suggests that there are almost 81 billion of mortgages in the book yet to default. This is considerably more than the cumulative defaults to date – and implies a massive increase in defaults. Whitney Tilson is right – prime mortgages owned by the GSEs are going to default in a massive way in the next couple of years.

I have done a similar analysis for Fannie Mae and I predicted that just over $125 billion of defaults were embedded in the default curves at that company.

Remember though that these are defaults, not losses. Severity is the key to the losses.

Neither company publishes severity by year of origination (something I would deeply desire). However Fannie Mae publishes its severity in each period for the whole book.

The severity at Fannie Mae was as low as 9% in 2005. I do not have an accurate table of severity by year of origination – but Fannie gives recovery data as follows (severity percentage = 1 minus recovery percentage):

Real estate owned net sales compared with unpaid principal balances (which is one minus severity numbers)

2005

93%

2006

89%

2007

77%

2008 q1

74%

2008 q2

74%

2008 q3

70%

2008 q4

61%

2009 q1

57%

2009 q2

54%

The severity numbers at Freddie Mac are consistently a little lower than at Fannie Mae. I think the reason is that Fannie Mae did most of Countrywide’s business and there was more valuation fraud at Countrywide. If this is the case it strikes me that Fannie has a good case against Bank of America (who now own Countrywide) but they have not chosen to litigate.

Either way, severity is rising though with the recent stabilisation of REO sales prices (more evident at Freddie than Fannie) I think we can presume some stabilisation at the new (higher) severity levels. Anyway I ran the model assuming end average severities for various books of business. This produces an estimate of losses yet to come.

Year

Defaults to come by year (billions)

Severity by year (percentage)

End losses

(billions)

2000

0.3

10%

0.0

2001

0.6

12%

0.1

2002

0.9

14%

0.1

2003

2.0

15%

0.3

2004

3.4

18%

0.6

2005

9.7

40%

3.9

2006

21.9

60%

13.2

2007

27.5

55%

15.1

2008

14.3

30%

4.3

Losses still to come

37.6

When I originally wrote this model Freddie Mac had already provided for 15.6 billion losses yet to come. That is the provisions number at the end of 2008 in the following graph.

image

Given that I thought that there was $37.6 billion of losses embedded in the book I thought that Freddie was under-reserved by $22 billion. This is a big number to be sure – but in the scheme of things that are said about the losses at Fannie Mae and Freddie Mac most people (certainly most taxpayers) would be happy that the hole in Freddie Mac’s book is “only” $22 billion. [The level of under-provisioning at Fannie Mae was similar… our estimate was that neither institution posed much threat to the US Treasury.]

Since I did this estimate Freddie Mac has actually realised $2.9 billion of losses and the reserves have risen to 25.2 billion. This means that Freddie has now provided for an additional 12.5 billion dollars. The remaining hole in Freddie’s accounts is now “small” – say 7.5 billion dollars.

Plausibility check

When you estimate something in such a convoluted way it is incumbent to run a plausibility check. Look again at the losses and reserve picture for Freddie Mac.

Note that Freddie is writing off roughly 900 million per until the last quarter. The spike in the last quarter to 1.9 billion was due to the expiry of the foreclosure moratorium as well as due to the generally bad housing market. I estimated that at the end of 2008 there were 37 billion in losses left to come. Since then they have realised $2.9 billion in losses including the spike in realised losses at the end of the foreclosure moratorium. I think there are now about 34 billion in losses left to come. If the next six months is twice as bad as the last six months then we will be running off at roughly $6 billion per half or $12 billion per annum. We can cope with three years that bad without threatening my estimate. Given that the early stage delinquency of the GSEs is currently falling (see this OTC report) I think this is a reasonable (if harsh) assumption.

Plausibility summary: my loss estimates pass this plausibility check. I have run half a dozen other plausibility checks (some quite convoluted and detailed). The estimates are robust to all of them.

Summary of Part IV

In this post I show how using naïve (but surprisingly robust) models using data in the cumulative default curves you can get estimates of the end losses of both Fannie and Freddie.

Using these models I show that the end losses in the traditional guarantee book of business are very close to the reserves currently embedded in Freddie Mac’s accounts. [The same applies at Fannie Mae too.]

This argues strongly against the notion that Fannie Mae and Freddie Mac will be substantial ongoing drains on the Federal budget. It also argues fairly strongly against the notion that the quasi-government GSEs cost taxpayers more than the private sector companies that they competed with. AIG – who led the FM Watch – an anti-Fannie-and-Freddie lobby group will wind up costing taxpayers considerably more than the GSEs.

Moreover the losses on the GSE’s core business (the losses modelled in this post) look like they are about the same as the original GSE capital base. If the GSEs had not (foolishly) purchased private label mortgage securities (the losses detailed in Part II) then the cost to the taxpayer would have been negligible.

This has big implications for the reform of GSEs – something supposedly under discussion at the NEC – and also of concern to many. The traditional guarantee business of the GSEs simply did not perform that badly during the worst mortgage crisis in modern finance. That should be borne in mind by the GSE critics.

As to what the end cost to the government will be – and whether there is any residual value in the remaining Fannie and Freddie securities – that is the subject of a future post in this sequence.

15 comments:

Anonymous said...

Really great thinking. I agree 100%. Remember they also have yearly earnings that could absorb losses ower a period of years.

Losses do not normally come all at once, but be smoothed out over the years. This is anyway normal for a company that want to survive.

Interesting also the 2008 vintage, which we now little of now, but will probably also mean substantial losses.

IF said...

As I have been sticking my head out before, my gut feelings are

1) severity: Not going to argue. Seems reasonable, if slightly low.
2) end cumulative default: way low. I don't see how the unemployed are going to make payments.
3) originations falling in the future? The GSEs are the market and they have increased loan limits. Ginnie Mae is ramping up, but so are the other two:

http://brucekrasting.blogspot.com/2009/07/fed-mortgage-report-whats-ginnie-mae-up.html

babar ganesh said...

i don't understand how the loss severity can be so high -- if i read it right 60% on an 80% mortgage gives a 68% decrease in property values on average for defaulting properties in the 2006 vintage -- without driving the default rate much higher.

roughly, if there are this many properties this far underwater, why would the default rate stay this low if the loss given default is so high? seems like more homeowners (even some of marginally better mortgages) would just walk away, and we'd end up with a higher default rate (and a higher loss obviously).

maybe you've done some analysis of loss probability versus loss severity against the pool of mortgages the gse's are likely to have? tough to get details on the data?

IF said...

babar ganesh: you assume that a house gets sold without delay, storage and maintenance cost. (Property taxes, blight laws.) The reality is often ugly. You also assume 20 percent down payment, which in 2006 was not the reality. Even now the people I personally know buying do so with less than 10 percent down. (Especially after considering gov. subsidies.) And these are PhD computer engineers with decent salaries.

John Hempton said...

I do not understand the loss severity either. The loans were never more than 80% LTV (or with supplementary mortgage insurance) when originated.

Many had supp insurance but only one insurance company has not paying now (which is TGIC).

To get 45% severity they need to have lost 60% in value.

My guess is that the loans that are actually being foreclosed on really are truly terrible - frauds and the like - or at least include many. Or the house is being trashed. The risk then is that the ordinary problems - meaning mom-and-pop loans underwater - are being deferred.

John Hempton said...

If - in this book if the loan had more than 80 LTV then it MUST BY LAW have supplementary mortgage insurance.

Only one mortgage insurer is not paying now (TGIC). The REALISED SEVERITY is thus AFTER collecting mortgage insurance.

The realised severity is really high. You are right that there are back-taxes, failures to collect etc... the reality is a mess...

But then the people who are current now the reality is probably much nicer for...

J

IF said...

You are right of course with respect to the mortgage insurance requirement. The statement that only one mortgage insurer has been bankrupted so far, makes me want to cry. Do you have reasons to believe that most of them will survive and protect the GSEs from additional losses? I honestly have no knowledge on this, but would have assumed that they are dead men walking, or at least depend on taxpayer largesse to make it.

John Hempton said...

The mortgage insurers are VERY profitable on current business - and they are surviving better than you would imagine possible.

If I had to weight the possibilities I still think they die. But I was once certain they died - and all certainty has disappeared.

If they die it will not massively change the proposition for the GSEs. Even the dead insurer (TGIC) is paying a good proportion of its claims.

But yes - the death of the mortgage insurers (or at least possible death) makes this harder.

J

Anonymous said...

I have also wondered about this. In my own thinking I am inclined to go for John's reasoning. Currently very few mortgages are foreclosed, and actual charge-offs are very low.

But those houses that they foreclose they are the worst of the pool. As Babar points out, we are 3 years into this crises with falling property prices, and with a severity rate of 60% after mortgages insurance, the underwater must be so huge no one would find it meaningful to pay their mortgage.

When FnF now enter the phase when more and more defaults are supposed to come, in my, view the underwater defaults become less for each month they wade through.

Those least underwater have the highest incentive to keep up payments, when you start coming under 40% below market value, people start walking away.

NPL's will still cost them in forgone revenues. therefore it is a mystery to me, why they waited since q1 2008 and have not foreclosed other than just the most severe cases.

It is even more mysterious when we can see that the severity rates has worsened from 75 to 54 since last year, meaning that waiting to foreclose have cost them dearly.

babar ganesh said...

is foreclosure always at their option, or are there cases where other parties (mortgage insurers or courts or holders of the mortgage they are insuring someone else) would force foreclosure?

James B. Shearer said...

roughly, if there are this many properties this far underwater, why would the default rate stay this low if the loss given default is so high? ...

This could happen if the properties defaulting are just those which are way underwater. Also there was quite a bit of fraud with fraudulent mortgages both very likely to default and very likely to have high severity of loss after default.

James B. Shearer said...

John Hempton, you appear to be assuming there won't be major losses for 2009 and later years. Is this obvious?

IF said...

babar ganesh: there are many parties involved in deciding if/when to foreclose. Surprisingly many don't have an incentive to foreclose. (Servicers for instance are motivated to drag things out as long as possible. Insurers also risk to get wiped out.) Once the house is more than 20 percent underwater only the GSEs (and maybe the local community if property taxes are being owed) have an incentive to start the expensive/time consuming process. I am sure Calculated Risk has all the details. Otherwise, interesting stories from one of the epicenters:
http://www.bubbleinfo.com/

More fun from across the Mojave:
"Boemio specializes in short selling, in a particularly Vegas way. Basically, she finds clients who owe more on their house than the house is worth (and that's about 60% of homeowners in Las Vegas) and sells them a new house similar to the one they've been living in at half the price they paid for their old house. Then she tells them to stop paying the mortgage on their old place until the bank becomes so fed up that it's willing to let the owner sell the house at a huge loss rather than dragging everyone through foreclosure. Since that takes about nine months, many of the owners even rent out their old house in the interim, pocketing a profit.

Tons of people were doing this, but there were consequences. Renters were being evicted, through no fault of theirs, with a couple of days' notice when the house finally went on the market. People are now paying a premium to live in apartment buildings, which in Vegas are almost always owned by a corporation. Sure, short selling damages the sellers' credit rating, but they just bought a new house, so they don't care."
http://www.time.com/time/nation/article/0,8599,1915962-2,00.html

John Hempton said...

I was wondering when someone would ask me about 2009. I am startled just how bad the 2008 year is panning out. You would have thought by 2008 the bad lenders were panned out.

People I gossip to suggest that 2008 originations improved dramatically as the year went on - primarily because the houses were purchased at such low prices.

If 2009 marks something near the bottom of the housing market then non-fraudulently originated loans with 20% down or solid supplementary insurance will have the usual level of mortgage losses - which is next to none.

But if you had asked me in 2008 early how the 2008 year would work out I would have thought quite well and I would have been wrong.

So I worry about 2009 too - even though logic suggests it will be a fairly good origination year.

J

John Hempton said...

Oh, and the story about Vegas is fascinating. Alas what happens in Vegas does not always stay in Vegas.

J

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