Tuesday, August 18, 2009

Modelling Fannie Mae and Freddie Mac – Part V

In Parts I to IV of this sequence I explained where the losses already realised at Fannie Mae and Freddie Mac came from – and where future losses might come from. I showed that the companies have almost reached reserve adequacy – a conclusion diametrically opposed to the consensus view that these companies are hopelessly insolvent even to the point that they threaten US government solvency. On losses the consensus appears to be simply wrong.

In this post I show how the revenue of the GSEs is up very sharply.

No competition

As far as Fannie and Freddie are concerned, the best thing about the mortgage crisis is that these institutions are now the whole market. The private sector market in US mortgages has almost entirely disappeared. They are even allowed now to do jumbo mortgages.

Lack of competition means fat margins – and just as the revenue at Bank of America rose sharply during the crisis so does the revenue at the GSEs.

Here is the quarterly sequence of net interest income for Freddie Mac. The numbers for Fannie are similar…


Net interest margin ($ millions)

2007 Q4


2008 Q1


2008 Q2


2008 Q3


2008 Q4


2009 Q1


2009 Q2


The growth in these numbers is breathtaking. Operating costs are roughly flat. You would think they are rising because foreclosure and credit management (which costs Freddie money). However I suspect that those costs are offset by lower bonus payments to staff and similar costs.

But with flat costs and revenue rising like this Fannie and Freddie are much more profitable on a pre-tax, pre-provision basis.

Not all of this growth in profit is sustainable. A bit is reversal of previously booked losses on derivative hedging instruments. (I explained this reversal in Part II and the explanation is technical – I do not feel the need to repeat the explanation here.)

Further Freddie Mac in particular has been an astoundingly good judge of when to hedge out duration risk. I wrote a post a while back about just how good Freddie’s trading has been. The seemingly superior interest rate risk management at Freddie has continued – though I would not bank on profits from that being permanent.

That said – the pre-tax, pre-provision profits at Freddie are probably going to run about $15 billion per year for a while. Much of that increase will be long-lasting as private sector competition in the mortgage market is not going to return rapidly – and so margins should remain fat. That $15 billion per year can offset an awful lot of losses.

What it means for the future of Freddie and Fannie is the subject of the next post.


RA said...

Keep in mind that a good amount of recent NIM gains is due to the very low level of funding costs, which in turn is due to Fed buying and the strengthening of the quasi govt guarantee. I am not sure that either of these forces are sustainable if the companies were to be completely private in the future.

John Hempton said...

I realise that the margins of banks and GSEs that have access to the quasi government guarantee have massively rising revenue.

That applies to Bank of America and to Fannie and Freddie.

The issue is that the things that kept the margin low - competition from AAA rated securitisation product - have gone away.

As of course has the AAA on that product.


Still you have to observe that pre-tax, pre-provision income is going gangbusters.

And if you think that any big bank is without contingent government guarantee you have not been looking. that is the lesson of this crisis.


RA said...

The GSE market is different because the Fed is purchasing securities there. I have been looking, very closely. Look where GSE spreads are vs bank spreads. And read FNM/FRE statements which say their positive income is mainly due to low funding costs.

Anonymous said...

FRE margins seems to have exploded. Read the FNM report and with the fair value losses on derivatives their own figures say 1.27% NIM, minus 46 basis point in derivatives losses, that is 79 basis point NIM.

FRE for some reason seams to have much higher NIM. Almost unimaginable.

I'm not aware of the exact way FNM account for NPL's forgone revenues, on what line in the P/L they account for losses. If they account for these losses in the NIM, the much higher NPL's could be the reason FRE has much higher NIM, but if the account for losses, on another line, I'm very puzzled by this huge difference in NIM between FRE and FNM.

Have you looked into this difference?

John Hempton said...

It is pointed out that Fannie has a MUCH lower net interest margin than Freddie.

During the last quarter the net interest income at Fannie was 3735 - over half a billion lower than at Freddie. And it is lower on a bigger book - suggesting fairly dramatically lower margins.

Some of this is just that Freddie has got the hedging better than Fannie. (See my post on how good Freddie is).

Some of this is the difference in how things are accounted - with Freddie issuing callable debt and running more income back through the P&L because of tricks of derivative accounting.

But there are lots of other effects - and frankly I would love some advice on this.

I followed Fannie and Freddie for years - and the accounting for their net interest income has always been fraught with difficulty.

I simply do not know how to break this up.

If I had uncertainties as to this model it is NOT on the credit side - I think we have enough to model that now.

It is on the income side and without access to the management to grill I have no idea. And the guys I know who might have had some idea - they are no longer at Fannie or Freddie.


VBPOutSourcing said...

This is a scary realization. I can only hope this simmer down a bit before these quasi-monopolies make or break the American dreams.

Don said...

This has been a fascinating series. I'm still trying to digest the implications of it.

Don the libertarian Democrat

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